Principles of Economics

Suppose the price elasticity of demand for text books is two and the price of the text book is increased by 10%. By how much does the quantity demand fall? Inter the result and discuss reasons for the fall in quantity demand?

Answer:

Given:

Price elasticity of demand for text books = 2

Price  elasticity  of  textbook  up by  10%

Solution:

    % Change  in quantity                ?

     ------------------------------- =   -------------- = 2

     % Change  in  price                   10%

Result:

Quantity  demand  is  down  by =  - 20%

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Elasticity of demand

Ped(Price elasticity of demand) measures the responsiveness of demand for a product following a change in its own price.

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided by the percentage change in price

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

Understanding values for price elasticity of demand (Ped)

ü  If Ped = 0 then demand is said to be perfectly inelastic. This means that demand does not change at all when the price changes – the demand curve will be vertical

ü  If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is smaller than the percentage change in price), then demand is inelastic. Producers know that the change in demand will be proportionately smaller than the percentage change in price

ü  If Ped = 1 (i.e. the percentage change in demand is exactly the same as the percentage change in price), then demand is said to unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending by the same at each price level.

ü  If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is elastic. For example a 20% increase in the price of a good might lead to a 30% drop in demand. The price elasticity of demand for this price change is –1.5

Reasons for the fall in quantity demand

The relationship between price elasticity of demand and a firm’s total revenue is a very important one. The diagrams below show demand curves with different price elasticity and the effect of a change in the market price.

When demand is inelastic – a rise in price leads to a rise in total revenue – for example a 20% rise in price might cause demand to contract by only 5% (Ped = -0.25)

When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2.5)

Firms can use price elasticity of demand (PED) estimates to predict:

ü  The effect of a change in price on the total revenue & expenditure on a product.

ü  The likely price volatility in a market following unexpected changes in supply – this is important for commodity producers who may suffer big price movements from time to time.

ü  The effect of a change in a government indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.

Elasticity of demand, in the case of any good, expresses the degree in which a change in its ratio to other goods will increase the demand. Elasticity varies for different classes of men according to their wealth and to the cost of the goods. If strawberries are a dollar a box in the city market, a slight fall in the price, say to seventy-five cents, will increase the demand but slightly. But if the price is fifteen cents and falls to ten, the increase in the demand will be marked, for the number of consumers to whom a difference of five cents is important is then very great. The demand for the staples is comparatively inelastic. A certain amount of simple food is necessary to support life; an increase in its price will not quickly check the demand. On the other hand, if the price of staple foods falls, no very great increase will take place in the demand.

Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination (also known as yield management). This is where a monopoly supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or yield management by many of our domestic and international airlines. 

The price elasticity of demand measures how much the quantity demanded responds to changes in the price. Demand tends to be more elastic if the good is a luxury rather than a necessity, if close substitutes are available, if the market is narrowly defined, or if buyers have substantial time to react to a price change.

◆ The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the elasticity is less than 1, so that quantity demanded moves proportionately less than the price, demand is said to be inelastic. If the elasticity is greater than 1, so that quantity demanded moves proportionately more than the price, demand is said to be elastic.

◆ Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold. For inelastic demand curves, total revenue rises as price rises. For elastic demand curves, total revenue falls as price rises.

◆ The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

◆ The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run.

◆ The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. If the elasticity is less than 1,so that quantity supplied moves proportionately less than the price, supply is said to be inelastic. If the elasticity is greater than 1, so that quantity supplied moves proportionately more than the price, supply is said to be elastic.

◆ The tools of supply and demand can be applied in many different kinds of markets. For analyzing the market for wheat, the market for oil, and the market for illegal drugs.

Solutions:

Concentrate on position on the demand curve and the formula:

The discussion of price elasticity of demand can be improved by placing emphasis where it belongs: on the relative price level. To put it simply, if the price of a product is in the upper half of a linear demand curve, then demand is price elastic; otherwise it is price inelastic.

The elasticity of a linear demand curve is the ratio of the length of the curve below the price to the length above. While the calculations of the length of line segments are not particularly simple, the intuition is helpful. Slope does not matter. What matters is where the price resides on a linear demand curve.

Further, although it is typically true that a firm mass producing a low cost good with little or no control over price is likely to operate in the price inelastic part of its demand curve, while a firm that is producing a high cost good in a monopolistic or monopoly market is likely to operate in the price elastic part of its demand curve, instructors cannot use these determinants to motivate a principles discussion of price elasticity of demand. Using two demand curves to show different elasticities without changing slope.

Conclusion:

With these types of Models and averaged results, we can not only measure Price Elasticity, but also check it against standard deviations and to know whether we are performing well or not.