What is elasticity of demand explain the determinants of demand?

There’s a lot more to a “market” than merely buying and selling. A plethora of activities  are undergone behind bringing a product into the market. It requires proper market research before deciding on the manufacturing of a new product. 

Different concepts in economics explain all these backstage happenings of a market. One such concept is elasticity. 

Elasticity measures the sensitivity of one economic variable against a change in another economic variable. We often hear about demand and supply in economics and also in elasticity. 

(You can also check out: What is elasticity in economics and what are its types). 

The demand and supply of a product are affected by several other factors like price. The quantity demanded of a product changes when there is either a surge or a decline in its price. This sensitiveness of demand against a change in price is explained by the Price Elasticity of Demand. 

What is Price Elasticity of Demand?

Price Elasticity of Demand (PED) is an economic tool that measures the change in quantity demanded of a product when there is a fluctuation in its price. 

The mathematical equation to calculate Price Elasticity of Demand is given as:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price  

• If this formula gives a number greater than 1, the demand is elastic. In other words, quantity changes faster than price. 

• If the number comes out to be less than 1, demand is inelastic. In other words, quantity changes slower than price. 

• If the number is equal to 1, the elasticity of demand is unitary. In other words, quantity changes at the same rate as price.

Since supply and demand are two related terms, a change in either of them will have an effect on the other. 

Economists use price elasticity to understand the change in demand or supply given there is a price change. This helps them break down the working of the real economy. 

Also sneak a peek at our blog on what is economics

A change in price does not always result in the same proportion of change in quantity demanded of a commodity. 

For example, a small change in the price of Air Conditioner would cause a sharp rise in the quantity demanded, whereas a large change in the price of sugar won’t increase the quantity demanded to the same extent. 

Several other factors affect the Price Elasticity of Demand (PED). Some goods are more sensitive or elastic while some are less. Availability of substitutes, type or nature of a product, income, price, and time are the five known factors that affect the PED. 

1. Nature or type of Good

The Elasticity of Demand for a good is affected by its nature. Different goods can be a necessity good, a comfort good, or a luxury good for a person. 

There is one more thing that is a single good can be a necessity for one person, a comfort for the second person, and a luxury for a third person. So, we can say that a good’s nature is relative. 

Now, let us understand how nature affects the elasticity of demand. 

i. A necessity good like vegetables, food grains, medicines and drugs, has an inelastic demand. Such goods are required for human survival so their demand does not fluctuate much against a change in their price. 

ii. A comfort good like a fan, refrigerator, washing machine, etc., has an elastic demand as their consumption can be postponed for a time period. 

iii. A luxury good like AC, Cars, Diamond has a relatively high elasticity of demand when compared to comfort goods. 

“We've done price elasticity studies, and the answer is always that we should raise prices. We don't do that, because we believe -- and we have to take this as an article of faith -- that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term.”

- Jeff Bezos, Amazon CEO

2. Availability of Substitutes 

The Price Elasticity of Demand is affected by many factors. 5 crucial factors among them are: Availability of goods, Price Levels, Income Levels, Time Period, and Nature of goods.

The following are the main factors which determine the price elasticity of demand for a commodity: 1. The Availability of Substitutes 2. The Proportion of Consumer’s Income Spent 3. The Number of Uses of a Commodity 4. Complementarity between Goods 5. Time and Elasticity.

Determinant # 1. The Availability of Substitutes:

Of all the factors determining price elasticity of demand the availability of the number and kinds of substitutes for a commodity is the most important factor. If for a commodity close substitutes are available, its demand tends to be elastic. If the price of such a commodity goes up, the people will shift to its close substitutes and as a result the demand for that commodity will greatly decline.

The greater the possi­bility of substitution, the greater the price elasticity of demand for it. If for a commodity substitutes are not available, people will have to buy it even when its price rises, and therefore its demand would tend to be inelastic.

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For instance, if the prices of Campa Cola were to increase sharply, many consumers would turn to other kinds of cold drinks, and as a result, the quantity demanded of Campa Cola will decline very much. On the other hand, if the price of Campa Cola falls, many consumers will change from other cold drinks to Campa Cola.

Thus, the demand for Campa Cola is elastic. It is the availability of close substitutes that makes the consumers sensitive to the changes in the price of Campa Cola and this makes the demand for Campa Cola elastic. Likewise, demand for common salt is inelastic because good substitutes for common salt are not available.

If the price of common salt rises slightly, the people would consume almost the same quantity of salt as before since good substitutes are not available. The demand for common salt is inelastic also because people spend a very little part of their income on it and even if its price rises it makes only negligible difference in their budget allocation for the salt.

Determinant # 2. The Proportion of Consumer’s Income Spent:

Another important determinant of the elasticity of demand is how much it accounts for in consumer’s budget. In other words, the proportion of consumer’s income spent on a particular commodity also influences the elasticity of demand for it. The greater the proportion of income spent on a commodity, the greater will be generally its elasticity of demand, and vice versa.

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The demand for common salt, soap, matches and such other goods tends to be highly inelastic because the households spend only a fraction of their income on each of them. When the price of such a commodity rises, it will not make much difference in consumers’ budget and therefore they will continue to buy almost the same quantity of that commodity and, therefore, the demand for them will be inelastic.

On the other hand, demand for cloth in a country like India tends to be elastic since households spend a good part of their income on clothing. If the price of cloth falls, it will mean great saving in the budget of many households and therefore they will tend to increase the quantity demanded of the cloth. On the other hand, if the price of cloth rises many households will not afford to buy as much quantity of cloth as before, and therefore, the quantity demanded of cloth will fall.

Determinant # 3. The Number of Uses of a Commodity:

The greater the number of uses to which a commodity can be put, the greater will be its price elasticity of demand. If the price of a commodity having several uses is very high, its demand will be small and it will be put to the most important uses and if the price of such a commodity falls it will be put to less important uses also and consequently its quantity demanded will rise significantly.

To illus­trate, milk has several uses. If its price rises to a very high level, it will be used only for essential purposes such as feeding the children and sick persons. If the price of milk falls, it would be devoted to other uses such as preparation of curd, cream, ghee and sweets. Therefore, the demand for milk tends to be elastic.

Determinant # 4. Complementarity between Goods:

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Complementarity between goods or joint demand for goods also affects the price elasticity of demand. Households are generally less sensitive to the changes in price of goods that are complementary with each other or which are jointly used as compared to those goods which have independent demand or used alone. For exam­ple, for the running of automobiles, besides petrol, lubricating oil is also used.

Now, if the price of lubricating oil goes up, it will mean a very small increase in the total cost of running the automobile, since the use of oil is much less as compared to other things such as petrol. Thus, the demand for lubricating oil tends to be inelastic. Similarly, the demand for common salt is inelastic, partly because consumers do not use it alone but along with other things.

It is worth mentioning here that for assessing the elasticity of demand for a commodity all the above three factors must be taken into account. The three factors mentioned above may reinforce each other in determining the elasticity of demand for a commodity or they may operate against each other. The elasticity of demand for a commodity will be the net result of all the forces working on it.

Determinant # 5. Time and Elasticity:

The element of time also influences the elasticity of demand for a commodity. Demand tends to be more elastic if the time involved is long. This is because consumers can substitute goods in the long run. In the short run, substitution of one commodity by another is not so easy. The longer the period of time, the greater is the ease with which both consumers and businessmen can substitute one commodity for another.

For instance, if the price of fuel oil rises, it may be difficult to substitute fuel oil by other types of fuels such as coal or cooking gas. But, given sufficient time, people will make adjustments and use coal or cooking gas instead of the fuel oil whose price has risen. Likewise, when the business firms find that the price of a certain material has risen, then it may not be possible for them to substitute that material by some other relatively cheaper one.

But with the passage of time they can undertake research to find substitute material and can redesign the product or modify the machinery employed in the production of a commodity so as to economise in the use of the dearer material. Therefore, given the time, they can substitute the material whose price has risen. We thus see that demand is generally more elastic in the long run than in the short run.

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