Elasticity of Demand Defined
Elasticity of demand is an economic term which denotes the rate of change of demand for goods and services due to change in prices and other economic variables (price, income, tax and consumer taste etc.). Elasticity of demand is measured by dividing percentage change in quantity demanded by percentage changed in economic variables. If elasticity of demand is higher for goods and services, then it will mean consumers are more sensitive of economic variables and likely to respond more to changes in economic variables.
A Little More on Demand Elasticity or Elasticity of Demand
Elasticity of demand measures how fluctuation in economic factors can cause change quantity for goods and services. Firms like to know how the changes in economic factors such as income, price of other goods, taxes, and taste can bring variation in quantity demanded. Elasticity of demand enables firm to make rational choices and to forecast future sales. For example, high elasticity of demand means a firm should be very cautious in changing price of goods and services. Consumers will be affected to a greater extent and may choose competitor or substitute goods.
Types of Demand Elasticity
Demand elasticity has many types. One of the most important types of demand elasticity is price elasticity. Price elasticity shows how consumers react to change in price of certain goods and services. Consumers often react to any change in economic variables. However, in some cases consumers respond to changes significantly. If demand for goods and services is inelastic then any change in price will have no or little effect on quantity demanded. Firms can do market research on how consumers respond to price changes and then set prices accordingly.
Another type is cross elasticity, which measures how demand for a certain goods and services change is relation to changes in price of other goods and services.
Interpretation and an Example of Demand Elasticity
Demand elasticity is measured in absolute values. If the demand elasticity is greater than 1 then it means consumers are more responsive to changes and slight changes in price (or other economic variables) can change demand. If elasticity is less than 1, it means demand is inelastic and change in economic variables does not bring significant change in quantity demanded. If elasticity of demand is equal to 1, then demand is unit elastic and quantity demand change in proportion to change in economic variables.
Let’s assume that company XYZ decreases the price of a soda bottle from $3 to $2, the demand increases from 100 to 120. Demand elasticity can be measured as percentage changes in quantity demanded (120-100/100= 20%) divided by percent of change in price ($3 – $2 / $2 = 20%). Thus the elasticity of demand measurement is .4. The demand is inelastic here, so the change in price has slight effects on demand.
References for Elasticity of Demand
Academic Research for Elasticity of demand
- ● The impact of food prices on consumption: a systematic review of research on the price elasticity of demand for food, Andreyeva, T., Long, M. W., & Brownell, K. D. (2010). American journal of public health, 100(2), 216-222. This paper analyses the effects of price change on the demand for various food products. The major aim is to show the differences in reply from the population to the increase in price of different food products. To achieve this, 160 studies on the price elasticity of demand for major food products were assessed for price elasticity.
- ● Factoring the elasticity of demand in electricity prices, Kirschen, D. S., Strbac, G., Cumperayot, P., & de Paiva Mendes, D. (2000. IEEE Transactions on Power Systems, 15(2), 612-617. This paper explores consumers’ behaviours towards the volatility of electricity prices. The main change in consumers’ behaviour is the modification of their usage to reduce electricity costs.The main objective is to show the effect that the market structure can have on the elasticity of the demand for electricity. A 26-system generator is taken into consideration for purpose of analysis.
- ● Price elasticity of demand for crude oil: estimates for 23 countries, Cooper, J. C. (2003). OPEC review, 27(1), 1-8. This paper uses a multiple regression model derived from an adaptation of Nerlove’s partial adjustment model to estimate both the short–run and long–run elasticities of demand for crude oil in 23 countries. The estimates so obtained confirm that the demand for crude oil internationally is highly insensitive to changes in price.
- ● On the elasticity of demand for income in terms of effort, Robbins, L. (1997). In Economic Science and Political Economy(pp. 79-84). Palgrave Macmillan, London. This paper explores the theory which states that the effects of a change in the terms on which incomes from work can be obtained depend on the elasticity of demand for income in terms of effort. This paper analyses the impact of the movements of unity and elasticity of demand in terms of income on the effects of tax and fall rates of wages.
- ● A theory of demand for products distinguished by place of production, Armington, P. S. (1969). Staff Papers, 16(1), 159-178. The “Theory of Demand for Products Distinguished by Place of Production” has been derived by Armington (1969) . That analysis assumes that consumer utility for goods in an industry is separable from the consumption of other products and imported goods and that their domestic counterparts are incomplete substitutes.
- ● Increasing returns, monopolistic competition, and international trade, Krugman, P. R. (1979). Journal of international Economics, 9(4), 469-479. This paper develops a simple, general equilibrium model of non-comparative advantage trade. The main aim is to show that trades, and gains from trades will occur even between countries with same taste and needs.
- ● Price elasticity of demand for municipal water: A case study of Tucson, Arizona, Young, R. A. (1973). Water Resources Research, 9(4), 1068-1072. This paper analyses estimates of the price elasticity of demand for municipal water in Tucson, Arizona derived using statistical regression procedures.
- ● Urban land value functions and the price elasticity of demand for housing, Kau, J. B., & Sirmans, C. F. (1979). Journal of Urban Economics, 6(1), 112-121. This paper provides evidence on the functional form of the relationship between land values and distance from the city center. Using hsitorical data for Chicago, the Box and Cox technique is employed to examine the land value function.
- ● A note on the effect of cost changes on prices, Bulow, J. I., & Pfleiderer, P. (1983). Journal of political Economy, 91(1), 182-185. This article aims to show the shortcomings of Summer’s approach (1981) in estimating the level of monopoly power in the cigarette industry. This done by analysing an imaginary firm believed to be facing constant marginal costs denoted with a given variable.
- ● The income elasticity of demand for single-family owner-occupied housing: An empirical reconciliation, Harmon, O. R. (1988). Journal of Urban Economics, 24(2), 173-185. This paper analyses the income elasticity of demand for single-family owner occupied housing. Using past studies on the permanent income elasticity of single-family owned housing of a stated range, this paper shows that differences in sample population with respect to duration of housing tenure explain a large portion of the variation in the estimates of this elasticity.
- ● The price elasticity of demand for common stock, Loderer, C., Cooney, J. W., & Van Drunen, L. D. (1991). The Journal of Finance, 46(2), 621-651. This research examines the price elasticity of demand for the common stock of a single firm. It goes on to show the different speculations surrounding the determinants of price elasticities. After numerous experiments and case studies, results show that most of this “believed” factors have little to no role to play in the price elasticity of demand for common stocks.
- ● Market structure, elasticity of demand and incentive to invent, Kamien, M. I., & Schwartz, N. L. (1970). The Journal of Law and Economics, 13(1), 241-252. This paper explores the different propositions of Harold and Demsetz regarding market structure and the incentive to purchase. The main objective is create additional considerations other than that of Harold and Demsetz on market structure and the incentive to purchase.