Course: Business Economics

Internal Assignment Applicable for December 2020 Examination

1.
a. A business firms sells a good at the price of Rs 450.The firm has decided to reduce the
price of good to Rs 350.Consequently, the quantity demanded for the good rose from
25,000 units to 35,000 units. Calculate the price elasticity of demand.
Answer:
Price elasticity of demand can be defined as the ratio of the percentage
change in quantity demanded to the percentage change in price. In other
words, Price elasticity of demand is a measure of a change in the quantity
demanded of a product due to change in the price of the product in the
market. It can be mathematically expressed as:

Price Elasticity of Demand = Percentage change in quantity demanded

Percentage change in price

Thus, the formula for calculating the price elasticity of demand is as

follows:

Where,
ep = Price elasticity of demand

P = Initial price
P = Change in price

Q = Initial quantity demanded

Q = Change in quantity demanded
Let us consider different values for price elasticity of demand (PED):-
1. If PED = 0 demand is perfectly inelastic. It means that demand does not change at all when the
price changes and hence the demand curve will be vertical.

2. If PED is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic. The demand curve of inelastic demand
is rapidly sloping.
 3. If PED = 1 (i.e. the % change in demand is exactly the same as the % change in price), then
demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level. The demand curve for unitary elastic demand is a
rectangular hyperbola.

4. If PED > 1, then demand responds more than proportionately to a change in price i.e. demand
is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand.
The price elasticity of demand for this price change is –3. In perfectly elastic demand, the
demand curve is represented as a horizontal straight line (in parallel to x-axis)

Types of Price elasticity of Demand (PED)

PED Value Type of PED Condition
Infinity Perfectly elastic demand Greater change in demand in response to percentage or smaller change in
the price.
0 Perfectly inelastic demand No change in demand in response to percentage or smaller change in the
 price.
>1 Relatively elastic demand A change in demand is greater than the change in price.
<1 Relatively inelastic demand A change in demand is less than the change in price.
1 Unitary elastic demand A change in demand is equivalent to change in price.

Here, as per given data in the question:-

Initial Price P = Rs 450

There is a fall in the price from Rs 450 to Rs 350.

Hence P = (Rs 450 – Rs 350) = Rs 100

Initial Quantity Q = 25,000 units
Change in Quantity ∆Q = (35,000 – 25,000) = 10,000

By substituting these values in the above formula, we get:

e p = (10000 X 450) / (100 X 25000)

= 4500000 / 2500000

=9/5

= 1.8

Thus, the absolute value of elasticity of demand is greater than 1.

b. “There is a high cross elasticity of demand between new and old cars”. Discuss the
statement by explaining the features of cross elasticity of demand. Also compare and
contrast cross elasticity with other types of elasticities of demand.
Answer:
The elasticity of demand is a degree of change in the quantity demanded of a product in response to
its determinants, such as price of the product, price of substitutes, and income of consumers. There
are three types of elasticity of demand:

Price Elasticity of Demand (PED):

It can be defined as the ratio of percentage change in quantity demanded to the
percentage change in price.

PED = Percentage change in quantity demanded

Percentage change in price

PED Value Type of PED Condition

Infinity Perfectly elastic demand Greater change in demand in response to smaller change in price.

0 Perfectly inelastic No change in demand in response smaller change in the price.

 demand
>1 Relatively elastic demand A change in demand is greater than the change in price.
<1 Relatively inelastic A change in demand is less than the change in price.
demand
1 Unitary elastic demand A change in demand is equivalent to change in price.

Cross Elasticity of Demand (CED):-

It can be defined as a measure of proportionate change in the demand for goods as a result of change
in the price of related goods.

CED = Percentage change in quantity demanded of X

Percentage change in price of related good Y

CED Type of CED Condition Example

Value
>1 Positive Increase in price of related product
results in an increase in the demand for
the main product and vice versa
<1 Negative Increase in the price of related product
results in decrease of the demand of
main product and vice versa
Substitute Goods. The quantity
demanded for tea increases with
an increase in price of coffee
Complementary Goods. The
demand for bread decreases with
the increase in price of butter.

0 Zero  Change in the price of related product  Independent Goods.

does not bring any change in the demand
for the main product

Income Elasticity of Demand (IED)

The Income elasticity of demand is the proportional change in the quantity demanded of good X
divided by the proportional change in the income of consumers.

IED = Percentage change in quantity demanded

Percentage change in Income

IED Type of IED Condition Example

Value
>1 Positive Change in income results in an increase in the demand for Normal Goods.
product and vice versa
<1 Negative Change in income results in an decrease in the demand for Inferior Goods.
product and vice versa

0 Zero  Change in the income does not bring any change in the  Utility Goods.
demand for product

There exists a high cross elasticity of demand between new and old cars since the demand for old
cars is highly elastic. Old cars will sell at relatively low prices compared to new cars as they have
been used for a while and this suggests how their demand is highly elastic. Old cars and new cars are
substitute goods. So when the price of new car increases, the demand for old car also increases.
Hence the value of cross elasticity of demand is positive.