AE 11 Managerial Economics - Price Elasticity (PDF)

AE 11 MANAGERIAL ECONOMICS TOPIC 3: QUANTITATIVE ANALYSIS USING ELASTICITY Prepared by: Instr. Cherry Bartolome LEARNING OBJECTIVE By the end of this topic, you should be able to: Explain the different types of elasticity of demand and how it affects revenue; Explain the differ...

AE 11 MANAGERIAL ECONOMICS TOPIC 3: QUANTITATIVE ANALYSIS USING ELASTICITY Prepared by: Instr. Cherry Bartolome LEARNING OBJECTIVE By the end of this topic, you should be able to: Explain the different types of elasticity of demand and how it affects revenue; Explain the different classifications of price elasticity of demand and illustrate it graphically; Apply various elasticities as a quantitative tool to forecast changes in revenues, prices and/or units sold; Illustrate the relationship between elasticity and revenue, marginal revenue and own price elasticity of demand THE ELASTICITY CONCEPT ELASTICITY is a quantitative measure of the responsiveness or impact of one variable to changes in another variable. It is the percentage change in one variable that arises due to a given percentage change in another variable. It describes how consumers behave in a market when there is a change in price. ELASTICITY is a measure of the responsiveness of quantity demanded or quantity supplied to a change on one of its determinants. It can be shown in an equation as: Elasticity (E) = % change in variable1 (V1) % change in variable2 (V2) Two important aspects of elasticity: (1) Whether elasticity (E) is positive or negative, and (2) Whether E is greater than 1 or less than 1 in absolute value. If E is positive, an increase in V2 leads to an increase V1. If E is negative, an increase in V2 leads to a decrease V1. If E is greater than 1, a small % change in V2 will lead to a greater change in V1. If E is less than 1, a % change in V2 will lead to a small change in V1. PRICE ELASTICITY OF DEMAND PRICE ELASTICITY OF DEMAND measures the responsiveness of quantity demanded to a change in price. Price Elasticity of Demand (PED) can be measured using two methods: Point Elasticity and Arc Elasticity using the Midpoint Method. A. POINT ELASTICITY is shown in the equation: Price Elasticity of Demand (PED) = % change in quantity* % change in price** *where % change in quantity (Q) = (QD2 – QD1) / QD1 ** where % change in price (P) = (P2 – P1) / P1 Example #1: Suppose there is a 5% increase in the price of sardines and a 10% decrease in the quantity demanded, what is the price elasticity of demand (PED)? Solution: Price Elasticity of Demand (PED) = % change in quantity* = 10 = 2 % change in price** 5 PED = 2 This means that if there is a 1% change in price, we can expect a 2% decrease in quantity demanded PRICE ELASTICITY OF DEMAND Example #2: Suppose the price of cappuccino increases from P90 to P110, what is the PED if demand falls from 100 to 90? Solution: Equation 3.1 Jimenez, 2023, p.35  PRICE ELASTICITY OF DEMAND B. ARC ELASTICITY measures the elasticity at the center of two points. To Equation 3.2 compute arc elasticity, we will use the MIDPOINT METHOD, the formula for which is shown in Equation 3.2. The advantage of the Midpoint Method is that we find the elasticity right at a 2 single point on the demand curve, which is more precise than finding the elasticity over the entire range between the two points. This method gives us a sort of average elasticity of demand at the center point between the two points on our demand curve. Jimenez, 2023, p.37 CLASSIFICATIONS OF PRICE ELASTICITY OF DEMAND There are 3 classifications of Demand Elasticity: 1. ELASTIC DEMAND - Demand is elastic if the price elasticity of demand (PED) is greater than 1. This means that a change in P, it will result to a more than proportionate change in QD. Higher total revenues may be obtained by lowering the prices of goods and services with elastic demand because these goods are sensitive to price changes. Examples: luxury goods, non-essential goods and services (wants) 2. INELASTIC DEMAND – Demand is inelastic if the PED is less than 1. This means that a change in P will result to a less than proportionate change in QD. Total revenue obtained will decline at higher prices. Examples: Prescription medicines, essential goods and services (necessities) 3. UNITARY ELASTIC DEMAND – Demand is unitary elastic if the PED is equal to 1. This means that changes in both P and QD are proportionate with each other. Total revenue remains constant despite changes in price. Examples: Electricity, household appliances (Baye, 2022, p.78) GRAPHICAL REPRESENTATIONS OF PRICE ELASTICITY OF DEMAND 1. Goods and services that have Perfectly Inelastic Demand are commodities with an elasticity of zero. This means that even if the price changes, the quantity demanded would still remain the same. In reality, there are no goods and services that are considered as perfectly inelastic because all things have changing demand. A product may be highly inelastic, but could never be perfectly inelastic, as demand changes over time. Figure 3.1 PED with Perfectly Inelastic Demand (Jimenez, 2023, p.38) GRAPHICAL REPRESENTATIONS OF PRICE ELASTICITY OF DEMAND 2. Goods and services with Inelastic Demand are commodities that are considered as necessities and have an elasticity less than 1. Looking at Figure 3.2, we can see that even if there is a large increase in price (25% from 40 to 50), demand have a minimal decline (5% from 100 to 95). One thing to take note with this demand curve is that it is steep compared to a unitary elastic demand or an elastic demand. Figure 3.2 PED with Inelastic Demand (Jimenez, 2023, p.39) GRAPHICAL REPRESENTATIONS OF PRICE ELASTICITY OF DEMAND 3. Goods and services with Unitary Elastic Demand are commodities that have an elasticity equal to 1. It shows that an increase in price will have a commensurate decrease in quantity demanded. Looking at Figure 3.3, we can see a 25% increase in price (from 40 to 50) will decrease demand by 25% (from 1000 to 750) as well. If a company sells goods with unit elastic demand, it must carefully assess its pricing strategy. The main reason is that a substantial change in price will result in a substantial change in the quantity demanded which can impact a firm’s profitability. Figure 3.3 PED with Unitary Elastic Demand (Jimenez, 2023, p.39) GRAPHICAL REPRESENTATIONS OF PRICE ELASTICITY OF DEMAND 4. Goods and services with Elastic Demand are commodities that have an elasticity greater than 1. It shows that an increase in price will lead to a higher decrease in quantity demanded. Looking at Figure 3.4, we can see a 25% increase in price (from 40 to 50) will decrease demand by 50% (from 100 to 50) as well. If a company sells goods with elastic demand, it is advisable that you decrease your price because a slight increase in price would greatly decrease your demand. Figure 3.4 PED with Elastic Demand (Jimenez, 2023, p.39) GRAPHICAL REPRESENTATIONS OF PRICE ELASTICITY OF DEMAND 5. Goods and services with Perfectly Elastic Demand are commodities that have an infinite elasticity. It shows that if price remains the same, quantity demanded would be infinite. In Figure 3.5, there is an infinite demand at price 50. If companies selling goods with Perfectly Elastic Demand set a certain price without changing it, they would always have a demand. Figure 3.5 PED with Perfectly Elastic Demand (Jimenez, 2023, p.40) IMPORTANCE OF PRICE ELASTICITY OF DEMAND Thing to note: Demand is usually neither perfectly elastic nor perfectly inelastic. In these instances, knowing the value of an elasticity can be useful to a manager. Large firms, universities and the government usually hire economists and statisticians to estimate the demand for products. The manager’s job is to interpret and use such estimates to determine prices, set production and sales goals to maximize profits. FACTORS AFFECTING THE PRICE ELASTICITY OF DEMAND Understanding the price elasticity of demand will allow managers to use it to assess the impact of price changes on sales volume and revenues. It is also as important to know the factors that affect the price elasticity of demand. These factors are as follows: 1. Availability of substitutes. A good with many close substitutes tends to have a more elastic demand because it is easier for customers to switch from that good to another. In these circumstances, a price increase leads customers to choose a substitute, thus reducing the quantity demanded for that good. By contrast, when there are a few close substitutes for a good, demand tends to be relatively inelastic. This is because consumers cannot readily switch to a substitute when the price increases. 2. Time Horizon. Goods tend to have more elastic demand over longer time horizons. The more time consumers have to react to a price change, the more elastic the demand for a good. On the other hand, demand tends to be more inelastic in the short-term. 3. Necessities vs Luxuries. Goods and services that are considered as necessities tend to have inelastic demand and luxuries have elastic demand.