Price Elasticity of Demand

Price Elasticity of Demand Homework help

Price Elasticity of Demand refers to the change in demand for the goods with a change in the prices of goods; provided other things remain constant i.e. unchanged. It measures the percentage change in the demand for the product with 1% change in the prices. It is a major determinant in setting the prices of products. The Price elasticity is generally in negative because of the inverse relation between Price and Demand. But the economists take the price elasticity in the absolute manner which can lead to misinterpretation of the results sometimes. If the Price Elasticity of Demand is greater than 1, it means it is relatively elastic; if it is equal to 1; it is perfectly elastic and if the elasticity is less than 1; it means it is relatively inelastic. Thus an economist has to interpret that how the demand for a product reacts to a certain change in the prices of the goods.


The Price Elasticity of Demand is determined by various numbers of facts. These can be understood as follows:


  1. Substitute Products: If the product has substitute products present in the market, it will have an elastic demand as with the minimal rise in the prices of the products, the consumer will be able to shift to the substitute product. Thus, a slight change in the price will result in the major shift in the demand.

  2. Income of the consumer: A consumer having a huge income will not be concerned about the changes in the price of the product. He will continue to consume the same amount of good without taking into consideration the changes in the price of the goods. The changes in the price will be immaterial for him.

  3. Brand Loyalty: Some consumers like to stick with the brands even when the prices of the products rise. This attachment to the brand can be due to the emotional attachment or other factors. In such instances, the consumer's demand the product does not change even after the rise in prices. He stays with the same brand.

  4. Duration of the goods: The duration of the products stat its price elasticity. The goods which can be stored and retained for a long period of time tend to have a high elasticity of demand; whereas the goods with less duration or the perishable natured goods, they tend to have an inelastic demand irrespective of the change in the prices.

  5. Necessity: The goods which are a necessity for the survival of the human beings tend to have an inelastic demand. The consumer will continue to consume the necessary commodity irrespective of the prices because these products ensure the survival. For example, Wheat, Medicines etc.

  6. The breadth of Definition of goods: The breadth of the definition of the goods defines the elasticity. If the goods are of broad nature and serve a wide group of customers or serve a large purpose, then their elasticity of demand will be relatively inelastic as compared to other products.

  7. Percentage of the income: The elasticity of the product also depends upon its percentage in the total budget. If a good is a negligible amount in comparison to the total budget, the rises in the prices of that good will not affect the demand for the product. But if the good’s price is material to the budget; even a slight change in the price of that product will render its demand elasticity highly elastic.

How to calculate Price Elasticity of Demand:

There are various formulae for calculating the price elasticity of demand:


Basic method to calculate Price Elasticity of Demand Ed= P/Q × ∆Q/∆P


Arc Elasticity: Ed= (P1+P2)/2)/(Q1+Q2)/2) × ∆Q/∆P = Ed = (P1+P2)/(Q1+Q2 ) × ∆Q/∆P


Where,
ΔQ is change in the Quantity i.e. Q1-Q2,
ΔP is change in the Income i.e. P1 – P2,
P1 is the price at the beginning,
P2 is the price at the end,
Q1 is the quantity at the beginning and
Q2 is the quantity at the end.

Relation of Price Elasticity to Marginal Revenue:

The following equation holds

R'=1+ 1/Ed

Where R' is the marginal revenue

P is the price

The above-given equation depicts the relation between the Marginal Revenue and the Price Elasticity of Demand.


Cross- Elasticity of Demand:

Cross Elasticity of demand refers to the percentage change in the quantity demanded due to the change in the prices of another good, provided other variables remain constant. For example, a rise in the prices of fuel will result in the demand for the fuel driven cars; a rise in the prices of computer hardware will result in the prices of the computer.


Thus, the relation between the goods can be Complementary or Substitute Goods. Complementary Goods means the goods that have a negative price elasticity of demand i.e. rise in the prices of one good will result in the fall in the demand for another good. Thus there is an inverse relationship between the both. Whereas Substitute Goods refers to the goods which can be replaced by another good and the rise in the prices of one product will result in the rise of the demand for the other good. Thus there is a positive price elasticity of demand between the both.

Income- Elasticity of Demand:

Income Elasticity of demand refers to the change in the quantity demanded of the product due to the change in the income of the people demanding that product, provided that other things remain constant. With the rise in the income of the buyer, he will consume more; thus resulting in a rise in the demand and vice versa. Income Elasticity of demand can be calculated as:


Ey = (% Change in Demand)/(% Change in Income)
Or, EY = ∆Q/∆Y  ×  I/Q
Where,
ΔQ stand for the change in the Quantity i.e. Q1-Q2,
ΔI stands for the change in the Income i.e. I1 – I2,
I stands for the  Income,
Q stands for the Quantity.

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