Elastic demand describes the situation where the price of a good has a fairly dramatic effect on the number of units sold. An example of this is that people will often purchase “impulse buy” products placed near cash registers only if the price is low enough that they can rationalize it away as being “just a buck” or “just a couple bucks.” Unit demand is an abstract concept where the number of units sold is one hundred percent dependent on the price; elasticity is then equal to one, which provides the name for unit demand. There are no real-world examples of this known except for momentary occurrences. Inelastic demand does not respond to price very well; examples include products people tend to buy anyway, such as gasoline, or luxury items where a buyer’s primary concern is not price.
Cross-price elasticity refers to cases where prices and demands for two different goods interact. An example might be the recent interplay of the price of gasoline, the demand for hybrid vehicles, and the subsequent panic of SUV dealers. The relationship between gas and hybrid cars is complementary; higher gas costs leads to greater demand for hybrids. On the other hand, the relationship between SUVs and hybrids is one of substitute goods; a person will generally not buy both. This is why excellent deals on SUVs started cropping up in response to the increased demand for hybrid cars.
Income elasticity is the way demand responds to changes in consumer income levels. For inferior goods—quite literally, goods that are inferior to other, similar goods—the mathematical relationship between income and demand is negative; consumers begin to substitute more expensive alternatives when more money is available to them. This might be the difference between buying generic cereal at the grocery store versus spending more for the perceived cachet of name-brands. Luxury items, on the other hand, are an example of normal goods or “superior goods,” as consumers want more of these the more income they have.
A real-world example of the concept of availability of substitutes can be found in the literature. Curhan (1972) described the way that the distribution of shelf space among competing brands affected prices in supermarkets, noting the availability of substitutes as a major factor in price. This shows that the price was elastic; the more available similar options a consumer had, the harder the brands had to try to lower prices to compete, or else unit sales would suffer.
The proportion of income devoted to a good affects both trivial and major purchases, but in different ways. Large purchases, such as houses and cars, tend to respond to price changes because a significant proportion of one’s income is usually involved; the price-demand relationship is elastic. Small purchases like fountain drinks, on the other hand, are relatively inelastic; no one batted an eyelash when Circle K increased its beverage price by a dime not too long ago, because the amount represented such a small portion of the average person’s income anyway.
The consumer time horizon is the idea that consumers need time to adjust to price changes and normalize them. Changing prices too quickly leads to consumer shock. This is why McDonald’s, being a smart company, has been very careful to move items up off its dollar menu one by one and dime by dime, rather than all at once. Subtly, the switch from “dollar menu” to “value menu” occurred before any of the prices even changed, shoving those changes over consumers’ mental event horizon so they would forget the menu had ever been a “dollar menu.”
As price drops from eighty to fifty units on the graph, demand is elastic. From fifty to forty units, demand is unit elastic. Then, from forty to zero, demand is inelastic.
Because of the changes in elasticity described above, revenue increases as the price is lowered for the first segment. More units are being sold because of the elastic demand. For the unit elastic portion in the middle, revenue flattens out; any decrease in price exactly cancels out the increase in demand. After that, the decreases in price overwhelm revenue and cause it to sink.
Curhan, R. C. (1972). The relationship between shelf space and unit sales in supermarkets. Journal of Marketing Research, 9(4), 406-412.