Demand elasticity is a tool used by economists and firms to determine price points of products used by the consumer. The law of demand states that increasing the price of a good reduces the goods quantity demanded. The relationship is important and somewhat obvious. Similarly, demand reacts to changes in incomes, the price of related goods, and advertising efforts. Demand elasticity measures the responsiveness of one economic variable to another and of the concepts used to determine these relationships (Graham 2013). There are several reasons why firms gather information about the price elasticity of demand (PED). PED is a measure used by economists to demonstrate the elasticity of the quantity demanded of a good or service to its change in price.
The price elasticity of demand is defined as a percentage change in quantity demanded caused by a 1% change in price. In simple terms the PED shows the relationship between price and quantity demanded and provides a precise calculation of the effect of change in price on quantity demanded (Riley 2012). As mentioned above there are several reasons why firms gather information about the PED of its products. A firm will be able to gather data on how customers respond to changes in price and can help the firm reduce risk and uncertainty. More specifically, knowledge of PED can help the firm forecast sales and set prices. Information on the PED can be used by a business as part of a policy of price discrimination. This is where a supplier decides to charge different prices for the same product to two different segments of the market for example peak and off-peak rail travel or prices charged by many of our domestic and international airlines (Riley 2012).
Economists use the words inelastic and elastic to describe how responsive quantity demanded is to price change. When demand is inelastic, quantity demanded changes very little when the price changes. When the price elasticity of demand is between zero and 1, demand is inelastic. In an extreme case, if demand is perfectly inelastic the price elasticity of demand equals zero and quantity demanded doesn’t change at all when the price changes. An example of perfect inelasticity would be for the demand of life-saving medicines. In other words, even if the price of the medicine doubles you would still buy the same amount in order to save your life (Graham 2013). When we explore the term elastic in regards to quantity demanded the inverse is true.
Quantity demanded changes a lot when the price changes and demand is considered to be elastic. An extreme example of a good that is perfectly elastic would be wheat. If a farmer tries to sell his wheat at a price one cent higher than the market price he won’t sell any wheat. Buyers will essentially go to any one of the million other wheat farmers and by their wheat at a penny less. If the farmer lowers his price of wheat to the market price he will be able to sell all the wheat he has grown. If he decreases as price by one cent below the market this will lead to an incredibly large quantity demanded (Graham 2013). Values for price elasticity of demand summary
1. If PED = 0 demand is perfectly inelastic-demand does not change at all when the price changes. – The demand curve will be vertical.
2. If PED is between 0 and 1 the percent change in demand from A to B is smaller than the percentage change in price, then demand is inelastic.
3. If PED = 1 the percent change in demand is exactly the same as the percent change in price, then demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same at each price level.
4. If PED > 1, then demand response more than proportionately to the change in price i.e. demand is elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand the price elasticity of demand for this price change is -3 (Riley 2012). There are several factors that affect demand elasticity: the number of close substitutes and ease of substitution, the time period allowed following a price change, luxury verse necessity and proportion of total expenditures. The availability of substitute goods affects PED because the more and closer the substitutes are available, the higher the elasticity is likely to be. Consumers can easily switch from one good to another even if there is only a minor price change made. The soft drinks Pepsi-Cola and Coca-Cola are an example of this. If Coca-Cola runs a sale and lowers the price per case by $.25 people will buy more Coca-Cola and less Pepsi-Cola creating elastic demand. If there are no close substitutes available the substitution effect is very small and thus the demands becomes inelastic.
The length of time affects PED in both the short run timeframe and the long run timeframe. The longer the price change holds, the higher the elasticity is likely to be, as more and more customers find they have the time and inclination to search for substitutes. An example of this is with the price of gasoline. If there’s a sudden rise in the price of gasoline consumers still need to buy the same amount of fuel to get to work in the short run. In the long run however, consumers will learn to decrease their demand for fuel by switching to carpooling or public transportation and/or even investing in vehicles with greater fuel economy (Wikipedia 2014). Whether a good is a luxury or necessity also influences how customers respond to price changes. If the good is a necessity and you increase the price, customers still have to buy that good. In many cases the quantity that they demand will remain the same and demand will remain inelastic.
In retrospect if the good is a luxury and customers can do without it, the quantity demanded will be very responsive to a price change. The demand for luxuries is therefore elastic (Graham 2013). The proportion of income spent effects PED because customers will change their spending behaviors on higher ticket items. For example when a consumer goes to buy a $30,000 car he or she will tend to shop around to try to save 10% on the sticker price. In this instance shopping around for a car would be elastic demand. On the other hand the same customer looking to buy a slice of pizza would probably balk at the idea of driving around trying to save 10% on a slice of pizza. Although the percentage difference is the same as the car and the slice of pizza, the pizza takes less of your income and you’re not as responsive to this 10% price difference.
When you compare the car purchase to the purchase of a slice of pizza the PED associated with a slice of pizza is therefore inelastic (Graham 2013). Cross price elasticity of demand directly deals with the influence on the quantity demanded of a particular product or good created by the price change in the related product. Related products have two categories, substitute goods and complementary goods. The cross price elasticity of demand is the percentage by which the demand of the first item will change if the price of the second item a related product rises by 1% while keeping all other things equal (Keat, Young, & Erfle). Substitutes are goods that can be used interchangeably or in other words one is used in the place of another. If we talk about snack foods you could use potato chips and pretzels as substitutes for each other. Another example for meat products would be chicken or beef.
Essentially if the price drops on chicken the consumer will buy more chicken and substitute it for beef. In the example of snack foods if the price of pretzels was cheaper than potato chips one might buy pretzels to substitute for the potato chips. Complementary goods are goods that are used together. An example of complementary goods would be a hamburger and french fries. If one were to buy more hamburgers you would expect them to buy more french fries. If the price for hamburgers were to increase you would expect the demand for hamburgers and french fries to also decrease because they are complements. In conclusion the larger the value either positive or negative for the cross price elasticity of demand, the stronger the relationship between the two goods. If the value of the cross price elasticity of demand was less than one and greater than zero one would conclude there is not a strong relationship between the two goods (Graham 2013).
Income elasticity of demand is defined as a measure of the percentage change in quantity consumed resulting from a 1% change in income. Basically stated if individual experiences a rise in income they will proportionally spend more. If a person experiences a decrease in income level they will spend less. As a person’s income rises people increase consumption of products and services proportionally, less than proportionally, and more than proportionally to the income rise. Income elasticity can either be positive or negative. If the income elasticity of demand is negative, then the commodity is an inferior good. An inferior good is one whose demand decreases as incomes increase or demand increases as incomes decrease. Examples of inferior goods are Rice and potatoes. As people make more income they buy less rice and potatoes.
A normal good is a good whose demand increases as income increases. Essentially as your income increases your demand for restaurant meals, movie tickets, new cars, better vegetables, and fruits increases. If your income were to suddenly decrease you would expect the opposite and therefore normal goods have a direct relationship between income and demand and the income elasticity of demand is positive (Income Elasticity 2014). A superior good is in many ways like a normal good but more of what might be considered a luxury, which isn’t purchased at all below a certain level of income, or have a wide quality of distribution, such as fine wine and automobiles. If a person decides to buy an automobile they could spend their money on a $20,000 car that would get them from point A to point B or they could spend their money on the hundred thousand dollar car that will do exactly the same thing. A superior good has positive income elasticity greater than one. People not only buy these items but they spend a lot of these items for their superior quality (Keat et al 2013).
Cross Price Elasticity. (2014). In Econport. Retrieved May 9, 2014, from Econ port website: http://www.econport.org/content/handbook/Elasticity/Cross-Price-Elasticity.html Factors Determining Price Elasticity of Demand. (2014). In Economics exposed. Retrieved May 8, 2014, from Economics exposed website: http://economics-exposed.com/factors-determining-price-elasticity-of-demand/ Graham, R. (2013). Managerial Economics for Dummies (K. Ewing, Ed.). Hoboken New Jersey: John Wiley and Sons Incorporated. Income Elasticity. (2014). In Econport. Retrieved May 9, 2014, from Econ port website: http://www.econport.org/content/handbook/Elasticity/Income-Elasticity.html Keat, P., Young, P., & Erfle, S. (2013). Managerial Economics (D. Battista, Ed., Seventh edition). Upper saddle River New Jersey: Pearson education Incorporated. Price Elasticity of Demand. (2014). In Wikipedia. Retrieved May 9, 2014, from Wikipedia website: http://en.wikipedia.org/wiki/Price_elasticity_of_demand Price Elasticity of Demand( PED). (n.d.). In Economics online. Retrieved May 8, 2014, from Economics online website: http://www.economicsonline.co.uk/Competitive_markets/Price_elasticity_of_demand.html Riley, G. (2012, September 22). Price Elasticity of Demand. In Tutor2u. Retrieved May 9, 2014, from Tutor2u website: http://www.tutor2u.net/economics/revision-notes/as-markets-price-elasticity-of-demand.html