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Measures of Elasticity of Demand for Price Setting
Discuss which measure of the different types of elasticity of demand is most useful for a business when setting the price for its product.
[CIE A level May June 2017]
This is a very tricky question and it's very easy to go out of subject!
This was indicated in the examiner's report : '...Inaccurate and largely irrelevant diagrams that were not needed to answer the question set often accompanied these explanations. Some candidates focused upon the usefulness of elasticity concepts in aiding the government when raising revenue through taxes. '
DO NOT dive into your essay by simply writing everything you know about elasticity. Remember to adapt your answer to the context of the question. In this case, pay attention to these keywords: '... useful for a business when setting the price for its product'
Step ➊ : Define ‘elasticity of demand’ in the introduction.
Elasticity of demand refers to the sensitivity of quantity demanded with respect to changes in another outside factor. Three types of elasticity of demand are price elasticity of demand, income elasticity of demand and cross elasticity of demand. In this essay, we will discuss the usefulness of each of these types of elasticity of demand and determine which is the most useful one for a business when setting the price for its product.
Step ➋ : Explain which measure of the different types of elasticity of demand can be used when setting the price for its product.
➤ 2.1 Price elasticity of demand is a useful tool for businessmen to make crucial decisions like deciding the price of goods and services.
Price elasticity of demand (PED) measures the change in demand as a result of a change in price The primary objective of any firm is to earn a profit or increase revenue. Different products exhibit different elasticities, which in turn has an influence on a firm's pricing decisions. Price elasticity of demand affects a business's ability to increase the price of a product. Elastic goods are more sensitive to increases in price, while inelastic goods are less sensitive.
A firm while fixing the price of the market has to determine whether its product is of elastic or inelastic nature. If the product is inelastic, the producer can earn profit by setting a high price. However, if the product is elastic, the producer must set low or at least a reasonable price so that the consumers are attracted to buy the goods.
For example, Fuel is the necessity for consumers. Therefore, firms who run the market of fuel can generate profit even by setting a high price for fuel.
On the other hand, luxury goods have a high price elasticity of demand because they are sensitive to price changes. High-priced products often are highly elastic because, if prices fall, consumers are likely to buy at a lower price. This is shown in the diagram below.
➤ 2.2 Cross elasticity of demand is one of the major tools that businessmen take help from in order to make correct pricing decisions.
Cross elasticity of demand (XED) is a measure of the degree of change in demand of a commodity due to change in the price of another commodity.
Cross elasticity is greater than zero when a rise in the price of commodity X causes a rise in demand for commodity Y. Such type of response can be observed in substitute goods such as Coke and Pepsi. If cross elasticity is lesser than zero when a rise in the price of commodity Y causes a fall in demand of commodity X. Such type of response can be seen in complementary goods such as tea and sugar.
The price of one product can directly affect the price of another if they are related to each other. That is why large firms which produce more than one product must evaluate cross-price elasticity between each of their products in order to efficiently set their price.
Companies are increasingly concerned with trying to get consumers to buy not just one of their products but a whole range of complementary ones, e.g., computer printers and cartridges. XED will identify those products that are most complementary and help a company introduce a pricing structure that generates more revenue.
For example, there is a high negative cross elasticity between-meal prices and the demand for soft drinks. Restaurants may charge a low price for food in order to attract customers and this will in turn generate more demand for soft drinks (which may be charged a higher price). This means that although the revenue from food sales falls, the demand for soft drinks increases.
➤ 2.3 Having knowledge of income elasticity of any product is essential in order to correctly price them.
YED is the measure of the change in demand of the commodity as a result of a change in income of consumers. Any products that are manufactured by producers can be classified into two types – normal goods and inferior goods. Normal goods are goods whose demand is directly proportional to the income of the consumers e.g. jewellery. Inferior goods are goods whose demand is inversely proportional to the income of the consumers.
Knowledge about the income elasticity of a product is important to a producer in order to make good pricing decisions. The demand for normal goods such as wine and jewellery tends to fall when consumers experience a fall in income (for example due to a recession). Thus, producers may decrease the price of such goods in order to make them more affordable and help to increase demand.
Step ➌ : Explain the limitations of the measures of elasticity of demand.
It should be noted that these measures of elasticity of demand are not always reliable.
There are several difficulties in calculating PED values from historical data. Collecting data from other sources, such as market research reports or surveys, is costly in terms of time and money and may not be particularly valid or reliable.
Similar problems occur when trying to estimate income elasticity. The data available are likely to be unreliable the longer the time span involved. It has also been assumed that producers can instantly switch from producing one product to another when there is a change in income. In practice, this is not the case. For example, in the case of agricultural goods, It may take months for new crops to be harvested. The harvest is also affected by a number of unpredictable factors such as weather, pests and diseases.
Cross elasticity of demand may be less useful as a product may have several complements or substitutes and it is difficult to predict whether other firms producing these complements and substitutes will change their prices.
Step ➍: Conclude which measure of elasticity is most useful for a business when setting the price for its product. (very important!)
It can be concluded that the price elasticity of demand is the most useful concept for a business when setting the price for its product, compared to income elasticity and cross elasticity. This is because there will be a more immediate effect on the firm's revenue by influencing prices using the knowledge of PED. It is easier for producers to influence their prices according to PED and it is also the most effective measure to increase profits across a range of industries. For example, hotels charge a higher price in summer than winter because the PED is more inelastic in summer. The price of train tickets is higher during peak hours compared to off-peak hours. Thus the knowledge of PED can be applied directly by businesses, compared to XED or YED which are less predictable and require research work. For example, XED may be less useful as a product may have several complements or substitutes and it is difficult to predict whether other firms producing these complements and substitutes will change their prices. It may be difficult to predict whether income will rise or fall in the future and set prices according to YED. It is thus easier to predict the PED of a product than the XED or YED of a product.
♕ Marking scheme
• (Up to 6 marks per type of elasticity of demand) (8 marks maximum)
For evaluation that assesses and compares
• the relative strengths and weaknesses of at least two measures of elasticity (3 marks)
• to reach a conclusion concerning which measure is most useful (1 mark) (4 marks maximum)
Candidates can refer to price, cross or income elasticity of demand. They must consider at least two measures. Many will explain how price elasticity is useful in predicting how total revenue will change as price changes depending Upon the price elasticity. Others might explain how businesses might find cross elasticity useful as the price of complements and substitutes change. Income elasticity might be useful if incomes are changing and businesses consider whether to change the price of normal or inferior goods. Two measures are necessary for the full marks available for the analysis
♕ Examiner’s report
Many candidates wasted valuable time here by explaining at great length the full range of values for price elasticity of demand. Inaccurate and largely irrelevant diagrams that were not needed to answer the question set often accompanied these explanations. Some candidates focused upon the usefulness of elasticity concepts in aiding the government when raising revenue through taxes. Again, this approach was irrelevant and failed to score. The better answers focused more closely upon the requirements of the question and made good use of the concepts of price, income and/or cross elasticity of demand to assess their usefulness to a business when setting the price of a product. As in the previous question, many candidates scored poorly for evaluation.