Elasticity of Demand - Key Concepts PDF

Elasticity of Demand: Key Concepts Elasticity measures how much one variable changes in response to a change in another (a measure of responsiveness). In the context of demand, Elasticity of demand, it shows how sensitive the demand for a product is to changes in its determinants. Economists fo...

Elasticity of Demand: Key Concepts Elasticity measures how much one variable changes in response to a change in another (a measure of responsiveness). In the context of demand, Elasticity of demand, it shows how sensitive the demand for a product is to changes in its determinants. Economists focus on two main types: 1\. Price Elasticity of Demand (PED) 2\. Income Elasticity of Demand (YED) 1\. Price Elasticity of Demand (PED) Definition: PED measures how much the quantity demanded of a product changes in response to a change in its price. percentage change in quantity demaned of the product Formula: PED= \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ percentage change in price of the product For example (book pg 68) if a product's price drops by 10% and demand increases by 15%, the PED would be -1.5 (usually reported as 1.5 to show the magnitude). Ranges of PED Values: \- Perfectly Inelastic Demand (PED = 0): Quantity demanded doesn't change with price changes. \- Perfectly Elastic Demand (PED = ∞): Any increase in price drops demand to zero. \- Inelastic Demand (0 \< PED \< 1): if the price goes up a lot the demand drops a little \- Elastic Demand (PED \>1): if the price goes up a bit the demand drops a lot \- Unit Elastic Demand (PED = 1): Demand changes exactly in proportion to price changes. Examples: \- Inelastic Demand: Price increase leads to a smaller proportional decrease in demand, increasing total revenue. Example: Raising yogurt price from \$1 to \$1.20 reduces demand slightly, increasing revenue. \- Elastic Demand: Price increase leads to a larger proportional decrease in demand, decreasing total revenue. Example: Raising hotdog price from \$2 to \$2.10 reduces demand significantly, lowering revenue. \- Unit Elastic Demand: Price change leads to a proportionate change in demand, keeping total revenue constant. What are the determinates of PED? Elasticity varies along a straight-line demand curve: \- Higher-priced products tend to have more elastic demand (consumers are sensitive to price changes). \- Lower-priced products tend to have more inelastic demand (consumers are less sensitive). 1\. Number and Closeness of Substitutes Description: \- The availability of close substitutes for a product is one of the most significant factors affecting its price elasticity. When consumers can easily switch to a different product if the price of one product increases, demand is typically more elastic. Conversely, products with few or no close substitutes tend to have inelastic demand. Examples: \- Butter vs. Margarine: If the price of butter rises, consumers can easily switch to margarine, a close substitute. This makes the demand for butter relatively elastic, as consumers will likely buy less butter if its price goes up. \- Petrol (Gasoline): Petrol has few close substitutes, especially in areas where public transportation is limited. As a result, even if the price of petrol increases, consumers may not significantly reduce their petrol consumption, making its demand relatively inelastic. \- Specific Brands of Soft Drinks: If the price of Coca-Cola increases, consumers can switch to Pepsi, another similar cola drink. This close substitutability among brandsmakes the demand for each brand more elastic than for the general category of cola drinks.3. Proportion of Income Spent on the Good Description: \- If a product takes up a large portion of a person's income, they are more likely to be sensitive to price changes, resulting in more elastic demand. Conversely, goods that constitute a small part of the budget tend to have inelastic demand, as price changes have minimal impact on the consumer's overall expenses. Examples: \- Daily Coffee: For someone who buys a coffee every day that costs \$2, a 10% increase to \$2.20 is unlikely to make much difference because the cost is low relative to their overall income. Therefore, demand for daily coffee is relatively inelastic. \- Luxury Cars: If a luxury car costing \$100,000 experiences a 10% price increase, that's a significant extra cost (\$10,000) for the buyer. This would likely deter some buyers, making the demand for luxury cars more elastic. \- Housing Costs: Housing is a substantial part of most people's budget. If rent prices rise significantly, people may look for alternatives, like moving to a cheaper neighborhood. This elasticity varies based on income and availability of alternatives but can be moderately elastic.