Price elasticity of demand (PED ) is the measure of the responsiveness of the demand for a certain good to a change in the price of this good. It is a measure of how consumers react to a change in price.
The formula used to calculate the price elasticity of demand for a given product is :
% change in quantity demanded of good A
% change in prices of good A
Figure 1 : demand
“VW on Monday revealed net income of ï¿½4.7bn ($6bn) last year, 14 per cent higher than in 2007, while sales increased 4.5 per cent to ï¿½114bn as VW sold 6.3m vehicles.”
This situation is shown in figure 1. There was a shift in demand curve to the right, from D1 to D2, as sales increased. VW sales increased from Q1 to Q2, and they could set higher price for their cars, which increased from p1 to p2.
Car market is a type of a monopolistically competitive market. Monopolistic competition has two basic assumptions. Firstly, the producers haven’t much impact on degree of control over price. It means that they have to keep low prices for cars, because the marker is very competitive. Secondly, there are many producers and many consumers, while no business has total control over the market price.
Moreover, it is assumed that all firms are profit-maximizers, and the same is with Volkswagen. It will not be concerned about revenue maximization or sales maximization, but only profit maximization. The number of workers it employs is also not important, nor environmental aims which are crucial these days. Most of the firms are not concerned about the environment, and this is why there is negative externality of consumption and production of VW cars. Manufactures emit greenhouse gasses and consumers’ cars also emit greenhouse gasses. However, Volkswagen wants only to maximize its profit.
As car market is monopolistically competitive market, figure 2 will best represents VW costs and revenues. “VW on Monday revealed net income of ï¿½4.7bn ($6bn) last year”, so there was abnormal profit which is marked as pink area on the figure 2. The abnormal profit is the total revenue minus total cost at the level of output where MC curve is equal to MR curve.
Figure 2 : abnormal profit
Figure 3. losses
It is said in the article that this year “earnings will not reach the high levels of previous years.”. It may be possible that VW will make only losses, which is shown in figure 3. Again, the total abnormal profit or loss is between the AC curve and AR curve at the level of output where profits are maximized (Q). The loss of Volkswagen is marked as the red rectangle in figure 3.
VW has many ways to increase demand for their cars. First of all, they should spend more money on innovation, because consumers can be attracted by VW cars with the newest technology. VW works in monopolistic competition and it can “steal” consumers from other car makers, who will prefer Volkswagen cars.
There are three possibilities of what VW may do. Volkswagen should shut down in the short run if it is unable to cover all its variable costs in the short run. This level of price is knows as shut-down price. Secondly, it may operate in the short run, when it is able to cover all its variable costs in the short run. This is known as break-even price and VW will operate in the short run so that it can make an abnormal profit in the long run. Finally, Volkswagen may operate at the profit-maximising level of output if it wants to make abnormal profit in the short run.