Impact of Elasticity of Demand on Pricing

Economics - GDP Inflation

TABLE OF CONTENT
QUESTION 1...................................................................................................................................1
Impact of elasticity of demand on pricing ..................................................................................1
QUESTION 2...................................................................................................................................2
Economies of scale and long run average cost curve .................................................................2
QUESTION 3...................................................................................................................................3
Elements bringing growth in GDP per capita .............................................................................3
QUESTION 4...................................................................................................................................4
Impact of changes on substitution bias and new goods bias .......................................................4
REFERENCES ...............................................................................................................................5

QUESTION 1
Impact of elasticity of demand on pricing
Price elasticity is defined as the measurement of responsiveness of target customers
towards the changes made in price of products or services. Thus the parameter is important in
terms of evaluating the changes in profitability or revenues when operational factors such as
price are changed. Price elasticity describes the relationship between the demand and price of
products so that company can effectively modify its pricing pattern and strategy (den Hoed,
2016). It can be calculated by dividing the percentage change in demanded quantity of product
with percentage change in price.
At present the elasticity of demand (EOD) for the new drug of pharmaceutical company
is 1.4 which is greater than 1. It shows that demand is elastic and it respond in greater proportion
to price changes. As a result if company will enhance its price then it will result in significant fall
in the revenue. Thus it is recommended that with 1.4 EOD company must lower its prices so that
number of sales can be increased and overall revenues will also be increased. Elastic nature of
EOD indicates that either customers have other alternative product choices or they are highly
sensitive towards the changes in price.
(Source: Price elasticity of demand, 2019)
(MR is marginal revenue, TR is total revenue and AR is average revenue)
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Illustration 1: Effect of PED on revenue

On the other hand if company has EOD between 0 and 1 then demand is known to be
inelastic and responsiveness of customers demand is in lower proportion as compare to changes
in price. Thus when company will have EOD as 0.6 then company is suggested to enhance its
prices. Due to increments in price though number of sales will reduce but overall revenue
generation will be increased (Goodwin and et.al., 2015). If the drug is highly effective and
customers does not find any other alternative for the product then such products can achieve
inelastic demand and then even at higher prices there will be increment in revenue without
affecting customers purchasing decision.
EOD equals to unity shows that demand is unit elastic and thus there is equal proportion
of demand changes as variations in the price. Thus when EOD is 1, the company will be
receiving maximum revenue and there will be no impact of increasing or decreasing prices. In
such case company must keep its prices constant so that number so sales can be retained.
QUESTION 2
Economies of scale and long run average cost curve
The auto mobile industry integrates the technology, physical capital and labour for the
production processes. For the long term sustainability and profitability all firms are required to
select the most feasible technology so that variable costs can be achieved. Thus in order to gain
least possible average cost for long term companies will aim at replacing expensive inputs with
relatively inexpensive options. Among certain manufacturing industries such as auto-mobiles
there are situations in which average production cost for each unit reduces significantly as the
level of output or sales is increased (Bade and Parkin, 2015). This situation refers to the
economies of scale and is also one of the characteristics of auto-mobile industry.
The long run average cost (LRAC) curve indicates the minimum or the least possible
production cost (average) when all input variables of production can be varied in accordance to
the production technology chosen by company. For the auto-mobile manufacturing firms LRAC
curve has downward slope which indicate economies of scale. A flat curve represents constant
return on sale while upward slope is indicator of diseconomies of scale (Moosavian and Ali,
2016). Within diseconomies there is direct proportionality in average cost and number of output
levels while in constant returns average cost of the units is independent of changes in outputs.
The conjunction of LRAC with market demand helps in determining the number of firms which
can exist in the given market segment in terms of competitiveness and market demand.
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In the situation when demand is higher than quantity present at the bottom of LRAC
curve in addition to the minimum production cost then the industry may experience strict
competition and significant number of firms may fight for the survival. On the other hand when
the demanded quantity is lower than the bottom value at LRAC curve then it is assumed that
only one firm will be there to dominate the market and remaining firm may not have survival in
long term (Ha and et.al., 2019). Thus in the given situation as demand is for only 2.5 firms which
are at bottom of cost curve it is expected that out of the four firms, at-least one of the auto
manufacturer will have to face struggle and in long term it may not survive.
QUESTION 3
Elements bringing growth in GDP per capita
The aggregate production function explains the ways in which real GDP (Gross domestic
product) depends upon inputs. Thus the various elements of aggregate functions consist of
variables such as machines, production facilities, human capital, natural resources. Knowledge ,
social infrastructure and labour resources. These elements tend to have different impact and role
in different countries depending upon their income level. When countries with low GDP per
capita catches up those with higher GDP, the process is known as convergence. The process of
convergence can take place with both high and low income countries when they raise their
investments in human and physical capital for enhancing GDP (Guilmi, Gallegati and Landini,
2017) . In low income countries such as Afghanistan such types of investment can provide huge
outcomes in terms of integration of new skills, equipments with labour force.
However in countries such as Australia in which incomes levels are very high such kind
of big investments are not considered to be influential in terms of major impact. Being a
developed country they are used to have huge level of capital investments and thus the marginal
gain received from such new investments will be either less significant or lower. Thus it can be
concluded that Australia and other high income countries tend to receive small return on
investment and they are required to invent new technologies so that low and middle income
countries like Afghanistan and India can get opportunity to converge their growth. The
continuous growth and innovation in technology in high income countries counterbalance the
small return on physical and human capital investments.
As compare to middle income countries, low income countries show better growth in per
capita GDP (Curtis and Irvine, 2017). However on comparison between high and middle income
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nations, the latter shows better growth. Countries such as India have low level of human capital
and thus investment in it must have large marginal effect (Basu and Stiglitz, 2016). Along with
the decline in marginal return technological advancements are also significant elements in
providing fast GDP growth in low and middle level countries. High income countries require
new technologies for brining considerable change while India or Afghanistan can use the
technology which has been effectively understood by the other nations.
QUESTION 4
Impact of changes on substitution bias and new goods bias
When prices are measured with fixed basket of goods then it results in the two primary
issues namely substitution and quality bias. Substitution bias does not allow to buy less
expensive items in excess and less of expensive items (Guilmi, Gallegati and Landini, 2017). In
other words with substitution bias consumers substitute cheaper goods for expensive goods in
response to price changes without bringing any change in market basket. On the other hand
quality/ new bias leads to situation in which fixed basket is not able to consider or encourage
quality improvements or advent of new products. Substitution bias takes place when the basket is
fixed because in such condition it is assumed that quantity of products purchased by people are
changed only when prices are varied but they remain constant over a period of time.
Thus in such situations inflation is overstated. When basket of goods is evolved over
time then this problem can be reduced to great extent. Inflation can be measured by several
measures such as consumer price index (CPI) which is based upon basket of goods (Goodwin
and et.al., 2015). When inflation rate is calculated by fixed basket of goods then substitution and
new goods bias are arise because it is not possible to immediately include new goods in the
market basket and thus price index does not reflect what people actually purchase.
If basic basket of goods is updated in every 5 years instead of 10 years then it will take
account of lower inflation rate and base year. Thus amount of substitution bias and quality bias
will also reduce because in that case the basket will show the actual products which are
purchased by consumers. Reduction in time period for measurement of inflation rate and fixed
basket of products will reduce the extent of issues related to substitution bias and quality bias.
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REFERENCES
Books and Journals
Bade, R. and Parkin, M., 2015. Foundations of macroeconomics. Pearson.
Basu, K. and Stiglitz, J.E. eds., 2016. Inequality and Growth: Patterns and Policy: Volume I:
Concepts and Analysis. Springer.
Curtis, D. and Irvine, I., 2017. Macroeconomics: Theory, Models, and Policy (Lyryx).
den Hoed, A., 2016. 201-07 Principles of Macroeconomics. Cell, 937(470), p.9737.
Goodwin, N. and et.al., 2015. Macroeconomics in context. Routledge.
Guilmi, C.D., Gallegati, M. and Landini, S., 2017. Interactive Macroeconomics. Cambridge
Books.
Ha, J., and et.al., 2019. Inflation: Concepts, Evolution, and Correlates. The World Bank.
Moosavian, S.A.Z.N. and Ali, S., 2016. The visual “big picture” of intermediate
macroeconomics: A pedagogical tool to teach intermediate
macroeconomics. International Journal of Economics and Finance, 8(9), p.234.
Online
Price elasticity of demand. 2019. [Online]. Accessed through
<https://www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_demand.
html>
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