Elasticity of Demand
Elasticity of DemandWhat DoesDemand ElasticityMean?In economics,
the demand elasticity refers to how sensitive the demand for a good
is to changes in other economic variables. Demand elasticity is
important because it helps firms model the potential change in
demand due to changes in price of the good, the effect of changes
in prices of other goods and many other important market factors. A
firm grasp of demand elasticity helps to guide firms toward more
optimal competitive behavior. Elasticities greater thanone are
called "elastic," elasticities less thanone are "inelastic,"and
elasticities equal toone are "unit elastic."
Price elasticity of demand
Price elasticity of demand measures the percentage change in
quantity demanded caused by a percent change in price. As such, it
measures the extent of movement along the demand curve. This
elasticity is almost always negative and is usually expressed in
terms of absolute value (i.e. as positive numbers) since the
negative can be assumed. In these terms, then, if the elasticity is
greater than 1 demand is said to be elastic; between zero and one
demand is inelastic and if it equals one, demand is unit-elastic. A
perfectly elastic demand curve is horizontal (with an elasticity of
infinity) whereas a perfectly inelastic demand curve is vertical
(with an elasticity of 0).
Income elasticity of demand
Income elasticity of demand measures the percentage change in
demand caused by a percent change in income. A change in income
causes the demand curve to shift reflecting the change in demand.
IED is a measurement of how far the curve shifts horizontally along
the X-axis. Income elasticity can be used to classify goods as
normal or inferior. With a normal good demand varies in the same
direction as income. With an inferior good demand and income move
in opposite directions.
Cross price elasticity of demand
Cross price elasticity of demand measures the percentage change
in demand for a particular good caused by a percent change in the
price of another good. Goods can be complements, substitutes or
unrelated. A change in the price of a related good causes the
demand curve to shift reflecting a change in demand for the
original good. Cross price elasticity is a measurement of how far,
and in which direction, the curve shifts horizontally along the
x-axis. A positive cross-price elasticity means that the goods
aresubstitute goods.
Price elasticity of demand(PEDorEd) is a measure used in
economics to show the responsiveness, orelasticity, of the quantity
demanded of a good or service to a change in its price. More
precisely, it gives the percentage change in quantity demanded in
response to a one percent change in price (holding constant all the
other determinants of demand, such as income). It was devised
byAlfred Marshall.
Price elasticities are almost always negative, although analysts
tend to ignore the sign even though this can lead to ambiguity.
Only goods which do not conform to thelaw of demand, such
asVeblenandGiffen goods, have a positive PED. In general, the
demand for a good is said to beinelastic(orrelatively inelastic)
when the PED is less than one (in absolute value): that is, changes
in price have a relatively small effect on the quantity of the good
demanded. The demand for a good is said to beelastic(orrelatively
elastic) when its PED is greater than one (in absolute value): that
is, changes in price have a relatively large effect on the quantity
of a good demanded.
PED is derived from the percentage change in quantity (%Qd) and
percentage change in price (%P).
PED is a measure of responsiveness of the quantity of a good or
service demanded to changes in its price.The formula for the
coefficient of price elasticity of demand for a good is:
The above formula usually yields a negative value, due to the
inverse nature of the relationship between price and quantity
demanded, as described by the "law of demand".
Point-price elasticityThe point measurement of priceelasticity
usesdifferential calculusto calculate the elasticity for an
infinitesimal change in price and quantity at any given point on
the demand curve:
In other words, it is equal to the absolute value of the first
derivative of quantity with respect to price (dQd/dP) multiplied by
the point's price (P) divided by its quantity (Qd)
Arc elasticityA second solution to measure PED is Arc
measurement in which two given points on a demand curve is chosen,
one as the "original" point and the other one as "new", where we
have to compute the percentage change in P and Q relative to
theaverageof the two prices and theaverageof the two quantities,
rather than just the change relative to one point or the other.
Loosely speaking, this gives an "average" elasticity for the
section of the actual demand curvei.e., thearcof the curvebetween
the two points. As a result, this measure is known as thearc
elasticity, in this case with respect to the price of the good. The
arc elasticity is defined mathematically as:
This method for computing the price elasticity is also known as
the "midpoints formula", because the average price and average
quantity are the coordinates of the midpoint of the straight line
between the two given points.However, because this formula
implicitly assumes the section of the demand curve between those
points is linear, the greater the curvature of the actual demand
curve is over that range, the worse this approximation of its
elasticity will be.Determinants of Price Elasticity of DemandThe
overriding factor in determining PED is the willingness and ability
of consumers after a price change to postpone immediate consumption
decisions concerning the good and to search for substitutes ("wait
and look").A number of factors can thus affect the elasticity of
demand for a good:
Availability ofsubstitute goods:the more and closer the
substitutes available, the higher the elasticity is likely to be,
as people can easily switch from one good to another if an even
minor price change is made;There is a strong substitution effect.
If no close substitutes are available the substitution of effect
will be small and the demand inelastic.
Breadth of definition of a good:the broader the definition of a
good (or service), the lower the elasticity. For example, Company
X's fish and chips would tend to have a relatively high elasticity
of demand if a significant number of substitutes are available,
whereas food in general would have an extremely low elasticity of
demand because no substitutes exist.
Percentage of income:the higher the percentage of the consumer's
income that the product's price represents, the higher the
elasticity tends to be, as people will pay more attention when
purchasing the good because of its cost;The income effect is
substantial.When the goods represent only a negligible portion of
the budget the income effect will be insignificant and demand
inelastic,
Necessity:the more necessary a good is, the lower the
elasticity, as people will attempt to buy it no matter the price,
such as the case ofinsulinfor those that need it.
Duration:for most goods, the longer a price change holds, the
higher the elasticity is likely to be, as more and more consumers
find they have the time and inclination to search for
substitutes.When fuel prices increase suddenly, for instance,
consumers may still fill up their empty tanks in the short run, but
when prices remain high over several years, more consumers will
reduce their demand for fuel by switching tocarpoolingor public
transportation, investing in vehicles with greaterfuel economyor
taking other measures.This does not hold forconsumer durablessuch
as the cars themselves, however; eventually, it may become
necessary for consumers to replace their present cars, so one would
expect demand to be less elastic.
Brand loyalty:an attachment to a certain brandeither out of
tradition or because of proprietary barrierscan override
sensitivity to price changes, resulting in more inelastic
demand.
Who pays:where the purchaser does not directly pay for the good
they consume, such as with corporate expense accounts, demand is
likely to be more inelastic.
Interpreting values of price elasticity coefficients
Perfectly inelastic demand
Perfectly elastic demand[10]Elasticities of demand are
interpreted as follows
ValueDescriptive Terms
Ed= 0Perfectly inelastic demand
- 1 < Ed< 0Inelastic or relatively inelastic demand
Ed= - 1Unit elastic, unit elasticity, unitary elasticity, or
unitarily elastic demand
-< Ed< - 1Elastic or relatively elastic demand
Ed= -Perfectly elastic demand
A decrease in the price of a good normally results in an
increase in the quantity demanded by consumers because of thelaw of
demand, and conversely, quantity demanded decreases when price
rises. As summarized in the table above, the PED for a good or
service is referred to by different descriptive terms depending on
whether the elasticity coefficient is greater than, equal to, or
less than 1. That is, the demand for a good is called:
relatively inelasticwhen the percentage change in quantity
demanded isless thanthe percentage change in price (so that Ed>
- 1);
unit elastic, unit elasticity, unitary elasticity, orunitarily
elasticdemand when the percentage change in quantity demanded
isequal tothe percentage change in price (so that Ed= - 1); and
relatively elasticwhen the percentage change in quantity
demanded isgreater thanthe percentage change in price (so that
Ed< - 1).
As the two accompanying diagrams show,perfectly elasticdemand is
represented graphically as a horizontal line, andperfectly
inelasticdemand as a vertical line. These are theonlycases in which
the PED and the slope of the demand curve (P/Q) arebothconstant, as
well as theonlycases in which the PED is determined solely by the
slope of the demand curve (or more precisely, by theinverseof that
slope).
INCOME ELASTICITY OF DEMAND
In economics,incomeelasticityofdemandmeasures the responsiveness
of the demand for a good to a change in the income of the people
demanding the good,ceteris paribus. It is calculated as the ratio
of the percentage change in demand to the percentage change in
income. For example, if, in response to a 10% increase in income,
the demand for a good increased by 20%, the income elasticity of
demand would be 20%/10% = 2.
A negative income elasticity of demand is associated
withinferior goods; an increase in income will lead to a fall in
the demand and may lead to changes to more luxurious
substitutes.
A positive income elasticity of demand is associated withnormal
goods; an increase in income will lead to a rise in demand. If
income elasticity of demand of a commodity is less than 1, it is
anecessity good. If the elasticity of demand is greater than 1, it
is aluxury goodor asuperior good.
A zero income elasticity (or inelastic) demand occurs when an
increase in income is not associated with a change in the demand of
a good. These would bestickygoods.
Income elasticity of demand can be used as an indicator of
industry health, future consumption patterns and as a guide to
firms investment decisions. For example, the "selected income
elasticities" below suggest that an increasing portion of
consumer's budgets will be devoted to purchasing automobiles and
restaurant meals and a smaller share to tobacco and margarine.
Cross elasticity of demand
Ineconomics, thecross elasticity of demandorcross-price
elasticity of demandmeasures the responsiveness of thedemandfor
agoodto a change in the price of another good. It is measured as
thepercentage changein demand for the first good that occurs in
response to a percentage change in price of the second good. For
example, if, in response to a 10% increase in the price of fuel,
the demand of new cars that are fuel inefficient decreased by 20%,
the cross elasticity of demand would be:
. A negative cross elasticity denotes two products that are
complements, while a positive cross elasticity denotes two
substitute products. These two key relationships go against one's
intuition, but the reason behind them is fairly simple: assume
products A and B arecomplements, meaning that an increase in the
demand for A is caused by an increase in the quantity demanded for
B. Therefore, if the price of product B decreases, then the demand
curve for product A shifts to the right, increasing A's demand,
resulting in anegativevalue for the cross elasticity of demand. The
exact opposite reasoning holds for substitutes.The formula used to
calculate the coefficient cross elasticity of demand is
or:
Dr. Uma Sankar Mishra, Associate Professor (Marketing
Management), IBCS,
SOA Deemed University, Bhubaneswar, Odisha
