Explain the concept of price elasticity of demand. Choose two goods and explain why they might have different price elasticity of demand.
Price elasticity of demand is a very important concept for people who run businesses. It has to do with how much the quantity demanded of a product will change when its price changes. Therefore, it helps a person set prices in such a way as to maximize their revenues.
The law of demand tells us that, ceteris paribus, people are willing and able to buy more of a good as its price declines and less of a good when its price increases. However, the law does not tell us that rate of change in quantity demanded. It does not tell us how much the quantity demanded will drop when the price increases or increase when the price drops. Price elasticity of demand is useful because it gives us this information.
There are many reasons why different products might have different levels of elasticity. Perhaps the most important is whether there are substitutes for that product. Think about the difference between gasoline and oranges. There are very few substitutes for gasoline, particularly in a short period of time. If the price of gas goes up, you cannot switch to running your car on something else. You might drive less, but you cannot really replace gas. By contrast, there are lots of substitutes for oranges. If their price goes up, you might buy apples, grapes, kiwi, strawberries, or any number of other fruits instead. There is no need to keep buying oranges as their price rises. For these reasons, the demand for oranges will be much more elastic than the demand for gasoline.
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As people’s preferences shift (due to popularity, season, politics, etc.), so does the quantity demanded of a certain good. For instance, in winter there’s a high demand for snow boots, but in summer there’s a low demand. The price elasticity of demand is a measure of how much the quantity demanded will change for a given good if there’s a change in price. Naturally, different goods will have different price elasticities because some goods are more/less dependent on price.
Take, for example, emergency medical services, like the ambulance. When you have a medical emergency, you have to pay to use the ambulance. If the cost of an ambulance increases, there will be very little change in the demand for ambulance services, since it’s a life-saving service that many cannot do without. In this case, there are no substitutes for an ambulance. A higher cost for the service will not result in a significant decrease in its demand. Therefore, ambulances can be said to be price inelastic (not responsive to price).
On the other hand, consider cars in a metropolitan area. If the price of cars is low, more people are likely to buy a car. If the price is high, fewer people will buy cars because it’s cheaper to ride the subway, bike, or walk. These other options are substitute goods for a car – when the price of a car rises, people will substitute another form of transportation for having a car. Therefore, cars in this situation can be considered price elastic (responsive to price).