Elasticity Of Demand While Setting Prices Essay

Questions:

1.As a producer, why is it important to consider the price elasticity of demand of your product when setting the price you are going to charge?

2.Explain the difference between Comparative advantage an absolute advantage.

Answers:

1.Price Elasticity of Demand

Introduction

‘Price elacticity of demand’ is defined as the the “degree of responsiveness of a change in demand to a change in one of its determinants while other determinants remain unchanged.” It is measured (Chauhan, 2009)


‘Price Elasticity of Demand’. Source: (Chauhan, 2009). Prepared by Author

The Consideration of Elasticity of Demand while Setting Prices.

Prices elasticity of demand is one the single most important factors to be taken into consideration while setting prices. If the price elasticity of a product is high, then even a slight increase in the prices will result in a large decrease in demand. Generally, goods will close substitutes (e.g: Coca Cola and Pepsi) and moderately luxury goods are highly price elastic. In such cases, producers may have to wary of increasing prices. In such situations, the increase in supply costs may have to be absorbed by producers to a great extent instead of passing it on to the consumers. (Baumol & Blinder, 1991)

On the other hand, if the price of a product is highly inelastic, then an increase or decrease in the prices does not affect the demand to a great extent. In general, the demand for everyday necessities is highly inelastic. For example, the price of sugar is highly inelastic in shortrun. Hence, even a high increase the prices will bring not result in a significant decrease in demand. In such cases, the increased costs may be transferred to consumers. (Baumol & Blinder, 1991

2.Comparison of Absolute Advantage and Comparative Advantage

The terms ‘absolute advantage’ and ‘comparative advantage’ are used in context of international trade within the of process of decision making regarding which products or services must be produced in order to maximize output. However, the ideas can be generalized for individuals and firms too.

Absolute Advantage

‘Absolute advantage’ is the advantage a country or a firm may have in producing a good or service that it can produce at the ‘lowest input costs’ and by using the minimum amounts of resources’ as compared to its competitors. (Mankiw, 2001)

Comparative Advantage

Comparative advantage refers to the “ability of a country to produce goods at a lower opportunity cost.” (Tucker, 2010) .Comparative advantages generally arise from specialization of skills or can be gained if a factors of production is present in abundance.“Comparative advantages are generally ascribed to supply side differences between countries in their technologies (as in the Ricardian Model) or in their factors endowments (as in the Hecksher Ohlin Theory).” (Maneschi, 1998)

According to Ricardo, “gains from trade are based only on comparative advantage.” Hence, countries or firms should produce goods and services that they have a comparative advantage in. (Mankiw, 2001) Hence, while making decisions regarding which product or service to specialize in, a country or firm must evaluate its comparative advantage. (Tucker, 2010)

Example

Source (Mankiw, 2001). Adapted by Author.

John and Gary both have skills in painting as well as in doing wall papers. The following are their outputs in each task per day.

Output per Week

Painting

Wall Paper

John

20

5

Gary

10

4

John has absolute advantage in painting as well as doing wall papers. However, to paint every room, John, gives up the production of wall paper in (5/20 = 0.25) 0.25 rooms. This is John’s opportunity cost for painting. Similarly, Gary has an opportunity cost for painting of (10/4= 0.4) 0.4 wallpapers. Thus, John has comparative advantage for painting.

If they work without specializing in any task:

Table 1: Output Without Specialization in 3.5 days

John

Gary

Rooms Painted

Rooms wall papered

Rooms Painted

Rooms wall papered

10

2.5

5

2

If John and Gary were to specialize in services they had a comparative advantage in, then:

Table 2: Trade with Specialization in half a week

John

Gary

Rooms Painted

Rooms wall papered

Rooms Painted

Rooms wall papered

14

1.5

2.5

3

Diagram 1 : Output and changes in output for Gary and John for 3.5 days

Hence, Total Consumption with Specialization and trade would be:

Table 3 Total Output due to specialization

Rooms Painted

Wall papers

Trade without specialization

15

4.5

Trade with specialization

16.5

4.5

Diagram 2 Total Output for 3.5 weeks

The benefits of specialization for Gary and John are as follows

Table 4: Individual Output with specialization and trade

John

Gary

Rooms Painted

Rooms wall papered

Rooms Painted

Rooms wall papered

14-3 = 11

1.5 +1= 2.5

2.5 +3 = 5.5

3 -1 =2

Bibliography

Baumol, W. J., & Blinder, A. S. (1991). Microeconomics: Principles and Policy.

Chauhan, S. (2009). MICROECONOMICS: Theory and Applications, Part 1. New Delhi: PHI.

Maneschi, A. (1998). Comparative Advantage in International Trade: A Historical Perspective. Cheltenham: Edward Elgar Publishing Limited.

Mankiw, G. ( 2001). Principles of Micro economics, 2nd Edition. Orlando, FL USA: Harcourt Brace & Company.

Tucker, I. (2010). Microeconomics for Today 6th Edition. Mason OH, USA: Cengage Learning

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