Economics Assignment Solution

ELASTICITY OF DEMAND

Elasticity indicates responsiveness of one variable to another and elasticity of demand means responsiveness (or reaction) of demand due to its determinants. Accordingly there are three main kinds of elasticity of demand.

Price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

PRICE ELASTICITY OF DEMAND

Price Elasticity of demand is a measure of the responsiveness of the demanded quantity to price changes.

The elasticity of demand for something is:  For instance, If price goes up 1% and as a result sales fall 2%, the elasticity is -2%/1%=-2.

Since changes in price and quantity usually move in opposite directions, usually we do not bother to put in the minus sign. We are more concerned with the co-efficient of elasticity of demand.

Values for price elasticity of demand

  1. If Ped = 0 demand is perfectly inelastic – demand does not change at all when the price changes – the demand curve will be vertical.
  2. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the percentage change in price), then demand is inelastic.
  3. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level.
  4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The price elasticity of demand for this price change is –3

Factors affecting price elasticity of demand

  • The number of close substitutes – the more close substitutes there are in the market, the more elastic is demand because consumers find it easy to switch
  • The cost of switching between products – there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract.
  • The degree of necessity or whether the good is a luxury – necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand.
  • The proportion of a consumer’s income allocated to spending on the good – products that take up a high % of income will have a more elastic demand
  • The time period allowed following a price change – demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending.
  • Whether the good is subject to habitual consumption – consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice).
  • Peak and off-peak demand – demand is price inelastic at peak times and more elastic at off-peak times – this is particularly the case for transport services.
  • The breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change.

Basic Concept of Time Value of Money

 

 

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