COURSE: Bachelor of Business Administration

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: 05th APRIL 2O10

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ACKNOWLEDGEMENTS
I would first like to express my immense gratitude to my lecturer, Mr. Baboo
Nowbutsing for his constant support and motivation that has encouraged me to
come up with this assignment.

I am also thankful to my family, friends and mates, who have rendered their whole
hearted support at all times for the successful completion of the assignment
question.

Table of contents

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Introduction to Demand…………………………………….……………………………………….Page 1

The meaning of Demand Elasticity………………………………………………………………Page 1

Price Elasticity of Demand…………………………………………………………………………...Page 2

Elastic and Inelastic Demand ……………………………………………………………………….Page 2

Determinants of Price Elasticity of Demand…………………………………………………Page 3

Conclusion…..………………………………………………………………………………………………Page 4

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Clearly illustrates giving examples the determinants of price
elasticity of demand.

Introduction to Demand

Demand refers to the quantities of a product that people are prepared, willing and able to
purchase over a given period of time at any prevailing price.

The law of demand states that if everything else were to remain constant this is known as ceteris
paribus, as price falls, the quantity demanded rises. Similarly as price increases, the
corresponding quantity demanded falls. There is an inverse relationship between price and
quantity demanded. This relationship leads to the downward sloping demand.

The figure below shows a downward sloping curve:

When a product’s demand shifts, different quantities of a product are demanded at each and
every price. The determinants of products demand shifts are consumer’s tastes and preferences,
consumer’s income, the market size, prices of related goods, consumer’s expectations, the size of
population and Government policies.

The meaning of Demand Elasticity

The quantity demanded of a good is affected by changes in the price of the particular good,
changes in price of other goods changes in income and changes in other relevant factors. In other
words demand elasticity reflects the extent to which changes in the product’s price affect the
quantity demanded by consumers. Elasticity is a measure of just how much the quantity
demanded will be affected by a change in price or income.

Assume that the price of gas increases by 1 percent. If quantity demanded consequently falls by
20 percent, then there is a very large drop in quantity demanded in comparison to the change in
price. The price elasticity gas would be said to be very high. If quantity demanded falls by 0.01

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percent, 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.

Different elasticities of demand measure the responsiveness of quantity demanded to changes in

the variables which affect demand. So price elasticity of demand measures the responsiveness of
quantity demanded to changes in price in the price of the good. Income elasticity measures the
responsiveness of quantity demanded to changes in consumer incomes. Cross elasticity measures
the responsiveness of quantity demanded to changes in the price of another good. Economists
could also measure population elasticity, tastes elasticity or elasticity for any other variable
which might affect quantity demanded, although these measures are rarely calculated.

Price elasticity of demand

Responsiveness can be measured in terms of percentage. 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. When there is a small
change in a product’s price resulting in a significant change in the quantity demanded there is
elastic demand. Demand is price elastic if the value of price elasticity is greater than one. 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. For instance, if a 10 percent rise in the price of
tomatoes leads to a 20 percent fall in the quantity demanded of tomatoes, then the price elasticity
is 20÷10 or 2 and therefore the demand for tomatoes is elastic. Demand is said to be infinitely
elastic if the value of elasticity is infinity.

In addition, when a change in a product’s price has only a slight effect on the quantity demanded
there is inelastic demand. Demand is price inelastic if the value of elasticity is less than one. If
demand for a good is price inelastic then a percentage change in price will bring about a smaller
percentage change in quantity demanded. 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, then the price elasticity is 1÷10 or 0.1 and therefore the demand for British rail commuter
traffic is inelastic. Demand is said to be infinitely inelastic.

Demand is of unitary elasticity if the value of elasticity is exactly 1. This means that a percentage
change in price will lead to an exact and opposite change in quantity demanded. For instance, a
good would have unitary elasticity if a 10 percent rise in price led to a 10 percent fall in quantity
demanded.

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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. A curve with unitary elasticity (c) is a hyperbola with the formula PQ=k where P is the
price, Q is the quantity and k is a constant value.

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. Economists however, argue that two factors in particular can be singled out: the
availability of substitutes and time.

The availability of substitutes

The better the substitutes for a product the higher the price elasticity will tend to be. For instance
salt has few good substitutes. When the price of salt increases, the demand for salt will change
little and therefore the price elasticity of salt is low. On the other hand spaghetti has many good
substitutes, from other type of pasta to rice potatoes, bread and other foods. A rise in the price of
spaghetti all other prices remaining constant, is likely to have a significant effect on the demand
for spaghetti. Hence the elasticity of demand for spaghetti is likely to be higher than that for salt.
The more widely the product is defined, the fewer substitutes it is likely to have. Spaghetti has
many substitutes but food in general has none. Therefore the elasticity of demand for spaghetti is
likely to be higher than that for food. Similarly the elasticity of demand of demand for boiled
sweets is likely to be higher than that for confectionery in general. A 5 per cent increase in the
price of boiled sweets, all other prices remaining constant, 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.

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Time Factor

Furthermore, time is another determinant of price elasticity of demand. The longer the period of
time the more price elastic is the demand for a product. For instance in 1973/74 when the price
of oil quadrupled the demand for oil was initially little affected. In the short term the demand for
oil was price inelastic. This is hardly surprising. People still needed to travel to work in cars and
heat their houses whilst industries needed to operate. Oil had a few substitutes. Motorists could
not put gas into their petrol tanks whilst businesses could not changed oil-fired systems to run on
gas, electricity or coal. However in the longer term motorists were able to and did buy cars
which were replaced by gas and electric systems. Businesses converted or did not oil fired
equipment. The demand for oil fell from what it would otherwise have been. In the longer run
the demand for oil proved to be price elastic. It is argued that in the short term buyers are often
locked into spending patterns through habit, lack of information or because of durable goods
they have already been purchased. In the longer term, they have the time and opportunity to
change those patterns.

Necessities and luxuries

Moreover it is argued that necessities have lower price elasticities than luxuries. Necessities by
definition have to be bought whatever their price in order to stay alive. So an increase in the
price of necessities will barely reduce the quantity demanded. Luxuries on the other hand are
goods which are not essential to existence. A rise the price of luxuries should therefore produce a
proportionately large fall in demand. There is no evidence, however, to suggest that this is true.
Food, arguably a necessity does not seem to have a lower elasticity than holidays or large cars,
both arguably luxuries. Part of the reason for this is that it is very difficult to define necessities
and luxuries empirically. Some food is a necessity but a significant proportion of what we eat is
unnecessary for survival. It is not possible to distinguish between what food is consumed out of
necessity and what is luxury. 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. A large car manufacturer, for instance, 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. On the other hand, its demand for steel would be far more price
elastic.

Conclusion
Ultimately, determining the concept of price elasticity of demand has an extraordinarily wide
range of applications in economics. In particular, an understanding of price elasticity of demand
is useful to understand the dynamic response of demand in a market, to achieve an intended
result or avoid unintended results.

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References
http://www.wikipedia.com

http://www.google.com

Alain Anderton Second Edition