economy questions

Question

By convention, a price elasticity of demand of 5 indicates that a 1% increase in price leads to a in the quantity demanded. (Answer is e, but I want to know why it's the answer)

a) 0.2% decrease

b) 0.5% increase

c) 5% increase

d) 0.2% increase

e) 5% decrease

Answer 1

Ashy,

The determinates of elastic demand are

1. more substitutes
2. higher price or percentage of income
3. less addictive
4. luxury goods
5. plenty of time

When a good is more elastic consumers are quicker to not buy and walk away from the product. A 1% increase in price causes the quantity demanded to fall by 5%. They will have many customers walk away because the demand for the good is elastic. If a candy bar is only a dollar and the price increases by 1% would you still by it? Of course you would , as the price only increased by 1 penny. Your demand is inelastic as it didn't change even with the 1% price increase. However what if the cost of a house is 10 million dollars. You call and offer them the full 10 million for the house and they tell you it has increased in price by 1%. Now 1% of 10 million dollars is 100,000. You might walk away as 100,000 is a much larger share of income (your demand is elastic) Both goods increased by 1% but I'm thinking that you would be much quicker to walk away from a 100,000 increase in price (the house) compared to a 1 penny increase with the candy bar (inelastic demand)

Cheers,

Charles