Define And Explain Price Elasticity Of Demand

1316 words - 5 pages

Price elasticity of demand is defined as how demand changes as a result of a change in price. It can be said that if a reduction in price leads to an increase in demand then demand is relatively elastic. Elasticity
is usually negative. There is an alternative scenario where demand will increase as price does so too. This happens only in the case of Giffen goods, where elasticity is positive. The formula for price elasticity of demand is:
Percentage Change in Quantity Demanded
Percentage Change in Price
     One determinant of price elasticity is the number and closeness of substitutes there are available for a good. The closer the goods are, the greater will be the price elasticity of demand of that good. The reason for this being that people will be able to switch to the substitutes when the price of the original good goes up. The greater the number of substitutes and the closer they are, the more people will be able to switch, and so the bigger the substitution effect will be of any price rise.
Another determinant is the proportion of income spent on the good. The higher the proportion of our income that is spent on a good, the more we will forced to cut back consumption in the event of a price rise, so the bigger the income effect and the more elastic the demand will be. This is the reason salt has a very low price elasticity of demand. We spend such a small proportion of income on salt that a relatively big percentage increase in the price of salt is borne by us without too much difficulty, so the income effect would be pretty small.
     One other determinant of price elasticity of demand is the time period. When prices rise people may take time to adjust their consumption patterns and find alternatives. The longer the time after a price change, then, the more elastic is demand likely to be.
     Income elasticity is a measure of responsiveness of the demand to a change in incomes. Income elasticity is important to firms considering the future market for their product. If the product has a high income elasticity of demand then sales are likely to expand rapidly as national income goes up, but also fall quickly should the economy move into recession. The formula for income elasticity of demand is:
Percentage Change in Quantity Demanded
Percentage Change in Income
     One of the determinants of income elasticity of demand is the degree of necessity of the good. In a developed country, the demand for luxury goods expands rapidly as people’s incomes rise, whereas the demand for basic goods, such as bread, only rises a little. So items like cars have a high income elasticity of demand, whereas items like potatoes have a low income elasticity of demand.
     For inferior goods, the quantity of goods demanded actually decreases as income goes up. This is true in cases of things like cheap margarine. As people earn more they switch to butter or better quality margarine. Inferior goods have a negative elasticity of demand.
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