Economic for decision making

Assignment -2
8. Explain the five types of price elasticity of demand and the
importance of decision making?
Price elasticity of demand:
Price elasticity of demand (Ep) is defined as the Rate of change of Price (P)
bringing about the rate of change of Quantity demanded (Qd). it can be also stated
as the ratio of percentage change in quantity demanded to the percentage change
in price.
Proportionate change in Qd
Ep=
Proportionate change in P
Δ𝑄
Q Δ𝑄 P
𝐸𝑝 = ⁄Δ𝑃 = ×
Q ∆P
P
∆𝑄 𝑃
= ×
∆𝑃 𝑄
Here,
ΔQ = Change in Quantity demanded Q = Initial Quantity
ΔP = Change in Price P = Initial Price
Types of Price elasticity of Demand:
The price elasticity of demand can be categorized by the absolute value of
Price elasticity, they are as follows
• Perfectly elastic demand (or) Infinitely elastic demand
o |Ep|= ∞
• Relatively elastic demand
o |Ep|> 1
• Unitary demand
o |Ep|= 1
• Relatively inelastic demand
o |Ep| < 1
• Perfectly inelastic demand
o |Ep| = 0
Perfectly elastic demand:
The perfectly elastic demand will occur when the change in price (ΔP)
is 0, thus |Ep|= ∞, when there is a small change in price, the quantity
demanded diminishes
Price

Quantity
Relatively elastic demand:
The demand is said to be elastic when the proportionate change in
quantity demanded |ΔQ /Q| exceeds the proportionate change in price
|ΔP/P| leading to |Ep|> 1.
(i.e.) |ΔQ /Q| > |ΔP/P|
Price

P1

P2

Quan
Quantity
Q1 Q2
Unitary Demand:
In unitary demand the proportionate change in quantity demanded
|ΔQ /Q| is equal to the proportionate change in price |ΔP/P|, thus |Ep|=1.
Hence in unitary demand where there is say 1% rise in price the
quantity demanded will also rise by 1%, it can be either positive or negative.
Price

P1

P2

Quan
Quantity
Q1 Q2

Relatively elastic demand:

The demand is said to be elastic when the proportionate change in
price |ΔP/P| exceeds the proportionate change in quantity demanded
|ΔQ/Q| leading to |Ep|< 1. (i.e.) |ΔP/P|>|ΔQ /Q|
Price

P1

P2

Quan
Quantity
Q1 Q2
Perfectly inelastic demand:
The perfectly inelastic demand will occur when there is change in price
the change in quantity demanded (ΔQ) is 0, thus |Ep|= 0
Price

Quantity
Q

Predicting percentage change in Quantity demanded:

Using price elasticity, the change in quantity demanded can be
calculated with known change in price and price elasticity of demand.
Let us assume, a firm has price elasticity Ep = -2.5 and they decide to reduce
price by 8% and wants the percentage change in quantity demanded.
%∆𝑄
−2.5 =
−8%
%∆𝑄 = [−2.5 × −8%] = 2.5 × 0.8
%∆𝑄 = 20%
Predicting percentage change in Price:
Using price elasticity, the change in Price can be calculated with
known change in quantity demanded and price elasticity of demand.
Let us assume, a firm has price elasticity Ep = -0.5 and they decide to increase
the sales by 15% and wants the percentage change in Price.
 15%
−0.5 =
%∆𝑃
0.15
%∆𝑃 = [15%/−0.5] = [− ]
0.5
%∆𝑃 = −30%
Importance of Elasticity:
Price elasticity of demand is a widely used in decision making of the
organization. It can be used for some of the following operations.
• In Fixing price
If the producer is producing a commodity whose demand is
relatively inelastic then the price can be set high for it. Similarly, for
an elastic demand the price can be set low for that commodity.
• Analyse competition
To analyse the competition, Cross price elasticity of demand is
used. The cross-price elasticity of demand is given as proportionate
change in quantity demanded 0f product A divided by the
proportionate change in price of product B
• In fixing tax
The Taxation policy of government is based on the concept of
elasticity of demand. Those commodities with relatively inelastic
demand will be taxed more because it will not affect their demand
much and vice versa.
• Production Planning
The concept of demand plays a major role in factors of
production, let us consider the above percentage change in quantity
demanded example. Here the increase in quantity demanded for the
decrease in price is 20%, Hence the company must increase the
production to meet the 20% increased demand.