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
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ACKNOWLEDGEMENTS I would first like to express my immense gratitude to my lecturer. 2 . I am also thankful to my family. who have rendered their whole hearted support at all times for the successful completion of the assignment question. Mr. friends and mates. Baboo Nowbutsing for his constant support and motivation that has encouraged me to come up with this assignment.

Page 2 .. .Table of contents Introduction to Demand The meaning of Demand Elasticity Price Elasticity of Demand Elastic and Inelastic Demand Determinants of Price Elasticity of Demand Conclusion ..Page 1 Page 1 .Page 2 Page 3 Page 4 3 . ..

as price falls. consumer¶s expectations. the quantity demanded rises. This relationship leads to the downward sloping demand. the corresponding quantity demanded falls.Clearly illustrates giving examples the determinants of price elasticity of demand. In other words demand elasticity reflects the extent to which changes in the product¶s price affect the quantity demanded by consumers. changes in price of other goods changes in income and changes in other relevant factors. The figure below shows a downward sloping curve: When a product¶s demand shifts. 4 . different quantities of a product are demanded at each and every price. The determinants of products demand shifts are consumer¶s tastes and preferences. the size of population and Government policies. There is an inverse relationship between price and quantity demanded. The law of demand states that if everything else were to remain constant this is known as ceteris paribus. the market size. The meaning of Demand Elasticity The quantity demanded of a good is affected by changes in the price of the particular good. willing and able to purchase over a given period of time at any prevailing price. prices of related goods. consumer¶s income. Elasticity is a measure of just how much the quantity demanded will be affected by a change in price or income. Similarly as price increases. Introduction to Demand Demand refers to the quantities of a product that people are prepared.

If demand for a good is price inelastic then a percentage change in price will bring about a smaller percentage change in quantity demanded. then the price elasticity is 20÷10 or 2 and therefore the demand for tomatoes is elastic. 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. If quantity demanded falls by 0. 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. 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. Demand is price inelastic if the value of elasticity is less than one. Different elasticities of demand measure the responsiveness of quantity demanded to changes in the variables which affect demand. For instance.1 and therefore the demand for British rail commuter traffic is inelastic. Demand is said to be infinitely inelastic. Demand is said to be infinitely elastic if the value of elasticity is infinity. The price elasticity gas would be said to be very high. Demand is price elastic if the value of price elasticity is greater than one. Economists could also measure population elasticity.01 percent. In addition. when a change in a product¶s price has only a slight effect on the quantity demanded there is inelastic demand. Income elasticity measures the responsiveness of quantity demanded to changes in consumer incomes. Price elasticity of demand Responsiveness can be measured in terms of percentage. although these measures are rarely calculated. 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. 5 . Cross elasticity measures the responsiveness of quantity demanded to changes in the price of another good. So price elasticity of demand measures the responsiveness of quantity demanded to changes in price in the price of the good.Assume that the price of gas increases by 1 percent. then there is a very large drop in quantity demanded in comparison to the change in price. if a 10 percent rise in the price of tomatoes leads to a 20 percent fall in the quantity demanded of tomatoes. If quantity demanded consequently falls by 20 percent. then the price elasticity is 1÷10 or 0. When there is a small change in a product¶s price resulting in a significant change in the quantity demanded there is elastic demand. tastes elasticity or elasticity for any other variable which might affect quantity demanded.

The figure below illustrates how price elasticity and inelasticity and unitary elasticity can be shown in a graph: (a) (b) (c) A horizontal demand curve (a) is perfectly elastic whilst a vertical demand curve (b) is perfectly inelastic. Similarly the elasticity of demand of demand for boiled sweets is likely to be higher than that for confectionery in general. the demand for salt will change little and therefore the price elasticity of salt is low. Therefore the elasticity of demand for spaghetti is likely to be higher than that for food. Economists however. This means that a percentage change in price will lead to an exact and opposite change in quantity demanded. from other type of pasta to rice potatoes. bread and other foods. the fewer substitutes it is likely to have. The availability of substitutes The better the substitutes for a product the higher the price elasticity will tend to be. is likely to have a significant effect on the demand for spaghetti. A 5 per cent increase in the 6 . For instance salt has few good substitutes. The more widely the product is defined. Spaghetti has many substitutes but food in general has none. A rise in the price of spaghetti all other prices remaining constant.Demand is of unitary elasticity if the value of elasticity is exactly 1. For instance. argue that two factors in particular can be singled out: the availability of substitutes and time. Q is the quantity and k is a constant value. Hence the elasticity of demand for spaghetti is likely to be higher than that for salt. a good would have unitary elasticity if a 10 percent rise in price led to a 10 percent fall in quantity demanded. 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. A curve with unitary elasticity (c) is a hyperbola with the formula PQ=k where P is the price. When the price of salt increases. On the other hand spaghetti has many good substitutes.

The longer the period of time the more price elastic is the demand for a product. Food. 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. both arguably luxuries. lack of information or because of durable goods they have already been purchased. On the other hand. It is argued that in the short term buyers are often locked into spending patterns through habit. In the longer term. determining the concept of price elasticity of demand has an extraordinarily wide range of applications in economics. to achieve an intended result or avoid unintended results. It is not possible to distinguish between what food is consumed out of necessity and what is luxury. its demand for steel would be far more price elastic. Time Factor Furthermore. Conclusion Ultimately. Motorists could not put gas into their petrol tanks whilst businesses could not changed oil-fired systems to run on gas. In the short term the demand for oil was price inelastic. time is another determinant of price elasticity of demand. In particular. A rise the price of luxuries should therefore produce a proportionately large fall in demand. 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. The demand for oil fell from what it would otherwise have been. For instance in 1973/74 when the price of oil quadrupled the demand for oil was initially little affected. People still needed to travel to work in cars and heat their houses whilst industries needed to operate. 7 . Necessities by definition have to be bought whatever their price in order to stay alive. they have the time and opportunity to change those patterns. There is no evidence.price of boiled sweets. all other prices remaining constant. A large car manufacturer. This is hardly surprising. Luxuries on the other hand are goods which are not essential to existence. Necessities and luxuries Moreover it is argued that necessities have lower price elasticities than luxuries. electricity or coal. However in the longer term motorists were able to and did buy cars which were replaced by gas and electric systems. an understanding of price elasticity of demand is useful to understand the dynamic response of demand in a market. Part of the reason for this is that it is very difficult to define necessities and luxuries empirically. Oil had a few substitutes. is likely to lead to a much larger fall in demand for boiled sweets than a 5 percent increase in the price of all confectionary. In the longer run the demand for oil proved to be price elastic. Businesses converted or did not oil fired equipment. to suggest that this is true. however. So an increase in the price of necessities will barely reduce the quantity demanded. Some food is a necessity but a significant proportion of what we eat is unnecessary for survival. arguably a necessity does not seem to have a lower elasticity than holidays or large cars. for instance.

References http://www.com http://www.wikipedia.google.com Alain Anderton Second Edition 8 .