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Elasticity Of Demand & Price Discrimination

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Questions:

1.As a producer, why is it important to consider the Price elasticity of demand of your product when setting the price you are going to charge?
 
2.Explain the difference between comparative advantage an absolute advantages.
 
 

Answers:

Elasticity of demand captures adjustment in demand quantity in relation to change in price. Demand changes differently for different type of goods. Demand plays an important role in pricing decision. Producers consider responses of demand at alternative prices. For goods with elastic demand, a small change in price makes a big difference its demand (Esteves & Reggiani, 2014). Opposite is the case for inelastic demand. These two situations are explained in the following diagrams.

Figure 1: Market with Elastic demand curve

(Source: as created by Author)

Figure 1 describes the market situation with a relatively elastic demand curve. The demand curve is DD, which is drawn flatter to explain the elastic nature of demand. SS is the initial supply curve. In order to increase the price from P to P1, producer has to shift the supply curved from SS to S1S1. Accordingly, the quantity supplied decreases from Q to Q1. From figure 1, it is clearly visible that a small increase in price requires a much larger decrease in quantity as PP1< QQ1.

Figure 2: Market with inelastic demand curve

(Source: as created by Author)

In figure 2, steeper demand curve shows the market situation with inelastic demand curve (Tomek & Kaiser, 2014). In times of inelastic demand, buyers cannot change their demand much even when price increases. As shown in the figure, producer needs to reduce supply quantity with a small magnitude to increase the price from P to P1. Here, quantity reduction is smaller than price increase.

Absolute and comparative advantages are two oldest theory of international trade.. Adam Smith developed the model of absolute advantage. The asic model was developed in a framework of two-country two-commodity. A country enjoys absolute advantage if it can produce more goods and services than another country with given amount of resources. Prior to development of comparative advantage model countries exchange goods based on their absolute advantages (Feenstra, 2015). A country exports the good in which it has absolute advantage and imports the good that involve higher cost.

 


Problem occurs where one country has absolute advantage in all goods. Comparative advantage gives a solution to this situation. Here specialization and exchange is determined based on opportunity cost involved in the production of goods (Viner, 2016). The concept of production possibility frontier is used to understand the opportunity cost. It is the cost of sacrificing one good to produce some other good. The situation is explained with the following example.

Table 1: Production of two goods in Country A and B

(Source: www.economicsonline.com)

In the example given above, country A is able to produce 30m of cars or 6m truck and the same for country B is 35 m or 21m. Here, when look for absolute advantage, country B is in a advantageous position for both the product. Therefore, going by absolute advantage theory no two-way trade relation is suggested.

However, country B has a comparative advantage in trucks production because of its lower opportunity cost.  In truck production country B is 3.5 times better than country A as compared to only 1.7 times in Cars production.

Figure 3: Opportunity cost of country A and Country B in Cars and Trucks

(Source: www.economiconline.com)

A country specializes and exports good in which it has a comparative advantage and import goods that involve greater sacrifice of other goods

 

References

Esteves, R. B., & Reggiani, C. (2014). Elasticity of demand and behaviour-based price discrimination. International Journal of Industrial Organization, 32, 46-56.

Feenstra, R. C. (2015). Advanced international trade: theory and evidence. Princeton university press.

Tomek, W. G., & Kaiser, H. M. (2014). Agricultural product prices. Cornell University Press.

Viner, J. (2016). Studies in the theory of international trade. Routledge.

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