What are the Price Elasticity of Demand and
the five factors that affect the price elasticity of
demand?
The word ‘Elasticity’ is used to define things that have a stretchy quality. You may
think of answering this question by using a rubber band and stretching it across your
fingers, but to economists, it means a whole different thing. The most commonly
used technique for measuring consumers' behavior relative to price changes is Price
Elasticity of Demand. To show how the consumption of a product is changed with
respect to a change in its price, we apply the concept of Price Elasticity of Demand.
A product is considered elastic if the supply or demand of a product changes
significantly with the price change.
The formula for Price Elasticity Demand:
Price Elasticity of Demand of a Product = Percentage Change in Quantity
Demanded of Product / Percentage Change in Price of Product
What is the Coefficient of Price Elasticity
Based on the coefficient and response to the change in price, demand for a product
may be elastic, perfectly elastic, inelastic, or perfectly inelastic.
As you know, the price and demand for a product go opposite directions, and the
coefficient's value will be negative. However, economists don’t use the negative sign
and only the coefficient.
Generally, elasticities can be divided into three main categories: Elastic, Inelastic,
and Unitary.
Types of Price Elasticity of Demand or Supply
What is an Elastic Demand?
In an Elastic demand or Supply, the elasticity is generally more significant than
one, indicating high responsiveness to price changes.
What is an Inelastic Demand?
In an Inelastic demand or Supply, the elasticity is less than one, generally indicating
low responsiveness to price changes.
What is a Unitary Elasticity of Demand?
Unitary Elasticity of Demand generally indicates proportional responsiveness to
either demand or supply.
For example, chronic medicines are highly inelastic. For people with chronic
diseases, the demand is so much that an increase or decrease in price doesn't affect
on demanded quantity because most people with chronic illnesses need to take
medication regularly irrespective of the cost. Other examples of elastic products may
include
On the other hand, movie theatre, for example, are highly elastic since if the prices of
the movie tickets increases, then fewer people will go out to watch them, whereas if
prices decrease, more people will go to watch them. Here we can see an increase or
decrease in price affecting the quantity demanded.
Factors that affect Price Elasticity of Demand
In general, three factors influence the price elasticity of demand for a
product.
Availability of Substitutes
Usually, the availability of suitable substitutes will lead to more elasticity. For
example, if the price of mustard oil increases, people may start using refined oil or
another type of oil. This means mustard oil is an elastic good since a small increase
in price will cause a large decrease in demand as consumers started buying more
refined oil instead of mustard oil.
However, if the price of cooking oil were to increase, there would probably be little
change in the consumption of cooking oil because there may only be a few healthy
substitutes for cooking oil. So, most people wouldn’t willingly stop using cooking oil
no matter what the price. So we would say cooking oil is an inelastic product. As we
can see, while a specific product tends to be elastic due to the availability of
substitutes, an entire industry tends to be inelastic. Usually, unique products or
goods such as diamonds are inelastic as they have few reserves.
Necessity
The second influential factor is a necessity. In general, if something comes under
necessity or survival needs, people tend to continue to buy that even if the
prices go up drastically, such as fuel or gas prices.
Time
In the long run, all goods tend to be more elastic than in the short run.
Suppose fuel prices become high, although immediately people wouldn't stop using
cars to drive to places because that is a necessity for most people and so fuel and
gas are generally considered inelastic. But however, with time people may shift to a
more fuel-efficient car or a car running on electricity. As we can see time enables to
people to find substitutes. So time is considered an influencing factor in the Price
Elasticity of Demand.
Are Luxury Goods considered Elastic?
People buy luxury goods and services after their necessity requirements are already
fulfilled so, in general, luxury goods are generally elastic in nature. Therefore we
can say that is pretty sensitive to price changes since if prices rise, there will be a
decrease in demand.
Income Elasticity of Demand
The sensitivity of the quantity demanded for a particular good relative to the change
in income of consumers who buy this good, keeping other things constant, is known
as Income Elasticity of Demand. By considering Income Elasticity of Demand we can
analyze whether a particular product or service is a luxury or necessity.
The Formula for Income Elasticity of Demand:
Income Elasticity =
Percent change in quantity demanded / Percent change in consumer income.
Cross Elasticity of Demand
Cross Elasticity of Demand measures how the quantity demanded one product or
service changes when the price for another product or service changes.
The Formula for Cross Elasticity of Demand:
The Percentage change in the demand for a product / The Percentage change
in the Price of the other goods
What is the Importance of Price Elasticity of Demand in Business
Elasticity plays a significant role in the success of a business. Companies with goods
and services that are inelastic can set higher prices with respect to companies that
provide elastic goods or services. The prior also needs a large amount of consistent
sales transactions to survive.
References:
https://www.investopedia.com/terms/e/elasticity.asp
https://scholar.harvard.edu/files/alada/files/price_elasticity_of_demand_handout.pdf
https://www.stlouisfed.org/education/economic-lowdown-podcast-series/episode-16elasticity-of-demand