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Use of Price Elasticity & Income Elasticity of Demand for Businesses

Paper type: Essay 4 (913 words)
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Price elasticity of demand and income elasticity are two important ideas in practical business activities. Price elasticity, which is represented by PED, measures the changes of one product’s demand in response to a changing in its price. We can write an equation in this way: Price elasticity of demand = percentage change in quantity demanded of the product / percentage changes in price of the product. This is abbreviated to: XED=%ΔQD / %ΔP. Income elasticity of demand (represented by YED) shows the relationship between a change in quantity demand and the changing in income.

The equation can be written as: Income elasticity of demand = percentage change in quantity demanded / percentage changes in income. Abbreviated to: YED=%ΔQD / %ΔY.

These are just two terms, but how they work is the most important part. For companies, price elasticity of demand is actually effects of prices’ changing on its own sales of products; and income elasticity of demand is effects of consumers’ changes on its sales.

Generally speaking, learning the two relationships can help the business find out the situation of the market and make right decisions.

Price Elasticity of Demand (PED) The value of price elasticity of demand is usually negative. The product with high value of PED is described to be elastic, while for one with low PED is said to be inelastic. Just an example to show this idea: when Mc Donald rises its price of burger from \$2 to \$2.3, and its demand falls from 20 million to 14 million, so its PED= (14 million-20 million)/20 million / ((\$2.3-\$2)/\$2 = 30% / 15% = 2. It’s a quite big value of PED, so this is elastic. In order to show the degree of elasticity, we use graphs. There are generally 5 types of graphs, and through them we can see the product’s PED, and company can make decisions in different situations.

Type 1: Elastic demand (Please ignore the numbers on it.) This occurs when a given % change in price causes a greater % change in demand. In this kind of graph’s condition, the value of PED is greater than 1 and less than infinity. It usually happens when the company has close substitutes, so a little change in price can cause a big changing in demand. When in a company the PED graph gets like this, it should consider decreasing the price a little to achieve more consumers. From the graph, we can see when the price drops a little, the area of revenue increases much.

Type 2: Inelastic demand This is when a given % change in price causes a smaller % change in demand. Its PED value will be greater than 0 and less than 1. Goods with this graph are usually necessaries, and even a relatively high change in price would not cause a big decrease in demand. Or, there are no big substitutes closely, so most consumers will still choose to buy it even if the price rises.

Type 3: Unit price elasticity of demand This is when a given % change in price results an equal % change in demand. Its PED value will be exactly 1. In this condition, the PED is easy to handle, because the price and the quantity demanded is proportional, so the revenue will remain constant. Thus, the company can change the price flexibly depending on the market’s situation. However this may not happen so frequently, because the real market is much more complicated.

Type 4: Perfectly elastic demand

This occurs when a constant price will cause the infinite change in the quantity demanded. In this case, the value of PED is infinite. For example, 2 people are selling the exactly the same goods in a small area, and if one of them gets his price below the other one, then he will get all of the consumers. This doesn’t happen frequently, because there may not be such goods that are exactly the same but different in price in a certain area.

Type 5: Perfectly inelastic demand

Perfectly inelastic demand curve describe the situation for the company that the price’s change will have absolutely no affect on the demand. PED here is 0. No matter how much the price increases or decreases (mostly increases), the demand will not change any. This often happens to the necessaries or monopolies that people have to choose to buy the good even the prices changes rapidly. For example, the gasoline’s price changes from \$2.3 to \$3.5, the demand will still remain about the same, because for such goods consumers have to pay for it.

Conclusion: Different goods will have different PED charts. Companies should change its price depending on different kind of charts. Generally, if a goods is in a competitive market, it can be high elastic, so it should consider to lower the price to increase revenue; contract to it while in a relatively not so competitive market, it can rise price to increase revenue when its PED is low. The goods that are new in the market should decrease the price to survive and achieve higher revenue (new products usually has high PED). Luxuries are mostly elastic, since they are not essential goods. However, PED is not exactly what it would happen in the market; it is limited in many situations, that the practical market condition and the competitors’ changing may have effect on the demand. So it’s better to just make it as a supplement, but not relying on it.

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