Price elasticity of demand
Significance of price elasticity of demand - market research
Firm's marketing department researches the possible outcomes of a price change. If the good is elastic, a price rise could cause the demand for that product to be reduced. If the good were inelastic, a price rise would have little affect on the demand for that product.
Price elasticity
Elastic - a little change in price leads to a large change in quantity
Inelastic - a large change in price leads to little change in quantity
Unit elastic - change in price is proportionate change in quantity
Calculation of elasticity using total outlay method
Total Outlay = Price x Quantity
Falling - Relatively elastic
Unchanged - Unit elasticity
Rising - Relatively inelasticity
Factors affecting elasticity of demand
- If the Good is a luxury good or necessity - Luxury goods tend to have an elastic demand and necessities tend to be inelastic
- The existence of substitutes - Where substitutes exist, demand tends to be elastic
- Whether the item constitutes a large or small proportion of a personal income - The demand for expensive items tends to be elastic whereas demand for cheaper items tends to be inelastic
- The length of time since a price change - Demand becomes more elastic the greater the length of time since the price change. This is because consumers have time to respond to price changes and switch products.
Price elasticity of supply
- Elastic supply - the quantity supplied to the market changes significantly when the price changes a little
- Inelastic supply - a small reaction in the quantity supplied when the price changes a little.
Factors affecting supply
- Time lags after a price change. Following a price increase a producer in the short run is restricted in their attempts to increase production. Supply will be virtually perfectly inelastic. This is because producers can only increase production by working their factors of production harder (labour + Capital). In the long run, the producer can increase inputs including the size of the production plant or capital to therefore increase production, in response to a price change, therefore making supply elastic.
- Ability to hold and Store Stock. The ability to hold stock will affect the ease at which producers can respond to price changes. The easier it is to hold stock the more elastic the supply. Whereas perishable goods is relatively inelastic.
- Excess capacity. If a firm is not operating with its existing resources at full capacity, supply is will elastic. This is because they now have allowance to respond quickly to any price increase simply by using existing resources more intensively, as opposed to half capacity.
Variations in competition
Market structures
Pure (perfect) Competition - A market structure where there are many buyers and sellers producing homogenous goods or services.
Market conditions characterized by:
- Many firms that is relatively small
- Homogeneous (identical) products
- No barriers to entry
- Sellers can sell all they can at market price
- Advertising is pointless
- Firms are price takers-market equilibrium price (consumers can leave and go to competition selling at lower prices) - Eg. Fish Markets, Fruit & Vege markets.
- Monopoly - A market structure where there is one large firm producing a unique product.
Market conditions characterized by:
- One firm selling product with NO competition
- No close substitutes
- Extremely high barriers to entry (govt regulations, high establishment costs)
- Firms are the price setter as it is the only firm that can provide the product/service
- Simple advertising (no need to "win" over consumers from competitors) - Eg. Sydney Water, Australia Post
Monopolistic Competition
- Market structure where there are many sellers producing differentiated products. No significant barriers to entry.
- Many firms that is relatively small
- Products are slightly differentiated - not identical thus giving firms some degree of price setting power
- Small barriers to entry - existing firms may have developed brand loyalty as result of product differentiation
- Advertising is important - Eg. Motels, Restaurants
Oligopoly
- Market structure consisting of a few large firms producing slightly differentiated products.
- Few relatively large firms each with significant share of market
- Similar but differentiated products
- High barriers to entry
- Sellers can sell all they can at market price
- Firms monitor behaviour of rival firms - compete through advertising rather than price-cutting - Eg. Supermarkets, Telecommunication
