CHAPTER-5
ELASTICITY OF DEMAND
INTRODUCTION
Elasticity of demand is a
concept in economics that measures the responsiveness or sensitivity of
quantity demanded to changes in price, income, or other factors. It helps us
understand how changes in these variables affect the demand for a particular
good or service. Elasticity of demand is an important tool for analyzing
consumer behavior, market dynamics, and making pricing and production
decisions.
The concept of elasticity of
demand is based on the understanding that changes in price or other factors can
impact the quantity demanded in different ways. Some goods are highly
responsive to price changes, meaning that a small change in price leads to a
significant change in quantity demanded. On the other hand, some goods are
relatively insensitive to price changes, and quantity demanded remains
relatively stable.
Elasticity of demand is
typically measured by calculating the percentage change in quantity demanded
divided by the percentage change in price or other relevant variables. The
resulting value indicates the degree of responsiveness of demand.
There are several types of
elasticity of demand, including price elasticity of demand, income elasticity
of demand, and cross elasticity of demand. Each type examines the impact of
specific factors on the demand for a product.
Understanding the concept of
elasticity of demand is crucial for businesses, policymakers, and economists.
It provides insights into consumer behavior, market dynamics, pricing
strategies, and policy formulation. By analyzing elasticity, firms can make
informed decisions regarding pricing, production levels, and product
differentiation. Policymakers can use elasticity to assess the impact of
taxation or subsidies on consumer behavior. Economists use elasticity to study
market structures, market efficiency, and the welfare effects of price changes.
Overall, elasticity of
demand is a fundamental concept in economics that helps us understand the
responsiveness of quantity demanded to changes in various factors. It plays a
vital role in decision-making, market analysis, and economic policy formulation.
DEFINITION
Elasticity of demand is a
measure of the responsiveness of quantity demanded to changes in price. It is
defined as the percentage change in quantity demanded divided by the percentage
change in price. In other words, it quantifies the sensitivity of consumer
demand to price fluctuations.
Mathematically, the
formula for price elasticity of demand (PED) is:
PED = (% Change in Quantity Demanded)
/ (% Change in Price)
The result of this
calculation can be positive or negative. A negative value indicates that the
demand is inversely related to price, meaning that as price increases, quantity
demanded decreases (and vice versa). A positive value indicates a direct
relationship between price and quantity demanded.
Elasticity of demand
is usually classified into three categories:
Elastic
Demand: When the percentage
change in quantity demanded is greater than the percentage change in price,
demand is considered elastic. In this case, consumers are highly responsive to
price changes, and a small change in price leads to a significant change in
quantity demanded.
Inelastic
Demand: When the percentage
change in quantity demanded is less than the percentage change in price, demand
is considered inelastic. In this case, consumers are relatively unresponsive to
price changes, and quantity demanded remains relatively stable despite price
fluctuations.
Unitary
Elasticity: When the percentage
change in quantity demanded is equal to the percentage change in price, demand
is considered to have unitary elasticity. In this case, the change in price and
quantity demanded are proportional.
The value of elasticity of
demand can vary across different goods and markets. It depends on factors such
as the availability of substitutes, the necessity of the product, consumer preferences,
and income levels. Understanding the elasticity of demand helps businesses make
pricing decisions, forecast sales, and analyze market dynamics. It also assists
policymakers in formulating effective economic policies and taxation
strategies.
PRICE ELASTICITY OF DEMAND
Price elasticity of demand
(PED) is a measure of the responsiveness of quantity demanded to changes in
price. It quantifies the percentage change in quantity demanded resulting from
a 1% change in price. Price elasticity of demand is calculated using the following
formula:
PED = (% Change in Quantity Demanded)
/ (% Change in Price)
The result of this
calculation can be positive, negative, or zero, indicating different degrees of
responsiveness of demand to price changes.
Elastic
Demand: When the absolute
value of PED is greater than 1, demand is considered elastic. This means that a
small change in price leads to a relatively larger change in quantity demanded.
In elastic demand, consumers are highly responsive to price changes, and a
decrease in price leads to a significant increase in quantity demanded (and
vice versa).
Inelastic
Demand: When the absolute
value of PED is less than 1, demand is considered inelastic. This implies that
a change in price results in a proportionally smaller change in quantity
demanded. In inelastic demand, consumers are less responsive to price changes,
and quantity demanded remains relatively stable despite price fluctuations.
Unitary
Elasticity: When the absolute
value of PED is equal to 1, demand is said to have unitary elasticity. This
means that the percentage change in quantity demanded is equal to the
percentage change in price. In unitary elastic demand, changes in price and
quantity demanded are proportionate to each other.
The interpretation of price
elasticity of demand can provide valuable insights into market dynamics.
Elastic demand indicates that price changes have a significant impact on
demand, and businesses need to carefully consider pricing strategies. Inelastic
demand suggests that price changes have a relatively small effect on demand,
and businesses can potentially increase revenue by raising prices.
It is important to note that
the price elasticity of demand can vary across different goods and markets. It
depends on factors such as the availability of substitutes, the necessity of
the product, consumer preferences, and income levels.
DEGREES OF PRICE ELASTICITY OF DEMAND
The degree of price
elasticity of demand refers to the extent to which quantity demanded responds
to changes in price. It can be categorized into three main degrees: elastic,
inelastic, and unitary elasticity.
Elastic
Demand: When demand is
elastic, a change in price leads to a relatively larger percentage change in
quantity demanded. The price elasticity of demand is greater than 1 in absolute
value. Elastic demand is characterized by a flatter demand curve, indicating
that consumers are highly responsive to price changes. Products with elastic
demand have readily available substitutes, and consumers are sensitive to price
fluctuations. In this case, a decrease in price will result in a significant
increase in total revenue for businesses, while an increase in price will lead
to a substantial decrease in total revenue.
Inelastic
Demand: In the case of
inelastic demand, a change in price leads to a proportionally smaller
percentage change in quantity demanded. The price elasticity of demand is less
than 1 in absolute value. Inelastic demand is characterized by a steeper demand
curve, indicating that consumers are less responsive to price changes. Products
with inelastic demand often have limited substitutes or are necessities. In
this case, an increase in price will result in a slight decrease in total
revenue, while a decrease in price will lead to only a slight increase in total
revenue.
Unitary
Elasticity: Unitary elasticity of
demand occurs when the percentage change in quantity demanded is exactly equal
to the percentage change in price. The price elasticity of demand is equal to 1
in absolute value. Unitary elastic demand is characterized by a linear demand
curve, indicating that the percentage change in quantity demanded is
proportional to the percentage change in price. Changes in price have an equal
effect on total revenue, resulting in no change in total revenue.
The degree of price
elasticity of demand is determined by various factors such as the availability
of substitutes, the necessity of the product, consumer income levels, and time
period considered. Understanding the degree of price elasticity of demand helps
businesses make pricing decisions, forecast demand changes, and determine the
revenue implications of price adjustments.
MEASUREMENT OF ELASTICITY OF DEMAND
The elasticity of demand
measures the responsiveness of quantity demanded to changes in price. It is
calculated using various methods, including the point elasticity method and the
arc elasticity method. Here are the two commonly used measures of elasticity of
demand:
Price
Elasticity of Demand (Point Elasticity): The price elasticity of demand measures the
responsiveness of quantity demanded to a change in price at a specific point on
the demand curve. It is calculated as the percentage change in quantity
demanded divided by the percentage change in price. The formula for price
elasticity of demand is:
Price Elasticity of Demand =
(Percentage Change in Quantity Demanded) / (Percentage Change in Price)
The result can be either
elastic (greater than 1), inelastic (less than 1), or unitary elastic (equal to
1).
Price
Elasticity of Demand (Arc Elasticity): The arc elasticity of demand measures the responsiveness
of quantity demanded to a change in price over a range or interval on the
demand curve. It is calculated as the average percentage change in quantity
demanded divided by the average percentage change in price. The formula for arc
elasticity of demand is:
Arc Elasticity of Demand =
((Q2 - Q1) / ((Q2 + Q1) / 2)) / ((P2 - P1) / ((P2 + P1) / 2))
This method takes into
account the midpoint between the initial and final price and quantity values,
providing a more accurate measure of elasticity when there are significant
price and quantity changes.
The calculated elasticity
value indicates the sensitivity of demand to price changes. If the elasticity
is greater than 1, demand is considered elastic, meaning that a small change in
price leads to a relatively larger change in quantity demanded. If the
elasticity is less than 1, demand is considered inelastic, indicating that a
change in price has a proportionally smaller effect on quantity demanded. A
value of 1 indicates unitary elasticity, where the percentage change in
quantity demanded is equal to the percentage change in price.
The measurement of
elasticity of demand helps businesses in pricing strategies, revenue
forecasting, and decision-making regarding product differentiation, promotion,
and market positioning. It provides insights into the market responsiveness to
price changes and assists in determining the optimal pricing levels to maximize
revenue and profitability.
FACTORS DETERMINING PRICE ELASTICITY OF
DEMAND
The price elasticity of
demand is influenced by several factors that determine the responsiveness of
quantity demanded to changes in price. These factors include:
Availability
of Substitutes: The
availability of close substitutes for a product affects its price elasticity of
demand. If there are many substitutes available, consumers can easily switch to
alternatives when prices change, making the demand more elastic. On the other
hand, if there are few or no substitutes, the demand tends to be inelastic.
Necessity
vs. Luxury Goods: Necessity
goods, such as basic food items or essential medications, tend to have
inelastic demand because consumers require them regardless of price changes.
Luxury goods, on the other hand, often have elastic demand as they are more
discretionary and sensitive to price fluctuations.
Time
Horizon: The time period under
consideration also affects price elasticity of demand. In the short run, demand
may be relatively inelastic as consumers may have limited alternatives or time
to adjust their consumption patterns. In the long run, however, demand becomes
more elastic as consumers have more time to find substitutes and adjust their
behavior.
Proportion
of Income Spent: The
proportion of income spent on a particular product influences its price
elasticity of demand. Goods that represent a significant portion of consumers'
income tend to have more elastic demand, as consumers are more responsive to
price changes when a larger portion of their budget is affected.
Brand
Loyalty: The presence of
strong brand loyalty can make demand relatively inelastic, as consumers may be
willing to pay higher prices for preferred brands and show less responsiveness
to price changes.
Market
Definition: The specific market
in which a product is considered also affects its price elasticity of demand.
Narrowly defined markets, such as specialized products or niche markets, may
exhibit more inelastic demand due to limited substitutes and fewer options
available to consumers.
Income
Level: Income level can
impact the price elasticity of demand. For normal goods, as income increases,
demand becomes more elastic, meaning consumers are more sensitive to price
changes. For inferior goods, as income rises, demand becomes less elastic, as
consumers may switch to higher-quality alternatives.
These factors collectively
determine the price elasticity of demand for a particular product or service.
Understanding these factors helps businesses make informed decisions about
pricing strategies, product differentiation, and market positioning to maximize
their revenue and profitability.
INCOME ELASTICITY OF DEMAND
Income elasticity of demand
measures the responsiveness of quantity demanded to changes in income. It
indicates how sensitive the demand for a good or service is to changes in
consumer income. The formula for calculating income elasticity of demand is:
Income Elasticity of Demand
= (% change in quantity demanded) / (% change in income)
Based on the value of
income elasticity, we can classify goods into three categories:
Normal Goods:
Income
Elasticity > 0: Demand
for the good increases as income rises.
Income
Elasticity < 1: Demand
for the good increases at a slower rate than income.
Examples: Cars, electronics, vacations. As income increases,
consumers have more purchasing power and tend to buy more of these goods, but
the increase in demand is not proportionate to the increase in income.
Inferior
Goods:
Income
Elasticity < 0: Demand
for the good decreases as income rises.
Examples: Generic or low-quality products, second-hand goods. As
income increases, consumers switch to higher-quality substitutes, leading to a
decrease in demand for inferior goods.
Luxury
Goods:
Income
Elasticity > 1: Demand
for the good increases at a greater rate than income.
Examples: High-end luxury items, luxury vacations. As income rises,
consumers can afford more luxury goods and tend to increase their demand for
such products at a higher rate than their income growth.
The magnitude of the income
elasticity value also indicates the strength of the relationship between income
and demand. A higher absolute value (greater than 1 or less than -1) suggests a
stronger relationship, while a value closer to zero indicates a weaker
relationship.
Understanding income
elasticity of demand is crucial for businesses and policymakers. It helps them
identify the income sensitivity of goods and adjust their strategies
accordingly. For businesses, it provides insights into market segmentation,
targeting specific income groups, and developing products that cater to
different income elasticities. Policymakers can utilize income elasticity to
assess the impact of income changes on different sectors of the economy and
formulate appropriate policies to promote economic growth and social welfare.
CROSS ELASTICITY OF DEMAND
Cross elasticity of demand
measures the responsiveness of the quantity demanded of one good to changes in
the price of another good. It helps us understand how the demand for one good
is affected by changes in the price of another related good. The formula for
calculating cross elasticity of demand is:
Cross Elasticity of Demand =
(% change in quantity demanded of Good A) / (% change in price of Good B)
Based on the value of cross
elasticity, we can determine the relationship between the two goods:
Positive Cross
Elasticity:
Cross
Elasticity > 0: The
two goods are substitutes.
An increase in the price of
Good B leads to an increase in the quantity demanded of Good A, or vice versa.
Consumers view the two goods as interchangeable and switch between them based
on price changes.
Examples: Coffee and tea, Pepsi and Coca-Cola. If the price of
coffee increases, consumers may switch to tea, leading to an increase in the
demand for tea.
Negative Cross
Elasticity:
Cross
Elasticity < 0: The
two goods are complements.
An increase in the price of
Good B leads to a decrease in the quantity demanded of Good A, or vice versa.
The two goods are consumed together, and an increase in the price of one
reduces the demand for the other.
Examples: Gasoline and cars, printers and printer ink. If the price
of printers increases, consumers may reduce their demand for printer ink.
Zero Cross Elasticity:
Cross
Elasticity = 0: The
two goods are unrelated or independent.
The change in the price of
one good has no effect on the demand for the other. The goods are not
substitutes or complements, and there is no observable relationship between
their demand.
Examples: Salt and televisions, shoes and computers.
Cross elasticity of demand
helps businesses understand the market dynamics and make strategic decisions.
For example, if two goods are substitutes, a business can adjust its pricing
strategy by considering the impact of price changes on the demand for both
goods. It also assists in market segmentation, targeting specific consumer
preferences, and identifying potential competitive threats. Policymakers can
utilize cross elasticity to assess market competition and make informed
decisions regarding antitrust regulations and trade policies.
VERY SHORT QUESTIONS ANSWER
Q.1. Explain price elasticity of
demand?
Ans. Responsiveness.
Q.2. State income elasticity of demand?
Ans. Responsiveness.
Q.3. State cross-elasticity of demand?
Ans. Substitutability
Q.4.What is the formula to measure
elasticity of demand?
Ans. The formula to measure the price elasticity of demand is:
Price Elasticity of Demand =
(Percentage Change in Quantity Demanded) / (Percentage Change in Price)
Q.5. When is demand perfectly elastic?
Ans. When the demand for a product is perfectly elastic, it means
that a small change in price will cause an infinite change in quantity
demanded. Consumers are extremely sensitive to price changes, and any increase
in price will result in zero demand for the product. The price elasticity of
demand in this case is equal to infinity.
Q.6. When is demand perfectly
inelastic?
Ans. Demand is perfectly inelastic when there is no change in
quantity demanded regardless of changes in price. This means that consumers are
completely unresponsive to price fluctuations, and the price elasticity of
demand is zero.
Q.7. When is demand elastic?
Ans. When the price elasticity of demand is greater than 1,
demand is considered elastic. This means that a small change in price will
result in a proportionately larger change in quantity demanded. Consumers are
highly responsive to price changes, and an increase in price will lead to a
significant decrease in quantity demanded, while a decrease in price will
result in a significant increase in quantity demanded.
Q.8. When is income elasticity of
Geffen goods?
Ans. Income elasticity of demand for Geffen goods is negative.
SHORT QUESTIONS ANSWER
Q.1. Define price elasticity of demand
what are its degrees?
Ans. Price elasticity of demand refers to the responsiveness
of quantity demanded to a change in the price of a product. It measures the
percentage change in quantity demanded divided by the percentage change in
price. The degrees of price elasticity of demand are as follows:
Perfectly
elastic demand: When
the demand is perfectly elastic, a slight change in price leads to an infinite
change in quantity demanded. The elasticity coefficient is equal to infinity
(Elasticity = ∞).
Relatively
elastic demand: If
the percentage change in quantity demanded is greater than the percentage
change in price, demand is said to be relatively elastic. The elasticity
coefficient is greater than 1 (Elasticity > 1).
Unit
elastic demand: Unit
elastic demand occurs when the percentage change in quantity demanded is equal
to the percentage change in price. The elasticity coefficient is equal to 1
(Elasticity = 1).
Relatively
inelastic demand: If
the percentage change in quantity demanded is less than the percentage change
in price, demand is said to be relatively inelastic. The elasticity coefficient
is less than 1 (Elasticity < 1).
Perfectly
inelastic demand: When
the demand is perfectly inelastic, a change in price has no effect on the
quantity demanded. The elasticity coefficient is equal to zero (Elasticity =
0).
Q.2. Define price elasticity of demand
how it is measured with point method?
Ans. Price elasticity of demand is a measure of the
responsiveness of quantity demanded to a change in price. It quantifies the
percentage change in quantity demanded resulting from a one percent change in
price.
The point method is one of
the ways to measure price elasticity of demand. It calculates the elasticity at
a specific point on the demand curve using the following formula:
Elasticity = (ΔQ/Q) / (ΔP/P)
Where:
·
ΔQ is the change in
quantity demanded
·
Q is the original quantity
demanded
·
ΔP is the change in
price
·
P is the original
price
To use the point method, you
need data on the original quantity demanded, the original price, and the
changes in quantity demanded and price. By plugging these values into the
formula, you can calculate the price elasticity of demand at a specific point
on the demand curve.
The resulting elasticity
value can be classified as elastic, inelastic, or unit elastic, depending on
its magnitude and sign. An elasticity greater than 1 indicates elastic demand,
less than 1 indicates inelastic demand, and equal to 1 indicates unit elastic
demand.
Q.3. Discuss total outlay method to
measure price elasticity of demand?
Ans. The total outlay method is another approach to measure
price elasticity of demand. It focuses on the effect of price changes on total
expenditure or total revenue.
The total outlay method
assumes that the goal of a firm is to maximize its total revenue or total
sales. It analyzes the impact of a price change on total expenditure (price
multiplied by quantity) rather than the percentage change in quantity demanded.
The formula for calculating
price elasticity of demand using the total outlay method is as follows:
Elasticity = (ΔTR/ΔP) ×
(P/Q)
Where:
·
ΔTR is the change in
total revenue
·
ΔP is the change in
price
·
P is the original
price
·
Q is the original
quantity demanded
To measure price elasticity
of demand using the total outlay method, you need data on the original price,
the original quantity demanded, and the changes in price and total revenue. By
plugging these values into the formula, you can calculate the price elasticity
of demand.
The interpretation of the
elasticity value remains the same as with other methods. An elasticity greater
than 1 indicates elastic demand, less than 1 indicates inelastic demand, and
equal to 1 indicates unit elastic demand.
The total outlay method
provides an alternative perspective on measuring price elasticity of demand by
considering the impact on total expenditure or revenue. It can be useful for
firms to assess the potential impact of price changes on their overall revenue.
Q.4. How price elasticity of demand is
measured? Give any two methods?
Ans. Price elasticity of demand can be measured using various
methods. Here are two commonly used methods:
Percentage
Method: This method measures
the percentage change in quantity demanded in response to a percentage change
in price. The formula for price elasticity of demand using the percentage
method is:
Elasticity = (% Change in
Quantity Demanded) / (% Change in Price)
By comparing the percentage
changes in quantity demanded and price, you can calculate the elasticity value.
An elasticity greater than 1 indicates elastic demand, less than 1 indicates
inelastic demand, and equal to 1 indicates unit elastic demand.
Midpoint
Method: The midpoint method
is a more accurate way to measure price elasticity of demand, especially when
dealing with large price ranges. It calculates the elasticity value based on
the average price and quantity between two points. The formula for price
elasticity of demand using the midpoint method is:
Elasticity = ((Q2 - Q1) /
((Q2 + Q1) / 2)) / ((P2 - P1) / ((P2 + P1) / 2))
Here, Q1 and Q2 represent
the initial and final quantities demanded, while P1 and P2 represent the
initial and final prices. By plugging these values into the formula, you can
calculate the elasticity.
These two methods provide
different approaches to measure price elasticity of demand. The percentage
method is simpler and widely used, while the midpoint method offers a more
precise estimation, especially when dealing with price ranges that span
different magnitudes.
Q.5. Explain the factors determining
price elasticity of demand?
Ans. The price elasticity of demand is influenced by several
factors that determine the responsiveness of quantity demanded to changes in price.
Here are the key factors:
Availability
of Substitutes: The
availability of close substitutes for a product affects its price elasticity.
If there are many substitutes available, consumers have more options to switch
to when the price changes, making the demand more elastic. On the other hand,
if there are few or no substitutes, the demand tends to be inelastic.
Necessity
vs. Luxury: The necessity or
luxury nature of a good also affects its price elasticity. Necessities like
food, medication, and basic utilities tend to have inelastic demand because
consumers are less likely to reduce their consumption even with price
increases. Luxury goods, on the other hand, are more elastic as consumers can
easily reduce their demand if prices rise.
Time
Horizon: The time period
considered also affects price elasticity. In the short run, consumers may have
limited options to adjust their consumption patterns, making demand less
responsive to price changes (inelastic). In the long run, consumers have more
flexibility to adjust their behavior, leading to a more elastic demand.
Proportion
of Income Spent: The
proportion of income spent on a product influences its price elasticity. Goods
that represent a significant portion of consumers' income tend to have elastic
demand. Even small price changes can have a substantial impact on the overall
budget, leading to more significant adjustments in demand.
Brand
Loyalty: Brand loyalty or
consumer preferences can affect price elasticity. Consumers who are highly
loyal to a specific brand may be less responsive to price changes and exhibit
more inelastic demand. They may be willing to pay a premium for their preferred
brand and be less likely to switch to alternatives.
Market Definition: The definition of the market and the level of specificity can impact
price elasticity. Narrowly defined markets with specific products may have more
elastic demand as consumers have more alternatives within that specific market.
Broader markets encompassing various substitutes may exhibit relatively
inelastic demand.
Understanding these factors
helps businesses and policymakers gauge the likely impact of price changes on
consumer demand. It allows them to make informed decisions regarding pricing
strategies, product differentiation, and market segmentation.
Q.6. Prove that price elasticity of
demand is different at different points on the same demand curve?
Ans. Price elasticity of demand can vary at different points
on the same demand curve. To prove this, we need to analyze the concept of
price elasticity and its calculation.
Price elasticity of demand
is calculated as the percentage change in quantity demanded divided by the
percentage change in price. It measures the responsiveness of quantity demanded
to changes in price. The formula for price elasticity of demand is:
Price Elasticity of Demand =
(% Change in Quantity Demanded) / (% Change in Price)
Now, let's consider a demand
curve and examine two different points on that curve. At each point, we can
calculate the price elasticity of demand.
At one point, let's say
Point A, the quantity demanded is Q1 and the price is P1. We calculate the
price elasticity of demand for Point A by considering a small change in price (∆P)
and the corresponding change in quantity demanded (∆Q).
At another point, let's say
Point B, the quantity demanded is Q2 and the price is P2. Again, we calculate
the price elasticity of demand for Point B by considering a small change in
price (∆P) and the corresponding change in quantity demanded (∆Q).
Since the demand curve
represents the relationship between price and quantity demanded, the slope of
the curve changes at different points. This implies that the percentage change
in quantity demanded and the percentage change in price will vary at different
points on the curve.
Therefore, the calculated
price elasticity of demand will be different at Point A and Point B because the
percentage changes in quantity demanded and price will differ due to the slope
of the demand curve.
In conclusion, price
elasticity of demand is different at different points on the same demand curve
because it depends on the specific price and quantity combinations and the
corresponding changes in price and quantity demanded at those points.
Q.7. Discuss the degrees of price
elasticity of demand?
Ans. The degrees of price elasticity of demand indicate the
extent to which the quantity demanded of a product responds to changes in its
price. There are three main degrees of price elasticity of demand:
Elastic
Demand: When the percentage
change in quantity demanded is greater than the percentage change in price,
demand is considered elastic. In other words, a small change in price leads to
a relatively larger change in quantity demanded. The elasticity coefficient for
elastic demand is greater than 1 (|Ed| > 1). This indicates that consumers
are highly responsive to price changes. Elastic demand typically occurs for
goods with close substitutes, luxury items, and non-essential goods.
Inelastic
Demand: When the percentage
change in quantity demanded is less than the percentage change in price, demand
is considered inelastic. In this case, a change in price has a proportionately
smaller effect on the quantity demanded. The elasticity coefficient for
inelastic demand is less than 1 (|Ed| < 1). This indicates that consumers
are less responsive to price changes. Inelastic demand is often seen for
essential goods, such as basic food items or medications, where consumers have
limited substitutes and necessities.
Unitary
Elastic Demand: When
the percentage change in quantity demanded is equal to the percentage change in
price, demand is considered unitary elastic. The elasticity coefficient for
unitary elastic demand is equal to 1 (|Ed| = 1). In this case, the change in
price leads to an equivalent change in quantity demanded. Unitary elastic
demand is relatively rare and represents a balanced responsiveness of consumers
to price changes.
The degree of price
elasticity of demand has important implications for producers and policymakers.
In the case of elastic demand, a decrease in price can lead to a significant
increase in revenue, as the quantity demanded rises more than proportionately.
Conversely, for inelastic demand, an increase in price can generate higher
revenue, as the quantity demanded decreases less than proportionately.
Understanding the degrees of
price elasticity of demand helps businesses make pricing decisions, assess the
impact of price changes on revenue, and determine the competitiveness of their
products. It also guides policymakers in implementing taxation policies,
regulating prices, and understanding consumer behavior in response to changes
in market conditions.
LONG QUESTIONS ANSWER
Q.1. Define elasticity of demand what
are the different methods to measure it?
Ans. Elasticity of demand is a measure of the responsiveness
of the quantity demanded of a product to changes in its price. It indicates how
sensitive consumers are to price changes and helps in understanding the demand
behavior.
There are several
methods to measure the elasticity of demand:
Price
Elasticity of Demand (PED): Price
elasticity of demand measures the responsiveness of quantity demanded to
changes in price. It is calculated as the percentage change in quantity
demanded divided by the percentage change in price. The formula for PED is:
PED = (% Change in Quantity Demanded)
/ (% Change in Price)
Income
Elasticity of Demand (YED): Income
elasticity of demand measures the responsiveness of quantity demanded to
changes in consumer income. It helps in understanding the relationship between
income and demand. It is calculated as the percentage change in quantity
demanded divided by the percentage change in income. The formula for YED is:
YED = (% Change in Quantity
Demanded) / (% Change in Income)
Cross
Elasticity of Demand (XED): Cross
elasticity of demand measures the responsiveness of quantity demanded of one
product to changes in the price of another related product. It helps in
understanding the relationship between different products and their demand. It
is calculated as the percentage change in quantity demanded of one product
divided by the percentage change in the price of another product. The formula
for XED is:
XED = (% Change in Quantity
Demanded of Product A) / (% Change in Price of Product B)
Point
Elasticity: Point elasticity
measures the elasticity of demand at a specific point on the demand curve. It
calculates the elasticity using the slope of the demand curve at that point.
The formula for point elasticity is:
Elasticity = (Change in Quantity
/ Average Quantity) / (Change in Price / Average Price)
These methods provide
quantitative measures of elasticity and help in understanding the
responsiveness of demand to various factors. They are useful for businesses in
making pricing decisions, forecasting demand, and understanding consumer
behavior.
Q.2. Explain the term price elasticity
of demand what factors determine it?
Ans. Price elasticity of demand is a measure of the
responsiveness of the quantity demanded of a product to changes in its price.
It helps in understanding how sensitive consumers are to changes in price and
how it impacts the demand for a product.
The factors that
determine price elasticity of demand are as follows:
Availability
of Substitutes: If
there are close substitutes available for a product, consumers have more
options to choose from. In such cases, even a small change in price can lead to
a significant shift in demand towards substitutes. Products with more readily
available substitutes tend to have higher price elasticity of demand.
Necessity
vs. Luxury: The necessity or
luxury nature of a product affects its price elasticity of demand. Necessities,
such as food or basic utilities, tend to have inelastic demand because
consumers cannot easily reduce their consumption even if the price increases.
On the other hand, luxury goods have more elastic demand as consumers can
easily reduce their consumption if the price rises.
Proportion
of Income Spent on the Product: If a product represents a significant portion of a
consumer's income, they are likely to be more sensitive to changes in its
price. Products that require a large portion of income, such as cars or
expensive electronics, tend to have higher price elasticity of demand.
Time
Horizon: The time available
for consumers to adjust their consumption patterns also affects price
elasticity of demand. In the short run, consumers may have limited options to
change their buying behavior, resulting in relatively inelastic demand.
However, in the long run, consumers have more flexibility to adjust their
consumption patterns, making the demand more elastic.
Brand
Loyalty: Brand loyalty and
product differentiation can impact price elasticity of demand. Consumers who
are highly loyal to a particular brand may be less responsive to price changes
and exhibit inelastic demand. Conversely, consumers who are less brand loyal
and more focused on price may exhibit more elastic demand.
These factors collectively
determine the price elasticity of demand for a product. A higher elasticity
indicates that consumers are more responsive to price changes, while a lower
elasticity indicates less sensitivity to price fluctuations. Understanding
these factors helps businesses make pricing decisions and predict the impact of
price changes on demand.
Q.3. Define price elasticity of demand
what are its degrees? Explain the importance of elasticity of demand in the
field of economics?
Ans. Price elasticity of demand refers to the measure of the
responsiveness of the quantity demanded of a product to changes in its price.
It quantifies the percentage change in quantity demanded resulting from a
percentage change in price.
The degrees of price
elasticity of demand are categorized into three main types:
Elastic
Demand: When the percentage
change in quantity demanded is greater than the percentage change in price,
demand is said to be elastic. In this case, a small change in price leads to a
proportionately larger change in quantity demanded. The elasticity coefficient
is greater than 1 (|Ed| > 1).
Inelastic
Demand: When the percentage
change in quantity demanded is less than the percentage change in price, demand
is considered inelastic. Here, a change in price results in a proportionately
smaller change in quantity demanded. The elasticity coefficient is less than 1
(|Ed| < 1).
Unitary
Elasticity: When the percentage
change in quantity demanded is equal to the percentage change in price, demand
is said to be unitary elastic. In this case, a change in price leads to an
equal percentage change in quantity demanded. The elasticity coefficient is
equal to 1 (|Ed| = 1).
The importance of price
elasticity of demand in the field of economics is as follows:
Pricing
Strategy: Price elasticity of
demand helps businesses determine the optimal pricing strategy for their products.
If demand is elastic, a decrease in price can lead to a significant increase in
revenue. Conversely, if demand is inelastic, raising prices may generate higher
profits. Understanding elasticity helps businesses make informed pricing
decisions.
Revenue
Forecasting: By knowing the
elasticity of demand for their products, businesses can forecast the impact of
price changes on their total revenue. Elastic demand suggests that price
changes will have a substantial effect on revenue, while inelastic demand
indicates a smaller impact. This information helps businesses estimate future
revenue and plan their operations accordingly.
Market
Analysis: Price elasticity of
demand provides insights into the competitiveness of a market. If demand is
highly elastic, it implies that consumers have a range of substitute products
to choose from. This information is valuable for market analysis, product
positioning, and understanding consumer behavior.
Taxation
and Government Policies: Elasticity
of demand is crucial in determining the effects of taxation and government
policies on consumer behavior. Taxes on goods with inelastic demand may
generate higher government revenue without significantly impacting consumer
demand. On the other hand, goods with elastic demand may experience a
substantial decrease in demand due to tax increases.
Resource
Allocation: Elasticity of demand
helps in efficient allocation of resources. When demand for a product is
elastic, resources can be reallocated to more profitable ventures. If demand is
inelastic, resources can be allocated to industries where demand is more responsive
to changes in price.
Overall, price elasticity of
demand is a fundamental concept in economics that assists businesses,
policymakers, and analysts in making informed decisions regarding pricing,
revenue forecasting, market analysis, taxation, and resource allocation.
