Chapter 2.

21: Elasticity of Demand

Elasticity is a measure of a variable's sensitivity to a change in another variable, most
commonly this sensitivity is the change in price relative to changes in other factors.

In business and economics, 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 because of a change in a
good or service's price.

Elasticity of demand therefore measures the degree of responsiveness of demand to the

changes in the factors that affect demand.

In economics, we focus on three (3) variables in terms of analysing how these affect demand.
These variables are price (PED), income (YED) and price of other goods (XED).

Price Elasticity of Demand (PED)

Price elasticity of demand is a measurement of the change in consumption of a product in

relation to a change in its price.

Economists use price elasticity to understand how supply and demand for a product changes when
its price changes. Economists have found that the prices of some goods are very inelastic. That is, a
reduction in price does not increase demand much, and an increase in price does not hurt demand
either.

For example, gasoline has little price elasticity of demand. Drivers will continue to buy as much
as they must, as will airlines, the trucking industry, and nearly every other buyer.

Other goods are much more elastic, so price changes for these goods cause substantial changes in
their demand or their supply.
 Not surprisingly, this concept is of great interest to
marketing professionals. It could even be said that their purpose is to create inelastic demand for the
products they market. They achieve that by identifying a meaningful difference in their products from
any others that are available.

Income Elasticity of Demand (YED)

Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain
good to a change in real income of consumers who buy this good, keeping all other things
constant.

The formula for calculating income elasticity of demand is the percent change in quantity demanded
divided by the percent change in income. With income elasticity of demand, you can tell if a particular
good represents a necessity or a luxury.

Income elasticity of demand measures the responsiveness of demand for a particular good to changes in
consumer income. The higher the income elasticity of demand in absolute terms for a particular good, the
bigger consumers' response in their purchasing habits—if their real income changes. Businesses typically
evaluate income elasticity of demand for their products to help predict the impact of a business cycle on
product sales.
Types of Income Elasticity of Demand

There are five types of income elasticity of demand:

1. High: A rise in income comes with bigger increases in the quantity demanded.
2. Unitary: The rise in income is proportionate to the increase in the quantity demanded.
3. Low: A jump in income is less than proportionate than the increase in the quantity
demanded.
4. Zero: The quantity bought/demanded is the same even if income changes
5. Negative: An increase in income comes with a decrease in the quantity demanded.

Depending on the values of the income elasticity of demand, goods can be broadly categorized as inferior
goods and normal goods. Normal goods have a positive income elasticity of demand; as incomes rise, more
goods are demanded at each price level.

Normal goods whose income elasticity of demand is between zero and one are typically referred to as
necessity goods, which are products and services that consumers will buy regardless of changes in their
income levels. Examples of necessity goods and services include tobacco products, haircuts, water, and
electricity.

As income rises, the proportion of total consumer expenditures on necessity goods typically
declines. Inferior goods have a negative income elasticity of demand; as consumers' income rises, they buy
fewer inferior goods. A typical example of such type of product is margarine, which is much cheaper than
butter.
Cross Elasticity of Demand (XED)

The cross elasticity of demand is an economic concept that

measures the responsiveness in the quantity demanded of
one good when the price for another good changes.

Also called cross-price elasticity of demand, this

measurement is calculated by taking the percentage
change in the quantity demanded of one good and
dividing it by the percentage change in the price of the
other good.

Companies utilize the cross elasticity of demand to establish

prices to sell their goods. Products with no substitutes have the
ability to be sold at higher prices because there is no cross-elasticity of demand to consider. However,
incremental price changes to goods with substitutes are analysed to determine the appropriate level
of demand desired and the associated price of the good.

Additionally, complementary goods are strategically priced based on cross-elasticity of demand. For
example, printers may be sold at a loss with the understanding that the demand for future
complementary goods, such as printer ink, should increase.

Substitute Goods

The cross elasticity of demand for substitute goods is always positive because the demand for one
good increases when the price for the substitute good increases. For example, if the price of coffee
increases, the quantity demanded for tea (a substitute beverage) increases as consumers switch to a
less expensive yet substitutable alternative. This is reflected in the cross elasticity of demand
formula, as both the numerator (percentage change in the demand of tea) and denominator (the price
of coffee) show positive increases.

Items with a coefficient of 0 are unrelated items and are goods independent of each other. Items may
be weak substitutes, in which the two products have a positive but low cross elasticity of demand.
This is often the case for different product substitutes, such as tea versus coffee. Items that are strong
substitutes have a higher cross-elasticity of demand. Consider different brands of tea; a price increase
in one company’s green tea has a higher impact on another company’s green tea demand.

Complementary Goods
Alternatively, the cross elasticity of demand for complementary goods is negative. As the price for
one item increases, an item closely associated with that item and necessary for its consumption
decreases because the demand for the main good has also dropped.

For example, if the price of coffee increases, the quantity demanded for coffee stir sticks drops as
consumers are drinking less coffee and need to purchase fewer sticks. In the formula, the numerator
(quantity demanded of stir sticks) is negative, and the denominator (the price of coffee) is positive.
This results in a negative cross elasticity.
Price Elasticity of goods and relationship with total revenue

Elasticity is important to pricing decisions because it helps us understand whether raising prices or
lowering prices will enable us to achieve our business objectives. How much will a lower price
increase sale? Will a price increase cause us to lose many customers or just a few? Price elasticity is
another factor to consider selecting the most effective pricing strategy. For shop owners and food
merchants, understanding price elasticity of demand is important. It helps you maximize profits and
know how much you can charge for items without losing customers.

Elasticity in price denotes a large impact on demand due to changes in price. Raising the price causes
decreased demand, while lowering the price stimulates increased demand. Inelasticity refers to the
situation where there is insensitivity to price–demand will not increase or decrease despite changes
in price.

The relationship between price elasticity of demand and a firm’s total revenue is an important one
since generating revenue is a necessary part of running a successful business. Total revenue is the
total amount of money a company makes by selling goods and services. Price elasticity is the
economic term which explains that if the price of a product goes up, consumers buy less of it. If the
price goes down, consumers buy more. Understanding whether the price of a product is elastic or
inelastic is essential for a company to develop an effective marketing campaign and survive in the
marketplace. Price elasticity is a tool that marketers can use against their competitors to increase
their share of a market.

The business firms consider the price elasticity of demand when they take decisions regarding
pricing of the goods. This is because change in the price of a product will bring about a change in the
quantity demanded depending upon the coefficient of price elasticity.

This change in quantity demanded because of, say a rise in price by a firm, will affect the total
consumer’s expenditure and will therefore, affect the revenue of the firm. If the demand for a product
of the firm happens to be elastic, then any attempt on the part of the firm to raise the price of its
product will bring about a fall in its total revenue.

Thus, instead of gaining from the increase in price, it will lose if the demand for its product happens
to be elastic. On the other hand, if the demand for the product of a firm happens to be inelastic, then