Discuss the usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product. [13]

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Essay requirements:

1. Definition of fashionable product
2. Clear explanation of how concepts determine price and revenue

• A stand needs to be taken on whether demand for smartphones are price elastic or inelastic, both are fine with supporting arguments

1. Clear distinction between PED for smartphones and PED for smartphone produced by a firm
2. Evaluate every scenario

Introduction

The usefulness of the concepts of elasticity of demand to a firm that produces a fashionable product can be discussed in terms of how they can aid the firm in making pricing and capacity decisions. We will be discussing smartphones in this essay.

Point: Price elasticity of demand (PED)

• PED allows a firm that produces smartphones to determine how to change its price to increase its total revenue
• Large number of substitutes for smartphones (Eg Apple and Sony) → Price elastic as consumers can easily switch to alternatives –> Decrease price attracts consumers and increases quantity demanded –> Increase in total revenue

• Explanation of graph above
  • Area A represents the gain in revenue resulting from the increase in the quantity demanded (Q) from Q0 to Q1 and area B represents the loss in revenue resulting from the fall in the price (P) from P0 to P1. Since the gain exceeds the loss, total revenue rises.

• Limitations
  • If firm has no or little excess capacity or if rival firms follow suit and decrease prices, a fall in its price may not lead to an increase in total revenue.
  • Smartphones by some firms may be price inelastic as they have special and unique features

• In such a case price should be increased as demand for smartphone is price inelastic → Fall in demand less than proportionate → Total revenue increases
• Explanation of graph above
  • Area C represents the gain in revenue resulting from the rise in price (P) from P0 to P1 and area D represents the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q0 to Q1. Since the gain exceeds the loss, total revenue rises.
• However, if the firm also sells a complementary good, such as phone covers, due to the negative XED between complements,
  • Rise in the price of its smartphones → Fall in revenue from the sale of phone covers → Probable decrease in its total revenue

Point: Cross elasticity of demand (XED)

• XED allows a firm that produces smartphones to determine how a change in price by a rival firm will affect the demand for its good
• Sub point: Reducing prices due to price matching
  • Rival firm reduces price due to positive XED between substitutes → Own firm need to follow suit to avoid decrease in demand
    • May lead to price war
      • Firm should instead use non price strategies to boost demand
    • Sub point: Increasing prices due to price matching
      • Rival firm increases price → Own firm may allow prices to remain constant → Quantity demanded increases → Total revenue increases
        • However, total revenue may not rise if firm has little/no excess capacity

Point: Income elasticity of demand (YED)

• YED allows a firm that produces smartphones to determine the future size of the market for its good and hence its production capacity
• Smartphones normal good → YED positive → Demand rises when income rises
  • If firm predicts an economic boom → Increase production to meet higher capacity when boom comes
  • Furthermore, some smartphones have YED > 1 → These smartphones are luxury goods → Firms should increase its production capacity by large amount
  • However
    • Certain low end smartphones have YED < 1 → They are a necessity → Firms do not need to increase production capacity be large amount
    • If firms predicts a recession → Reduce production to minimise excess capacity

Anti-thesis (General limitations to use of concepts of elasticity of demand in decision making)

• Data from past records may be irrelevant to calculating elasticities of demand as some of the determinants of demand may have changed
  • Technical analysis must not be the concluding factor for decision making due to changes in market environment
• Although data from current surveys on market conditions may be relevant to calculating elasticities of demand, however:
  • They may be unreliable as the public may not be fully truthful in answering them
  • The survey pool may be small and is not reflective of the actual market of the good
• Assumption of ceteris paribus made in calculating elasticities of demand is unlikely to hold in reality due to the constantly changing market conditions

Conclusion (General conclusion to usefulness of PED, YED and XED)

• PED can be useful to a firm that produces smartphones for making proactive business decisions
• YED and XED can be useful for making reactive business decisions
• Since YED and XED can only be useful when consumer’ income and prices of related goods change, one can argue that PED is more useful than YED and XED as it allows a company to be the initiator of change.
• However, if the firm sells a complementary good, XED can also be useful for making proactive business decisions.
  • Increase or decrease in price of primary product can affect the revenue generated from complementary products
• Although PED may allow a firm that produces smartphones to increase its total revenue, its profit may not necessarily rise if its total cost also rises.
• Further, profit motivation may not be the main goal of new entrants in the market, for instinct they may want to maximise market share to compete with existing firms.

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Attribution-NonCommercial-ShareAlike 4.0 International License (CC BY-NC-SA 4.0).  

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