Price Elasticity of Demand

Definition

Price elasticity of demand is a measure of how responsive the quantity demanded of a good or service is to changes in its price. It quantifies the relationship between the percentage change in quantity demanded and the percentage change in price.

5 Must Know Facts For Your Next Test

1. The price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
2. Goods with close substitutes tend to have more elastic demand, while goods with few substitutes tend to have more inelastic demand.
3. The price elasticity of demand can be used to determine the effect of a price change on total revenue, with elastic demand leading to an inverse relationship between price and total revenue.
4. Factors that influence the price elasticity of demand include the availability of substitutes, the proportion of the consumer's budget spent on the good, and the time horizon considered.
5. The price elasticity of demand is an important concept in pricing decisions, as it can help firms determine the optimal price to maximize revenue or profit.

Review Questions

• Explain how the price elasticity of demand affects an individual's consumption choices based on their budget constraint.
  • The price elasticity of demand is a key factor in how individuals make consumption choices based on their budget constraint. If a good has elastic demand, a change in its price will lead to a relatively large change in the quantity demanded. This means that consumers will be more responsive to price changes, adjusting their consumption accordingly to stay within their budget. Conversely, if a good has inelastic demand, a change in its price will lead to a relatively small change in the quantity demanded, and consumers will be less responsive to price changes when making their consumption decisions.
• Describe how the price elasticity of demand and supply can be used to determine the impact of a price change on total revenue.
  • The price elasticity of demand and supply can be used to predict the effect of a price change on total revenue. If demand is elastic (price elasticity of demand greater than 1), a decrease in price will lead to an increase in total revenue, as the percentage increase in quantity demanded is greater than the percentage decrease in price. Conversely, if demand is inelastic (price elasticity of demand less than 1), a decrease in price will lead to a decrease in total revenue, as the percentage decrease in price is greater than the percentage increase in quantity demanded. This relationship between price elasticity and total revenue is a key concept in pricing decisions for firms.
• Analyze how changes in income and prices can affect consumption choices, considering the role of price elasticity of demand.
  • Changes in income and prices can significantly impact consumption choices, and the price elasticity of demand plays a crucial role in understanding these effects. If the price of a good increases and the demand for that good is elastic, consumers will be more responsive to the price change and reduce their consumption of the good more dramatically. Conversely, if the demand is inelastic, consumers will be less responsive to the price change and reduce their consumption to a lesser extent. Similarly, an increase in income will lead to a greater increase in consumption for goods with elastic demand compared to goods with inelastic demand. Understanding the price elasticity of demand is essential for predicting how consumers will adjust their purchasing decisions in response to changes in income and prices.

Related terms

Demand Curve: A graphical representation of the relationship between the price of a good or service and the quantity demanded of that good or service, with price on the vertical axis and quantity on the horizontal axis.

Inelastic Demand: A situation where the quantity demanded of a good or service is relatively unresponsive to changes in its price, resulting in a price elasticity of demand value less than 1.

Elastic Demand: A situation where the quantity demanded of a good or service is highly responsive to changes in its price, resulting in a price elasticity of demand value greater than 1.