Elasticity of Demand

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The purpose of this essay is to define elasticity of demand, cross-price elasticity, income elasticity, and explain the elastic coefficients for each. I will explain the contrast of and significance of difference between the three. I will also explain whether demand would tend to be more or less elastic for availability of substitutes, share of consumer income devoted to a good, and consumer’s time horizon, and give examples of each. Then, I will explain the logical impacts to business decision making that result from each. Last, I will differentiate between perfectly inelastic demand and perfectly inelastic demand, and illustrate the difference between the terms.

Elasticity of demand, also known as price demand elasticity, is defined as the measurement of “the responsiveness of demand for a product following a change in its own price” (tutor2u.net). Sales may increase when a price goes down. Sales may also decrease when prices go up. Examples of products with elasticity of demand are appliances and cars. When prices go down on cars, more people will buy them. The same can be said for appliances. For necessities such as food and clothes, you will see no significant change in sales with changes in price. This is called inelasticity of demand (business dictionary.com).

According to Mike Moffatt, former About.com Guide, the cross-price elasticity of demand measures the rate of response of quantity demanded of a good, due to the price change of another good”. Consumers may purchase more of one good when the price of its substitute increases. If the two goods are complements, meaning, you can’t have one without the other, a rise in the price of one good should cause the demand for both goods to fall. The formula for cross-price demand of elasticity is: (% Change in Quantity Demand for Good )/(% Change in Price for Good ) (economics.about.com). The measurement of how much the demand for goods change, with respect to a change in income, depends on whether the goods are luxuries or necessities. This measurement is known as income elasticity. With the increase of income, the demand for necessities may increase, also, but at a slower rate. Sometimes the increase in income can go toward luxuries. The demand for luxuries tends to increase at a higher rate in response to the increase of income (investopedia.com). Inferior goods have negative income elasticity because if a consumer can go without them, they will stop buying them. According to The Penguin Dictionary of Economics, “a good that is not inferior is a normal good” (inferior good (2003)). A normal good can become inferior over a period of time. An example of this is when a small apartment that you no longer have the need for because of a growing family. Normal goods have a positive elasticity because the demands for normal goods rise with income. The coefficient of income elasticity measures the percentage in change between two variables. The two variables are demand and income (IED= % change in quantity demanded/ % change in income) (Amosweb.com). Normal necessities and normal luxuries have positive coefficients because income and demand move in the same direction. Although the coefficient for inferior goods is usually negative, they can turn into a positive over a period of time. For example, in a recession, the need for an inferior good may become a necessity, thus increasing the demand for that good (tutor2u.net). The coefficient for cross-price elasticity is the percentage of change in demand of a product (a) /change in price of a product (b) (Wikipedia.org). This formula sometimes yields a negative value due to the relationship between price and quantity demanded. It also depends on if the goods are substitutes or complements. For a substitute, the increase in price for one good (a) will lead to the increase in demand for the other good (b), which makes the value of goods positive (economicsconcepts.com). This depends on if variable (a) is a necessity. In this...
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