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Elasticity Economics : Theory And Applications

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Question:

Discuss about the Elasticity Economics for Theory and Applications.
 
 

Answer:

Introduction:

The place where transaction of goods, commodities and services takes place has been termed as market in economics. In other words, it is the place where interaction and trade between the two major groups namely the buyer and seller takes place. Market is the basic and very important concept in economics. It is the place where equilibrium is restored between the demand and the supply of goods and commodities. According to Pigou (2013) if the market is allowed to operate under free hand, any economy is able to reach its equilibrium stage and retain the position. Price of any commodity is decided here with the help of price mechanism (Mankiw 2014). Assuming that the market is operating under free hand and laissez faire the way in which equilibrium is maintained through price mechanism has been shown in the diagram below:

In the given figure, DD and SS are the demand and supply curves respectively intersecting at point E and giving the economy the equilibrium output Qo and price Po. Let it be assumed that due to some reason the price has escalated to P1. When the economy is allowed to work under free hand, the quantity demanded is going to be Q1 whereas the quantity supplied Q2. In other words there is going to be an excess supply of (Q2-Q1) within the economy and hence the sellers will be forced to reduce the price to get their products sold. Similar incidence happens if price is below Po where due to excess demand the sellers get the power to increase the price. In any of this scenario the price mechanism works and equilibrium is restored at price Po.

The given two cases talks about the ways in which people’s choices are determined while they decide to purchase and goods. People always have non-satiated wants but are restricted by the availability of resources and hence needs to make choices guided by certain criterion (Bernanke, Antonovics and Frank 2015). Those assumptions are:

  • Consumers are rationale
  • Consumer are non-satiated
  • There is availability of other goods either substitute or compliment
  • People have perfect information
  • Existence of laissez faire and ceteris paribus
 

Assuming the existence of these basic assumptions, the two cases has been discussed below.

Beef and Lamb are two kinds of meat serving the same purpose and can be considered as substitute commodity. Hence, when price of beef rises from Po to P1, the quantity of beef demanded falls and the quantity of lamb demanded increases from Qo to Q1. That is the demand curve of the substitute good lamb is going to be upward sloping when constructed against the price of beef.

A meal at a restaurant is not a necessity good but it does falls under normal goods. Hence, with the fall in price of food item there is going to be a increase in demand for restaurant meal as shown in the above figure.

On other hand with the increase in income of people (from Yo to Y1), there is an increase in the number of visit in restaurant (from Qo to Q1). In other words, there is a positive relation between the income earned and demand for restaurant meals.

The table below has been constructed to show the total revenue generated at each step and the change in the elasticity for demand in the economy for that particular good. The total revenue has been calculated as the product of the total quantity sold and the price charged per unit of the good at that stage (Saada 2013). On other hand, the elasticity of demand which highlights the responsiveness of the goods with respect to the variation in the price has been calculated by the following formula (Sowell 2014):

Price

Quantity demanded

Elasticity

Total revenue

$10

10,000

-3

100,000

$9

13,000

-2.76

117,000

$8

17,000

-2.35

136,000

$7

22,000

-0.95

154,000

$6

25,000

 

150,000

Table 1: Relation between TR & Elasticity

Source: Created by the Author

The elasticity is interpreted by taking the absolute value of that column. Hence, at price $10 the good is highly elastic in nature and as the price declined the elasticity of the goods declined too. Another thing that can be observed is that with the decrease in price of the good the revenue generated increased. Hence it can be stated from the table that there’s an inverse relation between the TR and the elasticity of the good. As TR increases with decrease in the price of goods, the elasticity of the good gets reduced.

Martha, an experienced pastry Chef went for one year leave and had to forgo $60,000 salary. She earned net revenue of $ 80,000 from publication of books and magazines. The profit she earned has been analyzed from two different views as follows:

Rent

$6000

Cost of computer

$4000

Forgone Interest

$400

Stationary

$2000

Total

$124,00

Table 2: Direct Cost incurred by Martha

Source: Created by the Author

Accountant’s View

Economist’s View

Revenue

$80,000

Revenue

$80,000

Direct Cost

$12,400

Costs (Opportunity + Direct)

$ 72400

Profit

$ 676,00

Profit

$ 7,600

Table 3: Profit of Martha

Source: Created by the Author

 

References:

Bernanke, B., Antonovics, K. and Frank, R., 2015. Principles of macroeconomics. McGraw-Hill Higher Education.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Pigou, A.C., 2013. The economics of welfare. Palgrave Macmillan.

Saada, A.S., 2013. Elasticity: theory and applications (Vol. 16). Elsevier.

Sowell, T., 2014. Basic economics. Basic Books.

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