Elasticity of Demand: A Close Investigation - Essay Example

Elasticity of Demand Elasticity of demand is a part of the demand analysis and is used where reliable results cannot be achieved through demand curves. Demand curve does measure the responsiveness but is not an adequate tool to compare the responsiveness of different commodities in different units, for example, labour (hours), land (acres), et cetera. Elasticity of demand is of various types namely price, income and cross elasticity of which the first two are discussed in the sections below. Price Elasticity of Demand Dr. Marshall introduced the concept of price elasticity which is defined as “the ratio of percentage change in quantity demanded to the percentage change in price” (Lekhi 2007:34). Price elasticity is expressed mathematically in the following manner (Depken 2006:74): Price elasticity differs for different commodities. Usually, it varies on a scale of zero to infinity where possible cases can be equal to zero, unity, less than and greater than one (Figure 1). These cases are called degrees of price elasticity of demand which are briefed as below (Mankiw 2008:93): Unity elasticity (ε= 1) Change in demand is exactly equal to the change in price. Examples in this category include education, housing, movies and radio and television services (Anderson et al. 1997). High elasticity (ε> 1) Change in demand is more than change in price. For example, airline travel, restaurants, automobiles, etc, fall under this category (Anderson et al. 1997). Perfectly elastic (ε= infinite) Slight change in price causes an infinite change in quantity demanded. Low elasticity (ε< 1) Change in demand is less than change in price. Zero elasticity (ε= 0) Change in price is not accompanied by any change in quantity. Salt, gasoline, physician services, legal services, et cetera come under this category (Anderson et al. 1997). Y Price X Figure 1: Degrees of Price Elasticity Income Elasticity of Demand According to Stonier and Hague, “income elasticity of demand shows the way in which a consumer’s purchase of any good changes as a result of change in his income” (Lekhi 2007:45). Thus, income elasticity represents the ratio of percentage change in quantity demanded to percentage change in income and is expressed as: An example illustrating income elasticity of demand is suppose when our monthly income is $ 500; the demand for ice-creams is of 10 units. However, if monthly income rises to $ 1000, the demand for ice-cream units also rises to 20 units. Thus, income elasticity in this case would be 2 (greater than 1). The income elasticity of demand is usually positive for wines, quality chocolates, mobile phones, leisure facilities and other luxury items. However, it is low for staple foods and mass transportation (Tutor 2u n.d). Determinants of price elasticity of demand There are numerous factors which determine the size of price elasticity of demand. Those major factors are enumerated below (Frank & Bernanke 2007:100): Nature of commodity- commodities also vary according to their categories. Price elasticity of necessary commodities of life is usually inelastic as people will buy them regardless of change in price. Rice, salt and food grains fall under this category. Demand for luxury goods is elastic as people buy more of them at lower prices and vice versa. However, luxury to a poor man can be the necessity to the rich. Hence, this thing has to be expressed carefully. Availability of substitutes- goods having their substitutes are price elastic while those having no substitutes are inelastic. Number of uses- demand is said to be elastic if it is put to multiple uses and inelastic if it is confined to a single use. Multiple-use goods are found to have more elastic demand. For example, coal will be demanded more in cooking, heating and other purposes if its price falls. On the contrary, its demand in all uses will diminish if its price increases. Income level- higher and lower income groups generate price inelasticity while middle income group gives rise to price elasticity. Rich people do not bother about price and continue their purchases, both at low or high prices. Poor people purchase only the required amount and are not enticed to buy higher quantity at lower prices or lesser quantity at higher prices. However, middle income groups are sensitive towards price changes and thus show variation in demands for goods and products. Price level- likewise income groups, elasticity also depends upon the pricing of goods. The demand is elastic for moderately priced goods while it is inelastic for low and high priced goods. Joint demand- demand is inelastic if a good is demanded jointly with other goods in the market. For example, if the demand for car is inelastic, the demand for petrol will also be inelastic. Time- elasticity of demand varies with the time period. For short run, it is usually inelastic because demand cannot change immediately due to price change. However, in the long run, there is enough time to incorporate changes and thus demand is more elastic in the long run. Habits- habits of individuals also determine the elasticity of certain commodities. This is because they will buy the commodity even if the prices go up. For example, smoker will continue smoking even if the price of cigarette goes up. Postponement- goods which can be postponed for consumption tend to be more elastic. For example, rise in the price of silk can be postponed while demand for medicines is inelastic because their consumption cannot be postponed. Income distribution- the elasticity of a good with small budget in the consumer’s income is less as he is ready to pay more for it than to go without it. Why short run demand curve is less elastic than the long run demand curve? Short run signifies period of fixed capacities and non-changeable behavior of characteristics. On the other hand, long run is the period where any characteristic of demand can be changed or altered. In general, short run is assumed to be of 1 year while long run spans across 3-5 years (Federal Highway Administration 2002). As discussed above, demand elasticity is the responsiveness of “quantity demanded to price changes” (Federal Highway Administration 2002). As such, short run demand curve is usually less elastic than long run demand curve. This is so because characteristics affecting demand can be increased or decreased in the long run while opportunities to do so are very less in the case of short run. For instance, in the case of fuel price rise, short run measures would be carpooling or reducing consumption by taking fewer trips. This would be reflected in the short run demand curve because the change in quantity demanded (drop) is less than the change in price (rise). Thus, short run demand curve will be inelastic (Figure 2). However, in the long run, manufacturers will provide fuel-efficient vehicles and commuters might also shift their residences and offices to nearer locations. Thus, the drop in quantity demanded is more than the rise in price which makes long run demand curve more elastic (Lipsey & Chrystal 2007:73). Also, long run demand curve for a product which is used in combination with other goods and durables is found to have more elastic demand curve than short run demand curves (Lipsey & Chrystal 2007:73). Figure 2: Long run demand vs. Short run demand curves Conclusion After going through the theory, it is clear that demand components serve as a useful tool in analyzing the market forces and assessing the supply structure to meet the demand. Not only close but distant factors can also be accounted for in the study of elasticity of demand and their impact can be judged. With the help of demand curves, companies can establish their strategies in the short and the long run and their probable effects on increasing or diminishing demand rate to a specified extent. Study of elasticity and demand curves find useful applications in many other areas like taxation, wages and international trade which increase its overall significance. References 1. Anderson, P.L, McClellan, R.D, Overton, J.P & Wolfram, G.L. (1997). Price Elasticity of Demand [online] available from < http://www.mackinac.org/1247> [accessed 20 Nov, 2010] 2. Depken, C.A. (2006). Microeconomics Demystified. Tata McGraw Hills. 3. Frank, R.H & Bernanke, B.S (2007). Principles of Economics. 3rd Ed. New York: Tata McGraw Hills 4. Highway Economic Requirements Systems- State version Technical Guide 2002. USA: Federal Highway Administration 5. Lekhi, R.K. (2007). ISC Economics. 9th Ed. New Delhi: Kalyani Publishers. 6. Lipsey, R.G & Chrystal, K.A. (2007). Economics. 11th Ed. New York: Oxford University Press 7. Mankiw, N.G. (2008). Principles of Economics. 5th Ed. USA: South-Western Cengage Learning. 8. Tutor 2u n.d. Income Elasticity of Demand [online] available from < http://tutor2u.net/economics/revision-notes/as-markets-income-elasticity-of-demand.html> [accessed 20 Nov, 2010] Read More