The Elasticity of Demand including Marginal Revenue and the Relationships between the Elasticity of supply, Cross Price and Income - Anqi Fang
Final Paper
Elasticity is used in measuring the responsiveness of one variable subject to changes in another. If the elasticity is positive, an increase in A leads to an increase in B. If the elasticity is negative, an increase in A leads to a decrease in B. If the absolute value of the elasticity is greater than 1, a small percentage change in A will lead to a relatively large percentage change in B. On the other hand, if the absolute value of the elasticity is less than 1, a given percentage change in A will lead to a relatively small percentage change in B.
Price elasticity of demand looks at how responsive people are to changes in price. Elastic demand is when the percentage change in quantity is larger than the percentage change in price. On the other hand, inelastic demand is when the percentage change in quantity is smaller than the percentage change in price. Demand for daily necessities such as food, fuel, and medicine tend to be inelastic. For example, demand for salt is inelastic because people won't reduce their purchases much when the price increases. On the contrary, demand for goods like new cars and entertainment tends to be elastic. If the price of entertainment increases by 10 percent, people are likely to reduce their purchases by more than 10 percent.
The U.S. government has been considering raising the tax on cigarettes to reduce smoking. From the standpoint of smokers, this policy is likely to be especially effective for the young because they tend to be more sensitive to higher cigarette prices. This demand is elastic because they have to either quit smoking, smoke less or switch to cheaper cigarettes depending on the price. Richer people and those who are addicted are less sensitive to price. From the standpoint of brands, this policy has more impact on some expensive brands because their customers would switch to other cheaper brands. Therefore, the demand for expensive cigarettes is more elastic than that for relatively cheap cigarettes. Overall, the demand for cigarettes has been estimated as -0.48 which means that if cigarette prices increase 10 percent people will buy 4.8 percent fewer cigarettes.
The price elasticity of demand can be calculated at a specific price and quantity. We can use the following formula to get the price elasticity: EQX,PX= (ΔQ/ ΔP)*(PX/QX). ΔQ/ΔP is the slope of the demand curve and (PX, QX) can be any point on the curve. For example, the equation for a demand curve is Q=100-4P, then what is the price elasticity at $5? Let's get the QX for PX= 5 first, so QX=100-4P=100-4*5=80. -4 is the slope of the demand curve, so ΔQ/ΔP=-4. Therefore, EQX,PX= -4*(5/80)=-0.25. Since it is less than 1 in absolute value, we say that the demand is price inelastic. If it is more than 1 in absolute value, the demand is price elastic.
Marginal revenue is the change in total revenue due to a unit change in output. Usually, with a linear demand curve, marginal revenue is less than the price for each unit sold because a seller must lower its price to attract consumers to purchase more. If a product's demand is inelastic (own price elasticity is less than one), lowering its price will reduce total revenue because the sale will not increase much; if its demand is elastic (own price elasticity is greater than one), lowering the price will increase total revenue; whereas if its demand is unitary elastic (own price elasticity is zero), lowering the price will not affect total revenue much.
"The demand for broadly defined commodities tends to be more inelastic than the demand for specific commodities," stated in Managerial Economics and Business Strategy. According to “Advertising Effects in Complete Demand Systems,” the own price elasticity of motor vehicles is -1.4 and this of transportation is -0.6. Suppose there is a car dealer. He wants to sell more to increase total revenue, so he chose to lower car prices to attract more potential customers. As the demand for cars is elastic, customers will be motivated to purchase more when price drops. Marginal revenue is decreased because unit price drops, whereas total revenue increases because the seller sells more than before. Then we suppose that the U.S. government wants to increase the benefits of citizens, so it decided to lower the prices for all transportation vehicles. Even thought prices are lower, total demand will not change, causing a decrease of total revenue.
Price elasticity of supplymeasures how much quantity supplied reacts to a change in prices. An increase in price tends to generate an increase in quantity supplied, while a decrease in price tends to generate a decrease in quantity supplied. Elastic supply is when the percentage change in quantity is larger than the percentage change in price. On the other hand, inelastic supply is when the percentage change in quantity is smaller than the percentage change in price. "When the price of an item increases, not only do existing firms tend to produce more, but additional firms are attracted to production of the item. However, it often takes a considerable amount of time for new firms to start producing an item. For this reason, supply tends to become more elastic over time, as the lure of profits attracts more sellers."
Banlangen, an Chinese herbal medicine, is effective for preventing colds. In April 2009, H1N1 influenza virus was first detected in the United States and then pervaded to other countries. In May, the first case was detected in China and the number of infected people rocketed. People were so afraid of it and tried to drink more Banlangen granules to prevent getting cold. The demand for Banlangen largely increased, causing a rightwards shift of the demand curve and an increase of the equilibrium price. However, the large increase in price did not bring much change in supply mainly because the production of the herb is limited. The supply of Banlangen is inelastic and the percentage change in quantity is much smaller than the percentage change in price.
Income elasticity measures the responsiveness of consumer demand to changes in income. It can tell us whether a good is a normal or an inferior good. If a product is a normal good, its income elasticity is positive meaning that higher income causes people to purchase more of the product. If a product is an inferior good, its income elasticity is negative because an increase in income causes people to buy less of the product.
The current economic recession is one of the largest downturns since the Great Depression. On a tight budget, many companies have to cut staff and lower salaries. As people make less money than before, they are inclined to save money and reduce unnecessary investments. Under the recession, people who planned to buy new cars will defer or give up their plans. As new cars are normal goods and non-essentials, demand for them falls sharply without any doubt. Let's take luxurious clothes and basic clothes as another instance. When people make more money, they tend to transfer from buying cheap clothes to expensive clothes. People with less income buy more basic clothes to satisfy their basic needs. When they make more money, they have money to spend on expensive clothes to get a higher quality and better brand recognition. Therefore, luxurious clothes are normal goods and basic clothes are inferior goods.
Cross-price elasticity measures the responsiveness of people in buying one product when the price of another product changes. It equals the quotient of percentage change in amount of A bought and percentage change in price of B. Cross-price elasticity can tell whether goods are substitutes or complements. If goods are substitutes, the elasticity will be positive; if goods are complements, it will be negative.
Let's take the vehicle market in the UK as an example. In recent years, prices of new cars have been either falling or relatively flat. Data on price indices for new cars and second-hand cars is shown in the chart below. As the price of new cars relative to people’s incomes has declined, this increases the market demand for new cars and decreases the demand for second-hand cars. Therefore, people tend to buy more new cars and less second-hand cars. New cars and second-hand cars are substitutes. A price increase of one product will encourage the sale of its substitutes, while a price decrease will discourage the sale of its substitutes. On the contrary, badminton rackets and badminton balls are complements. We need to have both of them because they function together. When the price of badminton rackets drops, demand for rackets and balls increases together; when the price of badminton rackets rises, demand for rackets and balls drops together as well.
Understanding what elasticity is and how it works are essential for corporations' managerial decisions. Customers also make purchase decisions with the help of elasticities.
Five quiz questions: 1. An income elasticity less than zero tells us that the good is A. an inferior good B. a normal good C. a substitute D. a complement
2. If the income elasticity for lobster is .4, a 40% increase in income will lead to a A. 16% decrease in demand for lobster B. 16% increase in demand for lobster C. 40% increase in demand for lobster D. 40% decrease in demand for lobster
3. The demand for which of the following commodities is likely to be more price inelastic? A. beverages B. food C. fast food D. beef
4. The demand for good X is given by lnQ xd = 120 - 0.9 lnPx + 1.5 lnPy - 0.7 lnM. Which of the following statements is correct? A. X has constant income elasticity B. X has inconstant income elasticity C. Cannot determine D. None of above is correct
5. A price elasticity of zero corresponds to a demand curve that is: A. Upward from left to right B. Upward from right to left C. Horizontal D. Vertical
Answers and explanations: 1. A Explanation: When X is an inferior good, an increase in income leads to a decrease in the consumption of X. Thus, an income elasticity is less than 0 when X is an inferior good.
2. B Explanation: Income elasticity is a measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income. Therefore, 40% increase in income will lead to .4*40%=16% increase in demand for lobster.
3. B Explanation: The demand for broadly defined commodities tends to be more inelastic than the demand for specific commodities. The demand for food is much less sensitive to price changes than is a particular type of food, such as beef. When the price of beef increases, consumers can substitute toward other types of food, including chicken, pork, and fish. Thus, the demand for beef is more elastic than the demand for food.
4. A Explanation: According to the formula of the elasticities for log-linear demand, when the demand function for good X is log-linear and given by InQ xd = A0 + A1InPx + A2 InPy + A3 InM + A4 InH, income elasticity for x equals to A3. Therefore, X has constant income elasticity, which is -0.7.
5. D Explanation: When demand is perfectly elastic, a manager who raises price even slightly will find that none of the good is purchased. The demand curve is horizontal. In contrast, when demand is perfectly inelastic, consumers do not respond at all to changes in price. In this case, the demand curve is vertical.
October 9, 2011
"The Income Elasticity of Meat: A Meta-Analysis"
The article is talking about using meta-analysis, which involves regressing a parameter commonly estimated in the literature on variables that control for study characteristics, to estimate the income elasticity for a variety of meats.
In statistics, a meta-analysis combines the results of several studies that address a set of related research hypotheses. In its simplest form, this is normally by identification of a common measure of effect size, for which a weighted average might be the output of a meta-analyses. Here the weighting might be related to sample sizes within the individual studies. More generally there are other differences between the studies that need to be allowed for, but the general aim of a meta-analysis is to more powerfully estimate the true "effect size" as opposed to a smaller "effect size" derived in a single study under a given single set of assumptions and conditions. Based on the meta-regression results, the income elasticities of lamb, pork, and poultry tend to be lower than those of other meats, and the income elasticity is sensitive to a few functional forms, data regression, publication, and regional characteristics. I feel that having a more clear understanding of income elasticity is beneficial to many people, such as policymakers.
The article starts with the qualitative idea:
Elastic = Responsive
Inelastic = Unresponsive. So what difference does demand elasticity make? If your demand is inelastic, the more you charge, the more revenue you take in, since the sell doesn't go down. Therefore, if profit is your goal, you should raise price when demand is inelastic. On the contrary, if your demand is elastic, the demand will change based on your price. If profit is your goal, you should not set the price too high or too low. In a market system, demand becomes elastic if consumers are price conscious and if they have an alternative. If you charge less than your competitor's price, you get all of the business. If you charge more than your competitor's price, you get no business. Your demand is now highly elastic near the competitor's price. This can be a highly unstable market because your competitor faces the same situation. Each of you has the temptation to cut price on the other until one of you goes broke. One thing is for sure: If there is a competitor in your market, and if the consumers care about price, then there's a definite limit to how high you can raise your price. For providers of health care, physicians, other practitioners, and hospitals, patient loyalty reduces the elasticity of demand and helps keep prices up. Managed care companies buy service from providers and sell it to patients. They stand in the market between the providers and the patients. For managed care companies, patient loyalty to providers is a problem. Managed care companies prefer that the patients be loyal to them, not to particular providers. That way the companies can switch providers whenever they want. They can pay providers less, while maintaining the prices ("premiums") they charge employers and the public. Managed care companies want providers' demand to be elastic, but their own demand to be inelastic. This is why managed care companies are so interested in developing measures of quality and means of quality control. If a managed care company can document and maintain something that it can credibly call "quality," then its demand will be less elastic. If it can do that without dependence on particular providers, it can really make some money, because it keeps its customers loyal while forcing the providers to compete with each other for the insurer's patients.
Price elasticity of demand indicates the responsiveness of demand for a good or service by consumers in the face of a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a 1% change in price. Elasticity differs between products. Essentials such as food, fuel and medicine are very inelastic, meaning that price increases generate only small drops in demand. However, discretionary items such as treats and purchases than can be postponed are more elastic. A rise in prices tends to have an exaggerated effect on sales. When elasticity is more than 1, the change in quantity demanded is proportionately larger than the change in price. This means that an increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue. In the extreme case of near infinite elasticity, the demand curve would be nearly horizontal, meaning than the quantity demanded is extremely sensitive to changes in price. When elasticity is less than 1, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic. When elasticity equals to 1, this case is referred to as unitary elasticity. The change in quantity demanded is in the same proportion as the change in price. A change in price in either direction therefore would result in no change in revenue.
"As Markets & Market System, Cross Price Elasticity of Demand"
Cross price elasticity measures the responsiveness of demand for good X following a change in the price of good Y (a related good). We are mainly concerned here with the effect that changes in relative prices within a market have on the pattern of demand. With cross price elasticity we make an important distinction between substitute products and complementary goods and services. The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. For example with two close substitutes, the cross-price elasticity will be strongly positive. Likewise when there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. Unrelated products have a zero cross elasticity. How can businesses make use of the concept of cross price elasticity of demand? Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use estimates of cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product. Pricing strategies for complementary goods: For example, popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements. In highly competitive markets where brand names carry substantial value, many businesses spend huge amounts of money every year on persuasive advertising and marketing. There are many aims behind this, including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a brand. When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival products will decrease. This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and turn consumer surplus into higher profit.
"Transit Price Elasticities and Cross-Elasticities"
Prices affect consumers' purchase decisions. For example, a particular product may seem too expensive at its regular price, but a good value when it is discounted. Similarly, a price increase may motivate consumers to use a product less or shift to another brand. Such decisions are said to be "marginal," that is, the decision is at the margin between different alternatives and can therefore be affected by even small price changes. Although individually such decisions may be quite variable and difficult to predict, in aggregate they tend to follow a predictable pattern: when prices decline consumption increases, and when prices increase consumption declines, all else being equal. This is called the "law of demand," Price sensitivity is measured using elasticities, defined as the percentage change in consumption resulting from a one-percent change in price, all else held constant. A high elasticity value indicates that a good is price-sensitive, that is, a relatively small change in price causes a relatively large change in consumption. The degree of price sensitivity refers to the absolutely elasticity value, that is, regardless of whether it is positive or negative. Price elasticities have many applications in transportation planning. They can be used to predict the ridership and revenue effects of changes in transit fares; they are used in modeling to predict how changes in transit service will affect vehicle traffic volumes and pollution emissions; and they can help evaluate the impacts and benefits of mobility management strategies such as new transit services, road tolls and parking fees.
A monopolist's marginal revenue is always less than or equal to the price of the good. Marginal revenue is the amount of revenue the firm receives for each additional unit of output. It is the difference between total revenue at the new level of output and total revenue at the previous output. Therefore, the monopolist's marginal cost curve lies below its demand curve. For a competitive firm there is no price effect. The competitive firm can sell all it wants at the given price. For a monopoly there is a price effect. It must reduce price to sell additional output. So the marginal revenue on its additional unit sold is lower than the price, because it gets less revenue for previous units as well (it has to reduce price to the same amount for all units). Like a competitive firm, the monopolist produces the quantity at which marginal revenue equals marginal cost. The difference is that for the monopolist, marginal revenue no longer equals price. The price that the monopolist charges is the price at which buyers are willing to buy the profit-maximizing quantity. Monopoly does not have a supply curve. There is no function of price that determines what quantity a firm will offer given a price. Instead, the quantity a firm offers is determined by the entire demand curve it faces. The shape of the demand curve determines the shape of the marginal revenue curve, which determines with the marginal cost curve the profit-maximizing quantity.
"Price and Income Elasticity of the Demand for Health Insurance and Health Care Services: A Critical Review of the Literature"
The price and income elasticities measured in the RAND Health Insurance Experiment of the 1970s remain a widely used source of elasticity estimated with respect to the demand for covered health care services. However, these estimates may fail to support today's analyses of health care utilization. Indeed, more recent anecdotal evidence and estimates suggest that the demand for some major components of health care may have changed significantly in the past 30 years. The research literature indicates that the demand for health insurance is, in general, price inelastic. That is, a percentage change in the price of insurance--to employers, employees, or individuals in the nongroup market--evokes a smaller percentage change in demand. However, the range of estimated elasticities is wide. Consistent with the HIE, more recent research has estimated the demand for insured health services to be inelastic with respect to price. Most estimates of the price elasticity of demand for health care services in general are about -0.2. Estimated price elasticities differ by type of service, but the differences are not generally large. Estimates of the income elasticity of demand for health care services based on observational studies consistently range from 0.0 to 0.2, suggesting that consumers do not use more health care as their income rises.
The price elasticity of supply is a number used to measure the sensitivity of changes in quantity supplied to given percentage changes in the price of a good, other things being equal. Price elasticity of supply indicates the percentage change in quantity supplied resulting from each 1 percent change in price. As supply curves generally slope upward, supply elasticity tends to be positive. An increase in price tends to generate an increase in quantity supplied, while a decrease in price tends to generate a decrease in quantity supplied. In the equation for price elasticity of supply, the signs of the numerator and the denominator are the same. The ratio, therefore, has a positive sign. As with demand, be sure you remember that the slope of a supply curve is an unreliable measure of its elasticity. The price elasticity of supply is related to, but isn't the same as, the slope of the supply curve. In general, a good's price elasticity of supply depends on the extent to which costs per unit rise as sellers increase output. If unit costs of production rise only slightly as output expands, small percentage increases in price will result in large percentage increases in quantity supplied. Under such circumstances, supply will be very elastic, because small increases in price will allow sellers the possibility of large additional gains. When the price of an item increases, not only do existing firms tend to produce more, but additional firms are attracted to production of the item. However, it often takes a considerable amount of time for new firms to start producing an item. For this reason, supply tends to become more elastic over time, as the lure of profits attracts more sellers.
"Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand"
The short-run price and income elasticities of gasoline demand have been studied extensively in the literature. Transportation analysts have hypothesized that factors such as changing land-use patterns, the implementation of the Corporate Average Fuel Economy program, the growth of multiple income households and per capita disposable income, as well as a decrease in the availability of non-auto modes such as transit, have changed the responsiveness of U.S. consumers to changes in gasoline price. The short-run price elasticity of gasoline demand is significantly more inelastic than in previous decades. In the short-run, consumers appear significantly less responsive to gasoline price increases. This result is robust and consistent across several empirical models and functional forms. The observed change provides evidence of a structural change in the U.S. market for transportation fuel and may reflect shifts in land-use, social or vehicle characteristics during the past several decades. Provided the results extend to long-run elasticities, these results suggest that technologies and policies for improving vehicle fuel economy may be increasingly important in reducing U.S. gasoline consumption.
Income elasticity measures whether a good is a normal or an inferior good. A product is a normal good when its income elasticity is positive, meaning that higher income causes people to purchase more of the product. For an inferior good, income elasticity is negative because an increase in income causes people to buy less of the product. Cross-price elasticity, often simply called just cross-elasticity, measures whether goods are substitutes or complements. It looks at the response of people in buying one product when the price of another product changes.For example, in recent years, the prices of new cars have been either falling or relatively flat. Data on price indices for new cars and second hand cars is shown in the chart below. As the price of new cars relative to people’s incomes has declined, this should increase the market demand for new cars and (ceteris paribus) reduce the demand for second hand cars. We can see that there has been a very marked fall in the prices of second hand cars.
Final Paper
Elasticity is used in measuring the responsiveness of one variable subject to changes in another. If the elasticity is positive, an increase in A leads to an increase in B. If the elasticity is negative, an increase in A leads to a decrease in B. If the absolute value of the elasticity is greater than 1, a small percentage change in A will lead to a relatively large percentage change in B. On the other hand, if the absolute value of the elasticity is less than 1, a given percentage change in A will lead to a relatively small percentage change in B.
Price elasticity of demand looks at how responsive people are to changes in price. Elastic demand is when the percentage change in quantity is larger than the percentage change in price. On the other hand, inelastic demand is when the percentage change in quantity is smaller than the percentage change in price. Demand for daily necessities such as food, fuel, and medicine tend to be inelastic. For example, demand for salt is inelastic because people won't reduce their purchases much when the price increases. On the contrary, demand for goods like new cars and entertainment tends to be elastic. If the price of entertainment increases by 10 percent, people are likely to reduce their purchases by more than 10 percent.
The U.S. government has been considering raising the tax on cigarettes to reduce smoking. From the standpoint of smokers, this policy is likely to be especially effective for the young because they tend to be more sensitive to higher cigarette prices. This demand is elastic because they have to either quit smoking, smoke less or switch to cheaper cigarettes depending on the price. Richer people and those who are addicted are less sensitive to price. From the standpoint of brands, this policy has more impact on some expensive brands because their customers would switch to other cheaper brands. Therefore, the demand for expensive cigarettes is more elastic than that for relatively cheap cigarettes. Overall, the demand for cigarettes has been estimated as -0.48 which means that if cigarette prices increase 10 percent people will buy 4.8 percent fewer cigarettes.
The price elasticity of demand can be calculated at a specific price and quantity. We can use the following formula to get the price elasticity: EQX,PX= (ΔQ/
ΔP)*(PX/QX). ΔQ/ΔP is the slope of the demand curve and (PX, QX) can be any point on the curve. For example, the equation for a demand curve is Q=100-4P, then what is the price elasticity at $5? Let's get the QX for PX= 5 first, so QX=100-4P=100-4*5=80. -4 is the slope of the demand curve, so ΔQ/ΔP=-4. Therefore, EQX,PX= -4*(5/80)=-0.25. Since it is less than 1 in absolute value, we say that the demand is price inelastic. If it is more than 1 in absolute value, the demand is price elastic.
Marginal revenue is the change in total revenue due to a unit change in output. Usually, with a linear demand curve, marginal revenue is less than the price for each unit sold because a seller must lower its price to attract consumers to purchase more. If a product's demand is inelastic (own price elasticity is less than one), lowering its price will reduce total revenue because the sale will not increase much; if its demand is elastic (own price elasticity is greater than one), lowering the price will increase total revenue; whereas if its demand is unitary elastic (own price elasticity is zero), lowering the price will not affect total revenue much.
"The demand for broadly defined commodities tends to be more inelastic than the demand for specific commodities," stated in Managerial Economics and Business Strategy. According to “Advertising Effects in Complete Demand Systems,” the own price elasticity of motor vehicles is -1.4 and this of transportation is -0.6. Suppose there is a car dealer. He wants to sell more to increase total revenue, so he chose to lower car prices to attract more potential customers. As the demand for cars is elastic, customers will be motivated to purchase more when price drops. Marginal revenue is decreased because unit price drops, whereas total revenue increases because the seller sells more than before. Then we suppose that the U.S. government wants to increase the benefits of citizens, so it decided to lower the prices for all transportation vehicles. Even thought prices are lower, total demand will not change, causing a decrease of total revenue.
Price elasticity of supply measures how much quantity supplied reacts to a change in prices. An increase in price tends to generate an increase in quantity supplied, while a decrease in price tends to generate a decrease in quantity supplied. Elastic supply is when the percentage change in quantity is larger than the percentage change in price. On the other hand, inelastic supply is when the percentage change in quantity is smaller than the percentage change in price.
"When the price of an item increases, not only do existing firms tend to produce more, but additional firms are attracted to production of the item. However, it often takes a considerable amount of time for new firms to start producing an item. For this reason, supply tends to become more elastic over time, as the lure of profits attracts more sellers."
Banlangen, an Chinese herbal medicine, is effective for preventing colds. In April 2009, H1N1 influenza virus was first detected in the United States and then pervaded to other countries. In May, the first case was detected in China and the number of infected people rocketed. People were so afraid of it and tried to drink more Banlangen granules to prevent getting cold. The demand for Banlangen largely increased, causing a rightwards shift of the demand curve and an increase of the equilibrium price. However, the large increase in price did not bring much change in supply mainly because the production of the herb is limited. The supply of Banlangen is inelastic and the percentage change in quantity is much smaller than the percentage change in price.
Income elasticity measures the responsiveness of consumer demand to changes in income. It can tell us whether a good is a normal or an inferior good. If a product is a normal good, its income elasticity is positive meaning that higher income causes people to purchase more of the product. If a product is an inferior good, its income elasticity is negative because an increase in income causes people to buy less of the product.
The current economic recession is one of the largest downturns since the Great Depression. On a tight budget, many companies have to cut staff and lower salaries. As people make less money than before, they are inclined to save money and reduce unnecessary investments. Under the recession, people who planned to buy new cars will defer or give up their plans. As new cars are normal goods and non-essentials, demand for them falls sharply without any doubt. Let's take luxurious clothes and basic clothes as another instance. When people make more money, they tend to transfer from buying cheap clothes to expensive clothes. People with less income buy more basic clothes to satisfy their basic needs. When they make more money, they have money to spend on expensive clothes to get a higher quality and better brand recognition. Therefore, luxurious clothes are normal goods and basic clothes are inferior goods.
Cross-price elasticity measures the responsiveness of people in buying one product when the price of another product changes. It equals the quotient of percentage change in amount of A bought and percentage change in price of B. Cross-price elasticity can tell whether goods are substitutes or complements. If goods are substitutes, the elasticity will be positive; if goods are complements, it will be negative.
Let's take the vehicle market in the UK as an example. In recent years, prices of new cars have been either falling or relatively flat. Data on price indices for new cars and second-hand cars is shown in the chart below. As the price of new cars relative to people’s incomes has declined, this increases the market demand for new cars and decreases the demand for second-hand cars. Therefore, people tend to buy more new cars and less second-hand cars. New cars and second-hand cars are substitutes. A price increase of one product will encourage the sale of its substitutes, while a price decrease will discourage the sale of its substitutes. On the contrary, badminton rackets and badminton balls are complements. We need to have both of them because they function together. When the price of badminton rackets drops, demand for rackets and balls increases together; when the price of badminton rackets rises, demand for rackets and balls drops together as well.
Understanding what elasticity is and how it works are essential for corporations' managerial decisions. Customers also make purchase decisions with the help of elasticities.
References:
Craig A. Gallet and John A. List. Cigarette Demand: a Meta-analysis of Elasticities. Retrieved from http://onlinelibrary.wiley.com/doi/10.1002/hec.765/pdf
Cross Price Elasticity of Demand. Retrieved from http://tutor2u.net/economics/revision-notes/as-markets-crossprice-elasticity-of-demand.html
2009 H1N1 Flu and You. Retrieved from http://www.cdc.gov/h1n1flu/qa.htm
Litman, Todd (2011). Transit Price Elasticities and Cross-Elasticities. Journal of Public Transportation.
Micheal R. Baye (2009). Managerial Economics and Business Strategy (7th ed.). Boston: McGraw-Hill Irwin.
M. R .baye, D. W.Jansen, and J. W. Lee (1992). Advertising Effects in Complete Demand Systems. Applied Economics, p.1087-96.
Price Elasticity of Supply. Retrieved from http://dotlearn.com/topics/Economics/1040/content/index.shtm?page=0
Raising Cigarette Taxes Reduces Smoking, Especially among Kids. Retrieved from http://dls.state.va.us/groups/taxcode/073002/RaisingReducesSmoking.PDF
Five quiz questions:
1. An income elasticity less than zero tells us that the good is
A. an inferior good
B. a normal good
C. a substitute
D. a complement
2. If the income elasticity for lobster is .4, a 40% increase in income will lead to a
A. 16% decrease in demand for lobster
B. 16% increase in demand for lobster
C. 40% increase in demand for lobster
D. 40% decrease in demand for lobster
3. The demand for which of the following commodities is likely to be more price inelastic?
A. beverages
B. food
C. fast food
D. beef
4. The demand for good X is given by lnQ xd = 120 - 0.9 lnPx + 1.5 lnPy - 0.7 lnM. Which of the following statements is correct?
A. X has constant income elasticity
B. X has inconstant income elasticity
C. Cannot determine
D. None of above is correct
5. A price elasticity of zero corresponds to a demand curve that is:
A. Upward from left to right
B. Upward from right to left
C. Horizontal
D. Vertical
Answers and explanations:
1. A
Explanation: When X is an inferior good, an increase in income leads to a decrease in the consumption of X. Thus, an income elasticity is less than 0 when X is an inferior good.
2. B
Explanation: Income elasticity is a measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income. Therefore, 40% increase in income will lead to .4*40%=16% increase in demand for lobster.
3. B
Explanation: The demand for broadly defined commodities tends to be more inelastic than the demand for specific commodities. The demand for food is much less sensitive to price changes than is a particular type of food, such as beef. When the price of beef increases, consumers can substitute toward other types of food, including chicken, pork, and fish. Thus, the demand for beef is more elastic than the demand for food.
4. A
Explanation: According to the formula of the elasticities for log-linear demand, when the demand function for good X is log-linear and given by InQ xd = A0 + A1InPx + A2 InPy + A3 InM + A4 InH, income elasticity for x equals to A3. Therefore, X has constant income elasticity, which is -0.7.
5. D
Explanation: When demand is perfectly elastic, a manager who raises price even slightly will find that none of the good is purchased. The demand curve is horizontal. In contrast, when demand is perfectly inelastic, consumers do not respond at all to changes in price. In this case, the demand curve is vertical.
October 9, 2011
"The Income Elasticity of Meat: A Meta-Analysis"
The article is talking about using meta-analysis, which involves regressing a parameter commonly estimated in the literature on variables that control for study characteristics, to estimate the income elasticity for a variety of meats.
In statistics, a meta-analysis combines the results of several studies that address a set of related research hypotheses. In its simplest form, this is normally by identification of a common measure of effect size, for which a weighted average might be the output of a meta-analyses. Here the weighting might be related to sample sizes within the individual studies. More generally there are other differences between the studies that need to be allowed for, but the general aim of a meta-analysis is to more powerfully estimate the true "effect size" as opposed to a smaller "effect size" derived in a single study under a given single set of assumptions and conditions.
Based on the meta-regression results, the income elasticities of lamb, pork, and poultry tend to be lower than those of other meats, and the income elasticity is sensitive to a few functional forms, data regression, publication, and regional characteristics. I feel that having a more clear understanding of income elasticity is beneficial to many people, such as policymakers.
Here is the link of the article,
http://web.ebscohost.com/ehost/detail?vid=3&hid=25&sid=671a978a-dde1-45c0-bbb4-07b6a6533eb6%40sessionmgr14&bdata=JnNpdGU9ZWhvc3QtbGl2ZQ%3d%3d#db=buh&AN=64992697
October 16, 2011
"Elasticity"
The article starts with the qualitative idea:
Elastic = Responsive
Inelastic = Unresponsive.
So what difference does demand elasticity make?
If your demand is inelastic, the more you charge, the more revenue you take in, since the sell doesn't go down. Therefore, if profit is your goal, you should raise price when demand is inelastic. On the contrary, if your demand is elastic, the demand will change based on your price. If profit is your goal, you should not set the price too high or too low.
In a market system, demand becomes elastic if consumers are price conscious and if they have an alternative. If you charge less than your competitor's price, you get all of the business. If you charge more than your competitor's price, you get no business. Your demand is now highly elastic near the competitor's price. This can be a highly unstable market because your competitor faces the same situation. Each of you has the temptation to cut price on the other until one of you goes broke. One thing is for sure: If there is a competitor in your market, and if the consumers care about price, then there's a definite limit to how high you can raise your price.
For providers of health care, physicians, other practitioners, and hospitals, patient loyalty reduces the elasticity of demand and helps keep prices up. Managed care companies buy service from providers and sell it to patients. They stand in the market between the providers and the patients. For managed care companies, patient loyalty to providers is a problem. Managed care companies prefer that the patients be loyal to them, not to particular providers. That way the companies can switch providers whenever they want. They can pay providers less, while maintaining the prices ("premiums") they charge employers and the public. Managed care companies want providers' demand to be elastic, but their own demand to be inelastic. This is why managed care companies are so interested in developing measures of quality and means of quality control. If a managed care company can document and maintain something that it can credibly call "quality," then its demand will be less elastic. If it can do that without dependence on particular providers, it can really make some money, because it keeps its customers loyal while forcing the providers to compete with each other for the insurer's patients.
Here is the link of the article,
http://hspm.sph.sc.edu/courses/econ/Elast/Elast.html
October 23, 2011
”Price Elasticity of Demand"
Price elasticity of demand indicates the responsiveness of demand for a good or service by consumers in the face of a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a 1% change in price. Elasticity differs between products. Essentials such as food, fuel and medicine are very inelastic, meaning that price increases generate only small drops in demand. However, discretionary items such as treats and purchases than can be postponed are more elastic. A rise in prices tends to have an exaggerated effect on sales.
When elasticity is more than 1, the change in quantity demanded is proportionately larger than the change in price. This means that an increase in price would result in a decrease in revenue, and a decrease in price would result in an increase in revenue. In the extreme case of near infinite elasticity, the demand curve would be nearly horizontal, meaning than the quantity demanded is extremely sensitive to changes in price.
When elasticity is less than 1, the change in quantity demanded is proportionately smaller than the change in price. An increase in price would result in an increase in revenue, and a decrease in price would result in a decrease in revenue. In the extreme case of elasticity near 0, the demand curve would be nearly vertical, and the quantity demanded would be almost independent of price. The case of zero elasticity is described as being perfectly inelastic.
When elasticity equals to 1, this case is referred to as unitary elasticity. The change in quantity demanded is in the same proportion as the change in price. A change in price in either direction therefore would result in no change in revenue.
Here is the link of the article,
http://www.netmba.com/econ/micro/demand/elasticity/price/
October 30, 2011
"As Markets & Market System, Cross Price Elasticity of Demand"
Cross price elasticity measures the responsiveness of demand for good X following a change in the price of good Y (a related good). We are mainly concerned here with the effect that changes in relative prices within a market have on the pattern of demand. With cross price elasticity we make an important distinction between substitute products and complementary goods and services. The stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. For example with two close substitutes, the cross-price elasticity will be strongly positive. Likewise when there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. Unrelated products have a zero cross elasticity.
How can businesses make use of the concept of cross price elasticity of demand?
Pricing strategies for substitutes:
If a competitor cuts the price of a rival product, firms use estimates of cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product.
Pricing strategies for complementary goods:
For example, popcorn, soft drinks and cinema tickets have a high negative value for cross elasticity– they are strong complements.
In highly competitive markets where brand names carry substantial value, many businesses spend huge amounts of money every year on persuasive advertising and marketing. There are many aims behind this, including attempting to shift out the demand curve for a product (or product range) and also build consumer loyalty to a brand. When consumers become habitual purchasers of a product, the cross price elasticity of demand against rival products will decrease. This reduces the size of the substitution effect following a price change and makes demand less sensitive to price. The result is that firms may be able to charge a higher price, increase their total revenue and turn consumer surplus into higher profit.
Here is the link of the article,
http://tutor2u.net/economics/revision-notes/as-markets-crossprice-elasticity-of-demand.html
November 6, 2011
"Transit Price Elasticities and Cross-Elasticities"
Prices affect consumers' purchase decisions. For example, a particular product may seem too expensive at its regular price, but a good value when it is discounted. Similarly, a price increase may motivate consumers to use a product less or shift to another brand. Such decisions are said to be "marginal," that is, the decision is at the margin between different alternatives and can therefore be affected by even small price changes. Although individually such decisions may be quite variable and difficult to predict, in aggregate they tend to follow a predictable pattern: when prices decline consumption increases, and when prices increase consumption declines, all else being equal. This is called the "law of demand,"
Price sensitivity is measured using elasticities, defined as the percentage change in consumption resulting from a one-percent change in price, all else held constant. A high elasticity value indicates that a good is price-sensitive, that is, a relatively small change in price causes a relatively large change in consumption. The degree of price sensitivity refers to the absolutely elasticity value, that is, regardless of whether it is positive or negative.
Price elasticities have many applications in transportation planning. They can be used to predict the ridership and revenue effects of changes in transit fares; they are used in modeling to predict how changes in transit service will affect vehicle traffic volumes and pollution emissions; and they can help evaluate the impacts and benefits of mobility management strategies such as new transit services, road tolls and parking fees.
Here is the link of the article,
http://www.vtpi.org/tranelas.pdf
November 13, 2011
"A Monopolist's Marginal Revenue"
A monopolist's marginal revenue is always less than or equal to the price of the good. Marginal revenue is the amount of revenue the firm receives for each additional unit of output. It is the difference between total revenue at the new level of output and total revenue at the previous output. Therefore, the monopolist's marginal cost curve lies below its demand curve.
For a competitive firm there is no price effect. The competitive firm can sell all it wants at the given price. For a monopoly there is a price effect. It must reduce price to sell additional output. So the marginal revenue on its additional unit sold is lower than the price, because it gets less revenue for previous units as well (it has to reduce price to the same amount for all units).
Like a competitive firm, the monopolist produces the quantity at which marginal revenue equals marginal cost. The difference is that for the monopolist, marginal revenue no longer equals price. The price that the monopolist charges is the price at which buyers are willing to buy the profit-maximizing quantity.
Monopoly does not have a supply curve. There is no function of price that determines what quantity a firm will offer given a price. Instead, the quantity a firm offers is determined by the entire demand curve it faces. The shape of the demand curve determines the shape of the marginal revenue curve, which determines with the marginal cost curve the profit-maximizing quantity.
Here is the link of the article,
http://www.albany.edu/~aj4575/LectureNotes/Lecture30.pdf
November 20, 2011
"Price and Income Elasticity of the Demand for Health Insurance and Health Care Services: A Critical Review of the Literature"
The price and income elasticities measured in the RAND Health Insurance Experiment of the 1970s remain a widely used source of elasticity estimated with respect to the demand for covered health care services. However, these estimates may fail to support today's analyses of health care utilization. Indeed, more recent anecdotal evidence and estimates suggest that the demand for some major components of health care may have changed significantly in the past 30 years.
The research literature indicates that the demand for health insurance is, in general, price inelastic. That is, a percentage change in the price of insurance--to employers, employees, or individuals in the nongroup market--evokes a smaller percentage change in demand. However, the range of estimated elasticities is wide.
Consistent with the HIE, more recent research has estimated the demand for insured health services to be inelastic with respect to price. Most estimates of the price elasticity of demand for health care services in general are about -0.2. Estimated price elasticities differ by type of service, but the differences are not generally large. Estimates of the income elasticity of demand for health care services based on observational studies consistently range from 0.0 to 0.2, suggesting that consumers do not use more health care as their income rises.
Here is the link of the article,
http://www.mathematica-mpr.com/publications/pdfs/priceincome.pdf
November 27, 2011
"Price Elasticity of Supply"
The price elasticity of supply is a number used to measure the sensitivity of changes in quantity supplied to given percentage changes in the price of a good, other things being equal. Price elasticity of supply indicates the percentage change in quantity supplied resulting from each 1 percent change in price.
As supply curves generally slope upward, supply elasticity tends to be positive. An increase in price tends to generate an increase in quantity supplied, while a decrease in price tends to generate a decrease in quantity supplied. In the equation for price elasticity of supply, the signs of the numerator and the denominator are the same. The ratio, therefore, has a positive sign. As with demand, be sure you remember that the slope of a supply curve is an unreliable measure of its elasticity. The price elasticity of supply is related to, but isn't the same as, the slope of the supply curve.
In general, a good's price elasticity of supply depends on the extent to which costs per unit rise as sellers increase output. If unit costs of production rise only slightly as output expands, small percentage increases in price will result in large percentage increases in quantity supplied. Under such circumstances, supply will be very elastic, because small increases in price will allow sellers the possibility of large additional gains.
When the price of an item increases, not only do existing firms tend to produce more, but additional firms are attracted to production of the item. However, it often takes a considerable amount of time for new firms to start producing an item. For this reason, supply tends to become more elastic over time, as the lure of profits attracts more sellers.
Here is the link of the article,
http://dotlearn.com/topics/Economics/1040/content/
December 4, 2011
"Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand"
The short-run price and income elasticities of gasoline demand have been studied extensively in the literature. Transportation analysts have hypothesized that factors such as changing land-use patterns, the implementation of the Corporate Average Fuel Economy program, the growth of multiple income households and per capita disposable income, as well as a decrease in the availability of non-auto modes such as transit, have changed the responsiveness of U.S. consumers to changes in gasoline price. The short-run price elasticity of gasoline demand is significantly more inelastic than in previous decades. In the short-run, consumers appear significantly less responsive to gasoline price increases. This result is robust and consistent across several empirical models and functional forms. The observed change provides evidence of a structural change in the U.S. market for transportation fuel and may reflect shifts in land-use, social or vehicle characteristics during the past several decades. Provided the results extend to long-run elasticities, these results suggest that technologies and policies for improving vehicle fuel economy may be increasingly important in reducing U.S. gasoline consumption.
Here is the link of the article,
http://www.econ.ucdavis.edu/faculty/knittel/papers/gas_demand_083006.pdf
Income elasticity measures whether a good is a normal or an inferior good. A product is a normal good when its income elasticity is positive, meaning that higher income causes people to purchase more of the product. For an inferior good, income elasticity is negative because an increase in income causes people to buy less of the product.
Cross-price elasticity, often simply called just cross-elasticity, measures whether goods are substitutes or complements. It looks at the response of people in buying one product when the price of another product changes.For example, in recent years, the prices of new cars have been either falling or relatively flat. Data on price indices for new cars and second hand cars is shown in the chart below. As the price of new cars relative to people’s incomes has declined, this should increase the market demand for new cars and (ceteris paribus) reduce the demand for second hand cars. We can see that there has been a very marked fall in the prices of second hand cars.