Elasticity of Demand
You can find cause-and-effect relationships everywhere, and they are
especially important to businesses. For example, Netflix had hoped that
lower prices would entice customers to rent more movies and thus increase
its overall revenues. The gamble paid off. Company CEO Reed Hastings
credited the market’s demand elasticity for the company’s success.
Elasticity is a general measure of responsiveness—an important cause-
and-effect relationship in economics. It tells us how a dependent variable,
such as quantity demanded, responds to a change in an independent
variable, such as price. Elasticity is a general concept that can also be
applied to other measures such as income or supply.
Demand Elasticity
Consumers react to a change in price by changing the quantity
demanded, although the size of their reaction can vary. This response is
known as demand elasticity— the extent to which a change in price causes
a change in the quantity demanded.
Elastic Demand
Economists say that demand is elastic when a given change in price
causes a relatively larger change in quantity demanded. To illustrate, look at
how price and quantity demanded change between points a and b on the
demand curve in Panel A of Figure 4.5. As we move from point a to point b,
we see that price declines by one-third, or from $3 to $2. At the same time,
the quantity demanded doubles from two to four units. Because the
percentage change in quantity demanded is relatively larger than the
percentage change in price, demand between those two points is elastic.
This type of elasticity is typical of the demand for products like green beans,
corn, or other fresh garden vegetables. Because prices of these products are
lower in the summer, consumers increase the amount they purchase during
that time. When prices are considerably higher in the winter, consumers
tend to buy canned or frozen products instead.
Inelastic Demand
For other products, demand may be inelastic, which means that a given
change in price causes a relatively smaller change in the quantity
demanded. This is typical of the demand elasticity for a product like table
salt. A change in the price for salt does not bring about much change in the
quantity purchased. Even if the price was cut in half, the quantity demanded
would not increase by much because people can consume only so much
salt. Similarly, if the price doubled, we would still expect consumers to
demand about the same amount, because people spend such a small
portion of their budget on salt.
Unit Elastic Demand
Sometimes demand is unit elastic, so that a given change in price
causes a proportional change in quantity demanded. When demand is unit
elastic, the percentage change in quantity equals the percentage change in
price. For example, a five percent drop in price would cause a five percent
increase in quantity demanded.
Examples of unit elasticity are difficult to find because the demand for
most products is either elastic or inelastic. Unit elasticity is more like a
middle ground that separates the other two categories of elasticity: elastic
and inelastic.
The Total Expenditures
To estimate elasticity, it is useful to look at the impact of a price change
on total expenditures, or the amount that consumers spend on a product at
a particular price. This is sometimes called the total expenditures test
Determining Total Expenditures
We find total expenditures by multiplying the price of a product by the
quantity demanded for any point along the demand curve. To illustrate, the
total expenditure under point a in Panel A of Figure 4.5 is $6, which is
determined by multiplying two units times the price of $3. Likewise, the total
expenditure under point b in Panel A is $8, or $2 times four units. By
observing the change in total expenditures when the price changes, we can
test for elasticity.
Three Results
The relationship between changing prices and total expenditures is
summarized in the four panels of Figure 4.5 on the previous page. The figure
shows how a decrease in price from $3 to $2 impacts total expenditures for
each of the demand curves. In each case, the change in expenditures
depends on the elasticity of the demand curve. The demand curve in Panel
A is elastic. When the price drops by $1 per unit, the increase in the quantity
demanded is large enough to raise total expenditures from $6 to $8. The
relationship between the change in price and total expenditures for the
elastic demand curve is described as “inverse.” In other words, when the
price goes down, total expenditures go up. The demand curve in Panel B is
inelastic. In this case, when the price drops by $1, the increase in the
quantity demanded is so small that total expenditures fall below $6. For
inelastic demand, total expenditures decline when the price declines.
Finally, the demand curve in Panel C is unit elastic. This time, total
expenditures remain unchanged when the price decreases from $3 to $2.
Determining Elasticity
If the changes in price and expenditures move in opposite directions,
demand is elastic. If they move in the same direction, demand is inelastic. If
there is no change in expenditure, demand is unit elastic. Even though all the
price changes we just discussed were decreases, the results would be the
same if prices had gone up instead of down. If the price rises from $2 to $3
in Panel A, spending falls from $8 to $6. Prices and expenditures still move
in opposite directions, as shown in the table.
Elasticity and Revenues
While this discussion about elasticity may seem technical and
somewhat unnecessary to you, knowledge of demand elasticity is extremely
important to most businesses. Suppose, for example, that you run your own
business and want to do something that will raise your revenues. You could
try to stay open longer, or you could try to advertise in order to increase sales.
You might, however, also be tempted to raise the price of your product in
order to increase total revenue from sales.
This might actually work in the case of table salt or medical services,
because the demand for both products is generally inelastic. However, what
would happen if you sold a product with elastic demand? If you raise the
price, your total revenue— which is the same as consumer expenditures—
will go down instead of up. This outcome is exactly the opposite of what you
intended! This is exactly why some businesses experiment with different
prices when they introduce a new product to the market. They may adjust
prices repeatedly to see how customers respond to new prices. If a business
can determine a new product’s demand elasticity, it can find the price that
will maximize total revenues. This is why demand elasticity is more
important than most people realize.
Determinants of Demand Elasticity
What makes the demand for a specific good elastic or inelastic? To find
out, we can ask three questions about the product. The answers will give us
a reasonably good idea about the product’s demand elasticity.
Can the Purchase be Delayed?
Sometimes consumers cannot postpone the purchase of a product.
This tends to make demand inelastic, meaning that the quantity of the
product demanded is not especially sensitive to changes in price.
For example, persons with diabetes need insulin to control the disorder.
An increase in its price is not likely to make diabetes sufferers delay buying
and using the product. The demand for tobacco also tends to be inelastic
because the product is addictive. As a result, a sharp increase in price will
lower the quantity purchased by consumers, but not by very much. The
change in quantity demanded is also likely to be relatively small for these
products when their prices go down instead of up. If the products were corn,
tomatoes, or gasoline from a particular station, however, people might react
differently to a price change. If the prices of these products were to increase,
consumers could delay buying any of these items without suffering any great
inconvenience.
Are Adequate Substitutes Available?
If adequate substitutes are available, consumers can switch back and
forth between the product and its substitute to take advantage of the best
price. If the price of beef goes up, buyers can switch to chicken. With enough
substitutes, even small changes in the price of a product will cause people
to switch, making the demand for the product elastic. The fewer substitutes
available for a product, the more inelastic the demand. Sometimes only a
single adequate substitute is needed to make demand elastic. For example,
in the past there were few substitutes for sending a letter through the post
office. Then fax machines allowed messages to be transmitted over phone
lines. Today many people use e-mail on the Internet or send instant
messages on their cell phones. Because of all these alternatives, it is more
difficult for the U.S. Postal Service to increase its total revenues by raising
the price of a first-class stamp.
Note that the size of the market is important. For example, the demand
for gasoline from a particular station tends to be elastic because consumers
can buy gas at another station. If we ask about the demand for gasoline in
general, however, demand is much more inelastic because there are few
adequate substitutes for gasoline.
Does the Purchase Use a Large Portion of Income?
The third determinant is the amount of income required to make the
purchase. If the amount is large, then demand tends to be elastic. If the
amount of income is small, demand tends to be inelastic. Finally, you may
have noticed that the answers to our three questions is not always “yes” or
“no” for each of the products shown in Figure 4.6. For example, some
products such as salt may be easy to classify, since each of the answers is
“no.” However, we have to use our judgment on others. For example, the
demand for the services of medical doctors tends to be inelastic even
though they require a large portion of income. This is because most people
prefer to receive medical care right away rather than taking the time to look
for adequate substitutes.
