MICRO ECONOMICS

ASSIGNMENT

PRICE ELASTICITY

SUBMITTED TO

MR. RAJ KUMAR

SUBMITTED BY

VIVEKSINGH.A

I - PGDM
INTRODUCTION

Price elasticity of demand (PED) is defined as the

responsiveness of the quantity demanded of a good or service to a change in its
price.

In other words, it is percentage change of quantity demanded

by the percentage change in price of the same commodity. In economics and
business studies, the price elasticity of demand is a measure of the sensitivity of
quantity demanded to changes in price. It is measured as elasticity that is it
measures the relationship as the ratio of percentage changes between quantity
demanded of a good and changes in its price.

In simpler words: demand for a product can be said to be very

inelastic if consumers will pay almost any price for the product, while demand for
a product may be elastic if consumers will only pay a certain price, or a narrow
range of prices, for the product.

Inelastic demand means a producer can raise prices without

much hurting demand for its product, and elastic demand means that consumers are
sensitive to the price at which a product is sold and will not buy it if the price rises
by what they consider too much.

Drinking water is a good example of a good that has inelastic

characteristics - in that people will pay anything for it. On the other hand, demand
for sugar is very elastic because as the price of sugar increases there are many
substitutions which consumers may switch to.
 A price fall usually results in an increase in the quantity
demanded by consumers (see Giffen goods for an exception). The demand for a
good is relatively inelastic when the change in quantity demanded is less than
change in price. Goods and services for which no substitutes exist are generally
inelastic.

Demand for an antibiotic, for example, becomes highly inelastic when

it alone can kill an infection resistant to all other antibiotics. Rather than die of an
infection, patients will generally be willing to pay whatever is necessary to acquire
enough of the antibiotic to kill the infection

Various research methods are used to calculate price elasticity:

 Test market
 Analysis of historical sales data
 Conjoint analysis

Price elasticity is always negative, although analysts tend to ignore the

sign. It is always negative due to the very nature of demand, if the price increases,
less is demanded, and thus quantity change is negative, leading to a negative price
elasticity of demand. Conversely, if price falls, this negative value will lead to a
negative price elasticity of demand value.

DEGREES OF PRICE ELASTICITY

The following are the different degrees of elasticity:
 Perfectly elastic demand
 Highly elastic demand
 Unitary elastic demand
  Relatively inelastic demand
 Perfectly inelastic demand

PERFECTLY ELASTIC DEMAND

This is one extreme of the elasticity range, when elasticity is
equal to infinity. In this case, unlimited quantities of the commodity can e sold at
the prevailing price and even a negligible increase in price would result in zero
quantity demanded. The perfectly elastic demand curve is a horizontal line, parallel
to the quantity axis.

PERFECTLY ELASTIC DEMAND CURVE

HIGHLY ELASTIC DEMAND

When proportionate change in quantity demanded is more than a

given change in price, the commodity is regarded to have a highly elastic demand.
In this case the proportionate change in quantity demanded is more than a
proportionate change in price. Such a degree of elasticity can be shown graphically
with a flatter demand curve and such goods are called luxuries.

HIGHLY ELASTIC DEMAND CURVE

UNITARY ELASTIC DEMAND

When a given proportionate change in price brings about an

equal proportionate change in quantity demanded, then demand for that commodity
is regarded as unitary elastic. Demand curve with unit elasticity are shaped like a
rectangular hyperbola, asymptotic to the axes; such cases of elasticity are
nevertheless uncommon in real life.

UNITARY ELASTIC DEMAND CURVE

RELATIVELY INELASTIC DEMAND

When change in quantity demanded is found to be offset by change in
its price, then the commodity has a relatively inelastic demand. In this case
proportionate change in quantity demanded is less than a proportionate change in
price. Such commodities have a steeper demand curve and are called necessities,
since they are less responsive to a given change in price.
PERFECTLY INELASTIC DEMAND

This is the other extreme of the elasticity range in which elasticity

is equal to zero. In this case the quantity demanded of a commodity remains the
same, irrespective of any change in the price, i.e., quantity demanded is totally
unresponsive to changes in price. Such goods are termed neutral and have a
vertical demand curve parallel to the price axis.
 PERFECTLY INELASTIC DEMAND

Value Meaning

Ed = 0 Perfectly inelastic.

- 1 < Ed < 0 Relatively inelastic or inelastic demand.

Ed = - 1 Unit (or unitary) elastic.

-∞ < Ed < - 1 Relatively elastic or elastic demand.

Ed = -∞ Perfectly elastic.
DETERMINANTS OF PRICE ELASTICITY DEMAND
A number of factors determine the elasticity:
 Substitutes: The more substitutes, the higher the elasticity, as people can
easily switch from one good to another if a minor price change is made.

 Percentage of income: The higher the percentage that the product's price is of
the consumer's income, the higher the elasticity, as people will be careful with
purchasing the good because of its cost.

 Necessity: The more necessary a good is, the lower the elasticity, as people
will attempt to buy it no matter the price, such as the case of insulin for those
that need it.

 Duration: The longer a price change holds, the higher the elasticity, as more
and more people will stop demanding the goods (i.e. if you go to the
supermarket and find that blueberries have doubled in price, you'll buy it
because you need it this time, but next time you won't, unless the price drops
back down again).

 Breadth of definition: The broader the definition, the lower the elasticity. For
example, Company X's fried dumplings will have a relatively high elasticity,
whereas food in general will have an extremely low elasticity (see Substitutes,
Necessity above).
REVENUE AND PRICE ELASTICITY OF DEMAND
A firm considering a price change must know what effect the
change in price will have on total revenue. Generally any change in price will have
two effects:
 The price effect: an increase in unit price will tend to increase revenue, while
a decrease in price will tend to decrease revenue.
 The quantity effect: an increase in unit price will tend to lead to fewer units
sold, while a decrease in unit price will tend to lead to more units sold.

Because of the inverse nature of the demand relationship the

two effects are offsetting. The firm needs to know what the net effect will be.
Elasticity provides the answer.

When the price elasticity of demand for a good is inelastic (|Ed|

< 1), the percentage change in quantity demanded is smaller than that in price.
Hence, when the price is raised, the total revenue of producers rises, and vice versa

When the price elasticity of demand for a good is elastic (|Ed| >
1), the percentage change in quantity demanded is greater than that in price. Hence,
when the price is raised, the total revenue of producers falls, and vice versa.

When the price elasticity of demand for a good is unit elastic

(or unitary elastic) (|Ed| = 1), the percentage change in quantity is equal to that in
price.

When the price elasticity of demand for a good is perfectly

elastic (Ed is undefined), any increase in the price, no matter how small, will cause
demand for the good to drop to zero. Hence, when the price is raised, the total
revenue of producers falls to zero. The demand curve is a horizontal straight line.
A banknote is the classic example of a perfectly elastic good; nobody would pay
£10.01 for a £10 note, yet everyone will pay £9.99 for it

When the price elasticity of demand for a good is perfectly

inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the
good. The demand curve is a vertical straight line; this violates the law of demand.

The formula used to calculate coefficients of price elasticity of

demand for a given product is
REFERENCE
www.economics.about.com
www.netmba.com
www.wikipedia.org
www.wisegeek.com