Question

What is the relationship between price elasticity and position on the demand curve? For example, as you move up the demand curve to higher prices and lower quantities, what happens to the measured elasticity? How would you explain that?

Short answer

As we move up the demand curve to higher prices and lower quantities, the measured price elasticity of demand increases, meaning that the demand becomes more elastic. This is because consumers become more sensitive to price changes due to factors such as the availability of substitutes, the higher proportion of income spent on the good, and having more time to adjust to the price change and seek alternatives.

Step-by-step solution

Define price elasticity of demand

Price elasticity of demand is a measure of how sensitive the quantity demanded of a good is to a change in its price. It is calculated as the percentage change in the quantity demanded divided by the percentage change in price. The formula for price elasticity of demand (Ed) is: \(Ed = \frac{\% \Delta Qd}{\% \Delta P}\), where %ΔQd represents the percentage change in quantity demanded, and %ΔP represents the percentage change in price.

Describe a demand curve

A demand curve is a graphical representation of the relationship between the price of a good and its quantity demanded, holding all other variables constant. The demand curve is downward-sloping, indicating that as the price of a good increases, the quantity demanded decreases, and vice versa.

Analyze the position on the demand curve

As we move up the demand curve, we are increasing the price and decreasing the quantity demanded. In this scenario, we will analyze what happens to the measured elasticity. There are three possible areas of elasticity on a demand curve: 1. Elastic: Elasticity is greater than 1, indicating that the percentage change in quantity demanded is greater than the percentage change in price. In this area, consumers are very responsive to price changes. 2. Unitary elastic: Elasticity is equal to 1, indicating that the percentage change in quantity demanded is equal to the percentage change in price. In this area, consumers are equally responsive to price changes. 3. Inelastic: Elasticity is between 0 and 1, indicating that the percentage change in quantity demanded is less than the percentage change in price. In this area, consumers are less responsive to price changes.

Relationship between elasticity and position on the demand curve

As we move up the demand curve, the price increases and the quantity demanded decreases. In general, the demand curve tends to be more elastic in the upper part and more inelastic in the lower part. This can be explained by various factors: 1. Availability of substitutes: At higher prices, consumers are more likely to find and switch to substitutes, making the demand more elastic. 2. Proportion of income: At higher prices, a good takes up a larger proportion of a consumer's income, making demand more sensitive to price changes. 3. Time: Higher prices may cause demand to be more elastic in the long run, as consumers have more time to adjust to the price change and seek alternatives. Overall, as we move up the demand curve to higher prices and lower quantities, the measured elasticity tends to increase (becoming more elastic). This can be explained by factors such as availability of substitutes, proportion of income, and the time dimension.

Key concepts

Demand Curve

The demand curve is central to understanding market economics and indicates how much of a product consumers will buy at different price points. Imagine a downward-sloping line on a graph where the vertical axis represents the price of a good, while the horizontal axis shows the quantity demanded. As the price decreases, consumers are generally willing to purchase more, which is why we see the curve slope from the upper left (high price, low quantity) to the lower right (low price, high quantity).

It's important to understand that the demand curve assumes all other factors, such as consumer income and tastes, remain constant. This concept, known as 'ceteris paribus', is essential because it isolates the effect of price changes on demand. The demand curve is not static and shifts based on various factors like changes in consumer preferences or income levels, indicating a change in demand.

Elasticity Measurement

Elasticity measurement is how economists quantify how demand for a good responds to changes in price. Specifically, price elasticity of demand (PED) measures the responsiveness or sensitivity of consumers when the price of a product changes. To compute PED, use the formula:
\(Ed = \frac{\% \Delta Qd}{\% \Delta P}\)

Where \(\% \Delta Qd\) is the percentage change in quantity demanded and \(\% \Delta P\) is the percentage change in price.

When PED is greater than 1, the demand is considered elastic, meaning quantity demanded changes significantly with a small price change. If PED equals 1, the demand is unit-elastic, indicating the quantity demanded changes proportionally to the price change. When PED is less than 1, the demand is inelastic; quantity demanded doesn't change much with price changes. Additionally, if PED is zero, the demand is perfectly inelastic, signifying no change in quantity demanded regardless of price changes. Conversely, if PED is infinity, the demand is perfectly elastic, meaning the quantity demanded changes drastically for the smallest price change.

Factors Affecting Elasticity

Various factors play a role in the elasticity of demand for a product. One significant factor is the availability of substitutes. When there are close substitutes available, consumers can easily switch to another product if the price increases, leading to elastic demand. Conversely, with few or no substitutes, demand tends to be inelastic.

Income proportion is another factor – if a good represents a large proportion of a consumer's income, the demand for that good is likely to be more elastic because price changes significantly impact the consumer's budget.

Time Period

The time consumers have to adjust to a price change also affects elasticity. Demand is more elastic over the long term as consumers find substitutes or change their habits. Short-term demand, however, is often inelastic because consumers need time to adjust their behavior.

Necessity vs. luxury is another consideration; necessary goods (like basic food items) have more inelastic demand, while luxury goods (like sports cars) tend to have elastic demand. Lastly, brand loyalty can cause inelastic demand as some consumers will continue buying their preferred brand regardless of price changes.