Question

What is the price elasticity of demand? Can you explain it in your own words?

Short answer

Price elasticity of demand is an economic measure that shows how sensitive the quantity demanded of a good is to a change in its price. It is calculated using the formula \(E_d = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}\). The result may be elastic (\(E_d > 1\)), inelastic (\(0 < E_d < 1\)), or unitary elasticity (\(E_d = 1\)), indicating how consumers would react to price changes. This helps businesses and policymakers make informed decisions about pricing, taxes, or subsidies.

Step-by-step solution

Understand Price Elasticity of Demand

Price elasticity of demand helps us to understand how sensitive the demand for a product is to a change in its price. A higher price elasticity indicates that demand is more sensitive to price changes, meaning that consumers would react significantly to a price change. On the other hand, lower price elasticity means that demand is less sensitive to price changes, and consumers' reaction to a price change would be relatively small.

Calculate Price Elasticity of Demand

Price elasticity of demand is calculated using the following formula: \[\% \text{ change in quantity demanded} = \frac{(Q_{2} - Q_{1}) / Q_{1}}{(P_{2} - P_{1}) / P_{1}}\] where \(Q_{1}\) and \(P_{1}\) are the initial quantity demanded and price, and \(Q_{2}\) and \(P_{2}\) are the new quantity demanded and price after the change. The price elasticity of demand is given by: \[E_d = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}\]

Interpret the result

After calculating the price elasticity of demand, it falls into one of the following categories: - Elastic demand (\(E_d > 1\)): An increase in price leads to a more significant decrease in quantity demanded, or a decrease in price leads to a more significant increase in quantity demanded. - Inelastic demand (\(0 < E_d < 1\)): An increase in price leads to a smaller decrease in quantity demanded, or a decrease in price leads to a smaller increase in quantity demanded. - Unitary elasticity (\(E_d = 1\)): A percentage change in price leads to an equal percentage change in quantity demanded. These categories help businesses and policymakers understand the responsiveness of consumers to price changes so they can make better-informed decisions regarding pricing, taxes, or subsidies.