In order to maximize profits, price and income elasticity of demand concepts can be applied by firms in order to come up with their business strategies. Hence, this essay aims to discuss about the impact of price and income elasticity of demand on automobile firms' decision and how the extent of elasticity can be applied to the relatively monopolistic automobile market.
Price elasticity of demand measures the responsiveness of quantity demanded of a good to a change in its price, ceteris paribus. The demand for the good is said to be elastic if the change in price results in a more than proportionate change in quantity demanded. Conversely, the demand for the good is said to be inelastic if the change in price results in a less than proportionate change in quantity demanded. Hence, if a firm expects the demand for its good to be price elastic, then it should lower the price.
[Insert a diagram with both demand elastic and inelastic curves]
A decrease in price will result in a more than proportionate increase in quantity demanded if demand is elastic. Therefore, total revenue is raised.
Conversely, if the firm expects its demand for good to be price inelastic, it should raise the prices to increase its revenue. This is because an increase in price will result in a less than proportionate decrease in quantity demanded.
Firms may also want to differentiate their goods in order to make the demand more price inelastic and hence raising their profits. This is because it enables firms to charge a higher price but yet sell more output, thus raising its total revenue. Product differentiation can be real differences or imaginary differences. Real differences include differences in size, colour and taste, specifications and quality of physical product. These can be altered often through research and development. Imaginary differences include brand loyalty and packaging. These can be done through persuasive advertising and innovative packaging.
Income elasticity of demand measures the responsiveness of the demand for a good to change in income, ceteris paribus. Positive income elasticity of demand of a good means that the demand for the good increases as income increases, conversely as income falls, demand for good falls. These goods are known as normal goods. These normal goods can then be classified into normal-necessity goods and normal luxury goods. Conversely, negative income elasticity of demand of a good means that the demand for the food decreases as income increases. These goods are known as inferior goods. Understanding income elasticity help firms decide in the type of goods to sell under different economic conditions. If a country is facing strong economic growth, firms should sell more normal goods, especially normal luxury goods where an increase in income will result in a more than proportionate increase in demand. However, during an economic downturn, the demand for normal goods falls. Normal necessities fall less than proportionately while normal luxuries fall more than proportionately. Firms may then want to consider producing and selling more inferior goods instead.
In the context of the automobile market which faces monopolistic competition, although there is product differentiation, demand is likely to be price elastic due to high availability of substitutes. Hence, the firms should lower its prices to raise its revenue. However, in terms of product differentiation, a monopolistic market may not have the economies of scale to spread cost overheads. Hence low cost innovation is possible but not high investments on research and development. In the long run, automobile market only earns normal profits.
Secondly, automobiles are considered to be normal luxury good that increases more than proportionately if income increases. Thus if economic growth is strong, they should decrease the price.
However, there are limitations of applying demand elasticity concepts. The estimates are based on past dates and resources hence, the data may not be applicable to current business environment as business conditions would have changed. Changes include a more affluent society due to greater economic growth and hence can represent status quo instead.
In conclusion, automobile producers are able to make use of price and income elasticity to help determine the pricing and output decisions. This allows the firms to raise output more easily and capture a greater market share. Therefore, there are a lot of possible uses for PED and YED concepts as applied to business.
JC Economics Essays: H1 H2 'A' level Economics Essay part (b): economics tutor's comments - For A level Economics, elasticity concepts are very important - as immediate revision, try to recall the definitions, the mathematical formulae, and what the magnitude of the numbers (or the sign, negative or positive, of the numbers) mean. This would be good economics revision for elasticity questions, and a very useful skill to have during examinations. Then, after recalling the economics material, try to apply the concepts to a particular context - in this case, the context of the economics exam question. Remember that students need to use real world examples in conjunction with economic theories. Economics tutors and examiners always appreciate good examples that are relevant, clear, and well known; however, this economics paper has actually done a rather good theoretical job without having relevant examples of car companies (in the USA, or Europe, etc). How else could this economics paper be better developed or improved? Thanks to students for contributions.
