The elasticity of demand measures the sensitivity of a change in a variable such as in this case, price, and the demand for that good. In other words, it measures the responsiveness of demand to the change in the variable.
PeD = % Change in Quantity Demanded / % Change in Price
Source: Nicholson, W. & Stapleton, D. C. (1985)
In all cases, ignore the negative sign as this is not important. Numbers under 1 (e < 1) are inelastic. Such products are oils and good that we need each day. Numbers above 1 (e > 1) are elastic meaning that an increase in price will cause a significant fall in demand. If the number equals 1 (e
= 1) then it is unit elastic. In essence, if there is elastic demand, people will purchase less reducing the total revenue of a firm. The opposite will happen if there is inelastic demand as people will purchase almost the same amount as before and total revenue will increase.
Factors that Determine Elasticity of Demand
What Determines the PeD?
The number and closeness of substitute goods. If there are many substitutes, it will be easier for consumers to switch to alternatives.
The proportion of income spent on goods is another factor. The higher the proportion, the more we will be force to cut consumption as the price rises. For example, for salt, even if the price rises, we would be willing to pay for it. But, if for example, interest rates increase, people will cut down on house purchases.
The time period also plays a part as people need to take the time to research substitutes.
There are three types of elasticity:
(a)Perfect Elastic Demand: This is shown by a horizontal straight line. If price was to change, the demand would fall to zero. Remember, perfect elasticity intersects with the Y axis.
(b)Perfect Inelastic Demand: This is shown be a vertical straight line. No matter how the price changes, the demand will remain constant. The closest perfectly inelastic item is oil.
(c) Unit Elastic Demand / Constant Elasticity: Shown by a slanted line in perfect proportion. The gradient is 1 all the way along. Any rise in price will be offset be an exact fall in demand - this leaves total consumer expenditure unchanged.
Income Elasticity of Demand
Income elasticity measures the responsiveness of demand to changes in consumer income.
YeD = % Change in Quantity Demanded / % Change in Income
What are the Determinants of YeD? (1) Degree of 'necessity of good'. If for example it is a basic good (giffin good), as income rises, the quantity demanded will stay the same. At the same time though, inferior goods will be more demanded. (2) Rate at which the desire for a good is satisfied as consumption increases. The quicker people are content, the less the demand will increase as income increases. (3) Level of income - poor people will respond much differently to rich people.
Cross-Price Elasticity of Demand
Cross price elasticity measures the responsiveness of demand for one product to a change in price of another. This allows predicting how much the demand curve for the first product will shift with a price change for the second product.
CeD = % Change in Quantity Demanded of Good A / % Change in Price of Good B
Substitutes: If good b is a substitute, the demand will rise for good a as the price for good b increases. Cross elasticity will be positive. The greater the number, the bigger the effect.
Compliments: If good b is a compliment to good a, the demand will fall for good a as the price for good b increases. The cross elasticity will be negative.
Uses of Elasticity Especially to Businessmen
Price elasticity
(i) To determine pricing policy. If the demand is inelastic, firms are able to raise their prices to receive greater revenue.
(ii) To estimate the impact of a price change.
(iii) To plan the change in quantity and the firms cost, and lastly.
(iv) The government can use this for planning indirect taxes.
Cross Elasticity:
(i) Firms can estimate the effect of a competitor's price cut on their demand.
(ii) Firms can estimate the effect of a change in price of a compliment (e.g computers and software).
Income Elasticity
(i) To determine what type of goods to produce and stock (e.g as GNP rises, firms may want to avoid giffen goods).
(ii) To help estimate potential changes in demand (as income grows overseas, new markets may emerge).
