Elasticity is a measure of responsiveness. It measures how much something changes when
there is a change in one of the determinants.
Elasticity of demand is a measure of how much the demand for a product changes when
there is a change in one of the factors that determine demand.
Most commonly used measures of demand responsiveness are:
A. price elasticty of demand (PED)
B. income elasticity of demand (YED)
Price elasticity of demand (PED)
Price elasticity of demand is a measure of how much the quantity demanded of a product
changes when there is a change in the price of the product.
It is usually calculated by using the following equation:
PED = %Δ in quantity demanded / %Δ in price
PED is usually the negative value which indicates that there is an inverse relationship
between price and the quantity demanded. However, in order to simplify matters,
conomists usually ignore the negative value that comes from the equation and simply give
the answer as a positive figure.
The possible range of values for price elasticity of demand can, in theory, go from zero to
infinity. Practically speaking, the actual PED values for a product will lie in between these
two extreme theoretical values.
A. perfectly inelastic demand (PED equals zero), the quantity demanded is completely
unresponsive to price changes; irrespective the price changes the quantity
demanded will be constant; the demand is depicted by the vertical line;
B. perfectly elastic demand (PED equals infinity), the quantity demanded is infinitely
responsive to price changes; at some price level the quantity demanded equals to
infinity and drops to zero if price is increased; the demand is depicted by the
horizontal line.
The extreme values of PED are simply theoretical and there are no single products that
would possess a PED value of zero or infinity.
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The range of values of PED is usually split into three categories:
A. inelastic demand (values: 0<PED<1); a change in the price of a product leads to a
proportionally smaller change in the quantity demanded of it; this means that if the
price is raised, the total revenue gained by firms will increase; the demand is
depicted by the relatively steep curve line;
B. elastic demand (values: 1<PED<infinity); a change in the price of a product leads to
a proportionally greater change in the quantity demanded of it; this means that if
the price is raised, the total revenue gained by firms will fall; the demand is depicted
by the relatively flat curve line;
C. unitary elastic demand (PED equals to 1); a change in the price of a product leads to
a proportionally equal change in the quantity demanded of it; this means that if the
price is raised, the total revenue gained by firms will remain the same; the demand
is depicted by the rectangular hyperbola line.
It is a common mistake to assume that elasticity is a measure of the slope of the demand
curve and that the value is always the same at any point on the curve. This is not the case.
For a straight line, downward-sloping demand curve, the value of PED falls as price falls.
We can see that the value of PED falls as we move down a demand curve. It is logical that
this should happen. Low-priced products have a more elastic demand than high-priced
products, because consumers are less concerned when the price of an inexpensive product
rises than they are when the price of an expensive product rises.
The determinants of price elasticity of demand
There are a number of determinants influencing the value of PED of different products and
services, the most powerful of them are as follow:
A. the number and closeness of substitutes
B. the necessity of the product and how widely the product is defined
C. the proportion of income spent on the product
D. the time period considered
The number and closeness of substitutes that are available is certainly the most important
determinant of PED. It is fair to say that the more substitutes there are for a product, the
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more elastic the demand will be for it. Also, the closer the substitutes available, the more
elastic the demand will be.
a. The demand for the product with lots of substitutes, such as household products,
will tend to have elastic demand.
b. The demand for the product with very few substitutes, such as gasoline, will tend to
have inelastic demand.
Another important determinant of elasticity is the necessity of the product that the
consumers face. The most necessary the product is, the more inelastic its demand becomes.
It is worth remembering that for many goods, necessity will change from consumer to
consumer, since different people have different tastes and necessity is often a subjective
view.
The elasticity of demand changes depending on how widely the product is defined. The
wider defined the product is, the more inelastic its demand becomes The food which a term
has a very wide meaning is far more inelastic than the specific types of food. The narrower
the definition, the demand becomes more elastic because consumers may easily switch.
The proportion of income consumers spend on products is also an important factor. If a
products costs relatively very little and constitutes a very small part of a person's budget,
then a change in price may cause very little change in quantity demanded, ie. the demand
will be quite inelastic.
As the price of a product changes, it often takes time for consumers to change their buying
and consumption habits. PED thus tends to be more inelastic in the short term and then
becaomes more elastic, the longer the time period it is measured over.
An understanding of price elasticity of demand can be very useful for firms and also for the
governments. For firms, the main use is for predicting the effect of their pricing decisions on
quantity demanded and as a result in their total revenues. For governments, it helps to be
aware of possible consequences on economic variables (such as tax revenue or arising
unemployment) when the indirect taxes are imposed.
There is a difference in the price elasticity od demand between the primary commodities
and the manufactured products.
The consumers of primary commodities are manufacturing industries which process the raw
material into finished products. They require the primary commodities in order to produce
their processed products. Such products tend to have inelastic demand as they are
necessities for those producers.
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On the other hand, the demand for manufactured goods tends to be more elastic, as there
are usually many more substitutes available to consumers since the product can be
differentiated by different producers.
Income elasticity of demand (YED)
Income elasticity of demand is a measure of how much the demand for a product changes
when there is a change in consumer's income. It is usually calculated by using the equation
below:
YED = %Δ in quantity demanded / %Δ in consumer's income
In YED, the sign obtained from the equation, whether it is positive or negative, is important.
The sign of YED tells us whether the product we are looking at is a normal good or an
inferior good.
a. For normal goods, the value of YED is positive; the demand increases as the income
of consumers increases. Consumers tend to buy more of the products.
b. For inferior goods, the value of YED is negative, the demand decreases as the
income of consumers increases. Consumers tend to limit their consumption.
In case of normal goods, two type of values of YED can be obtained.
A. income-inelastic demand: If the percentage increase in quantity demanded is less
than the percentage increase in income, then a YED value between zero and one is
obtained and the demand is said to be income-inelastic.
B. income-elastic demand: If the percentage increase in quantity demand is greater
than the percentage increase in income, the a YED value greater than one is
obtained and the demand is said to be income-elastic.
According to YED, three types of goods can be differentiated:
A. inferior goods, in which case the YED values are negative; the demand falls as the
income of consumers rises; people tend to switch from inferior goods to superior
goods when they can finally afford them;
B. normal goods, in which case the YED values are between zero and one; normal
goods are usually the necessities, the demand for them changes very little when the
income rises because people feel they already have enough of them;
C. superior goods, in which case the YED values are greater than one; superior goods
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are some kind of luxury consumption, as people have more income and they have
already satisfied their needs, they tend to purchase products that are non-essential
wants in greater number.
A knowledge of YED can be useful for firms when they are planning which markets to enter
and which products to sell. Products that have a high YED will see large increases in demand
as income level in a country rise and so their markets will grow quickly. Producers often
manufacture several versions of their product in order to appeal to consumers of different
incomes. They also want to be able to take advantage of their knowledge of changing
income to increase production of certain products and to decrease production of others.
Production in economies is usually seperated into three sectors:
A. primary sector, it consists of agricultural and extraction industries, such as fishing,
forestry and mining; their products are known as commodities or primary products
and include agricultural products, mineral deposits or fossil fuels;
B. secondary sector, it consists of industries which take commodities and raw
materials from the primary sector and use them to manufacture producer goods
and consumers goods; it also includes the construction sector;
C. tertiary sector, it consists of industries which produce services or intangible
products, such as financial services, education, information technology or
entertainment.
Sectoral change refers to the shift in the relative share of national output and employment
that is attributed to each of the production sectors as an economy develops over time. As
countries grow and living standards improve, there is a change in the proportion of the
economy that is produced in each sector. This does not mean that any sector is getting
smaller, just the relative proportion of output coming from this sector is likely to change.
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