With the use of diagrams, there are two extreme cases of elasticities in addition to the three types discussed. These are perfectly price elastic demand and perfectly price inelastic demand and are the only cases in which by looking at the gradient of the demand curve, it is sufficient enough to identify the price elasticity of demand throughout the curve. It is easy to point out these two extreme elasticities, a perfectly price elastic demand is represented on a graph as a horizontal linear line and perfectly price inelastic demand as a vertical linear line.
In the situation of a perfectly elastic demand, any change in price will result in the quantity demanded fall to zero and price elasticity coefficient would be infinite (tutor2u, 2006). Consumers will demand an unlimited quantity at a particular price thus making it extremely difficult for any market to fulfill these conditions, so this case is considered to be theoretical. Yet some individual sellers may experience perfectly elastic demand in certain conditions. The perfectly elastic demand curve is more associated with the perfectly competitive market, where no single seller would be able to influence the market price. If the seller decides to charge a higher price, then they would lose all their customers due to other sellers offering homogenous goods. Furthermore, the seller would not charge below the market price, as they would be making a loss in the short term and that they have the option to sell at the ongoing market price and generate the highest revenue possible. As a result, the demand curve in the view of the individual sellers will be perfectly elastic at the current market price.
Perfectly inelastic demand occurs when the percentage change in price, regardless of the size of change makes no difference to quantity demanded and the value of the elasticity will always equal to zero (tutor2u, 2006). On this occasion, consumers are prepared to pay any price to acquire a good and this again will be extremely difficult for any market to fulfill these conditions. Perfectly inelastic demand can however apply to a minority of goods. For instance, if a country suffers from a famine due to crop failure and an increase in the population, an individual would be prepared to pay any price to obtain some food. Therefore, it is debatable whether the government should regulate markets that are vulnerable to such catastrophic events and the exploitation of consumers.
Sloman et al (2004) explains that there are a variety of factors that can affect the price elasticity of demand, but there are only two factors that can be singled out and that is the availability of substitutes and time. If a good is widely available and has many close substitutes such as bread, will have a highly elastic demand. If the price of a particular brand of bread increases the demand for that good will decrease more than proportionately. This is because consumers can easily switch to another brand that they perceive to be of the same quality. If the good has little or no close substitutes available, such as petrol will have an inelastic demand and people will still buy close to a certain quantity regardless of price changes, so there will be little impact on the reduction in demand.
Anderton (2006) explains that demand tends to be more price elastic in the long run rather than the short run. An initial increase in price of a particular product may not at first respond substantially as it takes time for consumers to both notice and adjust to the price fluctuations. For instance, after the two global oil price shocks in the 1970’s where the price quadrupled, the reaction to the increase in oil prices was moderate. The demand for the commodity in the short run was price inelastic because people still needed to travel to work in their vehicles and heat their homes whilst industries still needed to operate. Oil had very little cost-effective substitutes at the time. As time passed, consumers had the opportunity to find alternatives and ways to reduce the consumption of fuel, thus making demand more responsive.
The price elasticity of demand is a crucial concept for all businesses to understand because it has implications for setting prices as it affects the firm’s sales revenue. If demand were relatively inelastic, the firm would be in a position to charge higher prices for a commodity. Consequently, a rise in prices would increase total revenue, as the decrease in quantity sold would be less than proportionate to the change in price. Nevertheless, if demand were relatively elastic, a reduction in a price of the good would lead to a more than proportionate change in quantity of sales, thereby leading to an raise total revenue. In competitive markets where there are similar goods and a number of substitutes, the organization must consider pricing as a competitive strategy. This is because as discussed, the price elasticity in such conditions will be mainly price elastic and the slightest change in price will affect sales volume by a greater amount. The business must be fully aware of the factors that affect the price elasticity of demand, as it will influence the yield of the organization.
The concept of price elasticity of demand is of significant importance in formatting tax policies of the government. Before the finance minister levies a tax on a particular good, he must consider whether the demand is relatively elastic or relatively inelastic. If the good is said to be relatively price elastic, a tax imposed will see consumers reduce their spending of the particular good the more the price increases from tax increases and consequently, total revenue will be reduced. Therefore, the government should not look at imposing taxes on elastic goods because they may not be able to accumulate sufficient taxes compared to imposing taxes on inelastic goods. This connection explains why the government normally charges indirect taxes such as the excise duties on alcohol, tobacco and petrol, all of which have a relatively inelastic demand.
The concept is also of use when setting prices for the goods and services they provide for the public such as the National Rail or transport tolls. During peak times, the price elasticity of demand will be inelastic and during off-peak times, the price elasticity of demand will be elastic. As a monopolistic supplier, they can adapt the price discrimination strategy where they charge different prices for the same product to different segments of the market. For example, they can charge higher prices in peak times and low prices in off-peak times, thus maximizing total revenue. If the market in question is monopolistic in nature, the same notion applies and the government is able to intervene and may propose a liberalization of the markets and closely regulate the prices to protect consumers from price fixing and exploitation. This in turn will make the intervened market more price competitive making demand relatively elastic.
The subject of economics is classed as a social science and studies how individuals and groups make decisions to satisfy their wants and needs with the limited resources. In reality, consumers hold all the power in the decision-making and can purchase anything they desire. However, the price mechanism is a system where market forces of demand and supply set prices and the decisions made by producers and consumers. The price elasticity of demand broadens this concept by measuring responsiveness or sensitivity of the demand. This is important to businesses as they seek to maximize profits and the use of price elasticity of demand will determine the best pricing policy to use to achieve the objective. It is also important to government, as they need to determine the correct prices for their own goods and services offered as well as regulating the taxes levied on private goods and services.
Bibliography
Sloman, J., Hinde, K. and Garratt, D. (2004) ‘Essentials of Economics’, Chapter 2.1 – Price Elasticity of Demand, 2nd Edition, Harlow: Pearson Education Ltd, p54-57
Begg, D. (2006) ‘Foundations of Economics’, Chapter 2-3 – Measuring Demand Responses, 3rd Edition, Berkshire: McGraw-Hill Education,
P32-38
Anderton, A. (2006) ‘Economics’, Price Elasticity of Demand, 4th Edition, Harlow: Pearson Education Ltd, p55-61
McAleese, D. (2011) ‘Economics for Business: Competition, Macro-stability and Globalisation’, Chapters 4.3, 4.4 and 4.5, 3rd Edition, Harlow: Pearson Education Ltd, p75-89
Grant, S., Vilder, C. and Smith, C. (2005) ‘Heinemann Economics A2 for AQA’, Chapter 5.7 – Competitive Markets, Oxford: Hardlines Ltd, p79-81
Riley, G. (2006) ‘AS Markets & Market Systems’, Price Elasticity of Demand, Eton College, Available: http://tutor2u.net/economics/revision-notes/as-markets-price-elasticity-of-demand.html [Accessed 20 November 2011]