Analysis the Elasticity of Demand and Its Effects on Companies

Topics: Price elasticity of demand, Supply and demand, Elasticity Pages: 13 (3500 words) Published: July 21, 2011
This report is prepared on behalf of Cows limited, a firm which specialises in the production and sale of high quality cheese. To analyse the performance of cheese in the market, some economic concepts must be understood.


Income Elasticity of demand

This is the measure of the responsiveness of demand to a change in income (Begg and Ward, 2007 pp.37). It measures how sensitive the demand of a product is to a change in the income of the consumers. It is measured as:

Income elasticity of demand (YE) = Percentage change in demand Percentage change in income
When the income elasticity of a product lies between 0 and minus infinity, it is an inferior product, and if the value is smaller than minus one (-1) the product is income elastic. The income elasticity of cheese is -1.46667 therefore it is an inferior and income elastic product. As the consumer income decreases, the demand of cheese will rise at a faster rate than the income of customers therefore shifting the demand curve to the right. This relationship can be shown graphically In Figure 1 below. At a constant price P0, a small drop in income of consumers will increase in the demand for cheese from point A to point B shifting the demand curve to the right.


P0 A B

D1 D2

Q1 Q2 Quantity

Figure 1: Income elasticity of demand.

Credit crisis and impact of the recession

Credit crisis occurs when funds are not available in the credit market, making it difficult for people or organisations to obtain credit from banks or other lenders. It occurred in the UK in 2007 and has since reduced the purchasing power of consumers and the ability to carry on with business. The recession which is a state of the economy when business activity declines and consumer spending is decreased.

In the recession, firms that focus on food production like Nestlé and Kellogs showed higher profit returns than counterparts that sell cleaning products because consumers prepare meals at home (The Economist 2009). Cheese is a consumer product which will still be consumed in the recession.

As an inferior product, more will be demanded by consumers due to the reduction in purchasing power. However in the recession, consumers are looking for a greater value for grocery purchases (Senauer and Seltzer, 2010). If the price of cheese is set too high, consumers would purchase a cheaper brand and this will reduce the demand and total revenue. Therefore, to increase the output and total revenue in the recession, the price of cheese should be reduced.

Cross price elasticity

This is the measure of the responsiveness of demand to a change in the price of a substitute or complement (Begg and Ward, 2007 pp.37).

Mathematically this can be expressed as:

Cross price elasticity (XYE) = Percentage change in demand of product X Percentage change in price of product Y
When the cross price elasticity of products lies between zero and plus infinity, they are substitutes. This means they render similar services to customers. The cross price elasticity of the most significant product that impacts the demand of cheese is 1.43333 this implies that the products are substitutes or rivals. This relationship can be shown graphically in Figure 2 below.

Price of substitute



Q1 Q2 Demand for cheese

Figure 2: Cross price elasticity.

As the price of the substitute increases from P1 to P2, consumers will demand less of it and more of cheese thereby increasing its quantity from Q1 to Q2.

Sensitivity to the price of other products/competitors.

As the price of the substitute product increases, the demand for cheese will...
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