Table of Contents
- What is elasticity in Economics?
- Explaining the elasticity of demand
- The 3 Types of elasticity of demand
- Demand Elasticity Vs Inelasticity
- Factors affecting price elasticity of demand
- Importance of elasticity of demand in business
- Determining the level of output
- Determining the price of commodities
- Determining the price of factors of production
- To a discriminating monopolist
- Forecasting demand
- Determining the prices of joint products
- Determining government policies
- Adoption of the policy protection
- Determining gains from international trade
What is elasticity in Economics?
Before talking extensively about the elasticity of demand, let us look at what elasticity in economics implies. Elasticity in Economics is the measure of the sensitivity of a variable to the change of another variable. It has to do with the degree to which a variable responds to the change of another variable. This implies that one variable is independent while the other variable is dependent, the change of one depends on the change of the other. In Economics, this sensitivity is usually the change in price and this change in price relates to the change in other factors. Therefore, it is a measure of the degree to which an economic factor or variable is sensitive to another.
It is an economic concept that measures the change in the total quantity demanded of goods and services relating to the changes in price. We consider a product to be elastic if the quantity demanded of that product changes extremely when the price changes. Here, a product is inelastic if the quantity demanded change is very little when its price changes or fluctuates. We shall explain the elasticity of demand extensively.
Explaining the elasticity of demand
The elasticity of demand is an economic measure of the rate at which demand is in relation to the changes in other variables or factors. The number of commodities demanded depends on different factors (determinants of demand) such as price, income, preference. Whenever there is a change in these factors or variables, there will equally be a change in the number of goods and services demanded.
The demand for goods and services either expands or contracts with the rise and fall in prices, and this relates to the changes in other factors. We call this quality of demand elasticity of demand when it changes in response to changes in price.
when elasticity is greater than 1.0, we suggest that it is the price that affects the demand for goods and services. when the value of the elasticity is less than 1.0, the demand becomes inelastic, which is insensitive to the changes to the price.
According to Marshall, “The elasticity (or responsiveness) of demand in a market is great or small accordingly as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price”.
The 3 Types of elasticity of demand
Basically, there are three types of elasticity of demand which include price elasticity, income elasticity, and cross elasticity of demand. Some books add the fourth one which is advertising elasticity of demand.
A) Price elasticity of demand
Price elasticity of demand is the degree of responsiveness of demand for goods and services to changes in price. The extent to which demand responds to the changes in price is not usually the same. Demand can be elastic, inelastic, or unitary elastic, we shall explain them in a more understandable way.
To calculate the price elasticity of demand, we divide the percentage change in quantity demanded by the percentage change in price. We express it in formula thus;
Ep = %ΔQd ⁄ %ΔP Where;
Ep = Price elasticity of demand
%ΔQd = Percentage change in quantity demanded
%ΔP = Percentage change in price
To further explain the price elasticity of demand, there are different types thus;
- Perfectly (infinitely) elastic demand
- Perfectly inelastic (zero elastic) demand
- Elastic demand (relatively or fairly elastic)
- Inelastic demand (relatively or fairly inelastic)
- Unitary (neutral) elastic demand
Perfectly (infinitely) elastic demand
Demand is perfectly elastic when a little change in price causes a large or a major change in demand. In this case, a slight fall in the price of a commodity causes the demand to rise to infinity. A slight rise in the price of a commodity leads to a fall in demand to zero. The elasticity degree helps to define the shape/slope of the demand curve, that is the slope of the demand curve determines the type of elasticity of demand. The flatter the slopes are, the higher the elasticity of demand. The demand curve of perfectly elastic demand is a horizontal straight line.
Because perfectly elastic demand is a theoretical concept, we cannot apply it in real life. Though we can apply it in cases like the perfectly competitive market and homogenous products, the perfect market also does not exist in real life. It is in cases like this that we assume that the demand for a product is perfectly elastic.
Looking from an organization’s point of view, the organization can sell as many products as it wants. This can happen as long as consumers are ready to purchase that product in a large quantity. This directly means that consumers can purchase all of the products on a slight decrease in price.
Perfectly inelastic (zero elastic) demand
This comes as a result of a situation whereby a change (increase or decrease) in price does not cause any change in the quantity demanded of well and services. The quantity demanded remains the same irrespective of any changes in price. The numerical value is zero
The demand curve of a perfectly inelastic demand takes the form of a vertical straight line.
Here, the demand remains constant irrespective of the price level. it is also a theoretical concept and we cannot apply it in real life. In cases of essential goods, the demand does not change alongside a change in price. Essential goods are those items that a consumer needs in order to sustain his life or health. A physical item required by a consumer in order to sustain health or life. The demand for essential products is perfectly inelastic.
Elastic demand (relatively or fairly)
This is a situation whereby the percentage change in demand is greater than the percentage change in the product’s price. The numerical value ranges from one to infinity, that is ep>1. For example, if the price of a product rises by 15% and its demand increases by 25%, we will say that the demand is elastic (relatively elastic).
The demand curve is a gradual sloping demand curve.
For example, the price of pizza in a particular restaurant increases from $5 to $10, consumers can switch to another restaurant to buy it. However, some consumers will still go to the first supermarket to buy pizza. Here, a little change in price leads to a larger change in the demand for pizza.
Inelastic demand (relatively or fairly)
Demand is inelastic (fairly) is a situation whereby the percentage change in demand is less than the percentage change in price. For example, the price of a product increases by 25% and the demand decreases by 10%, we will call the demand a relatively or fairly inelastic demand. The numerical value ranges from zero to one, or ep<1.
The demand curve of fairly inelastic demand is a rapidly sloping curve. Mostly, the change in demand shows a negative sign. This is because there is an inverse relationship between demand and price which results in a negative figure.
Unitary elastic demand
Unitary elastic demand for a product is the demand that changes at the same rate as its price. In other words, the change in demand is exactly equal to the change in the price of a product, its numerical value is equal to one, that is ep=1. Here, the product elasticity is negative. This is because a decrease in the price of a product does not help in generating more revenue. The demand still remains at the same level, it is only the quantity of goods sold that increases.
B) Income elasticity of demand
Income is one of the factors that affect demand for a commodity. Income elasticity of demand is the degree of responsiveness of demand to a change in the real income of consumers, keeping every other thing equal. It helps one to tell if a particular product is a necessity or it represents luxury.
The formula for calculating income elasticity of demand is the percentage in quantity demanded divided by the percentage change in income. Thus,
Ey = % ΔQd / % ΔY Where;
Ey = Income elasticity of demand
%ΔQd = Percentage change in quantity demanded
%ΔY = Percentage change in income
C) Cross elasticity of demand
This concept measures the degree of responsiveness of the demand of a product to the changes in the price of another product. We calculate it by dividing the percentage change in the quantity demanded of one product by the percentage change in the price of the other product.
Ec = % ΔQd (X) ⁄ %ΔP (Y) Where;
Ec = Cross elasticity of demand
% ΔQd (X) = Percentage change in the quantity demanded of commodity X
%ΔP (Y) = Percentage change in the price of commodity Y
D) Advertising elasticity of demand
Sometimes, advertising elasticity of demand is considered as the 4th; It is the degree of responsiveness of demand to the change in advertising expenses. We can express it using the formula below;
Ea = %ΔQd ⁄ %ΔAdEx where;
Ea = Advertising elasticity of demand
%ΔQd = Percentage change in quantity demanded
%ΔAdEx = Percentage change in advertising expenses
Demand Elasticity Vs Inelasticity
Elasticity means that the change in price leads to a significant change in demand. That is, a light increase or decrease in the price of a product leads to a huge increase or decrease in the quantity demanded of a product. On the other hand, inelasticity is a situation whereby a change in the price of a product does not lead to any significant change in the demand for that product.
Factors affecting price elasticity of demand
Availability of substitutes
Generally, the existence of more substitutes causes the demand to be more elastic. If the price of a product rises, consumers will switch to its close substitute. When consumers switch to its close substitute, the demand for the initial product will decline. If a commodity does not have a close substitute, people will buy it even when its price increases. Because of this, its demand will be inelastic.
For example, if the price of Pepsi increases, consumers will switch to Coke. This will however lead to a decrease in the demand for Pepsi. On the other hand, if the price of Coke falls, many consumers will switch from other Cola drinks to Pepsi. In this case, the demand for Pepsi is elastic. The demand for salt is inelastic because it has little or no substitutes. If the price of salt increases, people will still consume the same quantity as they used to be. The demand for salt is inelastic also because people only spend a little part of their income on it. When the price rises, it makes no change in their budget for salt.
If a product is highly needful for survival and comfort, people will continue to buy it. They will be willing to pay higher prices to get such products. For example, people need to fuel their cars, they need to transport themselves from one place to another.
The number of uses of a product
The higher the number of uses of a commodity, the higher its price elasticity of demand. If the price of a product with many uses is very high, its demand will be small. In this case, consumers will make the most important use of the commodity, that is its efficient use. If the price of such product falls, they will make less important use of it and its quantity demanded will rise.
For example, milk has several uses such as consumption, baking, making candies, and body creams. If its price rises very high, people will use it for important purposes like feeding babies and sick people.
Time has a major influence on the elasticity of demand. Demand tends to be more elastic over a longer period of time. This happens mostly because consumers can switch to other substitutes. In the short run, substitution is difficult. In other words, demand is usually inelastic in the short run.
Joint demand for goods
Joint demand for goods affects the elasticity of demand. Consumers are not really sensitive to changes in the price of commodities that are jointly used. They are more sensitive to the changes in prices for commodities that have independent demand.
For example, in maintaining a motor vehicle, people use lubricants to keep their engines sound. If the price of lubricants increases, it will imply a very little increase in the total cost of maintaining a motor vehicle. Here the demand for lubricants tends to be inelastic.
The commodity’s status in a consumer’s budget
How much the commodity matters in a consumer’s budget is an important factor that affects the price elasticity of demand. To explain it better, the amount of income a consumer spends on a particular commodity has a great influence on price elasticity. The more a consumer spends his income on a commodity, the higher the elasticity of demand for that product. The less income a consumer spends on a commodity, the lower the elasticity becomes.
For example, the demand for commodities such as soap and salt tends to be inelastic. This is because households spend just a little of their income on them. They continue to buy these commodities even when the prices increase. It makes no difference in the budget of the consumer because he continues to buy almost the same quantity.
On the other hand, the demand for commodities like clothes in some places is highly elastic. This is because households spend a large amount of their income on buying clothes. If the price of clothes decreases, it will imply a great saving in many people’s budgets. Sometimes, they will increase the number of clothes demanded. If the price of clothes rises, many people may not afford to buy as many clothes as they used to buy before. This will cause the quantity demanded of clothes to fall.
Importance of elasticity of demand in business
Determining the level of output
In order for a firm to be profitable in its production, it is important to study the demand for the products. This is because the number of goods should correspond with the demand for those goods. Because changes in price result in changes in demand, understanding the elasticity of demand is needful to determine the level of output.
Determining the price of commodities
It is important to understand the elasticity of demand and apply it to the pricing of your commodities. The rate at which demand falls with an increase in price is understandable through the knowledge of elasticity. It forms a basis for price determination.
If the demand for a commodity is inelastic, the producer can charge a high price. If the demand is elastic, he can charge a low price on the other hand. Understanding the elasticity of demand is necessary for managing a firm so as to maximize profit.
Determining the price of factors of production
It forms the basis for determining the prices of different factors of production. firms pay factors of production according to their elasticity of demand. That means if the demand for a factor is inelastic, the price will be high. On the other hand, the price of a factor will be low if the demand is elastic.
To a discriminating monopolist
Under a discriminating monopoly, pricing the same commodity in different markets depends on the demand elasticity in those markets. A discriminating monopolist fixes lower prices while he fixes higher prices in markets with inelastic demands.
A firm can easily forecast the future demand for its product in a market through the knowledge of income elasticity. It forms the basis for long-term production planning and management. Management helps to know the effects of changes in the levels of income and its impact on the demand for its products.
In a foreign market, a firm dumps its products based on the elasticity of demand in the market. The aim is to be able to face foreign competition.
Determining the prices of joint products
The elasticity of demand forms the basis for pricing joint goods. In this case, there is no clear knowledge of separate costs of production.
Determining government policies
The knowledge of elasticity helps the government in the formulation of its policies. When they want to impose price control on a commodity, they must consider the elasticity of demand of that commodity.
Adoption of the policy protection
The elasticity of demand is helpful in the adoption of policy protection. Governments give subsidy protection to only those firms that have an elastic demand. When firms/industries apply for grants or protection. Firms are unable to face foreign competition until they lower their prices through subsidies or raise the price of imported products. The government raises the prices of imported products by imposing heavy duties on them.
Determining gains from international trade
The elasticity of demand is helpful in the determination of gains from international trade. a country gains more from international trade when it exports goods that have less elasticity of demand. Also when it imports goods with high elasticity. It forms the basis of the volume of goods imported and the ones exported.
We have seen that elasticity of demand is the measure of the degree of responsiveness of demand to the changes in other variables. These variables in question are the factors affecting demand (determinants of demand or factors that determine demand). These factors can be price (which is the major factor), the income of the consumer, prices of other commodities, taste and preference of the consumer, the emergence of new commodities, the population, and time frame. We can see that other factors include taxation on commodities, future expectations, and advertisements.
This elasticity of demand measures the rate at which demand is sensitive to the changes in the price of the commodity and other factors. Whenever there is a change in these factors mentioned above, there will equally be a change in the quantity demanded of goods and services.
Elasticity as seen above is important to both the government body and business firms in formulating their business and economic policies.
We also looked at the different types of elasticity of demand which include the price elasticity of demand, income elasticity of demand, cross elasticity of demand, and the advertising elasticity of demand.
Extreme cases of elasticity of price elasticity demand lead to abnormal demand curves. This includes the perfectly elastic demand and the perfectly inelastic demand.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.