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What is meant by price elasticity of demand? How can we measure the elasticity of demand? Why is an understanding of elasticity of demand important to both business firms and the government?

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Introduction

Sarah Whiteway What is meant by price elasticity of demand? How can we measure the elasticity of demand? Why is an understanding of elasticity of demand important to both business firms and the government? Price elasticity of demand measures the responsiveness or sensitivity of the quantity demanded of a particular product to changes in its price, ie. If it is very responsive or not responsive at all. The price elasticity of a good can be represented as a figure, where the price elasticity of demand shows the percentage change in the quantity of a good demanded resulting from a 1% increase in its price. For example, it is known that for most goods, a fall in price will cause an expansion in demand, but if that expansion in demand is proportionately greater than the fall in price, then it would be said that quantity demanded is very responsive to a price change, therefore is said to be relatively elastic. ...read more.

Middle

Total outlay is found by multiplying price by the quantity that would be demanded at that price. In effect, the total outlay (or total expenditure) by consumers on a certain product is equivalent to the total revenue sellers of the product would receive at that price. Consider the following table as an example of using the total outlay method to measure the elasticity of demand: Price $ Quantity demanded (units) Total outlay (price x quantity) Elasticity 5 6 7 8 9 10 50 45 40 35 30 25 250 270 280 280 270 250 >inelastic >inelastic >unitary >elastic >elastic Relatively elastic demand occurs if total outlay moves in the same direction as the price change. As shown in Table 6.2, at a price of $5, consumers demand 50 units, therefore total outlay is $250. ...read more.

Conclusion

An understanding of elasticity of demand is important to both business firms and the government. Business firms need to understand price elasticity of demand for the goods they sell in order to decide on their optimal pricing policy, that is, the price at which goods may be sold at a satisfactory price for consumers and producers. If demand was relatively elastic, the firm would know that lowering the price would expand the volume of sales, therefore increasing total revenue. Conversely, if demand was relatively inelastic, the firm could increase the price, which would also lead to an increase in total revenue, since the drop in sales would be less than proportionate therefore there would not be a loss in revenue. Appreciation of the elasticity of demand in different price ranges is important for determining the best pricing policy for a firm and in deciding whether or not to change prices. ...read more.

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