Chapter 3 (B) ELASTICITY OF DEMAND
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Elasticity of demand is a concept in economics that measures how sensitive the quantity demanded of a good or service is to changes in its price. In simpler terms, it tells us how much the quantity demanded will change when the price of a product changes.
There are several types of elasticity of demand:
Price Elasticity of Demand (PED): This is the most commonly discussed type of elasticity of demand. It measures the responsiveness of quantity demanded to a change in price. Mathematically, it's calculated as the percentage change in quantity demanded divided by the percentage change in price. If PED > 1, demand is elastic (quantity demanded changes proportionally more than the change in price); if PED = 1, demand is unit elastic (quantity demanded changes exactly proportionally to the change in price); if PED < 1, demand is inelastic (quantity demanded changes proportionally less than the change in price).
Income Elasticity of Demand (YED): This measures how sensitive the quantity demanded of a good is to changes in income levels. It's calculated as the percentage change in quantity demanded divided by the percentage change in income. If YED > 0, the good is a normal good (as income rises, quantity demanded rises); if YED < 0, the good is inferior (as income rises, quantity demanded falls).
Cross-Price Elasticity of Demand (XED): This measures how sensitive the quantity demanded of one good is to changes in the price of another good. It's calculated as the percentage change in quantity demanded of one good divided by the percentage change in the price of another good. If XED > 0, the goods are substitutes (as the price of one good rises, the demand for the other good rises); if XED < 0, the goods are complements (as the price of one good rises, the demand for the other good falls).
Understanding elasticity of demand is crucial for businesses and policymakers. It helps firms make pricing decisions, forecast demand, and understand consumer behavior. For policymakers, it assists in designing effective taxation policies and assessing the impact of price changes on consumers' welfare.