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Qurratulain · #3 Sunday, October 22, 2006

Elasticity of Demand

1- Price elasticity of demand

Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X

• If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price elasticity = 2.0

• If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity = 0.25

• If the PED is equal to one, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change in price. Demand changes proportionately to a price change.

• If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical.

• If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This demand curve is associated with firms operating in perfectly competitive markets

Factors that determine the value of price elasticity of demand

1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong.

2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for opera tickets is more elastic than the demand for urban rail travel. The demand for vacation air travel is more elastic than the demand for business air travel.

3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.

4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand. Preferences are such that habitual consumers of certain products become de-sensitised to price changes.

5. Time period under consideration - Demand tends to be more elastic in the long run rather than in the short run. For example, after the two world oil price shocks of the 1970s - the "response" to higher oil prices was modest in the immediate period after price increases, but as time passed, people found ways to consume less petroleum and other oil products. This included measures to get better mileage from their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil became more elastic in the long-run.