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Price Elasticity Of Demand In Economy

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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 and Absolute advantage.

 

Answers:

1.Price Elasticity of Demand

Price elasticity of demand gauges the responsiveness of demand after an alteration in the price. According to the law of demand, a hike in the price of product results in a decline in the quantity purchased. The price elasticity of demand complements this understanding by revealing how much the amount purchased will fall due to a price increase (Frank, 2015). When setting the price of a commodity, the producer has to consider the price elasticity of demand to comprehend the possible effects of the price change. Therefore, lowering or increasing the price will significantly depend on whether the demand for the product is inelastic or elastic.

Inelastic Demand

If the demand for good or service is price inelastic, then a large shift in the price results in smaller variation in the demand. In the case of such products, the customers are less sensitive to changes in the price. Those commodities that are addictive, essential or lack substitutes are classified under this category. The purchasers will continue to procure relatively the same quantity even if the price changes (Gillespie, 2014). As a result, the producer can maximize the revenue by increasing the price of a product whose demand is price inelastic.

On the graph one below, an increase in the price of a product from 10 U.S Dollars to 20 U.S dollars causes a slight fall in quantity purchased, that is, from 10 units to 8 units. In this situation, the producer will earn more revenue at a price of 20 U.S dollars.

Graph 1: Inelastic Demand

 

If the demand for a commodity is elastic, then a small change in price causes a bigger deviation in demand. For such goods, the clients are extremely responsive to shifts in the prices. This phenomenon is tied to several reasons. For example, if the consumers can easily find a substitute then they will have small tolerance for price increment. Furthermore, if the good or service is not essential, then the users will be highly responsive to price fluctuations (McTaggart, Findlay, & Parkin, 2015). Therefore, a producer can increase the revenue for such product by reducing the price.

On the graph two below, if the producer decreases the price from 13 to 8 U.S Dollars, the quantity demanded will increase from 4 to 12 units. Therefore, at a price of 8, the business will generate more revenue.

Graph 2: Elastic Demand

2.Comparative Advantage and Absolute Advantage

Comparative advantage denotes the capacity of the country to produce certain product at lower opportunity cost in comparison to another country. The opportunity cost of generating a particular commodity is comparable to the potential advantage that could have been attained by selecting an alternative. If a country’s opportunity cost of manufacturing a product is lower compared to another nation’s opportunity cost of generating similar item using the same resources, then the country is said to have a comparative advantage (Krugman, Obstfeld, & Melitz, 2015). As a result, trading is mutually advantageous for countries.

On the contrary, absolute advantage denotes a scenario where a country can manufacture goods and services at a reduced cost per unit than another country. Apart from high efficiencies, absolute advantage can also arise from country’s natural endowment (Sloman, Wride, & Garratt, 2015). For example, consider two countries, Saudi Arabia and Nigeria. Mining oil in Saudi Arabia involves much simpler processes like drilling a hole. However, in Nigeria, substantial exploration and expensive technologies are needed for drilling and extraction. In this scenario, Saudi Arabia’s absolute advantage is caused by natural endowment.

 

Bibliography

Frank, R. H. (2015). Microeconomics and behavior. New York, NY : McGraw-Hill Education.

Gillespie, A. (2014). Foundations of economics. Oxford : Oxford Univ. Press.

Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2015). International economics: Theory and policy. Upper Saddle River, NJ: Pearson.

McTaggart, D., Findlay, C. C., & Parkin, M. (2015). Economics. Frenchs Forest, N.S.W: Pearson.

Sloman, J., Wride, A., & Garratt, D. (2015). Economics (9th ed.). Harlow : Pearson

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