COURSE: BACHELOR OF BUSINESS ADMINISTRATION
YEAR 1 // SEMESTER 1
MODULE:
BUSINESS ECONOMICS
TOPIC: DETERMINANTS OF PRICE ELASTICITY OF DEMAND
SUBMITTED TO: MR. BABOO NOWBUTSINGH
SUBMITTED BY: PRIYA DUSHMEE MUNGTAH
DATE OF SUBMISSION: 05 APRIL 2O10 TH
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ACKNOWLEDGEMENTS I would first like to express my immense gratitude to my lecturer, Mr. Baboo Nowbutsing for his constant support and motivation that has encouraged me to come up with this assignment. I am also thankful to my family, friends and mates, who have rendered their whole hearted support at all times for the successful completion of the assignment question.
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Table of contents
Introduction to Demand..Page 1 The meaning of Demand ElasticityPage 1 Price Elasticity of Demand...Page
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Elastic and Inelastic Demand .Page
2
Determinants of Price Elasticity of DemandPage
3
Conclusion..Page 4
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Clearly illustrates giving examples the determinants of price elasticity of demand. Introduction to Demand Demand refers to the quantities of a product that people are prepared, willing and able to purchase over a given period of time at any prevailing price. The law of demand states that if everything else were to remain constant this is known as cet eris paribus, as price falls, the quantity demanded r ises. Similarly as price increases, the corresponding quantity demanded falls. There is an inverse relationship between price and quantity demanded. This relationship leads to t he downward sloping demand. The figure below shows a do wnward sloping curve:
When a product¶s demand shifts, different quantities of a product are demanded at each and every price. The determinants of products demand shifts are consumer¶s tastes and preferences, consumer¶s income, the market size, prices of related goods, consumer¶s expectations, the size of population and Government policies.
The
meaning of Demand Elasticity
The quantity demanded of a good is affected by changes in the price of the particular good, changes in price of other goods changes in income and changes in other relevant factors. In other words demand elasticity reflects the extent to which changes in the product¶s price affect the quantity demanded by consumers. Elasticity is a measure of just how much the quantity demanded will be affected by a change in price or income.
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Assume
that the price of gas increases by 1 percent. If quantity demanded consequently falls by 20 percent, then there is a very large drop in quantity demanded in comparison to the change in price. The price elasticity gas would be said to be very high. If quantity demanded falls by 0.01 percent, then the change in quantity demanded is insignificant compared to the large change in price and the price elasticity of gas would said to be low. Different elasticities of demand measure the responsiveness of quantity demanded to changes in the variables which affect demand. So price elasticity of demand measures the responsiveness of quantity demanded to changes in price in the price of the good. Income elasticity measures the responsiveness of quantity demanded to changes in consumer incomes. Cross elasticity measures the responsiveness of quantity demanded to changes in the price of another good. Economists could also measure population elasticity, tastes elasticity or elasticity for any other variable which might affect quantity demanded, although these measures are rarely calculated.
Price elasticity of demand R esponsiveness
can be measured in terms of percentage. So price elasticity of demand is the responsiveness of changes in quantity demanded to changes in price is calculated by using the formula:
Percentage change in quantity demanded÷ Percentage change in price
Elastic and inelastic demand Different values of price elasticity of demand are given different names. When there is a small change in a product¶s price resulting in a significant change in the quantity demanded there is elastic demand. Demand is price elastic if the value of price elasticity is greater than one. If demand for a good is price elastic then a percentage change in price will bring about an even larger percentage change in quantity demanded. For instance, if a 10 percent rise in the price of tomatoes leads to a 20 percent fall in the quantity demanded of tomatoes, then the price elasticity is 20÷10 or 2 and therefore the demand for tomatoes is elastic. Demand is said to be infinitely elastic if the value of elasticity is infinity. In addition, when a change in a product¶s price has only a slight effect on the quantity demanded there is inelastic demand. Demand is price inelastic if the value of elasticity is less than one. If demand for a good is price inelastic then a percentage change in price will bring about a smaller percentage change in quantity demanded. For instance if a 10 percent rise in the price in the price of commuter fares on British rail southern region resulted in a 1 percent fall in rail journeys made, then the price elasticity is 1÷10 or 0.1 and therefore the demand for British rail commuter traffic is inelastic. Demand is said to be infinitely inelastic.
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Demand is of unitary elasticity if the value of elasticity is exactly 1. This means that a percentage change in price will lead to an exact and opposite change in quantity demanded. For instance, a good would have unitary elasticity if a 10 percent rise in price led to a 10 percent fall in quantity demanded.
The figure below illustrates how price elasticity and inelasticity and unitary elasticity can be shown in a graph:
(a)
(b)
(c)
horizontal demand curve (a) is perfectly elastic whilst a vertical demand curve (b) is perfectly inelastic. A curve with unitary elasticity (c) is a hyperbola with the formula PQ=k where P is the price, Q is the quantity and k is a constant value. A
The
determinants of price elasticity of demand
The exact value of price of price elasticity of demand for a good is determined by a wide variety of factors. Economists however, argue that two factors in particular can be singled out: the availability of substitutes and t ime. The
availability of substitutes
The better the substitutes for a product the higher the price elasticity will tend to be. For instance salt has few good substitutes. When the price of salt increases, the demand for salt will change little and therefore the price elasticity of salt is low. On the other hand spaghetti has many good substitutes, from other type of pasta to rice potatoes, bread and other foods. A rise in the price of spaghetti all other prices remaining constant, is likely to have a significant effect on the demand for spaghetti. Hence the elasticity of demand for spaghetti is likely to be higher than that for salt. The more widely the product is defined, the fewer substitutes it is likely to have. Spaghetti has many substitutes but food in general has none. Therefore the elasticity of demand for spaghetti is likely to be higher than that for food. Similarly the elasticity of demand of demand for boiled sweets is likely to be higher than that for confectionery in general. A 5 per cent increase in the 6
price of boiled sweets, all other prices remaining constant, is likely to lead to a much larger fall in demand for boiled sweets than a 5 percent increase in the pr ice of all confectionary. Time
Factor
Furthermore, time is another determinant of price elasticity of demand. The longer the period of time the more price elastic is the demand for a product. For instance in 1973/74 when the price of oil quadrupled the demand for oil was initially little affected. In the short term the demand for oil was price inelastic. This is hardly surprising. People still needed to travel to work in cars and heat their houses whilst industries needed to operate. Oil had a few substitutes. Motorists could not put gas into their petrol tanks whilst businesses could not changed oil-fired systems to run on gas, electricity or coal. However in the longer term motorists were able to and did buy cars which were replaced by gas and electric systems. Businesses converted or did not oil fired equipment. The demand for oil fell from what it would otherwise have been. In the longer run the demand for oil proved to be price elastic. It is argued that in the short term buyers are often locked into spending patterns through habit, lack of information or because of durable goods they have already been purchased. In the longer term, they have the time and opportunity to change those patterns.
Necessities and luxuries Moreover it is argued that necessities have lower price elasticities than luxuries. Necessities by definition have to be bought whatever their price in order to stay alive. So an increase in the price of necessities will barely reduce the quantity demanded. Luxuries on the other hand are goods which are not essential to existence. A rise the price of luxuries should therefore produce a proportionately large fall in demand. There is no evidence, however, to suggest that this is true. Food, arguably a necessity does not seem to have a lower elasticity than holidays or large cars, both arguably luxuries. Part of the reason for this is that it is very difficult to define necessities and luxuries empirically. Some food is a necessity but a significant proportion of what we eat is unnecessary for survival. It is not possible to distinguish between what food is consumed out of necessity and what is luxury. It is also sometimes argued that goods which form a relatively low proportion of total expenditure have lower elasticities than those which form a more significant proportion. A large car manufacturer, for instance, would continue to buy the same amount of paper clips even if the price of paper doubled because it is not worth its price while to bother changing to an alternative. On the other hand, its demand for steel would be far more price elastic.
Conclusion Ultimately, determining the concept of price elasticity of demand has an extraordinarily wide range of applications in economics. In particular, an understanding of price elasticity of demand is useful to understand the dynamic response of demand in a market, to achieve an intended result or avoid unintended results.
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References http://www.wikipedia.com http://www.google.com Alain Anderton Second Edition
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