Elasticity of Demand: Type, Formula, Key Factor

By | Januari 3, 2022

What it is: The elasticity of demand measures the responsiveness of demand to changes in determinants such as the price of the good itself (own-price) , prices of other goods, and income. To calculate it, you divide the percentage change in demand by the percentage change in those factors.

Types of elasticity of demand

Economists use three variables to measure the elasticity of demand for a good, namely:

  • The price of the item itself. 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 results in the income elasticity of demand.

To calculate all three, they are mathematically similar. You use the percentage change in quantity demanded as the numerator. Then, you divide it by the percentage change in the above factor. 

The price elasticity of the goods itself 

Own price elasticity of demand (own-price elasticity of demand)  measures the sensitivity of quantity demanded of a product to changes in price. For companies, this information is important to determine the impact of pricing strategies on total revenue. For example, when a company lowers prices, will it result in an increase in total revenue or not.

The formula for the price elasticity of demand is as follows:

Own price elasticity of demand (OPE) = % Change in quantity demanded of Product X /% Change in price of Product X

Categories of goods based on their own price elasticity of demand

We ignore the negative or positive sign of the calculated elasticity when classifying goods. As per the law of demand, quantity demanded has a negative correlation with price. If price goes up, quantity goes down. 

Since elasticity measures the significance of the impact (sensitivity) of changes in quantity demanded if prices change, we ignore such correlations to draw conclusions. Some literature then advises us to use absolute numbers of elasticity so as not to confuse.

Next, we can categorize goods into five categories based on the own price elasticity of demand:

  • Perfectly inelastic. Elasticity equals zero (OPE = 0)
  • Relatively inelastic. Elasticity is more than zero but less than one (0 < OPE < 11).
  • Unitary elastic . Elasticity equal to one (OPE = 1)
  • Relatively elastic. Elasticity equal to more than one (OPE>1)
  • Perfect elastic. Elasticity equals infinity (OPE = )
Perfectly inelastic

If a good is perfectly inelastic , a change in price does not affect the quantity demanded. Increasing or decreasing the price has no impact on the quantity demanded.

Perfectly inelastic
Perfectly inelastic

Such items are usually very important 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 to keep him from dying.

Relatively inelastic

If a good is relatively inelastic, the percentage change in quantity demanded is less than the percentage change in price. The absolute value of elasticity lies between 0 and 1.

Relatively Inelastic
Inelastis

That shows you the item is less sensitive to price changes. If the firm lowers the price by 5%, the quantity demanded increases by less than 5%. On the other hand, if the firm raises 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 will increase total income because the effect of a price change is more significant than the effect of a decrease in demand.

Unitary elastic

Unitary elastic is when the percentage change in quantity demanded is equal to the percentage change in price. The absolute value of elasticity equals 1. For example, if the price falls by 5%, the quantity demanded will increase by 5%. Vice versa, if the price increases by 5%, it decreases the quantity demanded by 5%.

Unitary elastic
Unitary elastic

For producers, raising prices or lowering prices does not have a better effect on income. Both generate an unchanged total revenue.

Relatively elastic

Relatively elastic means that the percentage change in quantity demanded is greater than the percentage change in price. The absolute value of elasticity is greater than 1.

Relatively Elastic
Elastic

In this case, consumers tend to be sensitive to price changes. If the price increases by 5%, the quantity demanded falls 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 income. That would result in a more significant increase in demand. Thus, the effect of an increase in demand is greater on income than the effect of a decrease in price.

Perfect elastic

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.

Perfect elastic
Perfect elastic

On the other hand, if the price increases, even if it is small, it will result in an infinite increase in demand. Therefore, the income will also be infinity.

Of course, in the real world, we are hard to find examples of such items.

Factors affecting the own price elasticity of demand

The first is the availability of substitute products. If substitute products are abundant, demand will be relatively elastic. Consumers have many options to meet the same needs. Therefore, if producers raise prices, they will switch to substitute products.

On the other hand, if there is limited availability of substitute products, demand is relatively inelastic. Consumers find it more difficult to find alternatives to meet their needs.

Second , the proportion of income that consumers spend on buying goods. If purchases consume a large part of their income, demand is relatively elastic. Consumers are relatively sensitive to price changes. Take cars for example. If automakers raise prices, consumers will reduce demand significantly.

Conversely, if a consumer spends a small portion of his income on goods, he will not reduce consumption significantly if prices rise. The demand for such goods will be relatively inelastic. Soap, shampoo and some of our daily products fall into this category. 

Third , the period since the price changed. In the short run, demand will be relatively inelastic. If prices change, consumers need more time to change buying patterns and find alternative products. 

On the other hand, in the longer run, demand will be relatively elastic. Take for example fuel oil. When prices continue to rise, in the short term, consumers do not necessarily switch to fuel-efficient vehicles. The supply may not yet be available because the manufacturer did not produce it. 

Over time, rising automakers see rising oil prices as an opportunity to introduce fuel-efficient cars. Increased supply encourages consumers to switch to these products.

Effect of price elasticity on total income

Total revenue equals price times quantity. Changes in income will depend on which is more significant, changes in price or changes in quantity.

Long story short, to increase total revenue, companies must:

  • Lowers prices if demand is relatively elastic. The effect of a price cut is less than the effect of an increase in the quantity demanded. Consumers are relatively sensitive to price changes. Thus, lower prices encourage them to buy significantly more.
  • Increases the price if demand is relatively inelastic. The effect of an increase in price is greater than the effect of a decrease in the quantity demanded. Consumers are less sensitive so their demand does not change too much if producers raise prices.

Cross price elasticity of demand

The cross-price elasticity of demand measures the responsiveness of the demand for a product when the price of an alternative product changes. These alternative products may act as substitutes or complementary.

To calculate it, we compare the percentage change in the quantity demanded of a product to the percentage change in the price of the alternative product. The following is the formula for the cross-price elasticity of demand:

Cross price elasticity of demand (CPE) = % Change in quantity demanded of Product X /% Change in price of Product Y

Category of goods based on cross price elasticity

Cross elasticity results in two product categories:

  • Substitute products
  • Complementary products
Substitute products

If the cross-price elasticity is more than zero (CPE > 0), then the two products are substitutes for each other. Rising product prices will increase demand for substitute products.

Take Pepsi and Coca Cola for example. Both serve relatively similar market segments. If the price of Pepsi increases, the quantity demanded of Coca Cola increases. Consumers turned from Pepsi to Coca Cola because they found it cheaper.

The elasticity value shows how close the two products are. If the value is high, the two are very close substitutions. Consumers are relatively sensitive to price changes in one product. The two products are close substitutes because they serve the same market segment, meet needs, and provide the same satisfaction.

On the other hand, if the elasticity is low, the two products are less substitutes for each other. Changes in the price of a product do not have much effect on the demand for substitute products. Consumers find the two products provide slightly different satisfaction.

Complementary products

Two products are complementary if the price cross elasticity is less than zero (CPE < 0). A change in the price of a product will reduce the demand for its complementary product.

Take tires and cars for example. If the price of a car goes up, the demand for tires will fall. The increase in the price of the car caused its sales to fall. Automakers are finally reducing demand for tires.

The absolute value of elasticity indicates how closely the two products act as complementary. If the absolute value is high, the two are close complements. An increase in the price of one product significantly reduces the demand for its complementary product.

Income elasticity of demand 

The income elasticity of demand measures the responsiveness of demand when income changes, assuming other factors are constant. As with the two previous elasticities of demand, you can calculate it by dividing the percentage change in the quantity demanded of a product by the percentage change in income. Here is the formula for the income elasticity of demand:

Income elasticity of demand (IE) = % Change in quantity demanded of product /% Change in income

Categories of goods by income elasticity

Economists divide goods into the following categories based on their income elasticity:

  • Normal stuff. This good has an income elasticity of more than 0 (IE > 0). Economists then divide them into two groups: necessities and luxury goods.
  • inferior goods. Goods category with income elasticity less than zero (IE < 0).
Necessary goods

Goods (necessities) is a subcategory of normal goods. They have an income elasticity between zero and 1 (0>IE>1). In other words, their demand is inelastic and therefore relatively less responsive to consumer income.

For example, when a consumer’s income increases by 5%, the demand for consumer goods increases by less than 5%. Increased income only makes consumers spend a small part of their income to buy products.

luxury goods

The elasticity of luxury goods is more than 1 (IE>1). They fall into the category of normal goods because when consumer income rises, demand for products increases.

However, 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%, then demand increases by more than 5%, indicating that consumers are spending a higher proportion of their income on products.

inferior goods

Inferior goods have elasticity less than 1 (IE<0). It shows you the inverse relationship between income and product demand. If income rises, 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 inferior, necessities or luxury varies between individuals, depending on their income range. Take motorcycles for example. Some people with low incomes consider it a luxury item. Meanwhile, for wealthy middle-income individuals, it was probably a normal good. And, for the super-rich, it is an inferior good.

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