Final answer:
Price elasticity of demand measures the responsiveness of quantity demanded to a price change. It's calculated by dividing the percentage change in quantity by the percentage change in price. The four determinants of price elasticity include availability of substitutes, proportion of income spent on the good, time period, and whether the good is a necessity or luxury.
Step-by-step explanation:
Price elasticity of demand is a measure that indicates how much the quantity demanded of a good responds to a change in the price of that good. It is calculated by dividing the percentage change in quantity demanded by the percentage change in price. The formula is:
Price Elasticity of Demand = (% change in quantity demanded) / (% change in price)
The four main determinants that can affect the price elasticity of demand for a product include:
- The availability of close substitutes: The more substitutes available, the more elastic the demand will be.
- The proportion of income spent on the good: Goods that take up a large portion of one's income tend to have more elastic demand.
- The time period considered: Demand generally becomes more elastic over time as consumers find alternatives or adjust consumption habits.
- The necessity versus luxury nature of the good: Necessities tend to have inelastic demand, while luxuries are more elastic.
Understanding price elasticity is important because it can help businesses and policymakers predict how changes in prices might affect demand and thus revenues. It also plays a crucial role in determining how the burden of a tax is divided between producers and consumers (tax incidence), and how demand and supply shifts can affect market equilibrium.