Question

QUESTION TWO [30]

2.1 Discuss the concept of price elasticity of demand. Include in your answer an explanation of the relationship of its key variables to the demand curve and the law of demand. (15)

2.2 Using relevant diagrams, explain how income elasticity of demand can help a business to evaluate the service it provides according to changes in demand and consumer income. (15)

Answer 1

2.1)Price elasticity of demand measures the change in demand for a good in response to change in price.The law of demand states that there is an inverse relationship between price and the quantity demmanded . The shape of demand curve also depends on price elasticity of demand . Demand for a good is  inelastic when a change in price has a relatively small effect on the quantity of the good demanded.Demand is elastic when a change in price has a large effect on the quantity of good demanded and demand for a good is unit elastic when percentage change in quantity demanded is equal to the percentage change in price.

2.2) Income elasticity of demand measures change in quantity demanded with change in income.A proper knowledge of income elasticity helps businesses to predict the effect of an economic cycle on sales.Luxury products with high income elasticity experience greater sales fluctuations over the business cycle than necessities . In case of necessities demand from consumers is less sensitive to business cycle changes.With increase in income , consumers can spend more on goods and services.The income elasticity of demand affect the demand pattern over a time period.For normal luxury goods( demand for which increases with incresae in income) , the income elasticity of demand is more than +1 and so with increase in income the demand for such goods increases .Again for necessities , the income elasticity of demand is positive but less than one. and for inferior goods(demand for which decreases with increase in income), the income elasticity of demand is negative . So when income rises , demand for such goods become less.Diagram given above.