1. F. James McDonald the former president of the US automobile workers federation suggested an average reduction of 4% in the price of the car. The automobile market was weak, which resulted in unemployment. Lower price would lead to greater sales and stimulate employment. McDonald believed that a 4% reduction in price would increase sales by 16%.David black, representing the management of the automobile manufacturers disagreed with McDonald’s estimation. Black cited studies which indicated price elasticity’s ranging from 0.5 to 1.5.Black made it clear that he was referring to the elasticity of demand in response to a permanent price change of all manufacturers. He admitted that the elasticity to a temporary price cut might be greater. The studies to which Black referred found elasticity’s ranging from 0.65 to 1.53.
a. Explain the concept of elasticity of demand and the factors that affect it.
From the decision-making perspective, the firm needs to know effect of changes in any of the independent variables in the demand function on the quantity demanded. Some of these variables are under the control of management, such as price, advertising, product quality, and customer service. For these variables, management must know the effects of changes on quantity to assess the desirability of institution the change. Other variables, including income price of competitor’s products, and expectations of consumers regarding future prices, are outside the direct control of the firm. Nevertheless, effective forecasting of demand requires that the firm be able to measure the impact of changes in these variables on the quantity demanded.
The most common used measure of the responsiveness of the quantity demanded to changes in any of the variables that influence the demand function is elasticity. In general, elasticity may be through of as a ratio of the percentage(%) change in one quantity(or variable) to the percentage(%) change in another, ceteris paribus(all other things remain unchanged). In other words, how responsive in some dependent variable to change in a particular variable? With these in mind, we define the price elasticity of demand(Ed) as the ratio of the percentage (%) change in quantity demanded to a percentage (%) change in price.
Where [pic]Q= Change in quantity demanded
[pic]P= Change in Price
Because of the normal inverse relationship between price and quantity demanded, the sign of the price coefficient will usually be negative. Occasionally, price elasticity’s are referred to as absolute values. The use of absolute values will be indicates where appropriate. Problems result when calculating elasticity if initial prices and quantities are used as bases, so economists typically use midpoint bases. The price-elasticity of demand is negative but, for convenience, we use absolute values to avoid the negative sign.
If price elasticity is less than one, then demand is relatively unresponsive to changes in price and is said to be inelastic. If elasticity is greater than one, demand is very responsive to price changes and is elastic. Demand is unitarily elastic if the elasticity coefficient equals one. Elasticity, price changes, and total revenues (expenditures) are related in the following manner: If demand is inelastic (elastic) and price increases (falls), total revenue will rise. If demand is elastic (inelastic) and price rises (falls), total revenue (expenditures) will fall. If demand is unitarily elastic (ed = 1), total revenue will be unaffected by price changes.
The number and quality of substitutes, the proportion of the total budget spent, and the length of time considered are three important determinants of the elasticity of demand. Demand is more elastic the more substitutes are available, the more of the budget the item consumes, and the longer the time frame considered. Along any negatively sloped linear demand curve, parts of the curve will be elastic, unitarily elastic, and inelastic. The price-elasticity of demand rises as the price rises.
Factors Affecting the Elasticity of Demand:-
Availability of Substitutes- The most important determinant of the price elasticity of demand is the availability and closeness of substitutes. The greater the number of substitute goods, the more price elastic is the demand for a product because a customer can easily shift to a substitute goods if the price of a product in question increases.
Durable Goods- The demand for durable goods tends to be more price elastic than the demand for nondurable. This is true because of the ready availability of a relatively inexpensive substitute in many cases; that is repairing a worn-out durable good, such as a television, car, or refrigerator, rather than buying a new one. Consumer of durable goods is often in a position to wait for a more favorable price, a sale, or a special deal when buying these items. This accounts for some of the volatility in the demand for durable goods.
Relative Size of Expenditures- The demand for relatively high-priced goods tends to be more price elastic than the demand for inexpensive items. This is true because expensive items account for a greater portion of a person’s income and potential expenditures than do low-priced. Consequently, we would expect the demand for automobiles to be more price elastic than demand for children’s toys.
Time Frame of Analysis- Over time, the demand for many products tends to become more elastic because of the increase in the number of effective substitutes that become available. For example, in the short run, the demand for gasoline may be relatively price inelastic because the only available alternatives are not talking a trip or using some from of public transportation. Over time, as consumer replaces their cars, they find another excellent substitute for gasoline- namely, more fuel-efficient vehicles. Also, other product alternatives may come available, such as electric cars or cars powered by natural gas or coal.
b. Interpret the meaning of David Blake’s demand estimate ranging from .65 to 1.53.Explain the significance of demand elasticity in taking business decision.
McDonald believed that,
4% reduction in price would increase sales by 16%
therefore, 1% reduction in price would increase sales by 4%
So, PED = 4
McDonald believed that PED was only Elastic. He did not consider the Rich end of the buyers who may not be much affected by this change. Thus PED should be Inelastic for them. The Middle Class buyers would get a chance to buy Automobiles at lower prices. So the sales would be high for some times. But, in time, as the Factors affecting Elasticity comes in action, sales may go down or not in future.
Blake, on the other hand, referred to statistical studies that considered both ends of the buyers (Range on the Demand Curve, where Elasticity was both greater and smaller than 1) and also other Factors of Elasticity.
For Long term offer, it considered the Factors of Elasticity and consecutive steps taken by the competitive Automobile companies. As a result, the Range of Elasticity was: PED = 0.5 (Inelastic for Rich) to 1.5 (Elastic for others) Average = 1.0
For Short term offer, it was affected less by the Factors of Elasticity. As a result, the Range of Elasticity was: PED = 0.65 (Inelastic for Rich) to 1.53 (Elastic for others) Average = 1.09
So Elasticity is more on the Short Run offer.