Understanding the law of demand pertaining to the elasticity of demand with other things equal measures consumers’ responsiveness or sensitivity to change in price of a product. The measuring of the degree of change or percentage of change will result in either elastic, inelastic, or unit demand. Elastic demand or “elasticity means the extent to which the quantity demanded changes when there’s a change in the price of a good” (Thinkwell, 2013). A product is considered elastic when the change in price increases the percentage change in quantity demanded.
When there is a decrease in the price of product increasing the demand of the product resulting in an increase in total revenue equals elastic demand. Even though the cost per product is less there is enough of the product sold to increase the overall total revenue. Elastic demand is also a reversible concept. A demand is truly elastic when the price of a product is increased the percentage of change in quantity will decrease with no loss of total revenue. Inelastic demand shows little to minimal change of total revenue when there is a percentage change in demand resulting from a change in the price of a product.
When a company lowers the price of a product the quantity demanded may increase but not enough to make a change in total revenue lost from decreasing the price per unit. A product is inelastic when consumers are unresponsive to the change of a products price. In addition, inelastic demand is also a reversible concept. If the product price is increased the total revenue will increase but will not result in a significant percentage change in demand of product greater than the percentage change of price.
Unit of demand is different from both elastic and inelastic. In fact unit elastic is “…the special case…. an increase or a decrease in the price leaves total revenue unchanged (McConnell, Brue, Flynn, 2012). ” This is measurement is found when both the percentage change of demand is equal to the percentage of change in price. With all other things equal any price changes either increase or decrease and the total revenue will remain unchanged making the product unit-elastic.
Cross Price Elasticity
To fully understand elasticity of demand we must know how substitute goods and complementary goods impact the measurements in a concept known as cross elasticity of demand or cross price elasticity. The purpose of price elasticity is to determine how consumers’ respond to price percentage changes of one product to the percentage of change demanded of another product. To measure cross price elasticity requires finding the percentage change of the one product divided by the percentage change of another product their coefficient will reflect either positive or negative results. (McConnell, Brue, Flynn, 2012)
Substitute goods are any similar products that can easily replace another product when the other product becomes scarce or too expensive. If the cross price elasticity formula is applied to the two products and results in a positive coefficient then the two products are considered substitutable. For example, if prices of diet coke increases causing consumers to purchase more diet pepsi then the results is a positive coefficient cross price elasticity or the products are substitute goods with greater substitutability. Complementary goods are products that depend on one another verses replacing one another.
An example of complementary goods are spaghetti sauce and spaghetti noodles which are purchased separately, but will not make a spaghetti meal without each other. When we input the percentage change in quantity demand for the spaghetti sauce divided by the percentage change for spaghetti noodles the results are a negative coefficient confirming the two products are complementary to one another, depend on each other. Complementary goods price changes will impact one another’s percentage of demand. For example, if the price of spaghetti sauce increases then the demand for the spaghetti noodles will decrease.
If the price of spaghetti sauce decreases then the demand of spaghetti noodles will increase. Therefore, when the output of the cross price elasticity formula results in a negative coefficient means that the products are complementary goods.
Income Elasticity Income elasticity of demand is used to measure how consumers respond to changes to their income and their buying power or demand of a product. To better understand how changes of income affect consumers decisions to either buy less of a specific product or more of a specific product we use the income elasticity formula.
The income elasticity formula is to divide the percentage change of the quantity of a particular product demanded over the percentage of change in a person’s income. The answer will result in either a positive or negative coefficient with a threshold of zero. If the results are a positive coefficient then that specific product is considered a normal/superior good; if the results are a negative coefficient that product is considered an inferior good. Normal goods or superior goods are those products that follow changes in a person’s income.
When applying the formula of income elasticity to normal good’s the coefficient will be positive meaning the consumer will demand more of these goods as income rises. However, if the consumer’s income falls so will the demand of the normal goods. With other things equal and a threshold of 0 the normal good’s quantity demanded will follow or move in the same direction as the consumers change in income. So if the consumer’s income increases the demand for normal goods will increase, and if the consumer’s income decreases then the demand for the normal goods will decrease.
Inferior goods are just as they sound being expendable meaning they will no longer be demanded with a change in a consumer’s income. When you apply the formula of income elasticity to the demand for an inferior product it will result in a negative coefficient. Inferior goods are those goods that will no longer be demanded if a consumer’s income increases due to the negative coefficient. However, if a consumer’s income decreases the demand for inferior goods will increase. With other things equal and income elasticity maintaining a threshold of zero the inferior goods demanded will move in the opposite direction of a consumer’s change in income. Inferior goods are represented by income elasticity coefficient is negative and < 0.
Availability of Substitutes The availability of substitute goods can increase the price elasticity of demand when there are larger amounts of readily available substitutes for a consumer to choose from. A consumer is more likely to make alternative choices when more options are available verses limited choices. For example, a consumer goes to the grocery store for cereal and milk.
Upon reaching the cereal they find their favorite cereal Coco Pebbles price has increased significantly. Luckily, there is a whole isle of different cereals to choose from at different prices. As the consumer processes the prices they are able to locate a reasonable substitute, Coco Puffs at a lesser price than the Coco Pebbles. When the consumer approaches the milk they find that the cost of milk has also increased. As the consumer processes this information they find that all forms of milk, 2% and whole milk prices have all increased so they have no other option but to pay the higher price for the milk, if they want to eat their cereal.
As you can see if more options are available to substitute the desired at a lesser cost the consumer can make choices forcing the price elasticity of demand to have greater elasticity or a greater response by consumers. However, if there are no alternative products available the consumer has no other choice but to pay the demanded price of the product. Element E & E1. Share of Income Devoted to Goods & Same Percentage of Change: Consumers generally budget or devote a proportion or a share of their monthly income for specific products or services regularly.
The dedicated shares of the income can be determined by the price of the product. If two of these regularly purchased products experience a 50% change in price what impact is on their proportion of income the consumer spends with other things equal. Consider one of the products is deodorant which normally costs $2. 00 increases to $3. 00 the consumer may not notice the price increase and continue to purchase the product regularly. This demonstration shows that the cost of the deodorant is a very small share or portion of the consumer’s income, making this product inelastic.
There will be little to no change in the quantity demanded of the deodorant. The other product or service purchased regularly is rent which normally costs $1,000. 00 monthly and increases to $1,500. 00. The consumer notices this significant increase and resorts to relocating to a lower rent facility. This demonstration shows that the cost of rent is a large portion of the consumer’s income and creates a reaction to seek lower rent showing this product is highly elastic. The consumer’s reaction results in change to stop paying the increased rent or similar to a decrease in quantity demanded.
Short and Long Term Response to Increase in Price Time is a significant contributor to the consumer’s sensitivity to any percentage of change in in price of a product. Shorter time periods of a price increase of a product the less essential time there is for a consumer to react to the increased price. Vice versa, the longer time period a product price increases allows the consumer more essential time to react to the increase. The consumer reaction time to price increases can best be explained by the Consumer Time Horizon concept.
Course mentor, Wade Roberts explains “Consumer Time Horizon: Consider the length of time the consumer has to make alternative choices. Demand is more elastic in the long run than it is in the short run. ” The short term increase in price of a product may not allow the consumer an opportunity to consider alternative choices to replace the product. For example, consider a price increase of milk per gallon for a short term of one month when the consumer generally purchases 2-3 gallons a month.
The consumer buys the first gallon of milk noticing a change in price but no significant change is considered at the point of purchase. The second gallon of milk is purchased the consumer reflects over the price increase of milk, but still purchases the product. By the third gallon of milk purchased at an increased price the consumer begins to consider the alternative substitutes. The following month when the consumer purchases another gallon of milk at regular price the milk alternative/substitute is dismissed.
The long term increase in price of product allows more time for the consumer to react and consider alternative choices to replace the product whose price increased. For example, if the price of milk increases for a long term of a year allows the consumer to consider the substitutes. The length of time the products price stays high the consumer will search for alternative solutions at a lesser price such as silk and other milk substitutes. Even though the consumer prefers milk products they will settle for a reasonable substitute during the long term price increase.