Price elasticity of demand



Price elasticity of demand

Article Summary

This article seeks to demonstrate my understanding of the economic concept of elasticity of demand. I intend to examine two fundamental concepts, supply and demand and in doing so this essay will look at defining and discussing income and cross price elasticity, consider the significant changes of elasticity overtime by using numerical examples and graphs, and finally apply this theory to the construction industry.

First and foremost, the theory of supply and demand is one of the essential theories of economics.  Supply is the amount of product that a producer is willing and able to pay at a particular price, whereas demand is the amount of product that a buyer is willing and able to buy at a specific price.  The model for supply and demand shows the relationship between a product's accessibility and the interest shown in it. Below is a graph demonstrating this:   

Equilibrium is when quantity supplied = quantity demanded, any price above the equilibrium will result in a situation where the quantity supplied exceeds the quantity demanded.

Economic Principles

Price elasticity of demand measures the responsiveness of demand to changes in price. It involves comparing the proportional changes in the price with the proportional changes in the quantity demanded. Economists express the relationship between the percentage changes in price and demand in the form of a ratio or coefficient. This is called the price elasticity of demand (PED) and is demonstrated below:

PED =          % Change In Quantity Demanded

                                    % Change In Price

It is said that when the demand elasticity is high it can be seen as a large negative number, thus the quantity demanded is sensitive to the price. The demand elasticity is 'low' if it is a small number and the quantity demanded is insensitive to the price, ('high' or 'low' refer to the size of the elasticity ignoring the minus sign) (Begg, Fischer, Dornbusch 2008:45). The demand elasticity falls when it becomes a smaller negative number and the quantity demanded becomes less sensitive to the price.  

 

Elasticity refers to the degree of responsiveness in supply or demand in relation to changes in price. If the elasticity of demand is greater than or equal to 1, meaning that the percent change in quantity is greater than the percent change in price, then the curve will be relatively flat and elastic: small price changes will have large effects on demand. If the elasticity of the demand curve is less than 1, meaning the percent change in quantity is less than the percent change in price, therefore the curve will be steep and inelastic (it will take a big change in price to affect demand) (Spark Notes 2008). This is shown in the graphs below:

                     Perfectly Elastic and Perfectly Inelastic Curves

Below are some numerical examples of elastic and inelastic demand:

Example 1                   Month 1                       Month 2

Price                            £70                              £75

Quantity                       105 tonnes                   100 tonnes

      P = P2-P1 = 75-70 = 5

      Q = Q2-Q1 = 100-105 = -5

EP =       Q x P1  = 5  x ...