Essay by PaperNerd ContributorUniversity, Master's October 2001

Question 1.

A. Price Elasticity of demand "ÃÂPrice elasticity of demand is defined exactly as the percentage change in the quantity demand divided by the percentage change in price.'(handout) The formula is: Ped (e) = Percentage change in quantity demand = %DQ Percentage change in price %DP So for example if a firm increases its product price by 5%, and because of this the quantity demand of the product leads to a 10% decrease, the price elasticity will be 0.5.

Ped = (-) 0.05 = (-) 0.5 (+) 0.10 The most important feature about price elasticity is that firms can get useful information about the effect of a price change on total revenue and they are able to accurately calculate it.

We could have three specific types of price elasticity: ÃÂÃÂ· Inelastic when the elasticity is smaller than 1 (e < 1). It means that even if the price changes significantly, the quantity demanded of the product is not going to change that much.

ÃÂÃÂ· Unit elastic is a situation in which the percentage change in quantity divided by the percentage change in price equals 1 (e = 1). E.g. Insulin for diabetic patients ÃÂÃÂ· Elastic (e > 1) it accrues when relative changes in quantity are larger than relative changes in price. If demand is elastic, a price increase lowers total revenue and a decrease in price raises total revenue.

Price elasticity can range from completely inelastic, where e = 0, to perfectly elastic where e = ÃÂÃÂ¥.

B. Income elasticity of demand The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in consumer income.

The formula is: Yed = Percentage change in quantity demanded = %DQ Percentage change in income %DI E.g. if the income changes to +20% and the...