BE/U2 Topic 2 Price Elasticity of Demand
The term ‘elasticity’ means the change in one variable in comparison to another variable. In Economics, elasticity is used especially to compare the effect of change of one variable on another.
The law of demand states the inverse relationship between the price of a product and its quantity demanded. However, this doesn’t tell us how far the changes in price of a product affect its quantity demanded.
Price elasticity of Demand is the responsiveness of quantity demanded to changes in price. In other words it is the percentage change in quantity demanded in comparison to the percentage change in price of a product.
Ed = Percentage quantity demanded / Percentage change in price = %∆Qd/%∆P.
For example, if quantity demanded goes up from 100 to 150 as a result of a change in price from 4 to 3, then we can calculate the price elasticity of demand as follows:
Percentage change in quantity demanded = ((150-100)/100) x 100 = 50%
Percentage change in price = ((4-3)/4) x 100 = 25%
Price elasticity of demand = 50%/25% = 2.
This means, at this point on demand curve, the percentage change in quantity demanded is 2 times any percentage change in price.
Determinants of Price Elasticity of Demand
(i) Number of substitutes
If a good has more substitutes, an increase in price of the good will result in people choosing to buy the substitute goods. Therefore, the more substitutes a good has, the more price elastic it becomes.
(ii) Necessities verses luxuries
If a good is considered as a necessity, increase in price of it will lead to a less proportionate reduction in quantity demanded. Whereas, if it is considered as a luxury, then it is usually price elastic
(iii) Percentage of one’s budget spent on the good
The greater the percentage of one’s budget that goes to purchase a good, the higher the price elasticity of demand for that product and vice versa.
As time passes buyers have more opportunities to be responsive to a price change. Even if people may not have many alternative products to shift to, it is more likely that as time passes, more substitutes will be available in the market. Therefore, the more the time passes after a change in price, the higher is the price elasticity of demand.
If the percentage change in quantity demanded is higher than the percentage change in price, the calculated elasticity demanded is greater than 1. In this case we say the demand is elastic.
If the percentage change in quantity demanded is less than the percentage change in price, the calculated elasticity demanded is less than 1. In this case we say the demand is inelastic.
Unit Elastic Demand
If the percentage change in quantity demanded is equal to the percentage change in price, the demand will be unit elastic. The calculated price elasticity of demand is equal to 1.
Perfectly Elastic Demand
In this case any change in price of a product results in infinite change in quantity demanded. For example, buyers are willing to buy all units, as much as the producers can produce at the price of 10. However, a very small change in price, say to 10.10, results in nobody buying anything. The quantity demanded falls to 0. In this case the demand is perfectly elastic. This is shown by a demand curve that is a horizontal line. This situation exists in perfect competition, where there are so many buyers and sellers in a market and no individual of them is able to influence the market price.
Perfectly Inelastic Demand
When demand is perfectly inelastic, it does not respond at all to the change in price. This situation could exist at some price levels of those goods which are absolute necessities. But this situation does not hold for too long, or it seldom exists for any product.
Elastic Demand and Total Revenue
Total revenue is calculated by multiplying price and quantity demanded of a product. If the demand for a product is price elastic, an increase in price will result in a more than proportionate reduction in the quantity demanded for the product. And thus, an increase in price will lead to a reduction in total revenue, if its demand at that point is price elastic.
Inelastic Demand and Total Revenue
If the demand for a product is price inelastic, an increase in price will result in a less than proportionate reduction in the quantity demanded for the product. And thus, an increase in price will lead to an increase in total revenue, if its demand at that point is price inelastic.