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Lecture FOUR

Lecture FOUR

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Lecture FOUR

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  1. Lecture-4 Price Determination & Elasticity Prepared by Ahmed Ameen Mohamed

  2. Chapter 4 - Price Determination • At the end of this chapter, student should be able to understand • Price control • Concepts of Elasticity • Types of elasticity • Factors affecting price elasticity of demand • Factors affecting elasticity of supply Prepared by Ahmed Ameen Mohamed

  3. Price determination • Pricing is the process of determining what a company will receive in exchange for its product. Prepared by Ahmed Ameen Mohamed

  4. Objectives of price determination • Maximize long-run & short-run profit. • Increase sales. • Increase market share. • To obtain the target of return of investment. • Company growth. • To obtain or maintain the loyalty and enthusiasm of distribution and other sales personnel Prepared by Ahmed Ameen Mohamed

  5. Prepared by Ahmed Ameen Mohamed

  6. Price controls • Price controls are legal restrictions on how high or low a market price may go. kinds of price controls: • Price Ceilings: a maximum price sellers are allowed to charge for a good. It’s an upper limit for the price. • Price Floors: a minimum price buyers are required to pay for a good. It’s a lower limit for the price. Prepared by Ahmed Ameen Mohamed

  7. Why Price controls? • During crisis times, emergencies or wars the government wants to protect the consumers from rapidly increasing prices. • If the equilibrium wage given by supply and demand for low skilled workers is below poverty level, the government can set a minimum wage for such category. Prepared by Ahmed Ameen Mohamed

  8. Price Ceilings Equilibrium Price ceiling Prepared by Ahmed Ameen Mohamed

  9. Possible inefficiencies price ceiling may bring up • Inefficient Allocation to Consumers • Wasted Resources • Inefficiently Low Quality • Black Markets Prepared by Ahmed Ameen Mohamed

  10. Price Floors • Price Floors: a minimum price buyers are required to pay for a good. • The minimum wage is a legal floor on the wage rate, which is the market price of labor Prepared by Ahmed Ameen Mohamed

  11. Price Price Surplus S S D D 4 4 3 3 Price Ceiling 2 2 100 Quantity of icecreams Quantity of icecreams 200 200 100 600 Price Floor Equilibrium Price Floor Prepared by Ahmed Ameen Mohamed

  12. Concept of Elasticity • Why Study Elasticity • The purpose of studying elasticity is to determine how a smallchange in price may result in either a large or small change inquantity. • The concept of elasticity is intended to measure the degree ofresponsiveness of a buyer or seller to a change in a keydeterminant, in particular price. Prepared by Ahmed Ameen Mohamed

  13. Importance of Elasticity • Determination of price • Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective • Basis of price discrimination • Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices • Determination of rewards of factors of production • Factors having inelastic demand are rewarded more than factors that have relatively elastic demand. • Government policies of taxation • Goods having relatively elastic demand are taxed less than those having relatively inelastic demand. Prepared by Ahmed Ameen Mohamed

  14. Elasticity of Demand • Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors. • Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants . Prepared by Ahmed Ameen Mohamed

  15. Four major types of elasticity of Demand • Price elasticity of demand, • Income elasticity of demand , • Cross elasticity of demand • Advertising (or promotional) elasticity Prepared by Ahmed Ameen Mohamed

  16. Price Elasticity of Demand • Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price. • Price is most important among all the independent variables that affect the demand for any commodity. Prepared by Ahmed Ameen Mohamed

  17. Price P D O Q1 Q1 Quantity D Price P1 P2 O Q1 Quantity Degrees of Price Elasticity of demand Perfectly elastic demand • ep=∞ (in absolute terms). • Unlimited quantities of the commodity can be sold at the prevailing price • A negligible increase in price would result in zero quantity demanded • Horizontal demand curve Perfectly inelastic demand • The other extreme of the elasticity range • ep=0 (in absolute terms) • Quantity demanded of a commodity remains the same, irrespective of any change in the price • Such goods are termed neutral • Vertical demand curve Prepared by Ahmed Ameen Mohamed

  18. Price D P1 P2 D O Q1 Q2 Quantity Price D P1 P2 D O Q1 Q2 Quantity Price D P1 P2 D O Q1 Q2 Quantity Highly elastic demand • Proportionate change in quantity demanded is more than a given change in price • ep >1 (in absolute terms) • Such goods are called luxuries Unitary elastic demand • Proportionate change in price brings about an equal proportionate change in quantity demanded • ep =1 (in absolute terms). • Demand curves are shaped like a rectangular hyperbola, asymptotic to the axes Relatively inelastic demand • Proportionate change in quantity demanded is less than a proportionate change in price • ep <1 (in absolute terms) • Such goods are called necessities Prepared by Ahmed Ameen Mohamed

  19. Determinants of Price Elasticity of Demand • Nature of commodity • Necessities are relatively price inelastic, while luxuries are relatively price elastic • Availability and proximity of substitutes • Price elasticity of demand of a brand of a product would be quite high, given availability of other substitute brands • Alternative uses of the commodity • If a commodity can be put to more than one use, it would be relatively price elastic Prepared by Ahmed Ameen Mohamed

  20. Proportion of income spent on the commodity • The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price • Reason is income effect • Time • Demand for any commodity is more price elastic in the long run • Durability of the commodity • Perishable commodities like eatables are relatively price inelastic in comparison to durable items • Items of addiction • Items of intoxication and addiction are relatively price inelastic Prepared by Ahmed Ameen Mohamed

  21. Income Elasticity of Demand (ey) measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus. Degrees: Positive income elasticity • Demand rises as income rises and vice versa • Normal good Negative income elasticity • Demand falls as income rises and vice versa • Inferior good Prepared by Ahmed Ameen Mohamed

  22. Cross Elasticity of Demand measures the responsiveness of demand of one good to changes in the price of a related good Degrees • Negative Cross Elasticity • Complementary goods • PositiveCross Elasticity • Substitute goods Prepared by Ahmed Ameen Mohamed

  23. Elasticity of supply • The elasticity of supply looks at the percentage change in quantity supplied. • Elasticity of supply is measured as the ratio of proportionate change in the quantity supplied to the proportionate change in price. High elasticity indicates the supply is sensitive to changes in prices, low elasticity indicates little sensitivity to price changes, and no elasticity means no relationship with price Prepared by Ahmed Ameen Mohamed

  24. Price Elasticity of Supply • Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. • It is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Prepared by Ahmed Ameen Mohamed

  25. 1. At any price above $4, quantity supplied is infinite. Supply $4 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, Quantity supplied is zero. Degrees of price elasticity of supply Price • Perfectly Elastic Supply - Elasticity equals infinity Quantity Prepared by Ahmed Ameen Mohamed

  26. Price • Unit Elastic Supply - Elasticity equals 1 • Elastic Supply - - Elasticity is greater than 1 $5 $4 100 125 Quantity Price $5 $4 Prepared by Ahmed Ameen Mohamed 100 167 Quantity

  27. Price Supply • Inelastic Supply- Elasticity is less than 1 • Inelastic Supply- Elasticity is less than 1 $10 $5 100 Quantity Price $5 $4 Prepared by Ahmed Ameen Mohamed Quantity 100 110

  28. Determinants of elasticity of supply • Spare production capacity • Stocks of finished products and components • The ease and cost of factor substitution/mobility • Time period and production speed Prepared by Ahmed Ameen Mohamed

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