There’s a lot more to a “market” than merely buying and selling. A plethora of activities are undergone behind bringing a product into the market. It requires proper market research before deciding on the manufacturing of a new product.
Different concepts in economics explain all these backstage happenings of a market. One such concept is elasticity.
Elasticity measures the sensitivity of one economic variable against a change in another economic variable. We often hear about demand and supply in economics and also in elasticity.
(You can also check out: What is elasticity in economics and what are its types).
The demand and supply of a product are affected by several other factors like price. The quantity demanded of a product changes when there is either a surge or a decline in its price. This sensitiveness of demand against a change in price is explained by the Price Elasticity of Demand.
What is Price Elasticity of Demand?
Price Elasticity of Demand (PED) is an economic tool that measures the change in quantity demanded of a product when there is a fluctuation in its price.
The mathematical equation to calculate Price Elasticity of Demand is given as:
Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price
Since supply and demand are two related terms, a change in either of them will have an effect on the other.
Economists use price elasticity to understand the change in demand or supply given there is a price change. This helps them break down the working of the real economy.
Also sneak a peek at our blog on what is economics
5 Factors Affecting the Price Elasticity of Demand
A change in price does not always result in the same proportion of change in quantity demanded of a commodity.
For example, a small change in the price of Air Conditioner would cause a sharp rise in the quantity demanded, whereas a large change in the price of sugar won’t increase the quantity demanded to the same extent.
Several other factors affect the Price Elasticity of Demand (PED). Some goods are more sensitive or elastic while some are less. Availability of substitutes, type or nature of a product, income, price, and time are the five known factors that affect the PED.
1. Nature or type of Good
The Elasticity of Demand for a good is affected by its nature. Different goods can be a necessity good, a comfort good, or a luxury good for a person.
There is one more thing that is a single good can be a necessity for one person, a comfort for the second person, and a luxury for a third person. So, we can say that a good’s nature is relative.
Now, let us understand how nature affects the elasticity of demand.
i. A necessity good like vegetables, food grains, medicines and drugs, has an inelastic demand. Such goods are required for human survival so their demand does not fluctuate much against a change in their price.
ii. A comfort good like a fan, refrigerator, washing machine, etc., has an elastic demand as their consumption can be postponed for a time period.
iii. A luxury good like AC, Cars, Diamond has a relatively high elasticity of demand when compared to comfort goods.
“We've done price elasticity studies, and the answer is always that we should raise prices. We don't do that, because we believe -- and we have to take this as an article of faith -- that by keeping our prices very, very low, we earn trust with customers over time, and that that actually does maximize free cash flow over the long term.”
- Jeff Bezos, Amazon CEO
2. Availability of Substitutes
The Price Elasticity of Demand for a good, with a large number of substitutes available, is very high.
The possible reason behind this is that even a small rise in the price of such goods will induce its buyer to look for its substitutes. An example of this can be an FMCG product like a packet of chips. A rise of ₹2 on a packet of Lays will induce the buyer to go for Haldiram’s chips.
Thus, the availability of a large number of close substitutes increases the sensitivity against change in price, or we can also say that this increases the Price Elasticity of Demand.
3. Price Level
The price level of goods plays a major role in determining the price elasticity of demand. Goods that fall in a higher price segment are more likely to have high elasticity.
A price rise will further push them in the higher segment while even a small decline in the price can put them in the affordable segment. An example of this can be mobile phones or laptops. A person with a budget of 15k won’t go for a phone that is 20% more costly.
On the other hand, goods that belong to the low-price segment are generally inelastic or relatively less elastic. An example can be a packet of matchboxes. Even a sharp rise in its price won’t throw it into the high-price segment.
4. Income Levels
Our society is divided into different classes based on incomes and lifestyle. Upper-class people generally have a higher income and live a lavish life whereas the lower class people can’t afford luxury items because they have a low income.
Income levels have a considerable effect on the elasticity of demand. The Elasticity of Demand for a commodity is generally very low for higher income level groups. The change in prices does not bother people from such groups.
Whereas the Price Elasticity of Demand of a commodity is very high for people belonging to low-income level groups. Poor people are highly affected by the change in the prices of commodities.
5. Time Period
The price elasticity of demand varies directly with the time period. The given time period can be as shorts as a day and as long as several years.
The price elasticity of demand is directly proportional to the time period. This means the elasticity for a shorter time period is always low or it can be even inelastic.
The reason stated for this is the redundant human nature to change habits. We generally stick to a commodity and respond very late to the price changes. However, the elasticity of demand is high in a longer time period as our habit changes over time. We can substitute the original product if its price changes in the long run.
These were the factors that affect the Price Elasticity of Demand. Let us now sum up the blog by looking at the key takeaways.
Recommended Read: Micro vs Macro Economics
Elasticity vs Inelasticity
An inelastic product is one that has a very small effect on the quantity demanded even if there is a significant price change. It can also be said that the quantity demanded for inelastic goods remains almost static or has no effect of change in any economic factor.
Inelastic products are generally necessity products. Inelasticity of demand ensures that there is an adequate supply of such goods.
Since the quantity demanded is the same regardless of the price, the demand curve for a perfectly inelastic good is graphed out as a vertical line. Such goods have no good substitutes, which also ensures the quantity demanded remains unaffected.
Price-Demand curve for Elastic Demand
Manufactures or providers of inelastic goods and services can generate good revenue. For businesses, revenue generated from inelastic goods can go both ways. This means that it can prove profitable as well as marginal.
In case of price fall, the quantity demanded remains the same resulting in less revenue generation. While in times of price hike businesses earn significant profits.
This is the major benefit of inelastic goods over elastic ones. Manufactures or providers of inelastic goods and services can generate good revenue.
PED = % Change in Quantity Demanded / % Change in Price
On the basis of results obtained from the above formula, the Price Elasticity of Demand is categorized as elastic, inelastic, or unitary.
The Price Elasticity of Demand is affected by many factors. 5 crucial factors among them are: Availability of goods, Price Levels, Income Levels, Time Period, and Nature of goods.