Question

Define three types of elasticity of demand. Indicate how you would use information from recent research paid by your company that the own 0.8 as previously thought. price elasticity of your product is-1.2and not-

Answer 1

Three types of elasticities-

1. Own price elasticity of demand - It gives by how much percentage the quantity demanded of a good will change if the price of that good increases by one percent. It is a negative quantity in case of ordinary goods whose demand declines when price increases but it is a positive quantity if the good is a Giffen good whose quantity demanded increases when price increases.

2. Income elasticity of demand- It gives by how much percentage the quantity demanded of a good will change if the income of the consumer increases by one percent. It is a positive quantity for normal goods whose demand increases when consumer's income increases but a negative quantity for inferior goods whose quantity demanded decreases when consumer's income increases.

3. Cross price elasticity of demand- It gives by how much percentage the quantity demanded of good X will change if the price of good Y increases by one percent. It is a positive quantity for those goods which are substitute of each other and a negative quantity for those goods which are complement of each other. When goods are substitute of each other ( like Coke and Pepsi) then if the price of one good increases, consumers shift to another good and the other good's consumption increases. When Goods are complement of each other then they are consumed together like bread and butter, so if price of one good increases, consumers demand less of the other good as well.

If the research shows that own price elasticity of demand of our good is -1.2 and not -0.8 then this means that the demand for our product is relatively more responsive to the changes in price. If we increase our product's price by 1% then the demand will decline by 1.2% whereas earlier it was declining by only 0.8%. Hence increasing the price of the product might decrease our revenue. Because the increase in revenue (revenue = quantity demanded X price ) resulted by price increase might be more than compensated by decline in quantity demanded, which is quite likely if the price is already high. Hence, now we will look for other options ( like cost cutting) to increase our profits rather than increasing our price.