PRINCIPLES OF ECONOMICS

Question: Suppose the price elasticity of demand for text books is two and the price of the text book is
increased by 10%.By how much does the quantity demand fall? Interpret the result and discuss reasons for the
fall in quantity demand.
Answer:
Introduction: Price elasticity of demand (PED) is defined as the responsiveness of the quantity demanded of a
good or service to a change in its price.
In other words, it is percentage change of quantity demanded by the percentage change in price of the same
commodity. In economics and business studies, the price elasticity of demand is a measure of the sensitivity of
quantity demanded to changes in price. It is measured as elasticity which measures the relationship as the ratio of
percentage changes between quantity demanded of a good and changes in its price.
In simpler words: demand for a product can be said to be very inelastic if consumers will pay almost any price for
the product, while demand for a product may be elastic if consumers will only pay a certain price, or a narrow
range of prices, for the product. Inelastic demand means a producer can raise prices without much hurting
demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is
sold and will not buy it if the price rises by what they consider too much.

Quantity Demand: A term used in economics to describe the total amount of goods or services that are demanded
at any given point in time. The quantity demanded depends on the price of a good or service in the marketplace,
regardless of whether that market is in equilibrium. The quantity demanded is determined at any given point along
a demand curve in a price vs. quantity plane.
When a given quantity of a good or service is demanded, as determined by its price, it will then impact the
amount of goods or services that will be purchased. The degree to which the quantity demanded changes with
respect to price is called elasticity of demand.

Mathematical definition:
To determine the elasticity of the supply or demand curves, we can use this simple equation:

Elasticity = (% change in quantity demanded / %

change in price)
Here in our example of Text Books:
Given Details:
Price Elasticity demand = 2
% increase of price of text books = 10

Substituting the above details in the equation, we can derive:

The % change in quantity demand fall as 20%.

Graphical representation: If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is
less than one, the curve is said to be inelastic.
The demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small
increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or
service in question is elastic. Meanwhile, inelastic demand is represented with a much more upright curve as
quantity changes little with a large movement in price.

Interpretation of results:
A good economist is not just interested in calculating numbers. The number is a means to an end; in the case of
price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. The higher
the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity suggests that
when the price of a good goes up, consumers will buy a great deal less of it and when the price of that good goes
down, consumers will buy a great deal more. A very low price elasticity implies just the opposite, that changes in
price have little influence on demand.

Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X

If PEoD > 1 then Demand is Price Elastic (Demand is sensitive to price changes)

If PEoD = 1 then Demand is Unit Elastic

If PEoD < 1 then Demand is Price Inelastic (Demand is not sensitive to price changes)

If the PED is equal to zero, the good is perfectly inelastic

If the PED is infinity, the good is perfectly elastic.

In the case of our good textbooks, we calculated the quantity demand fall to be 20% , price elasticity of
demand was given as 2 so our good is price elastic and thus demand is very sensitive to price changes.
In other words our good, textbooks is price elastic meaning demand is responsive a change in price. For a 10%
hike in price leads to 20% fall in quantity demanded, the price elasticity = 2.

Elasticity of Supply and Demand:

If quantity changes a lot, we say that demand is elastic and stretches. If quantity changes only a little, demand is
inelastic and the quantity does not stretch much. So in our case the quantity demand falls by 20% when price hikes
by 10% hence we can say that the demand is elastic and stretches. Here the PeD is = 2 , meaning greater than one,
hence demand is elastic. Note that although price and quantity demanded move in opposite directions, elasticity
will always be positive by convention.

Determinants:

Reasons for the fall in quantity demand:

1.

The number of close substitutes for a good / uniqueness of the product the more close substitutes in
the market, the more elastic is the demand for a product because consumers can more easily switch their
demand if the price of one product changes relative to others in the market. This is applicable for the text
books as well because this good has a lot of close substitutes, hence people can still get the same book at a
moderate price from a different supplier, and hence the quantity demand falls when price hikes.

2.

Durability of the commodity:Demand depends on the durability. When the price of text books rises by 10%
then people tend to keep the text book in good condition instead of buying a new one.On the other hand a
fall in price will induce people to discard the old one quickly and go for new one than they normally do
so.Thus greater the durablilty of the product , greater the incentive to the customer to lengthen its use or
reduce it in response to rise in price or fall in price,in such a case demand for the durable product will be
elastic.

3.

The degree of necessity or whether the good is a luxury goods and services deemed by consumers to be
necessities tend to have an inelastic demand whereas luxuries will tend to have a more elastic demand
because consumers can make do without luxuries when their budgets are stretched. I.e. in an economic
recession we can cut back on discretionary items of spending. However it is not always true.This factor is
very individualistic and hence need for textbooks can be necessity in some cases where the demand will be
inelastic and elastic if they consider buying textbooks as luxury

4.

The % of a consumers income allocated to spending on the good goods and services that take up a high
proportion of a households income will tend to have a more elastic demand than products where large
price changes makes little or no difference to someones ability to purchase the product. Again
aconsiderable amount of money is spent on text books and hence are more elastic in demand when compare
to other commodities.

5.

Range of Prices: At a very high or very low range of prices , demand tends to be inelastic. However text
books are products which are at middle range of prices hence demand tends to be more elastic because a
rise in price by 10% will affect a large number of people.

Determinants of Elasitcity applicable for other goods:

The time period allowed following a price change demand tends to be more price elastic, the longer that
we allow consumers to respond to a price change by varying their purchasing decisions. In the short run, the
demand may be inelastic, because it takes time for consumers both to notice and then to respond to price
fluctuations. This factor may not majorly determine elasticity of text books.

The cost of switching between different products there may be significant transactions costs involved in
switching between different goods and services. In this case, demand tends to be relatively inelastic. This
factor is again more suitable for products like mobile phones and not test books.

Whether the good is subject to habitual consumption when this occurs, the consumer becomes much less
sensitive to the price of the good in question. cigarettes and alcohol and other drugs.

Peak and off-peak demand - demand tends to be price inelastic at peak times a feature that suppliers can
take advantage of when setting higher prices. Demand is more elastic at off-peak times, leading to lower
prices for consumers. This factor is also more suitable to determine elasticity in terms of car rentals , train
fares, hotel accommodation depending on the seasons.

The breadth of definition of a good or service if a good is broadly defined, This factor is also more suitable
to determine elasticity of products like petrol, beef and are mostly inelastic.

Analysis of Results:

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity
varies among products because some products may be more essential to the consumer. Products that are
necessities are more insensitive to price changes because consumers would continue buying these products
despite price increases. Conversely, a price increase of a good or service that is considered less of a
necessity will deter more consumers because the opportunity cost of buying the product will become too

high. The product textbooks for example is more elastic when there is a 10% hike in price, meaning this kind
of price hike has happened in a period where the necessity of text books is not inevitable and people have
other options.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the
quantity demanded or supplied. Usually these kinds of products are readily available in the market and a
person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or
service is one in which changes in price witness only modest changes in the quantity demanded or supplied,
if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily
life. So in our example of textbooks we can interpret the result as under the given conditions the demand of
textbooks is elastic meaning these are readily available in the market with alternatives and not bad
necessity in day to day life.

Elasticity and revenue:

A firm considering a price change must know what effect the change in price will have on total revenue. Generally
any change in price will have two effects:
The price effect: an increase in unit price will tend to increase revenue, while a decrease in price will tend to
decrease revenue.
The quantity effect: an increase in unit price will tend to lead to fewer units sold, while a decrease in unit
price will tend to lead to more units sold.
In our example it has resulted in quantity effect.
Because of the inverse nature of the demand relationship the two effects are offsetting. The firm needs to know
what the net effect will be. Elasticity provides the answer.

Conclusion:Text books , the product under consideration here is elastic meaning the quantity demanded changes (
falls ) with changes in price (hike).Elastic goods have demand curves that approach horizontal lines. Elastic goods
are those with usually with very similar substitutes. The rise in price of textbooks has decreased the quantity
demanded , so the price elasticity of demand is positive.