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PRICE ELASTICITY OF DEMAND

Q) Define price elasticity of demand? A) Price elasticity of demand indicates the magnitude of change or the degree of
responsiveness of demand for a commodity to a change in its price. Mathematically, it is the ratio of proportionate (percentage) change in demand to proportionate (percentage) change in price. Symbolically, it is defined as; Price Elasticity of demand (Ed) = Percentage change in quantity demanded Percentage change in the price OR, Change in quantity demanded q * 100 Initial quantity demanded Q. Change in quantity price p * 100 Initial price P Ed = q/Q p/P

= q * P p Q Example: Price of a commodity has gone down from Rs.100 to Rs.50. As a result the quantity demanded has gone up from 200 to 400. Solution: Ed = q * P p Q = 200 * 100.. 50 200 = 2

Q) Explain various kinds (degree) of price elasticity of demand. A) Price elasticity of demand is the measurement of responsiveness of demand to change
in price. Demand for different goods responds differently to change in price. For instance, demand for salt does not respond or change at all even if its price falls by 50% whereas demand for apples responds very much when its price falls by 20% only. On the basis of change in demand as a result of changes in price, elasticity of demand can be classified into the following categories: (i) Elastic Demand or More than unit elastic demand (Ed >1): if percentage change in quantity demanded is more than the percentage change in price the commodity is said to have more than unit elastic (Ed >1) or Elastic

demand. For example, if price falls by 10%, the quantity demanded will go up more than 10%. The demand for luxury goods (AC, TV, refrigerator, Cars) is elastic. Price 10 5 Demand 20 40

In the diagram, Demand curve is an elastic demand curve. When price declines from OP to OP1, demand increases from OQ to OQ1, the change in price is only PP1, but the change in demand is OQ1 which is much more than the change in price. The slope of this curve is more inclined towards OX axis or it is a flatter curve. (ii) Inelastic Demand OR Less than unit elastic demand (Ed <1) : When the percentage change in quantity demanded is less than the percentage change in price, it is said to be less than unit / inelastic demand. For example, if price falls by 50%, the quantity demanded will go up to by 20%. The slope of the inelastic demand curve is steeper. Price 100 50 Demand 100 110

In the diagram, Demand curve is an inelastic demand curve. When price declines from OP to OP1, demand increases from OQ to OQ1 only. Thus it is evident that the change in demand is much less in comparison to the change in price.. the demand for necessary goods (basic foods items) is inelastic. (iii) Unitary elastic demand (Ed =1): When the percentage change in quantity demanded is equal to the Price Demand percentage change in price, it is said to be unitary elastic demand. The unitary elastic demand curve is a 100 100 rectangular hyperbola and the area of all rectangles formed on this curve is the same. For example, if 90 110 price falls by 10%, the quantity demanded will go up to by 20%. (iv) Perfectly elastic Demand (Ed 1) : When the demand for a commodity expands (rises) or contracts (falls) to any extent without change in price, the demand for the commodity is said to be perfectly elastic.

Price

Demand

10 10

10 20

For the diagram, it is clear that such a demand curve is a horizontal parallel to OX axis. In the diagram, price is OP, but demand can be OQ, OQ1, OQ2 etc. (v) Perfectly inelastic demand (Ed =0): When the demand of a commodity does not change as a result of change in its price, the demand is said to be perfectly inelastic demand. Here the elasticity of demand is equal to zero. This happens in case of goods which are absolutely essential like demand for a rare medicine or some very bad case of addiction to undesirable products like opium. Price 10 10 30 Demand 20 20 20

The perfectly inelastic demand curve is a vertical straight line parallel to OY axis. As it is clear from the diagram, price may be OP or OP1 or OP2, but the demand will be OQ. In other words, there is no effect of changes in the price on demand.

Q) If two demand curves intersect, at their point of intersection, which curve has higher elasticity of demand? A) If two demand curve intersect, at their point of intersection, the elasticity associated
with the flatter demand curve is higher. This is exhibited in the below diagram: The demand curves DD and D1D1 intersect at point E. at this point, OP is the price of the product. The claim is that, at price OP1, the elasticity is greater along the flatter demand curve D1D1 because the original quantity demanded is same, equal to OQ along both the demand curves. And if there is a decrease in price, say to OP1, the quantity demanded increases more along the flatter demand curve (by amount OQ to OQ2 as compared to OQ to OQ1, along DD curve). This implies that, while, the percentage change in quantity demanded is greater along D1D1. therefore, price elasticity associated with D1D1 is higher.

5) What factors affect the magnitude of price elasticity?

(i)

(ii)

(iii)

(iv) (v)

Availability of close substitute: If close substitutes of a product are readily available, its price elasticity of demand is likely to be high, because even a very small increase in price will make consumers switch to other products in a big way. Otherwise, in the absence of close substitutes, the elasticity is likely to be small (inelastic). Nature of commodity: More generally, the demand for essential products is likely to be inelastic. On the other hand, luxury: items are relatively dispensable. Hence the demand for these items is likely to be relatively elastic. Proportion of total expenditure spent on the product: If the expenditure spent on the product constitutes a very small fraction of the total expenditure on all goods and services we consume, then the price elasticity is likely to be small (Inelastic). The demand for salt is an example. On the other hand, if it is a high priced item and takes a major portion of our total expenditure, our demand for it is more sensitive to a change; that is elasticity of demand is likely to be high (Elastic). Habits: For people who are habitual is likely of a commodity has inelastic demand. Time period: All other things remaining the same, the longer the time period, more elastic is the demand for any product. (vi)Uses of a commodity: the greater the number of uses of a commodity the higher will be its price elasticity.

Q) What are the different methods of measuring price elasticity of demand? A) There are three methods of measuring price elasticity of demand:
a. Total expenditure / Total outlay method b. Proportional (Percentage) Method c. Point Method / Geometric Method I. Total expenditure / Total outlay method: This method was propounded by prof. Marshall. This method measures the elasticity of demand by measuring the effect on total expenditure as a result of a change in its price. Total expenditure is calculated by multiplying the quantity of the commodity purchased with its price. (TE = TQ * P) (i) Unit elastic Demand: If a fall or PRICE QUANTITY TOTAL rise in price leaves the total DEMANDED EXPENDITURE expenditure unaffected, elasticity 10 10 100 of demand is unity (Ed = 1). It is 5 20 100 shown below: (ii) More than unit elastic demand: if a fall in price leads to increase in total expenditure or a rise in price reduces the total expenditure, the elasticity of
PRICE QUANTITY DEMANDED TOTAL EXPENDITURE

10 5

10 20

100 100

(iii)

demand is said to be more than unity (Ed>1). There is a inverse relationship between price and total expenditure. Less than unit elastic demand: When a fall in price reduces total expenditure or a rise in price increases it, the elasticity of demand is said to be less than unity (Ed<1). PRICE QUANTITY TOTAL There is a same relationship DEMANDED EXPENDITURE between price and total 10 10 100 expenditure. 5 20 100

II. Proportionate or Percentage Method Price elasticity of demand indicates the magnitude of change or the degree of responsiveness of demand for a commodity to a change in its price. Price Elasticity of demand (Ed) = Percentage change in quantity demanded Percentage change in the price OR, Change in quantity demanded q * 100 Initial quantity demanded Q. Change in quantity price p * 100 Initial price P Ed = q/Q p/P

= q * P p Q When the answer is one, demand is unit elastic. When the answer is more than one, demand is elastic. When the answer is less than one, demand is inelastic. When the answer is zero, demand is perfectly inelastic. When the answer is infinite, demand is perfectly elastic.

III. GEOMETRIC / POINT METHOD: Elasticity of demand at a point on a straight line demand curve can be estimated with the help of point method. In the given diagram point E is given on the straight line demand curve AB having intercepts A and B respectively on the price axis and quantity axis respectively. Point elasticity, at a certain point along a straight line demand curve, is equal to the lower segment divided by the upper segment of the demand curve at that point. Ed at point E on the straight = Lower Segment EB Segment below the point line demand curve Upper segment AE Segment above the point

1) If the lower segment is equal to upper segment (EB = AE) elasticity of demand is equal to one. This will be so when point is located in the middle of the line. 2) If the lower portion EB is greater than upper portion AE, elasticity of demand will be greater than one. This will happen when the point is located in the upper half of the curve. 3) If lower portion is less than upper portion, elasticity of demand will be less than one. It so happens when point is located in the lower half. 4) If the point is located on OX axis, elasticity of demand will be zero because lower segment is zero. 5) If the point is located on the OY axis, elasticity of demand will be infinite because upper segment is equal to zero.