demand elasticity
Demand elasticity measures how sensitive the quantity demanded of a good or service is to changes in one of its determinants, such as price, income, or the price of related goods. It helps understand how demand responds to external factors. The most common types of demand elasticity are price elasticity, income elasticity, and cross-price elasticity.
1. Price Elasticity of Demand (PED)
- Definition: Price elasticity of demand measures the percentage change in quantity demanded of a good in response to a percentage change in its price.
- Formula: PED=% change in quantity demanded% change in pricePED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}
- Interpretation:
- Elastic Demand (PED > 1): A small change in price leads to a large change in quantity demanded. Consumers are very responsive to price changes. Examples include luxury goods or goods with many substitutes.
- Inelastic Demand (PED < 1): A change in price leads to a smaller change in quantity demanded. Consumers are less responsive to price changes. Examples include necessities like food, gasoline, or medicine.
- Unitary Elasticity (PED = 1): The percentage change in quantity demanded is equal to the percentage change in price.
- Perfectly Elastic Demand (PED = ∞): Any price increase leads to zero quantity demanded. This is rare and theoretical.
- Perfectly Inelastic Demand (PED = 0): Quantity demanded does not change regardless of price changes. Examples include life-saving drugs.
2. Income Elasticity of Demand (YED)
- Definition: Income elasticity of demand measures the responsiveness of quantity demanded to changes in consumer income.
- Formula: YED=% change in quantity demanded% change in incomeYED = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in income}}
- Interpretation:
- Positive YED: For normal goods, an increase in income leads to an increase in quantity demanded.
- Luxury goods have a high positive YED (YED > 1), meaning demand rises more than proportionally with income.
- Necessities have a low positive YED (0 < YED < 1), meaning demand rises less than proportionally with income.
- Negative YED: For inferior goods, an increase in income leads to a decrease in quantity demanded (YED < 0), as consumers switch to higher-quality alternatives.
- Positive YED: For normal goods, an increase in income leads to an increase in quantity demanded.
3. Cross-Price Elasticity of Demand (XED)
- Definition: Cross-price elasticity measures how the quantity demanded of one good changes in response to a price change in another good.
- Formula: XED=% change in quantity demanded of good A% change in price of good BXED = \frac{\% \text{ change in quantity demanded of good A}}{\% \text{ change in price of good B}}
- Interpretation:
- Positive XED: If XED > 0, the goods are substitutes (e.g., Coke and Pepsi). A price increase in one leads to an increase in demand for the other.
- Negative XED: If XED < 0, the goods are complements (e.g., printers and ink). A price increase in one leads to a decrease in demand for the other.
- Zero XED: If XED = 0, the goods are unrelated.
Importance of Demand Elasticity:
- Business Decision-Making: Firms use elasticity to decide on pricing strategies. If demand is elastic, they may lower prices to increase total revenue. If inelastic, they can raise prices without losing many sales.
- Government Policy: Elasticity helps assess the impact of taxes, subsidies, and price controls on the economy. For instance, taxes on goods with inelastic demand (like tobacco) can generate significant revenue.
- Consumer Behavior: Understanding elasticity helps predict how changes in the economy, such as income levels or the prices of other goods, affect consumer purchasing patterns.
Also Read
- Consumer Behavior: Utility, Indifference Curve, Consumer Surplus
- Types of Markets: Perfect Competition, Monopoly, Oligopoly
- Why Eid Milad un-Nabi is celebrated?
- Market Equilibrium: Determination of Prices
- Supply: Law of Supply, Elasticity
- Demand: Law of Demand, Elasticity