Elasticity of Demand: an Overview
Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price.
More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (holding constant all the other determinants of demand, such as income). It was devised by Alfred Marshall.
Equation
This is the price elasticity of demand equation.
Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to ambiguity. Only goods which do not conform to the law of demand, such as a Veblen good and a Giffen good, have a positive PED.
In general, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded.
The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded.
Revenue is maximized when price is set so that the PED is exactly one. The PED of a good can also be used to predict the incidence (or "burden") of a tax on that good. Various research methods are used to determine price elasticity, including test markets, analysis of historical sales data, and conjoint analysis.
Determinants
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. In other words, 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 thus 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 in 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.