Price Elasticity and Income Elasticity of Demand

 The reason why could be found if looked at the non-price determinants of elasticity. Those are: the substitution effect, the income effect, the degree of necessity, the addictive nature of the product, the number of uses of the product and the time period covered.

I will use wheat as an example of a primary commodity. Generally, wheat only has a few close substitutes. The less substitutes for a product, the more inelastic it becomes as there is less choice for the purchaser. An increase in price wouldn’t change demand by that much. Also, wheat tends to be relatively cheap. This means that it will only consume a small portion of the purchaser’s expenditure and so, an increase of price won’t affect them. Since primary commodities are a necessity, demand tends not to change that much if price changes – rendering it inelastic. Lastly, wheat is consumed immediately – in the short term.

This means that wheat, or primary commodities, are inelastic because products that are consumed in a short amount of time tend to be more inelastic.

Manufactured goods, on the other hand, such as laptops, are elastic in nature. Nowadays, laptops have a relatively high amount of close substitutes. For example, the gaming aspect of laptops could be replaced with gaming consoles. In this case, there is a choice for consumers to change what they buy. This means that if the price of laptops increase, consumers could switch to different, alternative products. Also, manufactured goods tend to be more of a luxury than a necessity. A huge increase in price will result in a significant decrease in demand. Normally, laptops are a big proportion of a consumer’s expenditure and that it is used over a long period of time. This causes laptops to be of elastic nature.

(b) Examine the importance to producers of price elasticity of demand and income elasticity of demand. [15 marks]

Both price elasticity and income elasticity are both indicators to producers of how much they need to either increase or decrease price in order to gain revenue.

Elasticity would determine how consumers react to price changes which would help producers to react accordingly in order to raise revenue. If a product is price inelastic, or that a change in price won’t affect demand by a significant degree, a price cut will increase sales but decrease total revenue. Conversely, an increase of price would result in a decrease of sales, but increase total revenue. This could be seen from figure 1.1

Figure 1.1 (Inelastic = 0 > PED > 1)

The decrease from P1 to P2 resulted in a much lower increase in demand (Q1 to Q2). In this case, total revenue fell. Equally, if price increases from P2 to P1, it will result in a much lower decrease of demand (Q2 to Q1) and total revenue would rise.

If a product is price elastic, an increase of price would lead to a bigger percentage of decrease in demand – causing total revenue to fall. Oppositely, if price decreased, demand would increase by a bigger percentage. This would increase total revenue.

Figure 1.2 (Elastic = 1 < PED < Infinity)

If price falls from P1 to P2, QD would increase by a bigger percentage from Q1 to Q2 and total revenue rises. Conversely, if price increases, it would lead to a fall in total revenue. A rise in price from P2 to P1 would a bigger decrease of demand. In this case, total revenue decreases.