Business significance of XED, PES, PED and YED

PED

PED is widely used by businesses when pricing their products in the market. It is most common with business where market segmentation is based on time, such as transport and leisure. Train operators for example seek to maximise profits by charging for peak and off peak, where demand will vary.

If Demand is inelastic then train operators can increase the price and their revenue would increase, however if a company such as Sony raised the price of their playstation 3 then demand would fall and revenue would decrease, this is because demand is elastic as there are close substitutes available such as the Xbox 360.

YED

Over time most products tend to become income elastic, this is because the standards are always improving so income tends to increase. Firms with Inferior products would suffer because of this and would aim to make their elasticity positive in order to survive their market.YED can be used by businesses to forcecast future demand

XED

Firms competing in markets with close substitutes would be looking at the XED very carefully. this maybe in order to steal market share, for example by lowering their prices, which would increase their revenue, however increasing prices in a competitive market would be dangerous as it is more likely that revenue would be lost.

Complements also come into consideration, for example if the price of strawberries increased, then the demand for whipped cream would decrease, this can effect businesses that supply both of these products.

PES

PES is always positive. In the short term supply tends to be inelastic as it is difficult to shift the resources into a market, however firms can hold stocks to cope with the sudden change in demand, making it supply elastic, they may hold onto stock in anticipation of a price rise.

An example would be tuna in America, the supply elasticity was 0.2, this meant that supply was not very responsive to a change in demand, hence it was inelelastic. However demand for tuna increased, as the health benefits were made obvious, because it was inelastic, price increased in the US market as a result.

Cross Elasticity of Demand XED

XED measures the responsiveness in demand of one product following a change in price of another product:

Change in quantity demanded of product A/change in price of product B

A (+) positive indicates that the products are substitutes, whereas if the elasticity is negative (-) it indicates that the products are complements, if the relationship is zero then there is no relationship between the two products whatsoever.

A higher positive XED indicates that the products are close substitutes whereas when the product has a highly negative XED it indicates that the products are strong complements.

 

How would this be analysed in an exam?

An exam question from the 2012 January OCR past papers which is relevant to this topic:

Using the information from fig 1, comment on wheathe chewing gum and theraputic chewing gum are substitutes

The question paper is available on the OCR website along with the markscheme, however I am just going to walk through on how this should be answered (as the case study is quite important aswell!)

• The XED for the 3 gums were 0.1, 0.2 and 0.3 (3 marks awarded for working out the XED)
• They are all positive therefore they are substitutes
• They are all XED inelastic
• all below 1
• Às the price goes up for theraputic gum, the demand for normal gum does not increase by so much

The above are all interpretations  that are made when analysing the figures, below are what you should do when you further comment to get the maximum marks for the question

• Questioning the reliability
• they are estimates
• other factors of demand may have influenced the inelastic nature
• users are not very likely to switch to normal chewing gum as the benefits are greater so price would not influence demand
• figures may change over time
• Inelastic estimates indicates weak substitutes

 

Income elasticity of Demand YED

YED measures the responsiveness in demand when there is a change in income:

%change in quantity demanded/%change in income

 

Normal goods are goods that have a positive YED, and inferior goods are goods that have a negative YED.

When income increases then demand for Normal goods increases, the more elastic a good is, reflects how much demand would rise.

Income inelastic: Is where goods for which a change in income produces a less than proportionate change in demand

 

Income elastic: os where goods for which a change in income produces a greater than proportionate change in demand

 

An example of a normal good is where income increase by 5%, this then leads to an increase of Apple Ipads by 8%, so remembering that negative and positive signs matter here, as a (+) sign means that the good is normal and if it is (-) sign it means that it is an inferior good, the YED is 1.6, this is YED elastic, so what does that mean for apple?

Well because it is a normal good:

• It tends to expand when income grows
• Apple will increase locating and advertising in high income areas
• they will do badly in a recession

And what if it was an inferior good that was effected?:

• They expand during recession
• Inferior goods will be more popular in low income areas
• Do well during recession

 

 

 

Price elasticity of Demand (PED)

 

The elasticity is the extent to which buyers and sellers respond to a change in market conditions…

Price elasticity of demand

PED measures the responsiveness in demand to a change in price, it is measured with the following equation:

% change in quantity demanded/%change in price

 

For example if Sony playstation raised the price of their Sony ps3 console by 5% and as a result of this demand for the games console fell by 10% it means that the price elasticity is:

10% (change in quantity demanded)/5% (change in price) = -2

This suggests that demand for the games console is responsive to a change in price, as it is above 2 it suggests that this product is price elastic:

Price elastic is when the percentage change in quantity demanded is sensitive to a percentage change in price

 

Price Inelastic therefore is when the percentage change in quantity demanded is NOT sensitive to a percentage change in price.

 

PED is greater than 1 = Price Elastic

PED is less than 1 = Price inelastic

PED 1 = where a change in price causes a proportional change in demand

So now we have looked at PED we need to ask the obvious questions, what factors affect demand for products?

• The availability and closeness of substitutes: This is an alternative to a particular product. The more close substitutes available for a product means that it is probably price elastic. So if we go back to the playstation example: It had an elasticity of 2 which shows that it is PED elastic, this implies that there are probably substitutes that are fairly similar to the product such as the XBOX 360
• The relative response to a product with respect to income: If the product takes up a small part of income, such as a packet of gum for example, then an increase in price would not really lead to such a large decrease in demand, in these instances, demand is thought to be price inelastic. However if a the product takes up a larger proportion of income, for example a holiday then demand would be more sensitive, making it more PED elastic. Some products are habit forming, such as Cigarettes. Therefore a change in price would not effect the demand for it by that much, no matter how much a proportion it may take up on the incomes, even for lower income families.
• Time: In the short term, changing buying habits may be hard, so during this period demand maybe price inelastic, however over time demand becomes more elastic as more substitutes become available. Consumption of a product can even be delayed, making it more price elastic, this is even more so as these products do not tend to be necessities such as home improvements.