Question

QUESTION 3 (20) 3.1 Briefly explain price elasticity of demand and how it is measured. (5) 3.2 Explain with diagrams and relevant examples, THREE (3) categories of price elasticity of demand. (9) 3.3 Explain any THREE (3) determinants of price elasticity of demand

Answer 1

Question 3.1: Briefly Explain Price elasticity of Demand and how it is measured.

Price Elasticity of Demand - Meaning

Price elasticity of demand is a measure used in Economics to show the responsiveness(elasticity) of the quantity demanded of a product or service to a change in its price, when other factors are constant.

In simple words, price elasticity of demand is the percentage change in quantity demanded in response to the percentage change in price of the product/ service.

In short, variation in demand in response to variation in price is called the price elasticity of demand.

Question 3.2: Explain with diagrams and relevant examples, three categories of price elasticity of demand.

1. Perfectly Elastic Demand (Ep = infinite)

The demand is said to be perfectly elastic

a) if the quantity demanded increases infinitely with a small fall in price

b)if the quantity demanded falls to Zero with a small rise in price

In the given figure, the demand curve DD is a horizontal straight line parallel to the x axis. It shows the negligible change in price causes infinite fall or rise in quantity demanded.

2. Perfectly inelastic demand (Ep=0)

The demand is said to be perfectly inelastic if the demand remains constant whatever may be the price change. Thus it is called zero elasticity. It does not have practical importance as it rarely found in real life.

In the above figure, the demand curve DD is a vertical straight line parallel to the y axis. It shows demand remains constant whatever may be the change in price.

3. Relatively Elastic demand (Ep>1)

The demand is said to be relatively elastic if the percentage change in demand is greater than the percentage change in price. That is, if there is a greater change in demand due to small change in price, it is called relatively elastic demand or highly elastic demand.

If the price falls by 5%, the demand increases more than 5%, then it is called relatively elastic demand.

In the above figure, the small fall in price from OP to OP1 has led to greater increase in demand from OM to OM1.

4. Relatively Inelastic demand (Ep>1)

The demand is said to be relatively inelastic if the percentage change in quantity demanded is less than the percentage change in price. There is small change in demand with the greater change in price.

For example, if price falls by 10%, demand increases less than 10%(say 5%). Then it is called relatively inelastic demand.

In the above figure, demand curve DD is steeper, which shows that the demand is less elastic. The greater fall in price from OP to OP1 has led to small increase in demand from OM to OM1. Similarly, greater increase in price leads to small fall in demand.

5. Unitary Elastic Demand (Ep =1)

The demand is said to be unitary elastic if the percentage change in quantity demanded is equal to the percentage change in price. In such type of demand, 1% change in price leads to exactly 1% change in quantity demanded. This type of demand is imaginary and rarely applicable in practical life.

In the above figure, demand curve DD is a rectangular hyperbola, which shows that the demand is unitary elastic. The fall in price from OP to OP1 has caused equal proportionate increase in demand from OM to OM1. Similarly, when price increases, the demand decreases in the same proportion.

Question 3.3: Explain any three determinants of price elasticity of demand

1. Availability of substitute goods: The more possible substitutes there are for a given good or service, the greater the elasticity. When several close substitutes are available, consumers can easily switch over from one good to another even if there is only a small change in price. Conversely, if no substitutes are available, demand for a good is more likely to be inelastic.

2. Proportion of purchaser’s budget consumed by the item: Products that consume a large portion of consumer’s budget tend to have greater elasticity. The relative high cost of such goods will cause consumers to pay attention to the purchase and seek substitutes. In contrast, demand will tend to be inelastic when a good represents only a negligible portion of the budget.

3. Degree of necessity: The greater the necessity for a good, the lower the elasticity. Consumers will attempt to buy necessary products regardless of the price. Luxury products on the other hand, tend to have greater elasticity.