Question #43893

1- Explain in detail the economic term Elasticity of demand?
2- Explain in detail the Diminishing marginal rate of substitution?

Expert's answer

1. Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in

quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income). Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

2. Under the standard assumption of neoclassical economics that goods and services are continuously divisible, the marginal rates of substitution will be the same regardless of the direction of exchange, and will correspond to the slope of an indifference curve (more precisely, to the slope multiplied by -1) passing through the consumption bundle in question, at that point: mathematically, it is the implicit derivative. MRS of X for Y is the amount of Y for which a consumer is willing to exchange X locally. The MRS is different at each point along the indifference curve thus it is important to keep locally in the definition. Further on this assumption, or otherwise on the assumption that utility is quantified, the marginal rate of substitution of good or

service X for good or service Y (MRSxy) is also equivalent to the marginal utility of X over the marginal utility of Y.

It is important to note that when comparing bundles of goods X and Y thatgive a constant utility (points along an indifference curve), the marginal utility of X is measured in terms of units of Y that is being given up. For example, if the MRSxy = 2, the consumer will give up 2 units of Y to obtain 1 additional unit of X. As one moves down a (standardly convex) indifference curve, the marginal rate of substitution decreases (as measured by the absolute value of the slope of the indifference curve, which decreases). This is known as the law of diminishing marginal rate of substitution.

quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income). Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods, have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.

2. Under the standard assumption of neoclassical economics that goods and services are continuously divisible, the marginal rates of substitution will be the same regardless of the direction of exchange, and will correspond to the slope of an indifference curve (more precisely, to the slope multiplied by -1) passing through the consumption bundle in question, at that point: mathematically, it is the implicit derivative. MRS of X for Y is the amount of Y for which a consumer is willing to exchange X locally. The MRS is different at each point along the indifference curve thus it is important to keep locally in the definition. Further on this assumption, or otherwise on the assumption that utility is quantified, the marginal rate of substitution of good or

service X for good or service Y (MRSxy) is also equivalent to the marginal utility of X over the marginal utility of Y.

It is important to note that when comparing bundles of goods X and Y thatgive a constant utility (points along an indifference curve), the marginal utility of X is measured in terms of units of Y that is being given up. For example, if the MRSxy = 2, the consumer will give up 2 units of Y to obtain 1 additional unit of X. As one moves down a (standardly convex) indifference curve, the marginal rate of substitution decreases (as measured by the absolute value of the slope of the indifference curve, which decreases). This is known as the law of diminishing marginal rate of substitution.

## Comments

## Leave a comment