What’s it: Elasticity of demand measures the responsiveness of a product’s demand to changes in determining factors such as its price (own-price), the price of other goods, and income. To calculate this, you divide the percentage change in demand by the percentage change for these factors.
Types of demand elasticity
Economists use three variables to measure the elasticity of demand for a good, namely:
- Own price. We call this the own-price elasticity of demand.
- Prices of related goods. We call this the cross-price elasticity of demand.
- Consumer income. It produces the income elasticity of demand.
To calculate the three, they are mathematically similar. You use the percentage change in the quantity demanded as the numerator. Then, you divide it by the percentage change in the factor above.
Own-price elasticity of demand
Own-price elasticity of demand measures the sensitivity of the quantity demanded of a product to changes in its price. For companies, this information is important in determining the impact of its pricing strategy on total revenue. For example, when a firm lowers prices, will it result in an increase in total revenue or not.
The formula for the price elasticity itself of demand is as follows:
- Own price elasticity of demand (OPE) =% Change in quantity demanded of Product X /% Change of price of Product X
Category of goods based on their own price elasticity of demand
We ignore the negative or positive signs of the elasticity calculation results when classifying goods. As with the law of demand, the quantity demanded has a negative correlation with price. If the price goes up, the quantity goes down.
Since elasticity measures the sensitivity of changes in the quantity demanded, we ignore such correlations. Some literature then suggests we use absolute numbers of elasticities to avoid confusion.
Furthermore, we can categorize goods into five categories based on the own-price elasticity of demand:
- Perfectly inelastic. Elasticity is equal to zero (OPE = 0)
- Relatively inelastic. Its own-price elasticity is more than zero but less than one (0 <OPE <11).
- Unitary elastic. Elasticity equals one (OPE = 1)
- Relatively elastic. Elasticity equals more than one (OPE> 1)
- Perfectly elastic. Elasticity is equal to infinity (OPE = ∞)
If an item is perfectly inelastic, the change in price does not affect the quantity demanded. Increasing or decreasing the price has no impact on the quantity demanded.
Such items are usually essential for survival. A rational person should be willing to pay any amount for goods if the alternative is death.
Take, for example, a person in the desert who is thirsty and dying. He did not bring water but brought a lot of money. Say, someone else offers him a bottle of water as long as he hands over all the money. Rationally, he would give all the money in his wallet, no matter how much, so that he would survive death.
If a good is relatively inelastic, the percentage change in quantity demanded is lower than the percentage change in price. The absolute value of elasticity lies between 0 and 1.
It shows you the item is less sensitive to price changes. If the firm decreases the price by 5%, then the quantity demanded increases by less than 5%. Conversely, if the firm increases the price by 5%, the quantity demanded falls by less than 5%.
So, for such goods, the company should increase the price to get more revenue. Remember, to calculate revenue, we multiply the quantity demanded by the price. Thus, when raising prices, it increases total revenue because changing prices is more significant than the effect of decreasing demand.
Unitary elastic is when the percentage change in quantity demanded is equal to the percentage change in price. The absolute value of elasticity is equal to 1. For example, if the price decreases by 5%, the quantity demanded will increase by 5%. Vice versa, if the price increases by 5%, it decreases the quantity demanded by 5%.
For producers, raising prices or lowering prices does not have a better effect on revenue. Both produce unchanged total revenue.
Relative elastic means that the percentage change in quantity demanded is greater than the percentage change in price. The elasticity is greater than 1.
In this case, consumers tend to be sensitive to price changes. If the price increases by 5%, the quantity demanded decreases by more than 5%. Conversely, if the price falls by 5%, the quantity demanded increases by more than 5%.
If the demand curve is relatively inelastic, lowering prices is the best option for increasing total revenue. That will result in a more significant increase in demand. Thus, the effect of increased demand on revenue is higher than the effect of a price decrease.
In this case, any increase in price, no matter how small, will cause the quantity demanded to fall to zero. Hence, if the firm raises prices, total revenue falls to zero.
Conversely, if the price increases, it will increase the demand infinitely, even if it is small. Therefore, the revenue will also be infinite.
Of course, it is difficult for us to find examples of such items in the real world.
Factors affecting the own-price elasticity of demand
First, the availability of substitute products. If the substitute products are abundant, the demand will be relatively elastic. Consumers have many choices to fulfill the same needs. Therefore, if producers raise prices, they will switch to substitute products.
Conversely, if there are limited substitute products available, the demand is relatively inelastic. Consumers find it more difficult to find alternatives to meet needs.
Second, the proportion of income that consumers spend on buying goods. If purchases consume a large proportion of their income, demand is relatively elastic. Consumers are relatively sensitive to price changes. Take a car, for example. If carmakers raise prices, consumers will reduce demand significantly.
Conversely, suppose the consumers spend a small portion of income on buying goods. In that case, they will not significantly reduce consumption if the price rises. The demand for such goods will be relatively inelastic. Soaps, shampoos, and some of our daily products fall into this category.
Third, the period since the price changed. In the short term, demand will be relatively inelastic. If prices change, consumers need more time to change buying patterns and find alternative products.
Conversely, in the longer run, demand will be relatively elastic. Take, for example, fuel oil. As prices continue to rise, consumers will not necessarily switch to fuel-efficient vehicles in the short term. The supply may be unavailable because the manufacturer did not produce it.
Over time, rising automakers see rising oil prices as an opportunity to introduce fuel-efficient cars. The increased supply encourages consumers to switch to these products.
Effect of price elasticity on total revenue
Total revenue equals price times quantity. Changes in revenue will depend on, which is more significant, changes in price or changes in quantity.
Long story short, to increase total revenue, a company must:
- Lowering prices when demand is relatively elastic. The effect of cutting prices is lower than the effect of increasing the quantity demanded. Consumers are relatively sensitive to price changes. Thus, lower prices encourage them to buy significantly more.
- Raising the price if the demand is relatively inelastic. The effect of a price increase is higher than the effect of decreasing the quantity demanded. Consumers are less sensitive, so their demand does not change much if producers increase prices.
Cross-price elasticity of demand
Cross-price elasticity measures the responsiveness of a product’s demand if the price of an alternative product changes. The alternative product may act as a substitute or complementary.
We compare the percentage change in the demand quantity of a product against the percentage change in the alternative product price to calculate this. The following is the formula for the cross-price elasticity of demand:
- Cross price elasticity of demand (CPE) =% Change in demand quantity for Product X /% Change in the price for Product Y
Category of goods based on cross-price elasticity
Cross elasticity results in two product categories:
- Substitute product
- Complementary products
If the cross-price elasticity is more than zero (CPE> 0), then the two products substitute each other. An increase in the product price will increase the demand for its substitute product.
Take Pepsi and Coca Cola, for example. Both serve relatively similar market segments. As Pepsi’s price went up, the quantity demanded Coca Cola increased. Consumers are turning from Pepsi to Coca Cola because they find it cheaper.
The elasticity value shows how close the two products are. If the value is high, these two are close substitutes. Consumers are relatively sensitive to price changes in one product. The two products are close substitutes because they serve market segments, fulfill needs, and provide the same satisfaction.
Conversely, if the elasticity is low, the two products substitute less for each other. Changes in the price of a product less affect the demand for the substitute product. Consumers find the two products to give slightly different satisfaction.
Two products complement each other if the cross-price elasticity is less than zero (CPE <0). Changes in the price of a product will reduce the demand for complementary products.
Take tires and cars, for example. If the price of a car increases, the demand for tires will decrease. The increase in car prices caused sales to fall. Automakers ultimately reduce the demand for tires.
Absolute value of elasticity shows how closely the two products act as complementaries. If the absolute value is high, they are close complements. An increase in the price of one product significantly reduces the demand for its complementary product.
Income elasticity of demand
Income elasticity of demand measures demands responsiveness when income changes, assuming the other factors are constant. As with the previous two demand elasticities, you can calculate this by dividing the percentage change in the demand quantity for a product by the percentage change in income. The following is the formula for the income elasticity of demand:
- Income elasticity of demand (IE) =% Change in the demand quantity of products /% Change in income
Category of goods based on income elasticity
Economists divide goods into the following categories based on their income elasticity:
- Normal goods. They have an income elasticity of more than 0 (IE> 0). Economists then divide them into two groups: necessities and luxury goods.
- Inferior goods. They have an income elasticity of less than zero (IE <0).
Necessities are a subcategory of normal goods. They have an income elasticity between zero and 1 (0> IE> 1). In other words, their demand is inelastic, so they are relatively less responsive to consumer income.
For example, when consumer income increases by 5%, the demand for necessities increases by less than 5%. Increased income only makes consumers spend a small part of their income to buy such products.
Elasticity of luxury goods is more than 1 (IE> 1). They fall into normal goods because when the consumer’s income increases, the product’s demand increases.
But, unlike necessities, luxury goods are elastic in demand. The percentage increase in demand is higher than the percentage change in income. For example, if income increases by 5%, demand increases by more than 5%. It shows consumers spend a higher proportion of their income on products.
Inferior goods have elasticity less than 1 (IE <0). It shows you the inverse relationship between income and product demand. If income increases, consumers reduce their purchases of these goods.
From the demand curve, an increase in income shifts the curve to the left. That contrasts with necessities and luxury goods, where an increase in income shifts the curve to the right.
Furthermore, categorizing goods as an inferior, necessity, or luxury varies between individuals, depending on their income range. Take a motorcycle. Some people on low incomes consider it a luxury. Meanwhile, for a wealthy middle-income individual, it is probably a normal item. And, for the super-rich, that is an inferior item.