How is the magnitude of price elasticity for an individual good determined? 1. By the degree to which the good is a necessity or luxury 2. By the extent to which substitutes are available 3. By the rate of income growth in the economy 4. By the relative importance of the good in the consumer's budget Select the correct answer using the code given below.

Correct — C, 1, 2 and 4. Price elasticity measures how strongly the quantity demanded of a good responds to a change in its own price, and three of the four listed factors bear on that directly. Whether a good is a necessity or a luxury matters, because a household cuts back on luxuries first and keeps buying salt whatever it costs. The availability of substitutes matters most of all, because a buyer who can switch will switch. And the share of the household budget the good takes up matters, since a price rise in a large item is felt and one in a trivial item is not. Statement 3 is about the growth of income in the economy, which shifts the demand curve and belongs to income elasticity, not to the responsiveness of demand to the good's own price.

• (a)1, 2 and 3 — This keeps the income-growth factor and drops the budget share. It gets the two strongest determinants right and then swaps the correct fourth for an irrelevant one.
• (b)1 and 4 only — Necessity and budget share are both genuine determinants, but leaving out the availability of substitutes removes the single most important influence on price elasticity.
• (d)3 and 4 — This retains the irrelevant factor and drops both of the strongest ones, keeping only the budget share.

Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. Its size depends on how easily the buyer can do without the good or replace it: close substitutes, luxury status, a large share of the budget and a longer time to adjust all raise elasticity, while necessity, addiction, absence of substitutes and a trivial budget share lower it. How the market is defined matters too, since demand for a brand of salt is far more elastic than demand for salt.

The four statements are not equally weighted, and reading them as a set makes the odd one obvious: three describe the buyer's situation with respect to this good, and one describes the macroeconomic climate. Income growth changes how much people buy at any price, which is a shift of the demand curve rather than a change in its responsiveness to price. Keeping that distinction — movement along a curve versus a shift of the curve — settles a whole family of prelims questions on demand.

• Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.
• Close substitutes raise price elasticity; their absence lowers it.
• Necessities have low price elasticity and luxuries high.
• A good taking a large share of the budget tends to have more elastic demand.
• The rate of income growth affects income elasticity and shifts the demand curve, rather than determining price elasticity.

• Mixing income elasticity into a question on price elasticity.
• Ranking substitutes below necessity when substitutes are the stronger influence.
• Assuming a cheap good must have elastic demand, when a small budget share usually makes it inelastic.

A code-based statement item on determinants; CAPF has also asked the same concept computationally, by giving two prices and two quantities and requiring the elasticity value.

• practice — not a real PYQ

  The demand for which one of the following is likely to be the most inelastic?

  • (a)Air travel
  • (b)Common salt
  • (c)Restaurant meals
  • (d)A particular brand of soap

  Answer(b) Common salt — a necessity with no substitutes and a negligible share of the budget.

• practice — not a real PYQ

  If the price of a good rises by 10 per cent and the quantity demanded falls by 20 per cent, the price elasticity of demand is

  • (a)0.5
  • (b)1.0
  • (c)2.0
  • (d)10.0

  Answer(c) 2.0 — 20 divided by 10, so demand is elastic.