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MB0042 - Q1. Explain what is price elasticity of demand and outline the determinants of price elasticity of demand with examples.

Answer:

Elasticity of Demand
Earlier we have discussed the law of demand and its determinants. It tells us only the direction of change in price and quantity demanded. But it does not specify how much more is purchased when price falls or how much less is bought when price rises. In order to understand the quantitative changes or rate of changes in
price and demand, we have to study the concept of elasticity of demand.

Meaning and Definition

The term elasticity is borrowed from physics. It shows the reaction of one variable with respect to a change in other variables on which it is dependent. Elasticity is an index of reaction.

In economics the term elasticity refers to a ratio of the relative changes in two quantities. It measures the responsiveness of one variable to the changes in another variable.

Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand to a given change in the price of a commodity.

It refers to the capacity of demand either to stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative changes in two quantities.ie, price and demand. According to prof. Boulding.

“Elasticity of demand measures the responsiveness of demand to changes in price” 1 In the words of Marshall,” The elasticity (or responsiveness) of demand in a market is great or small according to the amount demanded much or little for a given fall in price, and diminishes much or little for a given rise in price” 2.

Kinds of elasticity of demand
Broadly speaking there are five kinds of elasticity of demand.
They are Price Elasticity, Income Elasticity, Cross Elasticity, Promotional Elasticity and Substitution Elasticity. We shall discuss each one of them in some detail.

Price Elasticity of Demand
In the words of Prof. Stonier and Hague, price elasticity of demand is a technical term used by economists to explain the degree of responsiveness of the demand for a product to a change in its price.

Ep Percentage change in quantity demanded / Percentage change in price

where Ep is price elasticity

Demand risesby 80%, i.e. +80
----------------------------------------- = -4
Pr ices falls by 20%, i.e -20

Demand falls by 80%, i.e. -80

---------------------------------------- = -4

price rises by 20%,i.e. +20



It implies that at the present level with every change in price, there will be a change in demand four times inversely. Generally the co-efficient of price elasticity of demand always holds a negative sign because there is an inverse relation between the price and quantity demanded.





Symbolically Ep = ∆D / ∆P * P/D

= 40/-2 * 6/20 = -6

Original demand = 20 units original price = 6 – 00

New demand = 60 units New price = 4 – 00

In the above example, price elasticity is – 6.



The rate of change in demand may not always be proportionate to the change in price. A small change in price may lead to very great change in demand or a big change in price may not lead to a great change in demand. Based on numerical values of the co-efficient of elasticity, we can have the following five degrees of price elasticity of demand.

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