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Economics (Term Paper Sample)


Brief explanation of some economic terms.


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Elasticity of demand is the degree to which demand for goods or services varies with its price. Normally, sales increases with a drop in price and drop with increase in price.
Price elasticity of demand (PED)= % change in quantity demanded / % change in price. If PED=0, then the good is perfectly inelastic. If 0˂PED˂1 in absolute value, then the good is relative inelastic. If 1˂PED˂∞ in absolute value, then the good is relative elastic. If the PED=∞, then the good is perfectly elastic.
The rate of response of quantity demanded of one good due to a price change of another is called the cross-price elasticity. If two goods are substitutes, the demand of one good will increase when the price of the other good increases. When two good are compliments, the demand of one good will go down when the price of another good increases (Samwelson, 2001). Cross-price elasticity for two goods X and Y is
Exy= % change in the quantity X demanded/% change in the price of Y
If Exy ˂ 0, ie Exy less than 0, then X and Y are complements. When the price of X increases, the demand of Y decreases and vice versa.
If Exy=0, then X and Y are independent. As the price of X increases, the demand of Y remains constant.
If Exy ˃ 0, then X and Yare substitutes. When the price of X increase, the demand of Y increases and vice versa.
Income elasticity of demand is the measure of the rate of response of quantity demand due to an increase or a fall in the consumer income.
Income elasticity of demand (IEoD)= % change in quantity demanded/ % change in income
If IEoD˃1 then the good is a luxury and its demand decreases when the consumer income goes down and increases when consumer income goes up. If 0˂ IEoD˂1, then the good is normal and a necessity. It is not much affected by change in consumer income. If IEoD˂0, then the good is an inferior good. Its demand goes down when the consumer income goes up. This is because the consumer will shift to luxury good. If IEoD=0, then the good is not affected by the shifts in the consumer income (inelastic demand).
Whereas, in the price elasticity of demand we measure the responsiveness of the demand of a good due to changes in its price, in cross-price elasticity we measure the responsiveness of demand of a good due to changes in the prices of other goods. The other goods, in this instance may be substitutes or complementary goods. In contrast with these two instances, the income elasticity of demand measures the responsiveness of demand relative to changes in the consumer income levels. We try to answer the question, “how would the demand of good X respond to a change in the income level of the consumer?”
The elasticity therefore is significant to the producers because it enables them to determine the relationships between the pricing and the total company revenue. It enables them to know the extent to which high pricing can compromise the demand of their goods and revenue. It can also help in determining the complimentary goods so that the company may start producing them together. It is also important in analysing time lags in production.
Availability of substitutes makes demand for a particular good more elastic. This is because the consumers have alternatives and can easily shift if pricing is not appealing to them. When the proportion of the consumer's income expressed in percentage terms against the product's price is high, the elasticity is also high as consumers will give more consideration and will be more sensitive to its price when making a decision on whether to buy or not. Generally, product demand is more elastic when there is longer time period for consideration and search for substitutes. Consumers often need time to adjust to changes in prices. Price elasticity of demand is greater if longer time period is involved (Samwelson, 2001).
For the case of substitutes, an example is that if the price of chicken goes up, people may resort to eating fish if its price is relatively low. Therefore businesses that sell chicken should include the fish sellers in their list of competitors. If price of a rented house is 30% of the tenant’s income, it is likely the tenant will react more furiously when there is rent increase as compared to a tenant whose rent to salary proportion is 1%. This means that analysing the customers’ income should be part of the company’s market strategies. As fuel prices rise suddenly, consumers may still refill their tanks in the short run. However, when prices continue to remain high over a longer period of time, many people will curtail their demand by changing to carpooling or public transportation and purchasing vehicles with greater fuel economy. This may not apply to the consumer durables like cars. However consumers may have to replace their present cars with more economical ones, making the demand less elastic.
In business decision making, strategists should carry out operations research to determine the optimal pricing that would bring maximum profits (Samwelson, 2001).
Perfectly inelastic demand means that quantity demanded is unaffected by any change in price. The product does not have any substitutes and irrespective of the price consumers keep purchasing the same quantity. The elasticity coefficient is zero. In other words, the quantity is essentially fixed. It does not matter how much price changes, quantity does not budge. When demand is perfectly elastic the quantity demanded will remain constant at the equilibrium price and an increase in price will make the consumers stop buying the item...
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