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Wednesday, January 19, 2011

Price elasticity of demand

Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely,
it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.
Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED.
Availability of substitute goods: the more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made. There is a strong substitution effect. If no close substitutes are available the substitution of effect will be small and the demand inelastic.
Percentage of income: the higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost. The income effect is substantial.[30] When the goods represent only a negligible portion of the budget the income effect will be insignificant and demand inelastic.
Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it.
Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.
Breadth of definition of a good: the broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.
Brand loyalty: an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.
Who pays: where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.
Important Points:
ü When the price of a commodity having price elasticity relatively inelastic, is raised then more revenue is raised. Vice versa in case of commodity having price elasticity of demand relatively elastic.
ü Some price elasticities that were found in real world:
Cigarettes in US: -0.3 to -0.6 (General) -0.6 to -0.7 (Youth)
Oil in world: -0.4
Coca cola: -3.8 Mountain Dew: -4.4
Rice(China): -0.8

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