Types of Elasticity of Demand

 

 

Types of Elasticity of Demand

 

 

In economics, elasticity is the measurement of how changing one economic variable affects others. For example:

"If I lower the price of my product, how much more will I sell?"

"If I raise the price, how much less will I sell?"

"If we learn that a resource is becoming scarce, will people scramble to acquire it?"

In more technical terms, it is the ratio of the percentage change in one variable to the percentage change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between factors of production and elasticity of intertemporal substitution.

Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus.

In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis.

Generally, an elastic variable is one which responds a lot to small changes in other parameters. Similarly, an inelastic variable describes one which does not change much in response to changes in other parameters. A major study of the price elasticity of supply and the price elasticity of demand for US products was undertaken by Hendrik S. Houthakker and Lester D. Taylor

 

The quantity of a commodity demanded per unit of time depends upon various factors such as the price of a commodity, the money income of the prices of related goods, the tastes of the people, etc., etc.

Whenever there is a change in any of the variables stated above, it brings about a change in the quantity of the commodity purchased over a specified period of time. The elasticity of demand measures the responsiveness of quantity demanded to a change in any one of the above factors by keeping other factors constant. When the relative responsiveness or sensitiveness of the quantity demanded is measured to changes, in its price, the elasticity is said be price elasticity of demand.

When the change in demand is the result of the given change in income, it is named as income elasticity of demand. Sometimes, a change in the price of one good causes a change in the demand for the other. The elasticity here is called cross electricity of demand. The three main types of elasticity of demand are now discussed in brief.

(1) Price Elasticity of Demand:

Definition and Explanation:

The concept of price elasticity of demand is commonly used in economic literature. Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in its price. Precisely, it is defined as:

"The ratio of proportionate change in the quantity demanded of a good caused by a given proportionate change in price".

Formula:

The formula for measuring price elasticity of demand is:

Price Elasticity of Demand = Percentage in Quantity Demand /Percentage Change in Price

Example:

Let us suppose that price of a good falls from $10 per unit to $9 per unit in a day. The decline in price causes the quantity of the good demanded to increase from 125 units to 150 units per day. The price elasticity using the simplified formula will be:

Δq = 150 - 125 = 25

Δp = 10 - 9 = 1

Original Quantity = 125

Original Price = 10

Ed = 25 / 1 x 10 / 125 = 2

The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.

Types:

The concept of price elasticity of demand can be used to divide the goods in to three groups.

(i) Elastic. When the percent change in quantity of a good is greater than the percent change in its price, the demand is said to be elastic. When elasticity of demand is greater than one, a fall in price increases the total revenue (expenditure) and a rise in price lowers the total revenue (expenditure).

(ii) Unitary Elasticity. When the percentage change in the quantity of a good demanded equals percentage in its price, the price elasticity of demand is said to have unitary elasticity. When elasticity of demand is equal to one or unitary, a rise or fall in price leaves total revenue unchanged.

(iii) Inelastic. When the percent change in quantity of a good demanded is less than the percentage change in its price, the demand is called inelastic. When elasticity of demand is inelastic or less than one, a fall in price decreases total revenue and a rise in its price increases total revenue.

The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and look"). A number of factors can thus affect the elasticity of demand for a good:

Availability of substitute goods: the more and closer the substitutes available, the higher the elasticity is likely to be, as people can easily switch from one good to another if an even minor price change is made; There is a strong substitution effect. If no close substitutes are available the substitution of effect will be small and the demand inelastic.

Breadth of definition of a good: the broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.

Percentage of income: the higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost; The income effect is substantial. When the goods represent only a negligible portion of the budget the income effect will be insignificant and demand inelastic.

Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price, such as the case of insulin for those that need it.

Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes. When fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run, but when prices remain high over several years, more consumers will reduce their demand for fuel by switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking other measures. This does not hold for consumer durables such as the cars themselves, however; eventually, it may become necessary for consumers to replace their present cars, so one would expect demand to be less elastic.

Brand loyalty: an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.

Who pays: where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

PEDs, in combination with price elasticity of supply (PES), can be used to assess where the incidence (or "burden") of a per-unit tax is falling or to predict where it will fall if the tax is imposed. For example, when demand is perfectly inelastic, by definition consumers have no alternative to purchasing the good or service if the price increases, so the quantity demanded would remain constant. Hence, suppliers can increase the price by the full amount of the tax, and the consumer would end up paying the entirety. In the opposite case, when demand is perfectly elastic, by definition consumers have an infinite ability to switch to alternatives if the price increases, so they would stop buying the good or service in question completely—quantity demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so they would be forced to pay all of it themselves.

In practice, demand is likely to be only relatively elastic or relatively inelastic, that is, somewhere between the extreme cases of perfect elasticity or inelasticity. More generally, then, the higher the elasticity of demand compared to PES, the heavier the burden on producers; conversely, the more inelastic the demand compared to PES, the heavier the burden on consumers. The general principle is that the party (i.e., consumers or producers) that has fewer opportunities to avoid the tax by switching to alternatives will bear the greater proportion of the tax burden.

(2) Income Elasticity of Demand:

Definition and Explanation:

Income is an important variable affecting the demand for a good. When there is a change in the level of income of a consumer, there is a change in the quantity demanded of a good, other factors remaining the same. The degree of change or responsiveness of quantity demanded of a good to a change in the income of a consumer is called income elasticity of demand. Income elasticity of demand can be defined as:

"The ratio of percentage change in the quantity of a good purchased, per unit of time to a percentage change in the income of a consumer".

Formula:

The formula for measuring the income elasticity of demand is the percentage change in demand for a good divided by the percentage change in income. Putting this in symbol gives.

Ey = Percentage Change in Demand/   Percentage Change in Income

Example:

A simple example will show how income elasticity of demand can be calculated. Let us assume that the income of a person is $4000 per month and he purchases six CD's per month. Let us assume that the monthly income of the consumer increase to $6000 and the quantity demanded of CD's per month rises to eight. The elasticity of demand for CD's will be calculated as under:

Δq  =  8 - 6 = 2                                   

Δp = $6000 - $4000 = $2000

Original quantity demanded = 6

Original income = $4000

Ey = Δq / Δp x P / Q = 2 / 200 x 4000 / 6 = 0.66

The income elasticity is 0.66 which is less than one.

Types:

When the income of a person increases, his demand for goods also changes depending upon whether the good is a normal good or an inferior good. For normal goods, the value of elasticity is greater than zero but less than one. Goods with an income elasticity of less than 1 are called inferior goods. For example, people buy more food as their income rises but the % increase in its demand is less than the % increase in income.

Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. For example, the "selected income elasticities" below suggest that an increasing portion of consumer's budgets will be devoted to purchasing automobiles and restaurant meals and a smaller share to tobacco and margarine.

Income elasticitites are closely related to the population income distribution and the fraction of a the product's sales attributable to buyers from different income brackets. Specifically when a buyer in a certain income bracket experiences an income increase, their purchase of a product changes to match that of individuals in their new income bracket. If the income share elasticity is defined as the negative percentage change in individuals given a percentage increase in income bracket, then the income-elasticity, after some computation, becomes the expected value of the income-share elasticity with respect to the income distribution of purchasers of the product. When the income distribution is described by a gamma distribution, the income elasticity is proportional to the percentage difference between the average income of the product's buyers and the average income of the population

(3) Cross Elasticity of Demand:

Definition and Explanation:

The concept of cross elasticity of demand is used for measuring the responsiveness of quantity demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined as:

"The percentage change in the demand of one good as a result of the percentage change in the price of another good".

Formula:

The formula for measuring, cross, elasticity of demand is:

Exy = % Change in Quantity Demanded of Good X / % Change in Price of Good Y

The numerical value of cross elasticity depends on whether the two goods in question are substitutes, complements or unrelated.

Types and Example:

(i) Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an increase in the price of one good will lead to an increase in demand for the other good. The numerical value of goods is positive.

For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase in the price of Pepsi called good y by 10% and it increases the demand for Coke called good X by 5%, the cross elasticity of demand would be:

Exy = %Δqx / %Δpy =  0.2

Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes.

(ii) Complementary Goods. However, in case of complementary goods such as car and petrol, cricket bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for the balls (say by 6%). The cross elasticity of demand which are complementary to each other is, therefore, 6% / 7% = 0.85 (negative).

(iii) Unrelated Goods. The two goods which a re unrelated to each other, say apples and pens, if the price of apple rises in the market, it is unlikely to result in a change in quantity demanded of pens. The elasticity is zero of unrelated goods.