Answer to Question #249972 in Microeconomics for Thom

Question

With practical example. Discuss the following

1) Elasticity and income Elasticity of demand.

Ii) The relationship between price Elasticity, total revenue and marginal revenue.

III) The factors affecting price Elasticity of demand.

Answer 1

(1)

Elasticity of demand refers to the responsiveness of the quantity demanded of a commodity to changes in one of the variables on which demand depends such as the price of the commodity.

Example:

The price of a radio falls from Rs. 500 to Rs. 400 per unit. As a result, demand increases from 100 to 150 units.

Income elasticity of demand (YED) refers to the responsiveness of demand to changes in consumer's income. YED is useful for use by government and firms to decide what goods to produce and how change in income affects demand for their products. A normal good has a positive YED while an inferior good has a negative YED.

Example:

If an individual's income is increased by 15%, the quantity demanded for the good increases by 15% , YED will be 1. This implies that the good is a normal good.

(2)

Price Elasticity of demand is the percentage change in quantity demanded divided by percentage change in price. The elasticity is the reciprocal of the slope of the demand curve multiplied by the ratio of price over quantity.

Elasticity declines as we move down the demand curve. Elasticity is infinite at quantity=0 on the price axis and zero at price =0 on the quantity axis.

The total revenue at zero quantity is zero. As we move down along the demand curve, total revenue increases reaching its maximum at middle point of the demand curve and then declines reaching zero again at price =0.

Marginal revenue is referred to as the change in total revenue that occurs when we change the quantity by one unit.

$MR=\frac{∆TR}{∆Q}$

Marginal revenue is the slope of the total revenue curve.

(3)

Factors affecting price elasticity of demand:

• Nature or type of good - a cormfort good e.g. a washing machine has an elastic demand as their consumption can be postponed for a time period. A luxury good e.g. a car has relatively high elasticity of demand when compared with cormfort goods. Necessity good e.g. food or medicine has an inelastic demand. These goods are required for human survival so there is no much fluctuation in their demand against a change in their price.
• Price Level - goods whose price level is higher are more likely to have a high elasticity e.g. mobile phones. Goods whose price level is lower are generally inelastic or relatively less elastic e.g. matchboxes.
• Income levels - elasticity of demand for a good is generally very low for higher income level groups and very high for people belonging to low income level groups.
• Time period - the price elasticity of demand is directly proportional to the time period. Elasticity for a shorter time period is always low or can even be inelastic.
• Availability of substitutes - the price elasticity for a good with a large number of close substitutes, is very high.