INTRODUCTION
Elasticity is a
measure of a variable's sensitivity to a change in another variable, most
commonly this sensitivity is the change in quantity demanded relative to
changes in other factors, such as price.
In business and
economics, price elasticity refers to the degree to which individuals,
consumers, or producers change their demand or the amount supplied in response
to price or income changes. It is predominantly used to assess the change in
consumer demand as a result of a change in a good or service's
price.
When
the value of elasticity is greater than 1.0, it suggests that the demand for the good or service is more than proportionally affected by the
change in its price. A value that is less than 1.0 suggests that the demand is
relatively insensitive to price, or inelastic.
Inelastic means
that when the price goes up, consumers’ buying habits stay about the same, and
when the price goes down, consumers’ buying habits also remain unchanged.
If
elasticity = 0, then it is said to be 'perfectly' inelastic, meaning its demand
will remain unchanged at any price. There are probably no real-world examples
of perfectly inelastic goods. If there were, that means producers and suppliers
would be able to charge whatever they felt like and consumers would still need
to buy them. The only thing close to a perfectly inelastic good would be air
and water, which no one controls.
Elasticity
is an economic concept used to measure the change in the aggregate quantity
demanded of a good or service in relation to price movements of that good or
service.
A
product is considered to be elastic if the quantity demand of the product
changes more than proportionally when its price increases or decreases.
Conversely, a product is considered to be inelastic if the quantity demand of
the product changes very little when its price fluctuates.
For
example, insulin is a product that is highly inelastic. For people with
diabetes who need insulin, the demand is so great that price increases have
very little effect on the quantity demanded. Price decreases also do not affect
the quantity demanded; most of those who need insulin aren't holding out for a
lower price and are already making purchases.
On the
other side of the equation are highly elastic products. Spa days, for example,
are highly elastic in that they aren't a necessary good, and an increase in the
price of trips to the spa will lead to a greater proportion decline in the
demand for such services. Conversely, a decrease in the price will lead to a
greater than proportional increase in demand for spa treatments.
The demand for a
commodity is affected by different economic variables:
1.
Price of the commodity
2. Price
of related commodities
3. Income
level of consumers
Types
of Demand Elasticity
The quantity
demanded of a good or service depends on multiple factors, such
as price, income, and preference. Whenever there is a change in these
variables, it causes a change in the quantity demanded of the good or service.
On the basis of
different factors affecting the quantity demanded for a product, elasticity of
demand is categorized into mainly three categories: Price
Elasticity of Demand (PED), Cross Elasticity of Demand (XED), and Income
Elasticity of Demand (YED).
Price Elasticity of Demand (PED)
Any
change in the price of a commodity, whether it’s a decrease or increase,
affects the quantity demanded for a product. For example, when there is a rise
in the prices of ceiling fans, the quantity demanded goes down.
This measure of responsiveness of quantity demanded
when there is a change in price is termed as the Price Elasticity of Demand
(PED).
The mathematical formula given to calculate the
Price Elasticity of Demand is:
PED = %
Change in Quantity Demanded % / Change in Price
The result obtained from this formula determines the
intensity of the effect of price change on the quantity demanded for a
commodity.
Income
Elasticity of Demand (YED)
The income levels of consumers play an important
role in the quantity demanded for a product. This can be understood by looking
at the difference in goods sold in the rural markets versus the goods sold in
metro cities.
The Income Elasticity
of Demand, also represented by YED, refers to the sensitivity of quantity
demanded for a certain good to a change in real income (the income earned by an
individual after accounting for inflation) of the consumers who buy this good,
keeping all other things constant.
The formula given to
calculate the Income Elasticity of Demand is given as:
YED = % Change in Quantity Demanded%
/ Change in Income
The result obtained from this formula helps to determine
whether a good is a necessity good or a luxury good.
Cross
Elasticity of Demand (XED)
In a market where there is an oligopoly, multiple
players compete. Thus, the quantity demanded for a product does not only depend
on itself but rather, there is an effect even when prices of other goods
change.
Cross Elasticity of Demand, also represented as XED,
is an economic concept that measures the sensitiveness of quantity demanded of
one good (X) when there is a change in the price of another good (Y), and
that’s why it is also referred to as Cross-Price Elasticity of Demand.
The formula given to calculate the Cross Elasticity
of Demand is given as:
XED = (% Change in Quantity Demanded for
one good (X)%) / (Change in Price of another Good (Y))
The result obtained for a substitute good would
always come out to be positive as whenever there is a rise in the price of a
good, the demand for its substitute rises. Whereas, the result will be negative
for a complementary good.
These three types of Elasticity of Demand measure
the sensitivity of quantity demanded to a change in the price of the good,
income of consumers buying the good, and the price of another good.
Degrees of
Price Elasticity of Demand
The effect of change in economic variables is not
always the same on the quantity demanded for a product.
The demand for a product can be elastic, inelastic,
or unitary, depending on the rate of change in the demand with respect to the
change in the price of a product.
On the basis of the amount of fluctuation shown in
the quantity demanded of a good, it is termed as ‘elastic’, ‘inelastic’, and ‘unitary’.
·
An elastic
demand is one that shows a larger fluctuation in the quantity
demanded of a product, in response to even a little change in another economic
variable. For example, if there is a hike of $0.5 in the price of a cup of
coffee, there are very high chances of a steep decline in the quantity
demanded.
·
An inelastic
demand is one that shows a very little fluctuation in the
quantity demanded with respect to a change in another economic variable. An
example of this can be petrol or diesel.
·
Unitary elasticity is one in
which the fluctuation in one variable and quantity demanded is equal.
We can further classify
these elastic and inelastic types of demand into five categories.
1.
Perfectly Elastic Demand
When there is a sharp
rise or fall due to a change in the price of the commodity, it is said to be
perfectly elastic demand.
In perfectly elastic
demand, even a small rise in price can result in a fall in demand of the good
to zero, whereas a small decline in the price can increase the demand to
infinity.
However, perfectly
elastic demand is a total theoretical concept and doesn’t find a real
application, unless the market is perfectly competitive and the product is
homogenous.
The degree of
elasticity of demand helps to define the slope and shape of the demand curve.
Therefore, we can determine the elasticity of demand by looking at the slope of
the demand curve.
A Flatter curve will
represent a higher elastic demand. Thus, the slope of the demand curve for a
perfectly elastic demand is horizontal.
Fig 1: Perfectly elastic demand
2. Perfectly
Inelastic Demand
A perfectly inelastic demand is the one in which
there is no change measured against a price change.
Like perfectly elastic demand, the concept of
perfectly inelastic is also a theoretical concept and doesn’t find a practical
application. However, the demand for necessity goods can be the closest example
of perfectly inelastic demand.
The numerical value obtained from the PED formula
comes out as zero for a perfectly inelastic demand.
The
demand curve for a perfectly inelastic demand is a vertical line i.e. the slope
of the curve is zero.
Fig 2: Perfectly inelastic demand
3. Relatively
Elastic Demand
Relatively elastic demand refers to the demand when
the proportionate change in the demand is greater than the proportionate change
in the price of the good. The numerical value of relatively elastic demand
ranges between one to infinity.
In
relatively elastic demand, if the price of a good increases by 25% then the
demand for the product will necessarily fall by more than 25%.
Unlike
the aforementioned types of demand, relatively elastic demand has a practical
application as many goods respond in the same manner when there is a price
change.
The
demand curve of relatively elastic demand is gradually sloping.
Fig 3: Relatively elastic demand
4.
Relatively Inelastic Demand
In a relatively inelastic
demand, the proportionate change in the quantity demanded for a product is
always less than the proportionate change in the price.
For example, if the price of a good goes
down by 10%, the proportionate change in its demand will not go beyond 9.9..%,
if it reaches 10% then it would be called unitary elastic demand (as shown in
fig.5).
The numerical value of relatively inelastic
demand always comes out as less than 1 and the demand curve is rapidly sloping
for such type of demand.
Fig 4: Relatively inelastic demand
5.
Unitary Elastic Demand
When the proportionate change in the quantity
demanded for a product is equal to the proportionate change in the price of the
commodity, it is said to be unitary elastic demand.
The
numerical value for unitary elastic demand is equal to 1. The demand curve for
unitary elastic demand is represented as a rectangular hyperbola.
Fig 5: Unitary elastic demand
FACTORS THAT DETERMINE ELASTICITY OF DEMAND
There are three
main factors that influence a good’s price elasticity of demand.
A.
Availability of
Substitutes
In general, the
more good substitutes there
are, the more elastic the demand will be.
For example, if the price of a cup of coffee went up by $0.25, consumers might
replace their morning caffeine fix with a cup of strong tea. This means that
coffee is an elastic good because a small increase in price will cause a large
decrease in demand as consumers start buying more tea instead of coffee.
However, if the
price of caffeine itself were to go up, we would probably see little change in
the consumption of coffee or tea because there may be few good substitutes for
caffeine. Most people, in this case, might not willingly give up their morning
cup of caffeine no matter what the price. We would say, therefore, that
caffeine is an inelastic product. While a specific product within an industry
can be elastic due to the availability of substitutes, an entire industry
itself tends to be inelastic. Usually, unique goods such as diamonds are
inelastic because they have few if any substitutes.
B.
Necessity
As we saw
above, if something is needed for survival or comfort, people will continue to
pay higher prices for it. For example, people need to get to work or drive for
a number of reasons. Therefore, even if the price of gas doubles or even
triples, people will still need to fill up their tanks.
C. The Proportion of
Income Spent on the Good
The price elasticity of demand tends to be low when spending on a good is
a small proportion of their available income. Therefore, a change in the price
of a good exerts a very little impact on the consumer’s propensity to
consume the good. Whereas, when a good represents a large chunk
of the consumer’s income, the consumer is said to possess a more elastic
demand.
D.
Time
The third
influential factor is time. For instance, if the price of cigarettes goes up to
$2 per pack, someone with a nicotine addiction with very few available
substitutes will most likely continue buying their daily cigarettes. This means
that tobacco is
inelastic because the change in price will not have a significant influence on
the quantity demanded. However, if that person who smokes cigarettes finds that
they cannot afford to spend the extra $2 per day and begins to kick the habit
over a period of time, the price of cigarettes for that consumer becomes
elastic in the long run.
The Importance of Price Elasticity in Business
Understanding
whether or not the goods or services of a business are elastic is integral to
the success of the company. Companies with high elasticity ultimately compete
with other businesses on price and are required to have a high volume of sales
transactions to remain solvent. Firms that
are inelastic, on the other hand, have goods and services that are must-haves
and enjoy the luxury of setting higher prices.
Beyond prices,
the elasticity of a good or service directly affects the customer retention
rates of a company. Businesses often strive to sell goods or services that
have inelastic demand; doing so means
that customers will remain loyal and continue to purchase the good or service
even in the face of a price increase.
Examples of Elasticity
There are a
number of real-world examples of elasticity we interact with on a daily basis.
One interesting modern-day example of the price elasticity of demand many
people take part in even if they don't realize it is the case of Uber's surge
pricing. As you might know, Uber uses a "surge pricing" algorithm
during times when there is an above-average amount of users requesting rides in
the same geographic area. The company applies a price multiplier which allows
Uber to equilibrate supply and demand in real-time.
The COVID-19
pandemic has also shone a spotlight on the price elasticity of demand through
its impact on a number of industries. For example, a number of outbreaks of the
coronavirus in meat processing facilities across the US, in addition to the
slowdown in international trade, led to a domestic meat shortage, causing
import prices to rise 16% in May 2020, the largest increase on record since
1993.
Another
extraordinary example of COVID-19's impact on elasticity arose in the oil
industry. Although oil is generally very inelastic, meaning
demand has a little impact on the price per barrel, because of a historic drop
in global demand for oil during March and April, along with increased supply
and a shortage of storage space, on April 20, 2020, crude petroleum actually
traded at a negative price in the intraday futures market.
In response to
this dramatic drop in demand, OPEC+ members elected to cut production by 9.7
million barrels per day through the end of June, the largest production cut
ever.
CONCLUSION
Elasticity is
an economic measure of how sensitive one economic factor is to changes in
another. For example, changes in supply or demand to the change in price, or
changes in demand to changes in income.
If demand for a
good or service is relatively static even when the price changes, demand is
said to be inelastic, and its coefficient of elasticity is less than 1.0.
Examples of
elastic goods include clothing or electronics, while inelastic goods are items
like food and prescription drugs.
Cross
elasticity measures the change in demand for one good given price changes in a
different, related good.
We can conclude the by
stating the fact that the demand for a commodity is affected by several factors
and the three main types of elasticity of demand explains the effect of those
factors.
To explain the extent
of the effect of the economic variables on the quantity demanded, we have 5
other types of elasticity of demand which are perfectly elastic, perfectly
inelastic, relatively elastic, relatively inelastic, and unitary elastic.
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