Question

What do you understand by Elasticity of Demand? Write the various methods of measurement of Elasticity of Demand.

Hint:

Understanding elasticity helps firms determine whether they should raise or lower prices to maximize total revenue based on demand responsiveness.

Answer 1

Elasticity of Demand (also known as Price Elasticity of Demand, PED) measures the responsiveness of quantity demanded to a change in the price of a good or service. It indicates how much the quantity demanded will change when there is a change in the price of the product. If the demand is highly responsive to price changes, it is said to be elastic, whereas if it is less responsive, it is inelastic. The formula to calculate elasticity of demand is: \[ PED = \frac{%\Delta Q}{%\Delta P} \] Where: - \(%\Delta Q\) is the percentage change in quantity demanded, - \(%\Delta P\) is the percentage change in price. Elasticity can be classified into three categories based on the value of PED:
1. Elastic Demand: If \(PED > 1\), demand is elastic. A small change in price leads to a large change in quantity demanded. Luxury goods and goods with close substitutes tend to have elastic demand. 2. Inelastic Demand: If \(PED < 1\), demand is inelastic. A change in price has a relatively small effect on the quantity demanded. Necessities such as salt or water tend to have inelastic demand. 3. Unitary Elasticity: If \(PED = 1\), demand is unitary elastic, meaning the percentage change in quantity demanded is equal to the percentage change in price. Methods of Measuring Elasticity of Demand: There are several methods to measure the price elasticity of demand:
1. Percentage Method: This method calculates the percentage change in quantity demanded relative to the percentage change in price. The formula is: \[ PED = \frac{%\Delta Q}{%\Delta P} \] 2. Total Expenditure (Revenue) Method: This method examines the relationship between total revenue (TR) and price. If the price increases and total revenue decreases, the demand is elastic. If the price increases and total revenue increases, the demand is inelastic. If total revenue remains constant when price changes, the demand is unitary elastic. 3. Point Method: The point method is used when the change in price is very small. It calculates elasticity at a specific point on the demand curve using the slope of the demand curve. The formula is: \[ PED = \frac{P}{Q} \times \frac{dQ}{dP} \] Where \(P\) is the price, \(Q\) is the quantity, and \(\frac{dQ}{dP}\) is the slope of the demand curve. 4. Arc Method: The arc method is used when the price change is large. It calculates elasticity using average values of price and quantity over the range of the price change. The formula is: \[ PED = \frac{%\Delta Q}{%\Delta P} = \frac{\Delta Q/Q_{avg}}{\Delta P/P_{avg}} \] Where \(Q_{avg}\) and \(P_{avg}\) are the average quantities and prices before and after the price change. These methods help businesses, policymakers, and economists analyze consumer behavior and set optimal pricing strategies.