Price elasticity of demand refers to the extent to which use of a product falls or rises after increases or decreases in its price. If price elasticity of demand for a product were very low—that is, if it were inelastic—then demand would fall or rise only slightly in response to price changes. For instance, if price elasticity for a particular good were about —0.
There are two reasons for this emphasis. Preferences are a natural psychological concept. Faced with choice alternatives, it is reasonable to expect that a consumer will be able to rank the alternatives.
But when economists evaluate markets, they would like to have a representation of demand. If preferences are represented by a utility function, then demand can be derived from maximization of utility for various prices and income. In this section, we assume that the consumer has preferences that are represented by a utility function, and we then carry out this derivation of demand.
Once demand is represented by a function, it can be used to develop a model of exchange, and it can be combined with the supply functions of firms to model trade in a market. Utility functions There are several classes of utility functions that are frequently used to generate demand functions.
Each of these utility functions has specific properties and uses which are discussed below after the demand function for each is derived.
Diminishing Marginal Rate of Substitution Each of the utility functions examined below exhibits a property called "diminishing marginal rate of substitution. Figure 10 below demonstrates this idea.
The curve in the figure shows a many combinations of commodities X and Y that all result in the same utility. Combinations of X and Y that produce the same utility level are called an "indifference curve.
The marginal rate of substitution MRS going from x1, y1 to x2, y2 is 3, since the consumer is willing to give up 3 units of Y to get one additional unit of X.
The MRS going from x2, y2 to x3, y3 is only 1. This reduction in the marginal rate of substitution is one of the main assumptions about preferences or utility beyond the regularity assumptions that were described in earlier sections.
Diminishing MRS is both an intuitive condition on preferences, and also a mild assumption, but in almost all cases it is enough to guarantee that the demand for a commodity decreases as its price increases. The optimal consumption level for each commodity is determined by setting the slope of the indifference curve through a point x, y equal to the slope of the budget line.
Non-optimal consumption point a and optimal point b. The top graph in figure 12 shows three example budget lines and the tangency, with the optimal consumption point for each. Since the price of X for each of the budget lines is different, and the optimal consumption level for X is different in each of the three cases, the relationship between px, the price of X, and the consumption level of X can be traced out.
The lower graph in figure 12 traces out this relationship for a consumer with the indifference curves shown in the top portion of figure Optimal consumption points for three different prices top and corresponding demand function bottom. There is an important feature of the Cobb-Douglas utility function that is apparent in this figure.
This means that commodities X and Y are neither substitutes for one another nor complements to one another. The analysis below shows how this is done for the Cobb-Douglas utility function. The simplest way to find the slope of the indifference curve is to use implicit differentiation.
This tangency condition can be substituted into the budget equation to eliminate either x or y so that the demand for one of the commodities can be obtained.
CES Utility The Constant Elasticity of Substitution CES utility function is useful because this class of utility functions can be used to model commodities that are either substitutes for one another, or complements of one another.
Derived demand for CES utility The technique for determining demand functions is similar to the technique that was used above to determine the demand for the Cobb-Douglas utility function. The first step is to determine the slope of the indifference curve through a given point x, yand then set the slope of the indifference curve through x, y equal to the slope of the budget equation.Elasticity varies from product to product because some products may be more essential to the consumer than others.
Demand for products that are considered necessities is less sensitive to price. A fundamental building block of economic theory is the fact that increasing (or decreasing) the price of a commodity reduces (or increases) demand for that commodity.
Theory of Demand: Meanings of Demand. The word 'demand' is so common and familiar with every one of us that it seems superfluous to define it. The need for precise definition arises simply because it is sometimes confused with other words such as desire, wish want, etc. Continue reading.
Law of Demand.
|Purchase Solution||The degree to which demand or supply reacts to a change in price is called elasticity.|
|Price elasticity of demand - Wikipedia||Price elasticity of supply The price elasticity of supply measures how the amount of a good that a supplier wishes to supply changes in response to a change in price.|
Price elasticity of demand - PED - is a key concept and indicates the relationship between price and quantity demanded by consumers in a given time period. The price elasticity of supply measures how the amount of a good that a supplier wishes to supply changes in response to a change in price.
In a manner analogous to the price elasticity of demand, it captures the extent of horizontal movement along the supply curve relative to the extent of vertical movement. If the price elasticity of supply is zero the supply of a good supplied is "totally.
Economists use elasticity to measure consumer responsiveness to changes in the various determinants associated with demand. Elasticity addresses percentage changes i.e. a percentage change in quantity demanded divided by a percentage change in (own price, the price of another good, or income).