The law of demand states that: all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa. There are five determinants of demand: 1) Income. A rise in a person’s income will lead to an increase in demand, a fall will lead to a decrease in demand for normal goods. Goods which demand varies inversely with income are called inferior good; 2) Consumer Preferences. Favorable change leads to an increase in demand, unfavourable change lead to a decrease; 3) Number of Buyers.
One of the most important concepts of economics is supply and demand, which is the chief support of a market economy. The relationship between these two factors assists in outline the allocation of resources in the most effective way possible. The demand of a product or service represents the quantity desired by buyers. In other words, demand is the quantity of a product or service that people are keen to purchase at a certain price. The law of demand affirm that, if all other factors don’t alter, the higher the price of a product, the less buyers will demand it.
If the price level is below equilibrium, there will be excess demand in the short run. In both situations there should be a process taking the economy towards the equilibrium level of output. Consider for example a situation where aggregate supply is greater than current demand. This will lead to a build up in stocks (inventories) and this sends a signal to producers either to cut prices (to stimulate an increase in demand) or to reduce output so as to reduce the build up of excess stocks. Either way - there is a tendency for output to move closer to the current level of demand.
What determines this interconnection is how much of a good or service is supplied to the market or otherwise known as the supply relationship or supply schedule which is graphically represented by the supply curve. In demand the schedule is depicted graphically as the demand curve which represents the amount of goods that buyers are willing and able to purchase at various prices, assuming all other non-price factors remain the same. The demand curve is almost always represented as downwards-sloping, meaning that as price decreases, consumers will buy more of the good. Just as the supply curves reflect marginal cost curves, demand curves can be described as marginal utility curves. The main determinants of individual demand are the price of the good, level of income, personal tastes, the population, government policies, the price of substitute goods, and the price of complementary goods.
Supply and demand are not only affected by price. Price is only one factor of the many economic variables that exist. Production costs and income determine the amount of goods supplied and the amount demanded and contributes to price related determinates of supply and demand; consumers pay more when they have more, companies make more when it costs less. The inability of consumers to pay a certain price will force companies to lower their prices and consequently produce fewer goods.
The concept of Price Elasticity of Demand (PED) measures the responsiveness of quantity demanded by consumers to a change in product price. It is used by businesses to forecast sales, set the most effective price of goods and determine total revenue (TR) and total expenditure (TE). Similarly, governments also use price elasticity of demand when imposing indirect taxes on goods and setting minimum and maximum prices. Marginal revenue is also determined by the price elasticity of demand. Price elasticity of demand is used to predict the quantity shift in the supply curves and the effect on price for a product, and is usually always negative as it is the relationship between price and quantity demanded is an inverse one.
It is apparent that penetration pricing works on the assumption that price sensitive customers, also referred to as ‘cherry pickers’ (Kalish, 1985), switch brands when prices for substitutable products are lower. If a firm adopts a price penetration strategy when entering a new market, or when entering a new product into a market they are already working within, they will set a low price in order to try to undercut competitors. Such a strategy has the overall aim of escalating market share rather than achieving short term profits. All things considered, it can be understood that a penetration pricing strategy is aimed at generating sales among consumers who look for a 'good deal'. The future of an organisation which adopts such a strategy potentially lies with its consumers.
Recommend whether you believe that this firm should or should not cut its price to increase its market share. Provide support for your recommendation. With the elasticity of price being highly elastic and negative, any reduction in price leads to high sales. Nonetheless, this is only possible where the elasticity quotient is 1. Where the quotient is more than 1, a reduction in price results in increased demanded quantities and a subsequent increased sales until the point of unity.
EGT2 A – Elasticity of demand is a measurement tool typically used in economics to show the demand for a service or product in respects to a change in price. Elasticity provides the difference in percentage in the demanded amounts in regards to a one percent change in the product cost. Unit elastic demand presumes that an increase in price will cause a decrease in demand for that product; meaning when the price of a product increases by only a dollar, causing the demand for the good to decrease, the revenue would not be changed. A product is considered to be somewhat inelastic when the price elasticity price elasticity of demand is less than the absolute value, meaning the effects of pricing changes have little effect on the product in demand. Demand for a product is considered to be elastic once the price elasticity of demand is greater and the change in cost has a greater effect regarding the units of the product in demand.
a. Explain why the introduction of a minimum price above the equilibrium price reduces social welfare. “A minimum price occurs when a price is set by the government and firms cannot charge less than this” (Gillespie, 2011) in order for the minimum price to be effective it must be above the equilibrium price - this occurs when supply and demand are balanced whilst disregarding all external factors. (Figure 1) (Gillespie, 2011) The formation of equilibrium comes when the goods demanded are equivalent to the goods provided (DS); this allows the government to set a price floor (P1); this benefits society as in order for the market to be efficient minimum price must be above the; as when the supply produced exceeds (Q1) that demanded (Q2) by the public this allows consumers who can afford the goods or services to purchase regardless of the prices – this is beneficial to the reduction of social welfare as will suppliers have excess quantity, this drives as a trigger for producers to reduce their prices towards the price floor in order to increase demand for their product or service to make optimal profits allowing for consumers to get the best price as well as increasing consumer surplus for the original consumers. (Figure 2) ([price_controls_ceiling, n.d.) With the minimum price being below the equilibrium the demand will be excessive (Qd) in comparison to the supply produced (Qs) meaning that for the price the buyers are willing to pay the suppliers are only willing to supply a said amount of goods or services; causing the consumer surplus and the producer surplus to be lost due to the reduced quantity manufactured, this area then becomes dead weight loss; this can be avoided through the relocation of resources, though this creates a situation “in which nobody in an economy can be made better off without somebody else becoming worse off” (Nuttall and Lobley, 2001) known to be Pareto efficiency; as a result reducing wastage in resources which can impact negatively causing an increase in social welfare and ultimately clarifies that having the minimum price above equilibrium reduces social welfare.