(a) Distinguish between the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand.

[12] (b) Discuss the usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product. [13] (a) The elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded to a change in a determinant of demand, ceteris paribus. There are three concepts of elasticity of demand each relating to one of the determinants of demand: price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED). There are different definitions and formulas for PED, YED and XED. The PED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. Mathematically, it can be expressed as % Quantity Demanded PED = -----------------------------% Price The YED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in income, ceteris paribus. Mathematically, it can be expressed as % Quantity Demanded YED = ------------------------------% Income The XED for a good with respect to another good is a measure of the degree of responsiveness of the quantity of the first good demanded to a change in the price of the second good, ceteris paribus. Suppose that the two goods are good A and good B. Mathematically, it can be expressed as % Quantity Demanded of Good A XEDAB = -------------------------------------------% Price of Good B There are different implications of the values of PED, YED and XED. The PED for a good is negative due to the law of demand and the common practice among economists is to drop the negative sign. If the PED for a good is greater than one, such as in the case of gold, the demand is price elastic, which means that a change in the price will lead to a larger percentage change in the quantity demanded. If the PED for a good is less than one, such as in the case of food, the demand is price inelastic, which means that a change in the price will lead to a smaller percentage change in the quantity demanded. In the case of PED, economists are concerned with whether the value is greater or less

than one. However, in the cases of YED and XED, they look at whether the values are positive or negative. If the YED for a good is positive, such as in the case of clothing, the demand will rise when consumers income rises and goods of this nature are known as normal goods. If the YED for a good is negative, such as in the case of small television in Singapore, the demand will fall when consumers income rises and goods of this nature are known as inferior goods. While YED distinguishes between normal goods and inferior goods, XED distinguishes between substitutes and complements. If the XEDAB is positive, such as in the case of Coke and Pepsi, good A and good B are substitutes, which means that the two goods are alternatives to each other. If the XEDAB is negative, such as in the case of car and petrol, good A and good B are complements, which means that the two goods are consumed together. There are different determinants of PED, YED and XED. The PED for a good will be higher the larger the number of substitutes, the closer the substitutes, the lower the degree of necessity, the larger the proportion of income spent on the good and the longer the time period under consideration. The YED for a good will be lower the higher the level of income and wealth of consumers. The XED between two goods will be higher the more closely they are related. Hence, a large positive XED indicates very close substitutes and a large negative XED indicates very close complements. In conclusion, PED, YED and XED differ in terms of their definitions, formulas, determinants and the implications of their values.

(b) The usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product can be discussed in terms of how they can aid the firm in making pricing and capacity decisions. Assume that the fashionable product is smartphones. The concept of PED allows a firm that produces smartphones to determine how to change its price to increase its total revenue. The demand for smartphones produced by a firm is likely to be price elastic due to the large number of substitutes. Therefore, the firm can decrease its price to increase its total revenue as its quantity demanded will rise by a larger percentage.

In the above diagram, area A represents the gain in revenue resulting from the increase in the quantity demanded (Q) from Q0 to Q1 and area B represents the loss in revenue resulting from the fall in the price (P) from P0 to P1. Since the gain exceeds the loss, total revenue rises. However, if the firm does not have excess capacity or if rival firms follow suit, a fall in its price may not lead to an increase in its total revenue. Although the demand for smartphones produced by a firm is likely to be price elastic, it may be price inelastic because the smartphones may have some special features that cannot be found on other smartphones. In this instance, the firm can increase its price to increase its total revenue as its quantity demanded will fall by a smaller percentage.

In the above diagram, area C represents the gain in revenue resulting from the rise in the price (P) from P0 to P1 and area D represents the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q0 to Q1. Since the gain exceeds the loss, total revenue rises. However, if the firm also sells a complementary good, such as applications for the smartphones, due to the negative XED between complements, a rise in the price of its smartphones will reduce its revenue from the sale of the applications which may lead to a decrease in its total revenue. The concept of XED also allows a firm that produces smartphones to determine how a change in price by a rival firm will affect the demand for its good. For instance, if a rival firm decreases its price, due to the positive XED between substitutes, the firm will need to follow suit to avoid a decrease in demand. However, if this is likely to lead to a price war, the firm should instead use non-price strategies to boost demand. If a rival firm increases its price, the firm can increase its total revenue by charging the same price. However, its total revenue will not rise if it does not have excess capacity. The concept of YED allows a firm that produces smartphones to determine the future size of the market for its good and hence its production capacity. Since the YED for smartphones is positive, they are a normal good. Therefore, if the firm predicts an economic boom, it should increase its production capacity to meet the higher demand if the boom comes. Further, if the YED for smartphones is greater than one, which means that they are a luxury, the firm should increase its production capacity by a large amount. However, if the YED for smartphones is less than one, which means that they are a necessity, the firm need not increase its production capacity by a large amount. Conversely, if the firm predicts a recession, it should decrease its production capacity to minimise excess capacity if the recession comes.

The concepts of elasticity of demand may not be useful to a firm that produces smartphones as they are subject to several limitations. First, data from past records may no longer be relevant to calculating elasticities of demand as some of the determinants of demand may have changed. Second, although data from current surveys are relevant to calculating elasticities of demand, they may not be reliable because the respondents may not be truthful in their answers. Further, if the sample size of the surveys is small, the results may not be reflective of the actual market for the good. Having a larger sample size will result in a higher cost. Third, the assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold in reality. In the final analysis, PED can be useful to a firm that produces smartphones for making proactive business decisions and YED and XED can be useful for making reactive business decisions. Since YED and XED can be useful only when consumers income and the prices of related goods change, one can argue that PED is more useful than YED and XED. However, if the firm sells a complementary good, XED can also be useful for making proactive business decisions. Although PED may allow a firm that produces smartphones to increase its total revenue, its profit may not necessarily rise if its total cost also rises. Further, the firm may not want to maximise profit. For instance, if the firm is a new entrant, it may want to maximise market share to compete with the existing firms.

Authors comments Part A Students simply need to make an attempt to distinguish between the three concepts of elasticity of demand instead of explaining them in three separate paragraphs. The distinction between the three concepts of elasticity of demand can be made in terms of their definitions, formulas, determinants and the implications of their values. In theory, since a change in income or the price of a related good will lead to a change in demand (i.e. a shift in the demand curve), the term change in demand rather than change in quantity demanded should be used in the definitions and formulas for YED and XED. In practice, however, the term change in quantity demanded is more commonly used for these purposes. In the examination, students can use any of the two terms.

Part B A fashionable product is a rather broadly defined good. Therefore, students should narrow the definition to make the question manageable. For this purpose, I assume that the fashionable product is smartphones. Students should take a stand on whether the demand for smartphones produced by a firm is likely to be price elastic or inelastic. It does not matter much which stand you take so long as you support it well. What matters more is that you take a stand. Students should understand that there is a difference between the PED for smartphones and the PED for smartphones produced by a firm. Although the former is likely to be less than one, the latter is likely to be greater than one. Students should try to provide an evaluation for every scenario.