Elasticity of demand is a measure of responsiveness to a price change of a good or service. When demand is elastic, the percentage of a price change of a product will result in a larger percentage of quantity demanded (McConnell, p 77). It basically means reducing the price of a good service will result in a greater quantity demanded and an increase in revenue for the seller. When demand is inelastic, a change in price will result in a reduction of quantity demanded, which will then lead to a revenue decrease (McConnell, p 77). To demonstrate elastic and inelastic demand results,
Company A sells 100 pens at $1.00 a piece each day, making their revenue $100.00. Company A then decides to sell their pens at $.50, which results in a total of 250 pens being sold. The total revenue from the price drop is $125, resulting in an additional $25.00; therefore the demand in this scenario is elastic. If selling the pens at the decreased price of $.50 would result in more pens being sold, but less total revenue, the demand is said to inelastic. According to McConnell, when demand in unit elastic, the percentage change in price and the resulting percentage changes in demand are the same. The change in price will not increase or decrease revenue.
Cross price elasticity measures the response of demand to a change in price of another substitute or complimentary good (McConnell, p. 87). Substitute goods are goods that can be purchased in place of another good. Examples of substitute goods are soda (buying Coke vs. Pepsi), computers, and potato chips. A positive cross elasticity of demand means the increase of price in one good, for example Coca-Cola, will increase the demand of a substitute good, for example Pepsi.
As the price for Coke increases, consumers are more likely to purchase Pepsi at a lower price, thereby increasing its demand. Complementary goods are items that are typically purchased in conjunction within one another. Examples are ringed binders and notebook paper, pencils and erasers, and potato chips and dip. A negative cross elasticity of demand in complementary goods means that the increase in price of one good, an example being potato chips, will decrease the demand for the complementary product that goes with it, the dip.
Income elasticity measures the responsiveness of consumers to changes in their incomes (McConnell, p 88). Demand for normal goods tends to increase as consumers’ incomes increase and conversely, demand for inferior goods tends to decrease as consumers’ income increases.
Demand is elastic where there is a large availability of substitutes. The reason for this as the price of a good increases, if there is a large amount of substitutes for this particular good, the consumer will choose the substitute. As discussed earlier, soda is an excellent example of this elasticity. Airline tickets are another example. As one airline raises its cost of a ticket or to even pay for a bag to be checked, a consumer will more likely choose a cheaper ticket or an airline that doesn’t charge for baggage over the original. If there is no (or a very limited) amount of substitutes for a good, elasticity is said to be negative. A price change in medication will not likely change the behavior of a consumer relative to demand since there isn’t a substitute to taking the medication. Household utilities are another example of a limited amount of substitutes.
In discussing the proportion if one’s income devoted to a good concept, the household budget comes into play. In a given month, households pay for many different good and services. A change in price may or may not affect the households demand for those goods and services. Often, it is dependant on how much of the household budget is devoted to that good or service. Mobile phone service is an excellent example of a service that will most likely have a large amount of a household budget dedicated to it. A change in price in the cell phone service will most likely result in that family making a decision to change to a cheaper service, since that will have a large impact on their budget. On the other hand, that same household may purchase light bulbs each month. The amount of money dedicated to the purchase of light bulbs is so small, that a price increase will not likely affect the budget, therefore the family will not likely make a decision to change to a cheaper bulb.
The concept of time when discussing demand is important. When a consumer has a large amount of time to decide on the purchase of a good or service, the elasticity is positive. Conversely, if there is little time, the elasticity is said to be negative. According to McConnell, and excellent example of this is gasoline for automobiles. Gasoline prices change daily and more often than not, prices rise. A family, who owns a car and is dependent on that car for work, etc, will not likely stop buying gas in the sort-term, because it is crucial to their everyday living. However, that family over a long period of time may decide to find alternate means of travel, decreasing their demand for gas.
Using the graphs for elasticity of demand and total revenue, areas of elasticity, inelasticity and unit elasticity have been identified. Demand is elastic between the prices of $80.00 and $50.00, meaning the demand increases as the price decreases, resulting in an increase of total revenue. Between the prices of $50.00 and $40.00, the demand in unit elastic, meaning the percentage of drop in price resulted in the same percentage of increase in demand. Revenue remained unchanged in this price range. Between the prices of $40.00 and $0, the demand is inelastic, meaning the price drop has resulted in an increase in demand, but not enough to over come the decrease. Total revenue has been negatively impacted.