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Explain The Price Elasticity Of Demand Economics Essay

Price elastic of Demand is derived from the percentage change in quantity (% change quantity demand) and percentage change in price (%change in price).

Price elasticity of demand (PED/ Ed) is a used to show the sensitivity, or elasticity, of the quantity demanded of a good or service to a change in its price. In a nutshell, it gives the percentage change in quantity demanded in response to a single percent change in price.

Explanation

Price elasticity of demand is a measure of the responsiveness of the quantity of a good or service demanded to changes in its price. The formula for the coefficient of price elasticity of demand for a commodity is:

The above formula yields a negative value, due to the inverse nature of the relationship between price and quantity demanded, as described by the "law of demand”. For example, if the price increases by 10 percent and quantity demanded equally, then the elasticity at the initial price and quantity = −1 (due to inverse proportion between demand and price). However, economists often refer to price elasticity of demand as a positive value i.e., in absolute value terms.

Example

Suppose when the price of “A” is \$10 quantity demand for “A” is 1,000 units. Now the price of “A” is decrease by \$2 and the quantity demand for “A” jumps to 1500 units. Now we calculate what is the price elasticity of demand?

Data:

Initial Quantity = 1000 units

Change in Quantity = 500 units

Initial Price =\$10

Change in Price = \$2

Solution:

We know that Price elasticity of demand= %change in quantity demanded/Percentage change in price.

= {(500/1000)/ (2/10)}*100

= {0.5/0.2}

Price elasticity of Demand is =2.5

Interpretation of the above example

If the price is decrease by 1% than quantity demand for “A” is increased by 2.5%.

Elasticities of demand are interpreted as follows

Descriptive Terms

Ed = 0

Perfectly inelastic demand

- 1 < Ed < 0

Inelastic or relatively inelastic demand

Ed = - 1

Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand

- ∞ < Ed < - 1

Elastic or relatively elastic demand

Ed = - ∞

Perfectly elastic demand

When the percentage change in quantity demanded is less than the percentage change in price is known as inelastic(so that Ed > - 1).

When the percentage change in quantity demanded is equal to the percentage change in price is called unity(so that Ed = - 1).

When the percentage change in quantity demanded is greater than the percentage change in price is called elastic (so that Ed < - 1).

Normal Good:

A good for which an increase causes an increase in the demand, or a leftward shift in the demand curve. If demand increase as income increase, it a normal good, or a good with a positive income elasticity of demand.

Explanation:

In the above diagram it has been shown the demand curve of normal good before and after increase in purchasing power of a normal man i.e. in his income.

Before increase in income, he would demand for Q1 for price P1. When the income of the consumer will increase than his purchasing power will also increase. Because of increase in his income the demand for normal good will also increase and the demand curve will be shifted to some extent till both supply and demand curves come into equilibrium. Now he is ready to pay price P2 for Quantity Q2 of normal good.

INFERIOR GOOD:

A good for which an increase in income causes a decrease in demand, or a leftward shift in the demand curve. If demand decreases as income increases, it is an inferior good, or a good with a negative income elasticity of demand

Diagram

In the above diagram it has been shown the demand curve of inferior good before and after increase in income.

Before increase in income, consumers were dependent on inferior goods for their survival. On price P1 the demand for “X” was Q1.

When the income of the consumers will be increased than their purchasing power will also be increased. Because of increase in their income they start purchasing normal goods instead of inferior good. The demand for inferior goods will be decreased and it will be shifted downward and is shown in the figure.

Due to downward shift in demand curve for inferior goods price will be affected and it will be decreased from P1 to P2. Quantity demanded for inferior good will also decreased from Q1 to Q2.

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