Price Elascity of Demand BY vtc901ee The price elasticity of demand (PED) is “a measure of how much the quantity demanded of a good responds to a change in price of the good” (Mankiw 2007, p. 90). It is a form of measure to determine how willing consumers are to move away from the good as the price of the good rises. Most of the time, there are factors that determines the PED, such as availability of close substitutes, necessities versus luxuries, definition of the market and time horizon.
In order to calculate the PED, a formula is calculated using the percentage change in the quantity demanded divided y the percentage change in the price.
Elastic demand that has the coefficient of greater than 1 suggests that there would be a significant change in quantity demanded when there is a little change in price while inelastic demand has a coefficient of less than one, which has a little change in quantity demanded even when there is a significant change in price.
Unitary demand occurs when there is a coefficient of exactly one and there is an exact change in quantity demanded in proportion to the change in price (Bolotta et al. 2002). There are two ways to calculate the PED.
Firstly, it is called the point method or also nown as geometrical method (DEISU 2008). Under this method, we measure the elasticity of demand at any point of a demand curve using the formula, Elasticity at any point on the straight line can be calculated using the point method provided that the demand line is linear.
The better way to calculate the PED is by using the midpoint method, which is to calculate the PED between two points on a demand curve by averaging the 2 initial and final points chosen.
The midpoint approach averages the prices and quantities demanded, thus arriving at an average elasticity estimate for the range of values covered on the demand curve. The formula is, The product that is chosen to explain the theory of PED is rice. Rice is one of the perfect examples of inelastic demand applied in todays world, especially in Malaysia. There was an interesting finding made by Nik Mustapha and other researchers, where they find that rice tends to be inelastic, showing that rice has already occupied a special position in Malaysian diet as it is a staple food among the population (FEMI-JPM 2008).
Other countries in Asia are also affected by the demand for rice. In Thailand, the export price elasticity of demand for rice is ranged -1. 2 and -1. 9, which shows that it is an inelastic demand (FEMI-JPM 2008). The graph would be similar to Figure 3, whereby it has a steeper slope. This indicates that the consumer would pay at almost any price set in the market for the good as it is a necessity in food for them. The PED of the rice is important in terms of their pricing decisions as the total revenue can change along the demand curve, and this in return depends on the PED.
In this case, rice is considered to be inelastic, and for all inelastic demands, an increase in price will have an increase in total revenue (Mankiw 2007, p. 95). However, this is also crucial in determining the maximum profit that can be made using the PED. If all the farmers have good harvest, a large drop in price is necessary to encourage consumers to use the additional grain (Ingrimayne. com) this will cause the farmer’s income to decrease, thus it is important to know the PED of the rice. For instance, if the quantity of rice increases by 20%, it means that there could be a decrease of price by 40%.
In explaining on how the tax being imposed by the government can affects the production of rice, a fully labelled market diagram for rice (inelastic demand) is illustrated. Consumer surplus is the extra amount consumers are willing to pay from the ctual price whereas producer surplus is the amount sellers are paid for a good minus the seller’s cost of providing it (Mankiw 2007, pp. 139-144). Before the government impose tax on rice, consumer surplus and producer surplus are determined by equilibrium of price in the market.
By imposing the tax on rice, the quantity of rice sold falls and there is a wedge between the price that buyers pay and the price that sellers receive. Both surpluses are reduced because there is tax revenue imposed by the government, resulting in a deadweight loss, a condition where a fall in surplus exceeds tax revenue, a form of market distortion (Mankiw 007, p. 162). These tax revenues are classified as government revenue. Government revenue may differ depending on the size of the tax, as different tax size generates different tax revenue.
Since an inelastic demand decreases the quantity produced by a little, it can be assumed that the deadweight loss is also smaller, causing the tax revenue to increase slightly, as shown in Figure 10. Next, we will discuss the tax burden of the production of rice. Tax incidence is the distribution of tax burden among the participants in the market. In the rice market, taxes imposed on the buyers and the sellers are the same no matter whether the tax s charged on buyers or sellers, but the only difference is that who will send the money to the government (Mankiw 2007, pp. 24-127). To prove that, the following are the examples when a tax is charged on either buyers or sellers: The overall social welfare will be clearly shown once the effects of tax have on the quantity and price of the product, as the change in the total welfare decreases the consumer surplus and producer surplus, and usually exceeds the tax revenue raised maximised as there is deadweight loss incurred in the process of taxation, causing the quantity of goods decrease
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