Elasticity

Elasticity is an economic concept based on change. It measures how consumers and producers respond to changes in variables that affect demand and supply. Elasticity is important because it allows us to analyse what happens to demand and supply in markets when change takes place and to evaluate the consequences of change. For example, when the price of electricity rises we can use elasticity to analyse how consumers and producers will respond to the rise in price.  

Definition and measurement of price elasticity of demand

Price elasticity of demand is the responsiveness of quantity demanded for a good to a change in its price. It is measured by the equation: 

% change in Qd / % change in P

For example, if the price of film and TV streaming services such as Netflix increases from $20 per month to $24 (20 per cent increase) and quantity demanded falls from 10 million subscribers to 7.5 million subscribers (25 per cent decrease).  This is shown in diagram 2.15 and is calculated as:

-25% QD / +20% P = -1.25 or 1.25 (PED)

Interpretation

The value of PED is normally negative because of the law of demand. The negative value is often ignored because the PED value is nearly always negative. In future calculations, the PED will be expressed as a positive value.

Price elastic demand

If the PED value is greater than 1 then the good’s demand is price elastic.  This means a change in price leads to a proportionately greater change in quantity demanded.  In the film and TV streaming service example, the value is 1.25 which means for every 1% increase in price, the quantity demanded decreases by 1.25%. This is a price elastic relationship because the proportionate change in quantity demanded is greater than the proportionate change in price.

Theoretically, the demand curve can be perfectly horizontal or perfectly elastic. This gives a PED of infinity.  This is applicable in the theoretical market form of perfect competition.

Unitary elasticity of demand

If the PED value is 1 then PED is unitary. This means that for every 1 per cent change in price quantity demanded changes by 1%. It is unlikely a good will have a PED of 1 but the value could be close to 1. This is shown by a demand curve which is a rectangular hyperbola and is represented in diagram 2.16.

Price inelastic demand

If the demand for a good has a PED value of less than 1 then it is price inelastic.  This means that a change in the price of a good leads to a less than proportionate change in quantity demanded.  For example, if the price of rice rises from $0.50 to $0.55 and the quantity demanded falls from 4m units to 3.8m then the PED of rice is calculated as:

-5% QD / +10% P = 0.5 (PED)

The PED value of 0.5 means for every 1% change in the price of rice, the quantity demanded changes by 0.5%. This is shown in diagram 2.17. In theory, a perfectly vertical demand curve represents perfectly inelastic demand. This gives a PED of 0.

Demand curves with differing elasticities

Diagram 2.18 shows demand curves of different slopes to represent different PEDs. A horizontal demand curve is perfectly elastic (D) and with a relatively flat gradient (D1) is relatively elastic. A vertical demand curve (D3) is perfectly inelastic and one which has a relatively steep gradient is inelastic.

All demand curves (except the perfect ones) have a PED that changes from elastic to inelastic as the price of the good is reduced and this is shown in diagram 2.18.  The demand curves that represent elastic and inelastic demand situations are useful for illustrating the effects of price changes.

Elasticity along the demand curve

As the price of a good decreases along the demand curve the PED value falls.  Diagram 2.19 illustrates the demand curve for training shoes. As the price of the shoes falls from $50 to $45 the quantity demand increases from 2m units to 3m units. This is a PED of:

+50% QD/ -10% P = 5 (price elastic)

On the upper section of the demand curve, PED is price elastic.

When the price of the training shoes is reduced from $20 to $15 the quantity demanded rises by 8m to 9m units. This is a PED of:

+12.5% QD / -25% P = 0.5 (price inelastic)

PED falls as you move down the demand curve because a change in price at a relatively high price level has a greater proportionate effect on quantity demanded than the effect of a change in price at a relatively low price.  On the upper section of the demand curve in diagram 2.19, PED is price elastic because of the way percentages are calculated. A $5 price reduction from a price of $50 is a smaller percentage change than a $5 price reduction from a $20 price.

Similarly, a 1m quantity increase from 2m to 3m is a larger percentage increase than a 1m increase from 8m to 9m. When the PED is calculated it will have a greater value at higher prices on the demand curve and a smaller value at lower prices.     

Determinants of price elasticity of demand

Number and closeness of substitutes

The greater the number of close substitutes a product has the more price elastic its demand tends to be because consumers can easily swap between alternatives when the price of the good changes. 

This relates to the way you define the market for a good: the more precisely defined the market for a good, the more close substitutes it tends to have. There are many different brands of biscuits on the shelf of a supermarket, so any one brand of biscuit tends to be relatively price elastic. A rise in the price of Oreo biscuits, for example, may well lead to consumers switching to alternative brands such as Jaffa Cakes. If the market definition broadened from brands of biscuits to biscuits as a product, then there are fewer close substitutes (chocolate bars, crisps, cakes, etc.) and the demand for biscuits will be more inelastic.

Luxury or necessity

The demand for goods that are a necessity for a consumer tends to be more price inelastic than the demand for luxury products which tend to be more price elastic. This is because consumers need to keep buying necessity goods when their price increases. For example, if the price of electricity rises, quantity demand will fall by a proportionately smaller amount because people still need to use electricity to light their homes and run their appliances.  Consumers do not, on the other hand, need to keep consuming luxury products if their price increases.  For example, if the price of long-haul air tickets increases, people can take fewer holiday flights and the quantity demanded would fall by a relatively greater amount. 

Proportion of income

The demand for goods that account for a smaller proportion of household income tends to be more price inelastic.  This is because any change in price will have a relatively small impact on household income.  For example, consumers might spend a relatively small amount of their income on chewing gum each month, whereas they might spend a larger proportion of their income on train travel. A 20 per cent increase in the price of $1 a pack of chewing gum is likely to have a smaller impact on consumer income than a 20 per cent increase in the price of a $15 daily train ticket, so the PED of chewing gum tends to be more inelastic than the train tickets.

Type of consumer

High-income consumers tend to be less responsive to price changes for goods than people on lower incomes. This is because any price change will have a smaller real income effect on high-income consumers compared to low-income consumers. For example, if the price of a prestige watch rises from $2000 to $2500 then it may have little impact on a wealthy buyer who has an income of a million US$ per year. This is why the demand for luxury goods sold to wealthy individuals tends to be relatively price inelastic. The demand for high-end fashion labels such as Prada and Armani have relatively inelastic demand for their goods because they are targeted at wealthy consumers.

Time

Over time PED tends to become more price elastic because consumers can alter their consumption patterns in response to a price change. In the short run an increase in the price of petrol, for example, will lead to a relatively small decrease in the quantity demanded because petrol buyers can cut back on some leisure journeys, but they still have to get to work and take their children to school.

In the long run, buyers could change to a more fuel-efficient car and move to a house nearer to where they work. Thus the demand for petrol becomes more price elastic in the long run.

Diagram 2.20 shows how the PED for petrol increases from:

-25% QD / +20% P = 1.25 PED to

-60% QD/ +20% P = 3 PED

Price elasticity of demand and revenue

Revenue is the value of income a business receives from selling a good. It is calculated by:

price x quantity = total revenue

For example, an airline sells 500,000 seats a year at a price of $200 then the total revenue is:

500,000 x $200 = $100,000,000

Firms can use an understanding of PED to increase their total revenue.  When the demand for a good is price elastic, total revenue rises when the price is reduced and decreases when the price is increased. When the demand for a good is inelastic, total revenue rises when the price is increased and decreases when the price is reduced. 

An airline sells seats to a holiday destination. Ticket A is sold during the school summer holidays when demand is relatively price inelastic because families need to travel at that time and the seats are considered a relative necessity. Ticket B is sold outside school holiday time when demand is relatively price elastic because people do not have to travel at that time and seats are considered more of a luxury.

The table shows the price, quantity and revenue for tickets A and B before and after a 20 per cent increase in the price of seat tickets from time period year 1 to time period year 2. The total revenue for ticket A, which has price inelastic demand, increases by $128,000 and the total revenue for ticket B, which has price elastic demand, decreases by $84,000.

Diagram 2.21 shows how an increase in price for seat ticket A leads to a rise in total revenue. Area EFBG shows the total revenue after the price increase which is greater than area ABCD, which is the total revenue before the price increase.

The impact on total revenue of changes in PED along the demand curve

The business response to PED could be to make a judgement about the PED of the demand for the good they sell and then increase or decrease the price of their good in order to increase revenue and hopefully profits. It is important to remember that PED changes as you move along the demand curve and this will affect the revenue from a price change. In diagram 2.23 we can see that a rise in the price of the airline seat ticket with inelastic demand will lead to an increase in total revenue, but as PED rises the rate of increase of total revenue will slow down and peak when PED is unitary. Any increase in price as we move onto the elastic section of the demand curve will lead to a fall in revenue. The same thing happens if the price is reduced on the elastic section of the demand curve. Revenue rises and peaks when PED is unitary and then falls when PED is inelastic.

Government decision-making and price elasticity of demand

PED will be useful to governments when they are making policy decisions that affect the price of goods and services. PED will have an effect on tax, subsidy, maximum price and minimum price decisions made by governments. The specific effects of PED on these policies are covered in Unit 2.7 Governments and markets.

The price elasticity demand of commodities compared to manufactured goods

Economists are often concerned with the differences in PED between commodities and manufactured goods. The demand for agricultural goods tends to be relatively inelastic because they are often necessities and have fewer close substitutes compared to manufactured goods. If the price of a commodity such as rice increases then households reduce the quantity demanded by a proportionately smaller amount than the increase in price. This is because households depend on rice as part of their diet and there are relatively few close substitutes for it.

Manufactured goods such as personal computers (PCs) are often relative luxuries so the demand for them tends to be more price elastic. The demand for manufactured goods is also considered price elastic because of the number of substitutes they have. If the price of a PC rises people could buy a substitute for a PC like a new mobile phone or tablet computer.

Evaluating price elasticity of demand

PED is used extensively by businesses looking to increase revenue and profit from their pricing strategies. There are, however, some limitations to PED:

• It can change over time as consumer behaviour changes. A new competitor might enter the market for a good which makes the PED for a good more elastic.
• PED is based on the ceteris paribus assumption that price is the only variable that is changing. Income and the price of related goods, as well as other factors that affect demand, are all changing at the same time as the price of the good.
• When a firm changes price there is always going to be uncertainty about how consumers will react. If the price of a good rises above its anchor point then the quantity demanded might fall more than expected.