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PRICE THEORY
Useful in determining extent of change in price as well…
PRICE THEORY
- Useful in determining extent of change in price as well
PRICE ELASTICITY OF DEMAND
Measures degree of responsiveness of quantity demanded of a good to a change in its price, cet. paribus
- Note: Change in Px is due to shift in SS curve (TIGERSO)!
Uses of PED
Government: Tax revenue
PED < 1 e.g. cigarettes
- Impose indirect tax on good, increases price
- Less than prop. decrease in Qdd
- Increase tax revenue
EV
- Administrative costs/ costs of enforcement
- May increase DD for contraband cigarettes (which is illegal)
PED > 1
- Unlikely to gain tax revenue for govt
- But may be useful in discouraging consumption
Producers: Pricing Decisions
- Take PED values into consideration when making pricing decisions to maximise total revenue
- PED <1:
- Increase price, less than prop. fall in Qdd, increase in TR
- PED>1:
- Decrease price, more than prop. increase in Qdd, increase in TR
As PED changes over time, firms must adjust pricing strategies accordingly (e.g. plane tickets during peak season)
+ Marketing Strategies
- If PED>1, must decrease Px to increase TR
- BUT might trigger price war with competitors; rival firms try to undercut each other's Px in a bid to protect their mkt shares
- May result in decrease of TR instead
Hence, should try to reduce PED of the good such that TR can be increased through Px increase instead
- Via pdt differentiation (to reduce the substitutability of good)
- Create real differences betwn pdt and substitutes: through pdt development (new features, higher qly)
- Or perceived differences: through advertisement, celebrity endorsement to improve conr's perception of the good
Determinants
- Always link back to responsiveness!
- Why will/will not respond drastically to change in price?
Proportion of Income Spent on Good
- Greater portion of income = price elastic
- Bc a rise in price = large impact on how much money left to buy other goods
- Likely to respond more to a change in Px of such goods (link back to defn!)
- E.g. trip to London vs. table salt
Degree of Necessity
- Necessities = goods essential for survival for which there are no substitutes
- e.g. food, housing, medical care
- Lower deg. of necessity = luxury goods, which one can easily make do without
- Habit-forming goods: Higher deg. of nec., less likely to respond
- Cigarettes, Alcohol and other vices
- Px inelastic
EV: Diff. culture have varying deg. of nec. for certain goods
- Rice in Asia, pasta-based goods in EU
Number and Closeness of Substitutes
- Many and close substitutes = higher abs. PED value (>1)
- If Px of good increases, consumers can easily switch to relatively lower priced substitutes
- If mkt is broadly defined, there are fewer close substitutes (e.g. no substitutes for beverages, but many substitutes for soft drinks)
Time Adjustment Period
- The more time to adjust, the more Px elastic
- SR: Inelastic, as conrs may be unable to find good alternatives or easily change consumption patterns
LR: Elastic, more time to find or develop suitable substitutes and implement change to con. pattern
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INCOME ELASTICITY OF DEMAND
Measures degree of responsiveness of demand of a good to a change in consumer income, cet. paribus
- Note: Change in income shifts DD curve. Not a movement along DD curve!
Determinants
- Note -ve or +ve, and extent
Degree of necessity of good
- Income inelastic DD: 0 < YED < 1: Necessities; increase in Y leads to less than prop. increase in DD, e.g. staple food
- Income elastic DD: YED > 1: Luxury goods; increase in Y leads to more than proportionate increase in DD, luxury cars, restaurant meals
- Positive Y elasticity, YED > 0 means DD and Y move in same direction*
- Negative income elastic DD: YED < 0: Inferior goods, DD and Y move in opp. directions
- These gds have better qly substitutes available; as Y increase conrs will stop buying inf. goods and switch to sub.s
- E.g. hawker centre meals, budget airline flights
- Note: Not much discussion on more/less than prop. decrease in DD.
- Degree of nec. is dependent on...
Income levels
- Whether gd has high or low YED depends on Y level of conrs
- Ppl w/ lower Y respond differently from those with higher Y
- For high Y, meat may be considered necessity (0<YED<1)
- Low Y: it is a luxury good, YED > 1, DD may increase substantially
Consider LDC vs DC
Cultural Considerations
- Conr behaviour affected by culture of their cty
- Asia: Rice is a necessity, DD more Y inelastic than other countries
Uses of YED
Producers
- Affects type, amount and where
- Note: YED is not relevant in helping firm decide pricing policy (why??)
1. Production Plans
If Y is rising/expected to rise (due to EG):
- Likely to increase DD for YED > 0 goods (luxury and necessity)
Firms will:
- Type + amt: Increase production of normal/lux goods/ expand production facilities
- Type: Try to make YED more elastic; make them more luxurious by offering higher-end services, etc.; such that DD will increase more than prop.
If Y expected to fall (recession):
- Type: Switch to producing inferior goods (YED < 0)
- Mkting strategy: Promote gds as value-for-$$ (appeals to budget conscious conrs)
2. Location:
- Firm pdcing luxury goods: Locate their business where Y is rising strongly
- Vice versa
Government
- Can estimate effects of taxation policies
- If govt cuts Y tax, boosts Yd, can then use YED figures to calculate exact impact of tax cut on AD (how C increases)
- and hence determine how it affects tax rev. collected
CROSS ELASTICITY OF DEMAND
Measures the degree of responsiveness of DD for one good to a change in price of another good
Determinants
XED = 0, < 0 or > 0
Closeness of substitutes or complements
- XED positive and large: Very close substitutes; the closer the sub.s, the greater the effect of a change in Px of sub.s on the DD of the good
- Weaker substitute = positive and small
- XED negative and large: Very close complements; increase in Px of sub. leads to more than prop. decrease in DD of gd
- The magnitude of XED indicates degree of substitutability/complementarity
Uses of XED
Producers: Pricing policy
- If a firm and his rival's pdt has high XED, they must be alert to the pricing behaviour of his rival (e,g, Coke and Pepsi)
- If Coke decrease Px, Pepsi should follow suit bc if not will lead to more than prop. fall in DD
Note: if a firm produces 2 similar pdts (e.g. Coca-cola produces Coke + Sprite), should they reduce Px of coke?
Producer: Marketing Strategies
- Firms that have positive and large XED with another firm's good will try to reduce substitutability of their good
Product differentiation:
- Real differences: Increase qly, add features
- Perceived differences: Advertising, celebrity endorsement, improves customers' perception of good
- If negative and large XED, firm may link mkting strategy to the pricing policy of the other firm
- e.g. if Px of A falls, firm should stock up on B and display them more prominently
- e.g. can also bundle the 2 goods tgt for sale
PRICE ELASTICITY OF SUPPLY
Measures the degree of responsiveness of quantity supplied of a good to a change in its price, cet. paribus
- Note: movement along SS curve is brought on by change in DD (TIGERSIP)
Determinants
Level of Stocks / Ease of Accumulating Stocks
- High lvl of stocks = can readily get extra supplies of raw materials and components from inventories
- Able to respond quickly to a rise in Px by increasing o/p; PES>1
- Gd that can be stored easily w/o loss of qly or high expenses (ease of AS)
- Can easily store finished goods at low cost; able to meet sudden increase in DD (hence Px) by tapping on stocks, vice versa
- e.g. SS of processed food; PES higher than fresh food
Gestation Period
- SS of oil, iron ore and agri. pdts have long gestation periods
- Take years to make any substantial changes in Qss in response to change in Px; PES < 1
- Qss of beverages in coffee house can respond quickly to a change in Px as gestation period relatively short
- PES > 1
Availability of Spare Capacity
- By having sufficient spare cap., should be able to increase o/p quickly w/o a substantial rise in cost
- PES > 1
- O/p can be increased by using existing facilities to full capacity, however, the change in qty SS is limited as firms are unable to increase no. of hotel rooms (e.g.)
- Upon reaching full cap., it is more diff. to respond to a change in Px
- PES < 1
Degree of Barrier to Entry into Industry
- e.g. high BTE for industry of mineral extraction due to high initial capital outlay (high starting cost)
- When Px of minerals increase, few new pdrs can enter the industry to increase Qss, hence PES < 1
Factor Mobility: ease with which FOPs can be moved from one place/use to another
- Higher mobility = more price elastic SS
Geographical Mobility
- Ease with which FOPs can be physically transferred from places
- Enhanced if pdction areas in close proximity
- e.g. rising house Px in Shanghai, need to increase Qss of new housing
- Employ construction wkrs from nearby cities, can provide accommodation to ease their relocation
- Higher geog. mobility, better able to respond to change in Px
- PES > 1
Occupational Mobility
- Ease w/ which one pdr is able to transfer their wkrs from one use to another
- Enhanced if wkrs possess a variety of skills or if skills needed for both pdts are similar in nature
- e.g. Textile pdtion simpler, does not require highly skilled lbr
- Px increase, textile firm can employ more units of lbr and increase Qss easily; PES > 1
- e.g. Medical industry requires specially trained personnel
- With rise in DD and Px of medical services, hospitals unable to employ more medically trained personnel w/in short period of time to increase Qss; PES < 1
Time Adjustment Period
- SR: firms can increase o/p by using existing facilities to full capacity
- e.g. pay workers OT or hire more wkrs, Qss can increase somewhat
- Change in Qss limited as pdr unable to increase amount of input, e.g. heavy machinery
- LR: All FOPs (as compared to above only lbr and not capital) are variable; sufficient time for all inputs to be increased
- Pdrs can increase production capacity and new firms can enter industry
- Hence, SS more price elastic in LR (PES > 1)
To increase PES:
- Develop better storage systems
- Prolong shelf-life of pdts
- Develop better distribution systems
- SS-side policies (?)
- Hire wkrs with range of skills
- Allow inward migration of lbr
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EVALUATION
2. Measuring of elasticity values
- Only 3 factors in consideration: Px of good, income and Px of another good
- Other factors may be changing at the same time, causing Qdd or Qss to be changed
- Diff. to pinpoint what caused the change, may not actually be due to change in Px
- Value may be misleading
3. Elasticity values outdated
- Values obtained often are historical estimates of conr behaviour
- Mkt conditions may have changed; no longer relevant to that firm
- e.g. more substitutes will be developed as time goes by; PES and PED more elastic in LR
- Firms/Govts may make unwise decisions based on inaccurate values
1. Ceteris Paribus assumption
- Assume everything else remains constant in mkt other than the variables considered
- e.g. they assume cost conditions remain the same when pdtion changes
- However, e.g. PED > 1: Decrease Px = Increase Qdd more than prop = Increase TR
- But increase in Qdd requires an increase in pdtion which would lead to increase in COP
- Increase in cost may outweigh increase in rev