Price elasticity of demand is the method used to quantify how reactive consumers will be to changing prices. It is calculated by dividing the percentage change in quantity of an item demanded by the percentage change in the item price.
Elastic demand is when the percentage price increases results in a greater percentage decrease in demand or the reverse, when the percentage price decreases and results in a greater percentage increase in demand.
Conversely, inelastic demand is when the percentage price increase results in a lesser percentage decrease in demand, or the percentage price decrease results in a lesser percentage increase in demand.
On the other hand, unit elasticity is when the percentage increase or decrease in price results in an equal percentage decrease or increase in demand.
Cross Price Elasticity:
Cross price elasticity quantifies how reactive people are when purchasing one item, based on price changes of another item. It is calculated dividing the percentage change of the quantity demanded of the first item by the percentage change in the second item’s price.
One type of cross price elasticity relates to substitute goods where the consumer has the option to choose between many similar goods. In this situation the consumer will likely substitute one good for the lower priced similar product. Substitute goods are established when the cross price elasticity calculation returns a positive number
Another type of cross price elasticity relates to complementary goods.
Complementary goods are when one product is used along with another. Therefore, when demand for one increases or decreases, demand for the second, complementary good correspondingly increases or decreases. Complementary goods are established when the cross price elasticity calculation returns a negative number
Income elasticity relates to how consumers increase or decrease their purchase of types of goods based on their income. Logic would dictate that consumers demand more goods and services as their income increases and decreases as income decreases. This is true for normal or superior goods. However, the reverse is true for inferior goods; demand increases as income decreases and demand decreases as income increases.
Availability of Substitutes:
As noted earlier the availability of substitutes is directly related to the elasticity of a product. For example, if there are three brands of mint chewing gum available for $1 in the grocery store check-out aisle we might assume that about the same quantity of each brand would be purchased. However, if the price of one brand increased to $2, consumers who previously purchased that brand are likely to switch to one of the lower priced brands as a comparable substitute. Proportion of Income Devoted to a Good:
The proportion of income a consumer spends on a good is directly related to its elasticity. For example, if we look at the monthly rental rate of a luxury car ($500/mo) and a mobile phone ($50/mo) and assume that the monthly cost of each product increases by 50% so that the car rental now costs $750/mo and the phone $75/mo. While the percentage increase of each product is the same, the actual price increase, or proportion of income, is dramatically different.
Therefore, the same percentage change will affect the demand of each product differently. The demand for mobile phones may decrease, but, as mobile phone users are likely to still be able to afford their phones, they may choose to pay the increased price. The same percentage change of the price of the luxury car, as the actual price increase and thus proportion of income increase is much higher will decrease demand of the car by a much greater percentage as many more consumers will be unwilling or unable to afford the greater price increase.
Consumer’s Time Horizon:
A consumer may not be able to react to a large price increase quickly, thus in the short run, demand for the product may not have a dramatic change. However, in the long run, as consumers have the ability to adapt and find substitutes, the large price increase would result in a decrease in demand. Therefore, elasticity is greater in the long run.
For example, if the electric company increased prices exponentially, a consumer wouldn’t have much choice but to pay the increased prices in the short run. However, in the long run, they could switch their house to run off of solar power, thus eliminating their demand for electricity from the electric company.
Referencing the above charts: from prices 80 to 50 demand is elastic, from prices 50 to 40 demand is unit elastic, and from demand 40 to 0 demand is inelastic When demand is elastic a price decrease increases total revenue. Therefore, within the elastic range of the demand curve, a decrease in price will increase total revenue. Price change does not affect the total revenue within the unit elastic range of the demand curve. Therefore, total revenue is equal regardless of the quantity demanded within this range. However, with inelastic demand a price decrease will result in a corresponding decrease in total revenue. Therefore within the inelastic range of the demand curve, a decrease in price will result in less total revenue.