Elastic demand means the quantity demanded is responsive to price changes. When prices rise by 5%, according to the law of demand, the quantity demanded falls by more than 5%. Conversely, when prices fall by 5%, the quantity demanded rises by more than 5%.
Please note. Demand elasticity here refers to own-price elasticity of demand, not cross-elasticity of demand. I focus on the relationship between the quantity demanded of a product and its price, not the price of the related product.
How do you calculate the own-price elasticity of demand?
Own-price elasticity links the change in quantity demanded of a product or service and the change in its price. In a mathematical formula, we can write it as follows:
Own-price elasticity of demand = % Change in quantity demanded of product X /% Change at the price of product X
Demand is elastic when the absolute value of elasticity is more than 1. A small change in price results in a much more significant change in the quantity demanded. Why is its absolute value?
Let’s recall the law of demand. It says the quantity demanded has an inverse relationship with price. Thus, a higher price leads to a lower quantity demanded. The opposite result applies when the price decreases.
A good is an elastic demand when its price increase causes a higher percentage of quantity demanded. For example, if the price goes up by 3%, then the quantity demanded falls by more than 3%.
Why is elastic demand important?
Knowing the elasticity of demand is essential to determine the right pricing strategy. Proper pricing maximizes the revenue you get.
Let me explain.
Total revenue equals the price times the sales volume. As you change prices, the effect on total revenue will depend on how much impact it has on the quantity demanded (sales volume). In other words, the effect of price changes on total revenue depends on the elasticity of demand.
When you lower the price to stimulate sales, total revenue will increase only if the percentage increase in demand (sales) is more significant than the percentage decrease in price.
In contrast, if you raise the price, demand will go down. Your total revenue still increases if the percentage increase in price is higher than the percentage decrease in demand.
Let’s go back to the elastic demand. As the definition, elastic demand is if a price decreases by 3%, it will increase the quantity demanded by more than 3%. Thus, total revenue will increase.
But, if the price rises by 3%, the quantity demanded will fall by more than 3%. Total revenue will decrease.
In conclusion, when you face an elastic demand curve, then:
- A fall in prices will increase total revenue. The benefit of the quantity demanded an increase to total revenue will outweigh the effect of a price decline.
- An increase in price will decrease total revenue. The effect of reducing the quantity demanded on total revenue is greater than the impact of rising prices.
Why is the demand for a product more elastic?
Several reasons explain why the demand for an item is elastic. I would show you three reasons.
First, purchases cover a significant portion of the buyer’s income. When buying a product contributes a large part of your income, then demand will tend to be elastic.
Take the car as an example. When the price rises, you will immediately look for alternatives. You certainly won’t spend all of your income only for buying a car.
The opposite applies when prices fall. You will buy it.
Time length since the price change. The longer the time has passed since the price change, the more elastic the demand will be. That is why when wages rise, companies do not change their production methods in the short term.
However, if wages remain high in the long run, the company can automate the production process. They replace their labor with machines.
For this reason, labor demand will be relatively elastic in the short term. And, it will be inelastic in the long run.
Availability of close substitutes. Close substitute products offer similar utilities to satisfy consumer needs. Therefore, if they are more available, the demand for an item will be relatively elastic.
When the price of a product rises, consumers turn to substitute products. They can find it easily. And, because of that, they bear a small switching cost to get substitute products.
Take Pepsi and Coca Cola as examples, both of which you can easily find around you. When the price of Pepsi rises, you will switch to Coca Cola. Even so, when the price of Coca Cola, you will switch to Pepsi.
Remember. We conclude the effect of substitutes by assuming that their prices are unchanged. When the price of substitute products also changes, the outcome might not be the same.
What is the difference between elastic demand and inelastic demand?
Inelastic demand works in reverse with elastic demand. Inelastic demand is when the absolute value of price elasticity less than 1 but higher than 0. That is, demand is relatively unresponsive to price changes.
When the price goes up by 3%, the quantity demanded falls by less than 3%. Conversely, when prices fall by 3%, the quantity demanded will increase by less than 3%. Therefore, when faced with an inelastic demand curve:
- Total revenue will rise when producers increase prices. The quantity demanded decreases, but the percentage decrease is smaller than the percentage increase in price.
- Total revenue will decrease when producers lower prices. A falling price causes an increase in the quantity demanded. But, the percentage increase in quantity demanded is less than the percentage decrease in price.
Demand is relatively inelastic when:
- Little or even no substitute products are available.
- The purchase of goods covers a small portion of consumer income
- In the short term, after the price increase. It is less time for buyers to find alternative products.