Demand elasticity is a tool used by economists and firms to determine price points of products used by the consumer. The law of demand states that increasing the price of a good reduces the goods quantity demanded. The relationship is important and somewhat obvious. Similarly, demand reacts to changes in incomes, the price of related goods, and advertising efforts. Demand elasticity measures the responsiveness of one economic variable to another and of the concepts used to determine these relationships (Graham 2013). There are several reasons why firms gather information about the price elasticity of demand (PED). PED is a measure used by economists to demonstrate the elasticity of the quantity demanded of a good or service to its change in price. The price elasticity of demand is defined as a percentage change in quantity demanded caused by a 1% change in price. In simple terms the PED shows the relationship between price and quantity demanded and provides a precise calculation of the effect of change in price on quantity demanded (Riley 2012). As mentioned above there are several reasons why firms gather information about the PED of its products. A firm will be able to gather data on how customers respond to changes in price and can help the firm reduce risk and uncertainty. More specifically, knowledge of PED can help the firm forecast sales and set prices. Information on the PED can be used by a business as part of a policy of price discrimination. This is where a supplier decides to charge different prices for the same product to two different segments of the market for example peak and off-peak rail travel or prices charged by many of our domestic and international airlines (Riley 2012).
Economists use the words inelastic and elastic to describe how responsive quantity demanded is to price change. When demand is inelastic, quantity demanded changes very little when the price changes. When the price elasticity of demand is between zero and 1, demand is inelastic. In an extreme case, if demand is perfectly inelastic the price elasticity of demand equals zero and quantity demanded doesn't change at all when the price changes. An example of perfect inelasticity would be for the demand of life-saving medicines. In other words, even if the price of the medicine doubles you would still buy the same amount in order to save your life (Graham 2013). When we explore the term elastic in regards to quantity demanded the inverse is true. Quantity demanded changes a lot when the price changes and demand is considered to be elastic. An extreme example of a good that is perfectly elastic would be wheat. If a farmer tries to sell his wheat at a price one cent higher than the market price he won't sell any wheat. Buyers will essentially go to any one of the million other wheat farmers and by their wheat at a penny less. If the farmer lowers his price of wheat to the market price he will be able to sell all the wheat he has grown. If he decreases as price by one cent below the market this will lead to an incredibly large quantity demanded (Graham 2013). Values for price elasticity of demand summary
1. If PED = 0 demand is perfectly inelastic-demand does not change at all when the price changes. - The demand curve will be vertical.
2. If PED is between 0 and 1 the percent change in demand from A to B is smaller than the percentage change in price, then demand is inelastic. 3. If PED = 1 the percent change in demand is exactly the same as the percent change in price, then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level. 4. If PED > 1, then demand response more than proportionately to the change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand the price elasticity of demand for this price change is -3 (Riley...
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