If the price elasticity of demand is greater than one then demand is said to be elastic. I.e. if there is a change in price it leads to a more than proportionate change in demand. This applies to a lot of non-essential goods. For example holidays, you may be greatly encouraged to select one holiday over another if the price is cut. And so holidays are seen to be price elastic.
If for example Ford motor company knew their cars were price elastic then a cut in prices would attract a more than proportionate rise in demand. In other words the revenue gained through increased demand would outweigh the revenue lost in the price cut. And so total revenue would rise. Conversely if price rises the revenue gained through the rise in price will not outweigh the revenue lost through the fall in demand. This will lead to a fall in total revenue.
If on the other hand price elasticity of demand is less than one demand is said to be inelastic. I.e. if a proportionate change in price does not have a significant effect on demand the good is said to be inelastic. Cigarettes for example are so addictive that even though tax on them is raised every year cigarette companies do not lose anything as people still buy them. Thus cigarettes are seen to be price inelastic.
As you can see from the diagram a major fall in price (p to p1) has very little effect on quantity demanded (q to q1). Due to this many inelastic goods cannot be price cut to induce more buyers and instead rely on non-price competition for example advertising.
If Ford could make demand for its cars inelastic, which is the goal of most producers in business, it could rise it’s prices greatly and as this would not have a significant effect on demand revenue would greatly increase. This is however unrealistic with the amount of complementary and substitute goods available in the motorcar industry.
If however price elasticity of demand is equal to one it is said to be Unitary. This means a change in price will lead to exactly the same change in demand.
As you can see a fall in price (p to p1) leads to exactly the same amount increasing I quantity demanded (q to q1).
There are two special cases where price elasticity of demand could be perfectly elastic of perfectly inelastic. If a good or service is perfectly elastic the price elasticity of demand is equal to infinity. This is a very exceptional case as demand is infinite and there is no need to change price. If price elasticity of demand is equal to zero it is perfectly inelastic which means that a change in price will have no effect on quantity demanded.
There are numerous factors which effect price elasticity of demand. Some of these are Availability of substitutes, Income and Fashion.
Availability of substitutes, products with few substitutes, such as water, will tend to be quite price inelastic, as these products cannot be done without.
Income, this will greatly decide the type of good or service you can consume. If a person’s income rises of falls this could greatly affect the elasticity of some goods.
Fashion, for example advertising, can greatly increase the appeal for a product turning want to needs. This is called branding and can make the product more price inelastic.
Another concept of Elasticity is Cross price elasticity of demand. This is a measure of the responsiveness of quantity demanded of one good to a change in price of another good. It is a measured by dividing the percentage change in quantity demanded of one good by the percentage change in price of the other good. The formulae is:
Proportional (%) change in demand for good A
Proportional (%) change in price of good B
Substitute goods are goods that are a direct alternative such as tea and coffee. If good B is a substitute for good A the demand for A will rise as the price of B rises. This means that the cross price elasticity of demand will be positive.
Complementary goods are goods, which go together such as cereal and milk.
If good B is a complement for good A the demand for A will fall as the price of B rises. This means that the cross price elasticity of demand will be negative.
The car manufacturer Ford UK can use this concept to help itself
Income Elasticity of demand (IED) refers to the relationship between the level of income and the change in quantity demanded of a product. The formulae for IED is:
IED = % change in quantity demanded
% change in income
A normal good is one, which increases in demand as income increases. In other words there is a positive relationship between income and quantity demanded.
As you can see from the diagram an increase in income leads to an increase in quantity demanded. Of course this depends on the type of good. Most normal goods will rise by the same percentage as any rise in income.
Luxury goods however are not the same. A marginal increase in income may lead to a greater rise in quantity demanded. This indicates an elastic response from a change in income.
As you can see from the diagram a small rise in income leads to a more than proportional increase in quantity demanded.
A firm could use this information to their advantage. For example the car manufacturer Ford could try to alter the perception of its products, making the consumer see it’s products as luxury goods would give them more appeal. This could be achieved through advertising and would mean that Ford could take advantage of higher demand at higher prices for the high-income consumer. During an economic boom there would be a substantial increase in demand as a result of this, however this may back fire on them if there was a recession, which would cause a massive decline in demand.
There are certain goods that can be highly inelastic. This would mean that there would have to be a large increase in income for demand to be affected at all. A good example of such good might be basic goods such as vegetables. These types of goods do not really have any attractiveness and will only very slowly increase in a boom time. However these goods would not be affected in a recession.
Inferior goods actually see a fall in demand as income rises. This could be a product with a bad reputation.
Elasticity in the business world as a very wide and diverse use if handled properly. Firms could gain much to their advantage with knowledge of elasticity’s and greatly maximise profits. On the other hand having no knowledge of elasticity’s may lead you to make bad decisions.
References:
Sloman,J.(200), Economics, 4th Edition, Prentice Hall, Chapter 2
