The law of demand states that a fall in the price of a product raises the quantity demanded for the product, whereas an increase in price leads to a decrease in quantity demanded for the product. The price elasticity of demand measures the extent of the responsiveness of the quantity demanded to a change in price. Demand for a product is elastic if the quantity demanded responds substantially to changes in the price, and the percentage change in quantity demanded is greater than the percentage change in price. Demand is inelastic if the quantity demanded responds only slightly to changes in the price, which indicates that the percentage in price is greater than the percentage in quantity demanded for a certain product.
However, the extent of responsiveness of quantity demanded to a change in price depends on the nature of a particular good or service in the market. The price elasticity of demand partly depends on the availability of close substitutes. When a large number of substitutes are available, consumers respond to a higher price of a product by buying more of the substitute the product and less of the relatively more expensive product. In addition, goods or services that are considered necessities tend to have less elastic (more inelastic) demand, whereas goods or services that are considered luxuries have more elastic (less inelastic) demand.
- Explain why the demand for the good or service provided by a firm is elastic or inelastic. How does the elastic or inelastic demand influence pricing decisions by the firm to maximize profit? What are the impacts of elastic demand and inelastic demand on total revenue?
- Provide examples on how the availability of close substitutes affects price elasticity of demand for a good or service.
- Give specific examples of necessities or luxuries, and explain how they affect price elasticity of goods or services.