Factors affecting price elasticity of demand.

University Degree Business and Administrative studies

EP101 Microeconomic Theory and Applications Assignment I

I. INTRODUCTION

“Economics is the study of how people allocate their limited resources to satisfy their unlimited wants” (MILLER, R.L., 2000, p.5). In other words, it is all about studying how people make choice (ESTRIN, S., LAIDER, D., 1995, p.1). In making choices, consumers show their preferences which maximises the level of satisfaction.

The indifference curve analysis is used to depict customer’s preferences graphically. This paper is meant to distinguish inferior good from normal good by using indifference curve analysis as well as illustrating how price elasticity of demand is different between these two types of goods. There are several things that I would like you to pay special attention to. First, to simplify work, it is assumed that there are only two goods for the consumers to choose from, namely food and clothing, to create their own basket of goods and services (bundle). Second, I am only concerned with the “goods” but not the “bads”. That is, in my analysis, I will treat all goods as desirable. Third, throughout the analysis, whenever indifference curve is in regard, I will measure food on the horizontal axis and clothing on the vertical axis. Lastly, not all the figures here are drawn to scale.

II. INDIFFERENCE CURVE ANALYSIS

Indifference Map

Since a certain level of satisfaction is resulted from consuming goods and consumers have the ability to show their preferences (one combination over the other or two or more bundles being considered to be providing the same level of satisfaction, making him/her indifferent), an indifference curve can be drawn by joining all the combinations of bundles that a consumer sees as indifferent. By forming a set of indifference curves, the result is an indifferent map.

Figure 1.1 shows three indifference curves μ1, μ2 and μ3. Note that I will stick to the four assumptions that were mentioned in Pindyck and Rubinfeld’s “Microeconomics”: 1) Completeness 2) Transitivity 3) More is better than less 4) Diminishing marginal rate of substitution. Therefore all the three indifference curves slope convexly downward from left to right and that any indifference curve lying to the right of an indifference curve carries combinations of the two goods that provide higher level of satisfaction (3 & 4). This particular consumer feels indifferent between point D and point B but point A is preferred to D and B while point E is even more preferred to A, B and D (2).

Budget Constraint

So far I have only taken into consideration of consumer preferences but leaving a very important element yet to discuss – budget constraint. With the indifference map alone we can only tell which bundle is more preferred to the other but we cannot tell exactly which point the consumer will choose to maximise satisfaction with a given budget. The budget constraint of the consumer can be illustrated by drawing a straight line connecting all possible combination of F (amount of food) and C (amount of clothing) that the consumer can purchase with ALL of his/her income. The assumption here is that s/he will spend all, saving is being left out. Figure 1.2 shows an example of a budget line where M is the total amount spent (which should be equal to the total income). Any point to the right of the budget line cannot be accommodated by the consumer with the given income.

By combining the indifference map and the budget line, a model of consumer choice can be formed, stating the point where the consumer can achieve the highest affordable possible satisfaction which is indicated by the point on the indifference curve which is tangent to the budget line. This is illustrated by Figure 1.3 below.

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We can see that consumer equilibrium is at point A where s/he can obtain the highest possible and affordable satisfaction and is with no tendency to change (since any point on μ1 has a lower level of satisfaction and those on μ3 and on μ2 other than A are not affordable). Consumption is at (F1,C1). With an increase in income or a decrease in price of either good, the budget line will shift outward, resulting in a different equilibrium (maybe at E or any point that is on a higher indifference curve and is tangent to the budget line).

Normal Good VS Inferior Good

By definition, a normal good is one that the consumer wants to buy more as the his/her income increases while an inferior good lies on the contrary, quantity demanded drops as the consumer earns more.

When price changes, there will be two effects, namely substitution effect and income effect. Substitution and income effects for normal good work in the same direction. That is, both are > 0 during a price fall and both are < 0 during a price increase so demand curve slopes downward.

However, this is not the same for inferior goods in which the income and substitution effects move in opposite direction. While substitution effect always stay > 0 for both types of goods when there is a decrease in price, income effect will be < 0 (demand drops) although the price fall means a relative increase in the real purchase power. This exactly reflects the nature of an inferior good.

Income and Substitution Effects for Normal Good

a). Substitution Effect

When price falls, the consumer will consume more of food (from F1 to F2) that has become cheaper and less of clothing (from C1 to C2) that is now relatively more expensive. The new budget line becomes B2B2 where the consumer chooses to consume market basket B on the same indifference curve μ2 (considering that s/he started off at A on μ2). This effect measures the change in the purchase of the goods that results from the change in their relative prices alone. The result is a movement along the indifference curve (from A to B). In this case the utility (satisfaction) remains constant.

b). Income Effect

The consumer enjoys an increase in real purchasing power (represented by a shift of budget line from B1B1 to B1B3 which is parallel to B2B2) because s/he can buy the same amount of food for less money and thus has money left for additional expenditures (purchases). The consumer chooses to buy at market basket D at F3C3. It is a change in the consumption of the goods resulting from the change in the purchasing power of money that occurs as a result of a price change. In this case the utility increases, lying on μ3.

E) The Income and Substitution Effects for Inferior Good.

Now let’s see Figure 1.5 which shows the situation when food is an inferior good.

The consumer started off equilibrium at market basket A (consuming F1C1 on μ2) on budget line B1B1. A price fall in food shifts the budget line to B1B3 (due to the income effect), where the consumer chooses market basket D on indifference curve μ3, consuming F3C3.

The substitution effect could be measured by drawing a new budget line B2B2 which is parallel to budget line B1B3, and is tangent to indifference curve μ2, intersecting at the equilibrium B (consuming F2C2).

Now we can see that on the higher budget line B1B3 the consumption of food is at F3 while the consumption of food is more at F2 on the lower budget line B2B2. This means that with an increase in income there is a decrease in the consumption of food. This exactly fits into the definition of an inferior good.

However the substitution effect is larger than income effect in this case and the demand curve still manages to slope downward as every other normal goods. In real life, there can be case that the income effect is large enough to overweigh the substitution effect, thereby forming an upward sloping demand curve. These goods are generally known as Giffen Goods (named after Sir Robert Giffen). All inferior goods, other than the giffen goods, should have a downward sloping demand curve. The difference is that the demand curve of a normal good should have a more flattened slope than that of the inferior good since the aggregate change in quantity demanded when reacting to a price change is larger for a normal good. Having said this will lead to the next topic – Price Elasticity of Demand.

III. PRICE ELASTICITY OF DEMAND

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price, with all other factors held constant. A drop in price will attract the existing consumers to buy more and the new consumers to try, hence increasing the quantity demanded and vice versa. Price elasticity of demand, Ed is used to measure the percentage change in quantity demanded with a 1-percent change in price. Therefore Ed is defined as the magnitude of: (%ΔQ) / (% ΔP) where Q is quantity demanded and P is price. Since price and quantity demanded usually move in the opposite directions (a price rise will lead to a fall in quantity demanded and vice versa), Ed is usually a negative number but many times Ed is taken as an absolute value, therefore being positive.

Price Elasticity of Demand – Normal Good

As previously mentioned, the demand curve for a normal good is more flattened in shape than that of an inferior good due to the fact that the aggregate change in quantity demanded for an inferior good during a price fall will be weakened by the income effect (an increase in real purchase power leads to a decrease in quantity demanded).

Figure 1.6 corresponds to Figure 1.4 (normal good) in terms of F123. The consumer was originally at point α with P1F1. If price falls to P2, s/he changes to consume at point β consuming at F3. This change can be broken down into two parts: F1F2 (substitution effect) and F2F3 (income effect). Since for normal good a fall in price will result in both substitution and income effects being > 0, F1F3 is substantially high. The price elasticity of demand for this can therefore be expressed as:

Ed = (F3 – F1) / (P2 – P1)

It would be clearer if I plug in some figures into this formula. Let’s make the following assumptions:

F1 = 15 units

F2 = 25 units

F3 = 30 units

P1 = $10

P2 = $5

Then the formula will look like this:

Ed = (F3 – F1) / (P2 – P1) = (30 - 15) / ($5 - $10) = -3

Price Elasticity of Demand – Inferior Good

Figure 1.7 corresponds to Figure 1.5 (inferior good) in terms of F123. Same as Figure 1.6, the consumer started off at point α with P1F1. If price falls to P2, the consumer changes to point β with P1F3. If the substitution effect is considered alone, the quantity demanded will change to F2, that is > 0. However, when the income effect is taken into account, the quantity demanded falls to F3 (that is, income effect < 0) since a price fall (higher relative income) will lead to a lower consumption of inferior goods. While the income effect diminishes the aggregate change in quantity demanded, F1F3 is relatively low when compared to that of the normal good in Figure 1.6.

Once again the following numbers are plugged in:

F1 = 15 units

F2 = 25 units

F3 =23 units

P1 = $10

P2 = $5

Then the formula will look like this:

Ed = (F3 – F1) / (P2 – P1) = (23 - 15) / ($5 - $10) = -1.6

Price Elasticity of Demand – Normal VS Inferior Goods

Now we can draw the conclusion that income effect can increase the price elasticity of demand for normal good but decrease that of the inferior good.

Factors Affecting Price Elasticity of Demand Other Than Income Effect

Besides income effect, there are other factors that might affect price elasticity of demand of a certain good. Miller, Pindyck and Rubinfeld suggested the followings which I found more important.

Availability of substitutes: the more possible substitutes and the closer they are, the greater the elasticity. If the price of fountain pens increases, more people will swift to use ball pens.
Degree of necessity or luxury: luxury products tend to have greater elasticity since people do not always need them while necessity products (such and food and clothing) are part of people’s life and there can be a minimal change in quantity demanded even with a raise in price. Habit-forming products can become "necessities" to some consumers.

Proportion of the purchaser's budget consumed by the item: products that consume a large portion of the purchaser's budget tend to have greater elasticity since a price increase will then represent an essential effect on the total budget.
Time period considered: elasticity tends to be greater over the long run because consumers have more time to adjust their behaviour and more people will know about the price change after a certain period of time. However for some durable goods, opposite happens since the consumers will halt their purchase decision in the short run until they are forced to replace the old stocks in the long run.
Permanent or temporary price change: similar to d), not many people will notice a one-day sale and hence will elicit a different response than a permanent price decrease.

IV. CONCLUSION

From all the analysis above, the aggregate increase in quantity demanded for an inferior good during a price fall is less than that of the normal good due to the negative income effect of the inferior good (an increase in relative income or real purchase power leads to a decrease in consumption).

As for price elasticity of demand, since income effect diminishes the aggregate increase in quantity demanded for an inferior good during a price fall, an inferior good is less price elastic in demand than a normal good.

However, this paper did not discuss how other factors may also affect price elasticity of demand such as availability of substitutes, time period to be considered, etc. Generally speaking, knowing whether a good is inferior or normal can help predict the possible changes to consumer behaviour when there is a change in price, hence, minimising the risk associated with any pricing strategies. For the same token, we can as well categorise goods after experiencing the results in demand with a price change. This helps management plan marketing strategies and marketing mix.

V. REFERENCE

ESTRIN, S., LAIDER, D., (1995), Introduction to Microeconomics, 4th Edition, New Jersey: Prentice-Hall, Inc.
MILLER, R.L., (2000), Economics Today, 10th Edition, New York: Addison-Wesley Publishing Company Inc.
PINDYCK, R.S., RUBINFELD, D.L., (2001) Microeconomics, 5th Edition, New Jersey: Prentice-Hall, Inc.