Are you more of a bookworm or a tech person? If your income increased by a certain percentage, which proportion of the increase would you allocate to buy some of your favourite items? Would you buy a few books or new headphones? In economics, the amount in which the demanded quantity of a good changes in response to any of the factors that affect it, such as income, is measured by the elasticity of demand. If you knew your demand elasticity, you would be able to predict how the demanded quantity of your favourite items would respond to your income change. Let’s study the elasticity of demand in more detail.
The elasticity of demand measures the responsiveness of the quantity demanded of a good or service to a change in any of the demand determinants.
The demand determinants are all the factors that shift the demand curve like income, for example. Imagine there is an increase in your income and you decide to spend more on your favourite books. The proportion in which your demanded quantity of books will change relative to the increase in your income is how sensitive your demand is. This sensitivity is what the elasticity of demand measures.
Types of elasticity of demand
We can broadly divide demand determinants by the effect they have on the demand, into:
• Own price determinant.
• Other determinants.
A change in the own price of a good leads to a movement along the demand curve (it will either be a contraction or expansion of demand), whilst a change in other determinants shifts the demand curve. Demand elasticity can also be broadly divided into price elasticity of demand and other elasticity as shown in the table below:
| Types of demand elasticity |
|---|
| Based on the own price determinant | Based on the other determinants |
| Price elasticity of demand | Income elasticity of demand |
| Cross-price elasticity of demand |
| Other types |
Note that there are other types of elasticities based on other determinants, such as advertising elasticity of demand.
How to calculate the elasticity of demand?
The elasticity of demand calculation is as follows:
The percentage change in the demanded quantity is divided by a percentage change in the demand determinant.
The formula for the elasticity of demand is:
You can find a percentage change in a variable by using the following formula:
Due to a wage bonus, Paul’s disposable income rises from 100£ to 150£ (that is an increase of 50%). He decides to go to the cinema more often so he increases his spending on tickets from 20£ to £40 (that is an increase of 50%). His income elasticity of demand for cinema tickets is then: 50% / 50% = 1 in absolute value.
What types of demand exist based on the value of the elasticity?
There are three types of demand that are based on how much the quantity demanded responds to a change in a demand determinant.
These are:
• Unitary elastic demand
• Inelastic demand
• Elastic demand
Unitary elastic demand
Demand is unitary and elastic if a change in its determinant leads to a proportionate change in the quantity demanded.
Mary enjoys a cup of green tea every morning. However, the price of green tea has recently gone up by 100% and she decides to consume coffee (a substitute good) instead. She entirely offsets her tea consumption by coffee consumption (coffee consumption rises by 100%) as her demand has a unitary cross-price elasticity.
Inelastic demand
Demand is inelastic if a change in its determinant leads to a less than proportionate change in the quantity demanded.
Kate loves clothes and dressing up. She considers high-street fashion brands (like H&M or Zara) to be affordable, but she finds that designer brands (such as Louis Vuitton) are a luxury for her income level. If she gets a raise (increase in income), her demand for Louis Vuitton will not change much as it is relatively income inelastic compared to her demand for a high-street clothing brand.
Elastic demand
Demand is elastic if a change in its determinant leads to a more than proportionate change in the quantity demanded.
Mike loves good quality food. Whenever he gets a raise or a bonus (increase in income) he celebrates by buying more food and making an amazing gourmet meal. However, he increases his purchase of food by more relative to the increase in his income as his demand is income elastic.
What factors affect the elasticity of demand?
The elasticity of demand depends on a variety of factors that affect consumer preferences. Below are some of the most prominent factors that affect demand elasticity.
Market definition
The elasticity of demand depends on how broadly the market for a product is defined. The broader the market definition, the less elastic the demand will be. In contrast, the narrower the market definition, the more elastic the demand will be.
If, for example, we define the market as our monthly ‘utilities’ then, in general, it would be a very inelastic good as we depend on light and running water in our homes and consume them without question. However, if we define the market as ‘electricity’, then its demand will be relatively more elastic as there are other energy providers that our household can switch to. Market definition effect holds for all three types of elasticities mentioned earlier: price, income, and cross-price elasticity.
Let’s define the market as ‘electricity’. If your income falls, you can shop around and find a different energy provider (say, EON Energy) that will save you some money over time (demand is relatively more income elastic). After comparing prices online you decide to switch to Octopus Energy because it provides electricity at a cheaper price.
Time horizon
In general, the longer the time horizon, the more elastic demand is. This is due to several factors, mainly technological changes, economies of scale and production capacity, and general market developments over time. In the short run, demand is relatively inelastic, but in the long run, it becomes more elastic.
At the beginning of the recent global pandemic, high demand led to an increase in the price of face masks. Limited production capacity meant that the suppliers could not respond by immediately increasing the supply to stabilise the prices. This led to consumers buying masks at higher prices as they needed them in the short run (price inelastic demand). Over time, technological processes improved, suppliers increased their production capacities, and the price of face masks reduced.
Check your understanding. Can you think of more examples of how the time horizon affects income and the cross-elasticity of demand?
Availability of substitutes
The availability of substitutes determines how elastic or inelastic the demand for a good is. Demand for a good with a lot of substitutes that are deemed appropriate by consumers will tend to be more elastic than the demand for a good with fewer or no substitutes. That is because consumers can switch away from one good to another more easily when there are more substitutes available.
The demand for a particular type of bread is relatively more price elastic than the demand for a particular type of petrol. This is because consumers can purchase many alternative types of bread and close substitutes. However, if your car runs on diesel, there are no close substitutes for it, so your demand for diesel is less elastic than your demand for rye bread.
Check your understanding. Can you think of more examples of how the availability of the substitutes affects income and cross-elasticity of demand?
Luxury goods versus necessities
Demand for luxury goods tends to be more elastic than for necessities. This is because necessities are required for subsistence and their absence can cause significantly lower consumer utility. Luxuries, however, are goods on which subsistence does not depend, and therefore are more elastic.
Consumer utility
The utility is the satisfaction that a person obtains from consuming a good or service.
The demand for luxury cars is income elastic. If consumers’ income falls by some amount such that they won’t be able to afford a Porsche car, then they simply won’t purchase it. However, if consumers’ income falls, their demand for food is unlikely to reduce much (less income elastic). This is because food is a necessary good for subsistence.
Check your understanding. Can you think of more examples of how market definition affects price and cross-elasticity of demand?
Elasticity of demand is a fundamental concept in economics. If you think you have grasped it well, check your knowledge with the flashcards!
Elasticity of Demand - Key takeaways
- The elasticity of demand is a measure of the responsiveness of the quantity demanded of a good or service to a change in any of the demand determinants.
- Demand elasticity can be broadly divided into price elasticity of demand and other elasticities such as income and cross-elasticity of demand.
- The elasticity of demand is calculated as a percentage change in the quantity demanded divided by a percentage change in the demand determinant.
- Demand is unitary elastic if a change in its determinant leads to a proportionate change in the quantity demanded.
- Demand is inelastic if a change in its determinant leads to a less than proportionate change in the quantity demanded.
- Demand is elastic if a change in its determinant leads to a more than proportionate change in the quantity demanded.
- Four main factors affect the elasticity of demand: market definition, time horizon, availability of substitutes, and luxuries vs necessities.
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