Question

The price of good A has recently increased by 7 percent. As a result, the quantity demanded has decreased by 3 percent.

1. Is the demand for good A elastic or inelastic? Explain why.

2. Does good A likely have many substitutes or only a few substitutes?
Explain why.

3. As a business manager, how would knowing the price elasticity of demand
for your firm's products help you determine the prices of the products?
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Answer 1

1. The elasticity of demand is given by

E_p = %change in quantity demanded / % change in price

Here given that

% change in quantity demanded = 3%

And % change in price = 7%

So, E_p = 3%/7% = 3/7 = 0.43

Now since E_p < 1 . so we can say that elasticity of demand for good A is inelastic . It means that quantity demanded falls less than the increase in price. If E_p > 1 it would mean that the demand is elastic and quantity demanded falls more than the increase in price. If E_p = 1 then it means that the elasticity of demand is unit elastic and quantity demanded falls equal to the increase in price.

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2. The good A has inelastic demand as found in part1. It means that the good A is most likely to have less number of substitutes. If there would have been more substitutes then due to increase in price of A by 7%, the consumers would have shifted to consuming substitutes and thus demand of A would have fallen for more than 7%. In other words if there would have been more number of substitutes of A then the elasticity of demand for A would have been more than 1. This is not the case . So, we can safely say that good A is most likely to have less number of substitutes.

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3. As a business manager knowledge of price elasticity of demand is a very useful tool. As explained in part1 if E_p < 1 the quantity demanded falls less than the increase in price. If E_p > 1 it would mean that the demand is elastic and quantity demanded falls more than the increase in price. If E_p = 1 then it means that the elasticity of demand is unit elastic and quantity demanded falls equal to the increase in price.

Suppose for a good E_p is less than 1 then the manager by knowing this will increase the price of the product since he knows that the quantity demanded would fall by less than the increase in price and thus overall revenue for the firm will increase due to an increase in price. Similarly if E_p >1 then it won’t be profitable to increase the price (in fact here if he decreases the price then the profit of the firm will increase as a result of increase in demand) and if E_p = 1 then the manager would be indifferent to increase or decrease the price.