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Topics: Supply and demand, Price elasticity of demand, Elasticity Pages: 12 (2748 words) Published: February 1, 2013
1. F. James McDonald the former president of the US automobile workers federation suggested an average reduction of 4% in the price of the car. The automobile market was weak, which resulted in unemployment. Lower price would lead to greater sales and stimulate employment. McDonald believed that a 4% reduction in price would increase sales by 16%.David black, representing the management of the automobile manufacturers disagreed with McDonald’s estimation. Black cited studies which indicated price elasticity’s ranging from 0.5 to 1.5.Black made it clear that he was referring to the elasticity of demand in response to a permanent price change of all manufacturers. He admitted that the elasticity to a temporary price cut might be greater. The studies to which Black referred found elasticity’s ranging from 0.65 to 1.53.

a. Explain the concept of elasticity of demand and the factors that affect it.


From the decision-making perspective, the firm needs to know effect of changes in any of the independent variables in the demand function on the quantity demanded. Some of these variables are under the control of management, such as price, advertising, product quality, and customer service. For these variables, management must know the effects of changes on quantity to assess the desirability of institution the change. Other variables, including income price of competitor’s products, and expectations of consumers regarding future prices, are outside the direct control of the firm. Nevertheless, effective forecasting of demand requires that the firm be able to measure the impact of changes in these variables on the quantity demanded.

The most common used measure of the responsiveness of the quantity demanded to changes in any of the variables that influence the demand function is elasticity. In general, elasticity may be through of as a ratio of the percentage(%) change in one quantity(or variable) to the percentage(%) change in another, ceteris paribus(all other things remain unchanged). In other words, how responsive in some dependent variable to change in a particular variable? With these in mind, we define the price elasticity of demand(Ed) as the ratio of the percentage (%) change in quantity demanded to a percentage (%) change in price.

Where [pic]Q= Change in quantity demanded

[pic]P= Change in Price

Because of the normal inverse relationship between price and quantity demanded, the sign of the price coefficient will usually be negative. Occasionally, price elasticity’s are referred to as absolute values. The use of absolute values will be indicates where appropriate. Problems result when calculating elasticity if initial prices and quantities are used as bases, so economists typically use midpoint bases. The price-elasticity of demand is negative but, for convenience, we use absolute values to avoid the negative sign.

If price elasticity is less than one, then demand is relatively unresponsive to changes in price and is said to be inelastic. If elasticity is greater than one, demand is very responsive to price changes and is elastic. Demand is unitarily elastic if the elasticity coefficient equals one. Elasticity, price changes, and total revenues (expenditures) are related in the following manner: If demand is inelastic (elastic) and price increases (falls), total revenue will rise. If demand is elastic (inelastic) and price rises (falls), total revenue (expenditures) will fall. If demand is unitarily elastic (ed = 1), total revenue will be unaffected by price changes. The number and quality of substitutes, the proportion of the total budget spent, and the length of time considered are three important determinants of the elasticity of demand. Demand is more elastic the more substitutes are available, the more of the budget the item consumes, and the longer the time frame considered. Along any negatively sloped linear...
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