The law of demand states that when prices increase demand decreases and when prices decrease demand increases. This means that a consumer will respond to a price decrease by buying more and will respond to a price increase by buying less. There are several factors that influence demand: the increase or decrease of income, substitution goods, and complementary goods, diminishing marginal utility, and tastes or preferences.
A way to measure the impact of price change on a product is by measuring the elasticity of the demand on that product. When price change impacts willingness or ability to buy a product, the product’s demand is elastic. A demand curve shows the size of demand at various price intervals. There are some goods that have static demand curves because there is a constant demand for such goods even if there is a change in price. The demand for a good that is insensitive to price change is an inelastic demand. Understanding price elasticity makes it possible to observe the influence of price changes on sales revenue and volume. There are several factors that influence price elasticity of demand: available substitutes, time, expenditure share, and luxury versus necessity.
Available Substitutes. One of the main factors of price elasticity is the amount of available substitutes for a good or product. When there are more available substitutes for a good or product, there is more elasticity of demand for that good or product. When the price of non-essential products increases, consumers will often look for available substitutes for that product, which makes the demand for the non-essential product decrease. When there are few alternatives to the product, or if the availability of substitutes are poor, the demand becomes inelastic because consumers cannot quickly turn to an alternative product.
A common example of a broad commodity is food. Food is an essential good, and the demand for it is not sensitive to price change, making the demand inelastic. However, if there is a shortage of a specific type of food, such as a specific type meat, the demand becomes more elastic than that of a broad commodity. When the price of a specific type of meat rises, the consumer can choose to buy a protein source other than meat, or a different type of meat that costs less. (Baye and Price, 2014, p. 85)
An example of an essential good that has few available substitutes is gas. There are few substitutes for gas, and they are often very expensive. When there is a shortage of liquid petroleum fuel, there is a higher demand and the price increases. According to Lynn Doan and Joshua Falk’s article California Gas Stations Shut as Oil Refiners Ration Supplies (2012) Costco and other petroleum suppliers rationed their gas supplies in the Midwest in 2012. Independent gas stations shut down because the gas prices were too high for them to be able to make a profit. Even with the gas shortage, the consumption of gas in the U.S. in 2012 did not decrease. It actually continued its annual increase according to the government’s annual consumer report on the consumption of gas (EIA, 2014). This is because with no viable alternatives to gas consumers were willing to pay the increased price.
Time. Another main factor that affects the elasticity of demand is time. In general, the longer the period of time, the more elastic the demand will be. In relation to available substitutes, the greater the period of time for the consumer, to more likely they will find available substitutes for a product. Take the gas example, if the gas price increased and did not decrease over a long period time, consumers would be less willing to pay the increased price, and seek out those other, less obtainable resources. If the gas prices were to continue to rise with no foreseeable decrease, consumers would begin buy smart cars or hybrid vehicles, carpool, or stop driving altogether and walk or use bicycles more often. The demand for the short-term spike in prices of gas was inelastic, while the demand for a long-term increase in price would be elastic.
Another example in which time gives the consumer more chances to seek out substitutes for goods and services is if all milk producers in the nation were to raise the price of milk by fifteen percent. Some consumers would notice and react to the price change quickly, and revert to an available substitute. Most consumers within the first week, however, would already have their meals planned out and would by the milk regardless of the increase in price. If data was collected after the first week, the milk producers would see an increase in their revenue by fifteen percent.
After a few more weeks, more consumers might begin looking for other alternatives to milk, or ways to consume less of it. They would use foods that have a similar nutritional value, such as other dairy products. Or some would choose powdered milk for their less urgent needs such as cooking or feeding a cat. If data was collected six months after the price increase, the milk producers might find that the demand for milk is more elastic over a longer period of time when the consumers were given a chance to find more alternatives. (McGraw-Hill, 2014)
Expenditure Share. Income has a considerable effect on a consumer’s sensitivity to price change and thusly on demand elasticity. If a good or service costs a sizable portion of a consumer’s income, then the demand tends to be more elastic for that good or service. If there is a change of price in this type of product, there will be a highly noticeable effect of that price change as it affects the consumer’s budget at a higher degree. If the price increases the consumer is more likely to decrease their spending on that product. Comparably, the less amount of income that a consumer spends on a product, the less elastic the demand is for that item.
An example of the effect of expenditure share on demand is the demand for refrigerators versus the demand for microwaves. The demand for a refrigerator is predicted to be more elastic than that of microwaves because the expenditure required to purchase a refrigerator would be a larger percent of the consumer’s budget. If the price of a microwave were to increase, then the demand would for it would be more elastic as well. Price elasticity is directly related to the amount of a consumer’s income spent on a good. (McGraw-Hill, 2014)
Another example of expenditure share on demand is the observation of the two products: food and transportation. In the biological sense, food is more important because it is a life necessity. Therefore, it would be predicted that food would have a more inelastic demand that transportation. However, the market shows that consumers spend a much larger percentage of their income on food rather than transportation, so the demand for transportation is actually more inelastic than that of food. (Baye and Price, 2014, p. 85)
Luxury versus Necessity. The demand for necessity tends to be inelastic because there are not many substitutes for necessities. For luxury products, however, the demand is elastic because there are many available substitutes for luxury. For example, instead of buying a luxury boat, a family could decide to use that money to go on vacation. A family could not be made to choose a luxury boat over food because food is a necessity for life, or a broad commodity.
The importance of demand elasticity is to be able to measure the responsiveness of consumers when there is a change in the price of a product. This is closely related to the law of demand. There are many factors related to the demand elasticity of goods: Available substitutes, time, expenditure share, and luxury versus necessity are some of the main factors.
Baye R. Michael, Prince T. Jeffrey, (2014). Managerial economics and business strategy. McGraw-Hill/Irwin, 84-87
Doan, Lynn. Prince, Harry, (2012). California gas stations shut as oil refiners ration supplies. Bloomberg.
E.I.A., (2014). Natural gas. U.S. Energy Information Administration.
Maurice C.R. Thomas, (2014). Elasticity and demand. McGraw-Hill Education.