Elasticity of demand is a gauge of how sensitive buyers will be to a price change of a product. This is measured using a formula. This formula is the percentage change in quantity demanded divided by the percentage change in price. Using percentages to compute the equation is called the midpoint formula and it allows one set of results to be applicable to both positive and negative changes when figuring elasticity of demand. The result is converted to an absolute value, which is the coefficient of demand. This coefficient determines if demand is elastic, inelastic or unit elastic.
The demarcation of elasticity in the demand coefficient is one. If the number is one then demand is unit elastic. This means that any change in price is offset to an equal degree by an opposite change in demand. Thus, total revenue would stay the same despite the changes. Specific instances of unitary elasticity are hard to find in the real world but a close example could be cars that retain a core of brand loyalty among consumers allowing the brand to retain sufficient numbers after a price increase to maintain revenue.
A demand coefficient less than one indicates that demand is inelastic. This means that price changes would not have a great effect on demand. If prices go up, total revenue will go up as well. If prices go down, so will revenue. An example of this is liquor sales. Consumers develop loyalty to specific brands and varieties so they will follow them through price fluctuations.
Products with a demand coefficient greater than one are elastic. Generic products that are easily substitutable typify elastic demand. Price and revenue move in opposite directions. If prices go up, revenue goes down because consumers can easily find a comparable product elsewhere. An example of this is restaurants. If one restaurant starts charging more than other comparable establishments, consumers will go elsewhere to eat out. The reverse is also true, if prices go down, then total revenue will go up (McConnell, Brue, & Flynn, 2012).
Cross elasticity of demand seeks to compare products to one another to determine if the two products are substitutable or complementary. Substitutable products can easily replace one another and are indicative of elasticity. Complementary products naturally go together, that is to say, if one product is purchased, then the other will most likely be purchased as well.
The equation used to determine cross elasticity is as follows: the percentage change in quantity demanded of product X is divided by the percentage change in the price of product Y to arrive at the coefficient of cross elasticity. This number is either a positive or a negative number. This is critical as zero is the threshold of cross elasticity. A result of zero means the two items in questions are unrelated and do not influence each other.
If the number is negative, or less than zero, then the two items are complementary, meaning that the two are usually purchased together. Therefore, price fluctuations of one are reflected in sales of the other. An example of this would be charcoal and lighter fluid.
When the equation results in a positive number, or greater than zero, then the two products are substitute goods. This means that the two products are closely related so a change in the price of one will influence sales of the other. Specific brands of breakfast cereal are good examples of this. If the price of say, Wheaties, increases, consumers will opt for a similar cereal like Corn Flakes, because it is now cheaper (McConnell, Brue, & Flynn, 2012).
Another factor that influences demand is the income elasticity of demand. This concept explains how consumers buying decisions are influenced by changes in their income. This is revealed through another coefficient arrived at by dividing the percentage change in the amount demanded of a good by the percentage change in the income of the consumer. Again, the threshold for this equation is zero.
If the result is negative, the good is defined as inferior and demand will go down as incomes rise. An example of this is mass transit tickets.
Conversely, if the result is positive the good is called normal or superior, and demand will increase as incomes increase. Most goods fall into this category but a good example would be smartphones and the accompanying service plans (McConnell, Brue, & Flynn, 2012).
As a rule, price elasticity of demand is easy to see by how many substitute products exist in a given market. An example of this is fruit juice. A visit to any grocery store will show dozens of different varieties and brands of fruit juice. This makes demand for one particular brand of juice elastic because consumers will be very sensitive to price changes and will readily substitute one brand for another.
Elements E & E1
Price elasticity of demand is also influenced by how large a price is compared to an individual income. Price increases will more greatly affect a buying decision for a high-ticket item than a low one. Consider price increases of five percent for bread and mortgage payments. The increase in the price of bread will probably not change the amount of bread purchased by a household at all. On the other hand, and increase in home prices by five percent will be much more likely to keep a family renting until the market comes back down, thus not making a purchase at all given the price increase. On the demand side, bread would not be affected while the housing market would stagnate.
The consumer’s time horizon is another factor to consider in elasticity. Assume that local cable prices have risen 15 percent. In the short-run, if the consumer wants to continue watching TV, then the additional price must be paid. In the long-run, however, consumers may experiment with other forms of programming access, such as the internet, satellite or specific media providers, and ultimately abandon cable altogether. This shows that in this instance, consumer demand is much more elastic in the long-run.
These two graphs show the demand curve and total revenue of a product. To determine elasticity, the total revenue (TR) test is applied to the demand curve. This test is price multiplied by quantity equals TR. Along the demand curve the TR test shows increasing returns from falling prices up to the quantity of four units. Elasticity is shown by increasing TR with falling prices and more units selling. Unit elasticity is the point where returns from price reduction and sales increase equal each other. Inelasticity shows TR falling from further price reduction and increased sales. In the demand curve graph, demand is elastic from $80 to $50, unit elastic from $50 to $40, and inelastic from $40 to $0.
In the TR graph, the elastic range is seen as TR increasing to its highest point at four units. From there TR levels off between four and five units, showing the unit elastic range. From there, TR drops off with every additional unit showing that demand is inelastic after five units.
McConnell, C. R., & Brue, S. L., Flynn, S. (2012). Economics (19th ed., pp. 48-90). McGraw-Hill.