Price Elasticity of Demand (PED)

Price elasticity of demand (PED), this is a measurement applied in economics to indicate the responsiveness of the amount of a good and service demanded to a change in its value, more specifically, it provides the proportion change in the amount demanded in response to 1% change in value, while holding all the other factors of the demand constant, for example, the income. PED is usually a negative number, even though analysts tend to disregard the sign though this can end up to vagueness, only commodities which do not obey the rules to the law of demand, for example, Giffen and Veblen commodities have a positive PED (Frank, 2008). In general, the demand for commodities turns to be inelastic or relatively inelastic when the price elasticity of demand is ≤ 1; this implies that changes in value have a relatively small effect on the quantity of the commodity demanded. On the other hand, the demand for a commodity is elastic or relatively elastic when price elasticity of demand is ≥1 and this implies that changes in value have relatively large effect on the quantity of a commodity demanded. The formula for the PED:

PED =   Percentage change in quantity demanded

Percentage Change in Prices

Cross elasticity of demand, this is evaluating the speed of commodity demanded, because of a price change of another commodity. For instance, if two commodities are substitutes, the seller expects to see customers buying more of one commodity when the value of its substitute goes up. Similarly, if the two commodities are complements, the seller expects to see a value increase in one commodity to lead to decrease of demand for both commodities. The cross elasticity of demand is said to be positive when both commodities are substitutes, for example, Coca-cola and Pepsi are said to be negative when both commodities are complements, for example, butter and bread (Moffatt, 2010). This is the formula for computing Cross elasticity of demand CPEoD=   (percentage change in quantity demanded for commodity X) ÷ (percentage change in price for commodity Y).

Income elasticity of demand, this determines the degree to which customers react to a change in their revenues by purchasing less or more of a particular commodity, having in mind revenue is the determinant of demand. Negative income elasticity of demand means that quantity demanded and revenues shift in opposite directions, for example, the rise in income and the decrease of demand for the commodity. This coefficient represents an inferior good, for example, retread tires. The income elasticity of demand is said to be positive when income and quantity demanded shift towards the same direction and this represents normal commodities (Amosweb.com, 2010). The income elasticity of demand can be computed as follows:

Ei = (%u2206Q / Q) ?‘(%u2206 I / I)

Therefore, if Ei ≥0 normal good, Ei ≤0 inferior good, Ei =0 income elasticity of demand for commodities consumed is entirely insensitive to changes in income, for example, necessity and if Ei ≥1 luxury commodities because as income goes up, the share of that commodities also goes up, for example, foreign travel (Amosweb.com, 2010).

Price Mechanisms

The government or company may try to impose some measures in order to control the price fluctuations. This is normally done through the use of the demand-supply model. Various actions that may be taken so as to limit or reduce prices are discussed below.

Government income or taxation is used by the government to control aggregate demand and supply. The use of taxes reduces the domestic supply and demand in that the taxation of imports reduces the goods entering the country as government receives some income from the taxed goods. Taxation decreases the individual disposable income and it also lowers companies’ profit and any investments that may be funded by such profits. Taxation is an additional cost of doing business and it thus affect the aggregate supply like any other cost. Therefore, a rise in taxation reduces supply of goods or services produced by the firms. This implies the demand will reduce as a result of reduction in disposable income as well as the supply by the firms will also decrease. This means that the price of such goods and services will decrease as a result of shift of supply and demand curve (Hmc.edu, 2009).

The government may also use quotas to limit imports. A physical restriction on the amount and import value is introduced by quotas. The government restrict the amount of goods coming into the country in that the supply of goods reduces, thus leading to shifting of the supply curve to the left and low price (Hmc.edu, 2009).  Free trade may be restricted by the government preferential behaviour during distribution of the spending projects, which prefer domestic over foreign suppliers. These policies of procurement are normally against free trade principle in the EU market. However, they continue to be developed nations trading policies features in the Western Europe (Riley, 2006).

Financial aid use can distort free trade of the services and goods between countries, for instance, the utilization of subsidies in the steel industry or domestic coal, or broadly criticized utilization of the subsidies (exports refunds) to the European farmers using CAP (Common Agricultural Policy) that was disapproved since it destroyed farmers’ incomes and profits in the developing nations (Riley, 2006).

Nations use predatory pricing such as dumping which is one of the price discrimination techniques. The idea is used where firms in more or one nation produces proof that the manufacturer from one nation is exporting goods at a lower price compared to the intrinsic value of the goods or production costs. According to World Trade Organization (WTO), rules true dumping is illegal (Riley, 2006).

Price discrimination is carried out by businesses where they charge varying prices to varying group of clients for the same service or good. This practice has become extensive in almost all the markets. This type of pricing strategy is mainly applied by the firms which have unrestricted pricing power. Monopolies use this pricing strategy to gain market advantage and or as an entry barrier to any firm wishing to enter the industry (Riley, 2006).

The scheme of buffer stock is used by firms as interventional storage or as ever-normal granary. The firms carrying out this type of practice try to utilize commodity storage in order to stabilize prices in the economy or in a single market. Particularly, goods are purchased during periods of excess supply in a country. These goods are then stored and sold later when the economy is facing product shortages (Economicshelp.org, 2009). An example of this type of scheme is the minimum and maximum price set by the government. A floor price is determined when there are a lot of goods in the market and the government normally begins purchasing the products in this period, thus making sure that there is no fall in price. Similarly, if price increases almost to reach the ceiling, government lowers the price through selling the stock on hold. For the time being, the government should either keep the commodity off the market (by destroying the commodity) or store it. In case the government decide to store the commodity, it price stabilizes and in turn, it may stabilize the price level in the economy, thus preventing inflation (Economicshelp.org, 2009).