The elasticity of demand - Essay Example

The elasticity of demand in essence expresses the degree of responsiveness of demand to changes in demand determining factors, own price, price of a related good and income of the consumer apart from qualitative factors such as tastes and preferences. Own Price Elasticity of Demand The sensitivity of demand of a product with respect to changes in its own price is identified as the own price elasticity of demand. To state this alternatively, own price elasticity of demand is defined as the percentage change in demand per percentage change in the price of the product, other things remaining the same. Therefore, the own price elasticity of demand is expressed as the ratio of percentage change in demand and the percentage change in price of the good in question. So, own price elasticity of demand for the good X with a per unit price PX shall be given by the expression: EPx = (percentage change in quantity demanded of X)/ (percentage change in PX) This can be calculated as either at a movement from a point on the demand curve to another, which is known as arc elasticity or as the limiting value of arc elasticity known as point elasticity of demand. Own price Arc elasticity of demand can be expressed as: Where x and PX are averages of the initial and final quantities and prices. Thus is Xi (i = 1,2) and Pxi (i = 1,2) represent the initial and final quantity and prices in the equation above, x = (X1+X2) / 2 and Px= (Px1+Px2) / 2. Conventionally, this is the formula used to compute own price elasticities for all perceptible changes in prices and quantities. However for changes assumed to be infinitesimally small, so that the movement is not perceptible and it is as if the consumer stays on the same point on the demand curve almost, we use the limiting value of arc elasticity of demand, known as point elasticity of demand. Point own price elasticity of demand is expressed as: Since for all normal goods quantity demanded varies inversely with price, own price elasticity is always negative, though the extent to which demand varies inversely is not the same for all goods. If EPx < -1, it implies that the sensitivity of demand to price changes is quite high. Demand is said to be elastic in this case. Again, if EPx > -1, it implies that the responsiveness of demand to own price changes is not very high. Own price elasticity of demand is said to be inelastic in that case. Finally, if EPx = 1, then demand is said to be unitarily elastic. Own price elasticity of demand is higher for goods for which consumers have readily available substitutes as in that case in case of very small changes in own prices, ceteris paribus, the substitutes become more attractive. Further, short term price changes lead to greater sensitivity to demand compared to long term changes. Resultantly, temporary price changes tend to increase elasticity more than that compared to a permanent change. The elasticity of demand depends upon which point the consumer is at. At the top left corner of the demand curve, X = 0 and thus [(dx/dPx) (Px/ X)] = infinity. As gradually we move downward along the demand curve X rises and PX falls and elasticity falls. At the horizontal intercept of the demand curve PX = 0 and thus [(dx/dPx) (Px/ X)] = 0. Thus elasticity falls to zero at the horizontal intercept of the demand curve. At the midpoint of the curve, elasticity is unitary. Cross Price Elasticity: Cross price elasticity of demand is essentially the degree of responsiveness exhibited by the demand for one good to a change in price of another good (Y). The cross price elasticity works essentially through the substitution effect. When the price of a related good Y changes, depending upon whether it is a substitute or a complement, the relative attractiveness of X also changes and as a result the demand of X responds to a change in PY. Cross price elasticity of demand is expressed as: If this cross price elasticity of demand is positive, that is if the demand for X rises following a rise in the price of Y, it implies that X has now become relatively more attractive compared to Y to the consumer. Thus, X and Y are substitutes. Again if cross price elasticity of demand is negative, that is if the demand for X rises following a fall in the price of Y, it implies that X has now become relatively more attractive along with Y to the consumer. Thus X and Y are complements. Analogously, if cross price elasticity of demand is zero it implies that the two, goods X and Y, are unrelated. Income Elasticity of Demand Income elasticity of demand reflects the degree of responsiveness of the demand of any good to changes in income of the consumer. This is actually a reflection of the income effect. It is expressed as: where M represents the income of the consumer. Now, if the demand for a product varies positively, i.e., increases with a rise in income, that is income elasticity is positive, the good is identified to be normal. If on the other hand, the demand for any product falls as the income of the consumer rises, it implies the consumer opts for other goods instead of good X. The good X is identified as being inferior. Finally, if the demand for any good responds more than proportionately, that is the value of income elasticity of demand is found to be greater than unity, the good in question is identified to be a luxury good. References: Ison, S., & Wall, S., (2006) “Economics”, Prentice Hall Samuelson, P. A., & Nordhaus, W.D., (2002) “Economics” McGraw-Hill, NY Read More