Elasticity of demand refers to the degree to which demand for a good increases or decreases when the market price of the good changes. If the demand changes in perfect inverse proportion to the price, then it is said to be perfectly elastic; if the demand changes not at all when the price of the good changes, then it is said to be perfectly inelastic. Any demand/supply relationship that falls in between these two boundaries is said to have an elasticity coefficient between 1 (perfect elasticity) and 0 (perfect inelasticity).
Cross-price elasticity refers to the relationship between two complementary or two substitute goods. For example, non-digital cameras and film are two complementary goods, because consumers of one are likely to be consumers of the other. Baseball tickets and concert tickets sold for events occurring simultaneously in nearby locations are substitute goods, in that consumers can choose one or the other but not both. In each case, a change in the price of one good affects the demand for the other. If film becomes more expensive, that will decrease the demand for non-digital cameras; however, if concert tickets become more expensive, that will increase the demand for baseball tickets. Complementary goods generate a negative cross-elasticity, while substitute goods generate a positive cross-elasticity. In this case, positive or negative elasticity is denoted by the positive or negative numerical value of the coefficient.
Income elasticity refers to the elasticity of demand in relation to the income of all potential buyers in the market. For example, if a doubling in consumer incomes resulted in a 50% increase in demand for a good, the coefficient of income elasticity for that good would be .5. Income elasticity is usually a positive number, but not always; for example, the demand for small, cheap cars would have negative income elasticity, as would the demand for lottery tickets.
Many factors affect the elasticity of demand for a good. One is the availability of substitute goods. When no substitute goods are available, demand tends to be inelastic. For instance, the demand for funeral home services is inelastic, simply because a given number of people die and there is really no practical way to dispose of a body other than through the services of an undertaker. Conversely, the demand for Big Macs is very elastic because there are so many other hamburgers, tacos, chicken breasts, etc. available to the hungry consumer.
The share of a consumer’s income also affects demand. The demand for new cars is fairly inelastic, simply because the purchase of a new car is a significant expenditure for almost all consumers. Conversely, the demand for coffee is elastic because coffee is relatively inexpensive, considered as a share of consumer income.
The time horizon of a purchase is a further driver of demand. Demand for a good that is only purchased once every few years tends to be inelastic. For example, most people buy one washing machine every five to ten years and are not potential customers for another machine until their existing one breaks down for good. Conversely, the demand for laptop and notebook computers is relatively elastic because of the short (<2 years) lifespan of the product.
A widespread example of the impact of elasticity of demand on pricing structures is seen in municipal water utilities. The twin goals, somewhat contradictory, of any municipal water utility are to provide its customers with the water they need while at the same time, discouraging excess consumption and ensuring there are no threats to supplies. These goals are usually met by charging very low rates for that portion of consumption the demand for which is inelastic, i.e., the normal, everyday needs of the household for washing, drinking, and bathing, and charging increasingly higher, or “graduated” rates, for consumption the demand for which is elastic, i.e., watering lawns, keeping swimming pools filled, etc. Espy, Espy, and Shaw (1997) found that “Population density, household size, and temperature do not significantly influence the estimate of the price elasticity. Pricing structure and season are also found to significantly influence the estimate of the price elasticity” (Espy et al., 1369). For instance, were the price of water to triple, most people would still bathe and wash their clothing, but some significant portion would stop watering their lawns, or at least do so to a lesser extent. Therefore, pricing changes would affect the “top tier,” or optional, element of consumption much more than they would the “necessities” element of consumption: a case where the elasticity of demand varies as a function of total consumption.
Perfectly elastic demand is that which is driven solely by price, i.e., the price of the good is the sole determinant of people’s consumption decisions. Perfectly inelastic demand is when for all intents and purposes, price does not matter. An example of the former would be the price of a gold coin worth $100. If the price drops below $100, demand will skyrocket; if it rises above $100, demand will essentially cease to exist. An example of perfectly inelastic demand would be surgery to repair a broken leg. There is, actually, no such thing as perfectly inelastic demand as such as long as there exists an actual decision to be made by the consumer, in that for some nonzero portion of the population, the price of that good will be too high.
The impact of a price decrease of a particular good depends on the elasticity of demand, ceteris paribus. That elasticity can vary across different ranges of the consumption spectrum. By definition, a decrease in the price of a high-elasticity good will produce a proportionate increase in demand, while if the demand is inelastic, there will be little change in price. On the revenue side, revenues will not be affected as much in a high-elasticity situation. On the other hand, if demand is inelastic, by definition, a price decrease will not affect sales very much, so revenues will decrease as the profit per unit decreases without any compensating increase in sales volume. Unit-elastic demand assumes a proportional relationship between demand and units sold, meaning that a price decrease (or increase) should leave revenues unchanged.
Espey, M., Espey, J., & Shaw, W. D. (1997). Price elasticity of residential demand for water: A meta‐analysis. Water Resources Research, 33(6), 1369-1374.
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