<Last updated 10.04.2020>
Hi! If you are interested in Economics, I’ve prepared the below to help you understand better these concepts. You should take a look at this short article in which I explain what is Elasticity and specifically what we mean by Elasticity of Demand.
In general, he have discussed the fact that the Law of Demand and the Law of Supply describe how the quantity demanded and quantity supplied changes when price changes. However we never emphasized how much the quantity changes relative to the price change. Different products have different changes in quantity demanded or supplied. This is where Elasticity comes into consideration.
In order to measure the degree of change in quantity demanded from a price change we use Elasticity of Demand: the measurement of the degree of change in quantity demanded from price changes when other factors affecting demand stay fixed.
Elasticity of Demand= % change in quantity demanded / % change in price or
ED = % ΔQ / % ΔP
ED = % 40 / % 20 = -2 or just 2 : elastic
ED = % 20 / % 40 = -0.5 or just 0.5 : inelastic
Elastic Demand: If a good has elastic demand, it means that people respond intensely to price changes. The price change in percentage terms is lower than the % change in quantity demanded. This means ED < – 1 or (in absolute value just > 1 in this case).
Inelastic Demand: If a good has inelastic demand, it means that people respond with less intense to price changes. The price change in percentage terms is higher than the % change in quantity demanded. ED > – 1 or (in absolute value just < 1 in this case).
Unit Elastic Demand: ED = – 1 or (in absolute value) just = 1
Perfectly Inelastic Demand: ED = 0 or (in absolute value) just = 0
Perfectly Elastic Demand: ED = 00 or (in absolute value) just = 0
Since demand is determined by consumer preferences, elasticity depends on economic, social and psychological factors that form consumer desires.
What determines elasticity and so consumer response to price changes?
a) What kind of need is satisfied: Satisfaction of basic needs > demand for most of the goods or services satisfying basic needs is inelastic (food, clothes, fuel). For other goods that satisfy luxury needs and wants there is high elasticity.
b) The existence of Substitutes: Goods that have close substitutes (scarce substitutes) they have higher elasticity of demand. i.e. Pork meat vs Lamb meat are close substitutes so there is higher elasticity of demand for these.
c) The percentage of income that is spent on the good: For the goods that a large part of income is spent on them, their demand has high elasticity (more expensive leads to people demanding much less quantity) > household budget suffers.
d) Time: Due to lack of information, the power of habit and uncertainty the initial response to price change from people/consumers will be small on quantity demanded. In the long-run, when the information is passed on and spread around (i.e. the information for the existence of substitutes) Demand has higher elasticity, since preferences changed (i.e. heat oil vs air-conditioning and other means of generating heat).
f) Goods lifetime: Goods that have higher lifetime usually have higher demand elasticity.
Where is this knowledge applied? To know about price elasticity, is very important for policy makers > business decisions and government decisions.
Government policymakers will use the demand elasticity for setting a tax policy. In order to increase its revenue, the government prefers to set high taxes on goods satisfying basic needs since an increase in the cost of buying those goods will not decrease much the quantity demanded leading to an increase in government revenue. Yes, its unfair for the people with low income.
A business will use the knowledge of Demand Elasticity for setting a pricing policy: > Price Increase/Decrease > Discounts > Offers
An increase in wages, which leads to an increasing in the price, when demand for the good is inelastic, increases revenues due to the fact that quantity demanded will not change much.
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Thank you for reading my articles and watching my videos.”