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VARIOUS METHODS OF PRICEELASTICITY OF DEMAND

Submitted to

Ms. ANJU BATRA

(FACULTY, MBA)Submitted by

MUHAMMAD SALIM07217003909

MBA 1

ST

SEMESTER

PRICE ELASTICITY OF DEMAND

The relative response of a change in quantity demanded to a change in price. More specifically the priceelasticity of demand is the percentage change in quantity demanded due to a percentage change in price.This notion of elasticity captures the demand side of the market. A comparable elasticity on the supplyside is the price elasticity of supply. Other notable demand elasticities are income elasticity of demandand cross elasticity of demand.The price elasticity of demand reflects thelaw of demand relation between price and quantity. Anelastic
demandmeans that thequantity demandedis relatively responsive to changes in price. Aninelastic
demandmeans that the quantity demanded is not very responsive to changes in price.Suppose, for example, that the price of hot fudge sundaes increases by 10 percent (say $2.00 to $2.20).The higher price is bound to cause the quantity demanded to decline. The price elasticity of demandanswers the question: How much? If the quantity demanded decreases by more than 10 percent (sayfrom 100 hot fudge sundaes to 50 hot fudge sundaes), then demand is elastic. If the quantity demandeddecreases by less than 10 percent (say from 100 hot fudge sundaes to 99 hot fudge sundaes), thendemand is inelastic.

A Summary Formula

The price elasticity of demand is often summarized by this handy formula:

price elasticity of demand=percentage change in quantity demandedpercentage change in priceAccording to the law of demand, higher demand prices are related to smaller quantities demanded. Assuch, the numerator and denominator of this formula always have opposite signs--if one is positive, theother is negative. If the demand price increases and the percentage change in price is positive, then thequantity demanded decreases and the percentage change in quantity demanded is negative. Whencalculated, the price elasticity of demand, therefore, is always negative.However, it is often convenient to ignore the negative sign when evaluating the relative response of quantity demanded to price. For example, quantity demanded is very responsive to price if a 10 percentincrease in price induces a 50 percent decrease in quantity demanded. This generates a large "negativenumber," which is actually a small "value." To avoid the possible confusion over a big number being asmall value, the negative value of the price elasticity of demand is generally ignored and focus is placedon the absolute magnitude of the number itself.

Slope and Elasticity

The price elasticity of demand is related to, but different from, the slopeof thedemand curve. Consider the
formula for calculating the slope of the demand curve.slope=Change in priceChange in quantity demandedNow consider the formula for calculating the price elasticity of demand.price elasticity of demand=percentage change in quantity demandedpercentage change in priceThe key differences between these are:

•

First, price is in the numerator and quantity is in the denominator for slope. In contrast, quantity isin the numerator and price is in the denominator for elasticity. At the very least, slope is theinverse of elasticity. When one is bigger the other is smaller.

•

Second, slope is calculated using the measurement units for price and quantity. In contrast,elasticity is calculated using percentage changes. As such, slope includes the measurement units(such as dollars per hot fudge sundae), whereas elasticity is just a number with no measurementunits. The value of slope changes if the measurement units change (such as cents versusdollars). Not so for elasticity. Elasticity is in relative values not absolute measurement units.

Three Determinants

Three factors that affect the numerical value of the price elasticity of demand are the availability of substitutes, time period of analysis, and proportion of budget. A given good can have a different priceelasticity of demand if these determinants change.

•

Availability of Substitutes

: The ease with which buyers can find substitutes-in-consumptionaffects the price elasticity of demand. The general rule is that goods with a greater availability of substitutes is more sensitive to price changes. With more substitutes available,buyers can easily respond to price changes. Consider, for example, Auntie Noodles FrozenMacaroni Dinner, an enjoyable, nutritious, and satisfying meal. Unfortunately for the AuntieNoodles company, it is one of thousands of comparable food products on the market. Thenumber of available substitutes makes the price elasticity of demand extremely elastic.

•

Time Period of Analysis

: The longer the time period of analysis, the more responsive quantitiesare to price changes. Brief periods do not allow buyers the time needed to adjust their consumption decisions to price changes. Buyers need time to find substitutes-in-consumption.Longer time periods allow buyers the time needed to find alternatives. For example, the demandfor 4M Cable Television is not very elastic. Given the lack of close substitutes, buyers continue tobuy even though prices rise, especially for brief periods like a few months. However, givenenough time (years? decades?) buyers are able to seek out alternatives such as satellite dishes,and thus change their quantity demanded of cable television, resulting in a more elastic demand.

•

Proportion of Budget

: The price elasticity of demand depends on the proportion of the budgetthat buyers devote to a good. The rule is this: The larger the portion, the more responsivequantity demanded is to price changes. A house, for example, is a BIG budget item for mostnormal human beings. A relatively small change, say 1 percent on a $100,000 house, can make aBIG difference in the buyer's decision to buy. As such, relatively small changes in price are likelyto induce relatively large changes in quantity demanded.

MEASUREMENT OF ELASTICITY OF DEMAND1) PERCENTAGE METHOD

The credit for measuring the elasticity of demand by this method goes to Flux. That is why, it issometimes called Flux’s percentage method. According to this method, elasticity of demand is the ratio of the percentage (or proportionate) change in quantity demanded to a percentage (or proportionate)change in its price.

price elasticity of demand=percentage change in quantity demandedpercentage change in priceProportional change in quantity can be expressed as where q

1

is the initial and q

2

is the newquantity demanded.

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