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Determinants of Elasticity of Demand

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❶Several Uses of Commodity: Microeconomic Theory 3rd ed.

Determinants of Elasticity of Demand

Such as, Wheat is required in daily life and hence its demand cannot be postponed. On the other hand, the items whose demand can be postponed is said to have elastic demand. Such as the demand for the furniture can be postponed until the time its prices fall.

The substitutes are the goods which can be used in place of one another. The goods which have close substitutes are said to have elastic demand. Such as, tea and coffee are close substitutes and if the price of tea increases, then people will switch to the coffee and demand for the tea will decrease significantly.

Whereas, if there are no close substitutes for a product, then its demand is said to be inelastic. Such as salt and sugar do not have their close substitutes and hence lower is their price elasticity. The elasticity of demand also depends on the complementary goods, the goods which are used jointly. Such as car and petrol, pen and ink, etc. Here the elasticity of demand of secondary supporting commodity depends on the elasticity of demand of the major commodity.

Such as, if the demand for pen is inelastic, then the demand for the ink will also be less elastic. The price range in which the commodities lie also affects the elasticity of demand. However, more production would mean more warehouses, more cold storages and even more transport vehicles. If this related infrastructure does not grow, producers may have to willfully cut down their production to avoid wastage. So, if the related infrastructure is easily scalable, then the supply of such a product will be highly elastic or else it will be inelastic.

Storage capacity is not the only issue. The supplier also needs to consider whether or not the goods that they hold are perishable or not. Perishable goods have a limited shelf life and the buyers know it. The buyers can wait for some time and producers will have to lower the prices or take the losses that arise from wastage.

The supply of perishable goods is therefore highly elastic since whatever has been produced has to be disposed off at the earliest. However, when it comes to non perishable goods it has been observed that the supply is usually inelastic since producers can hold on for as long as they have to. They are under no immediate compulsion to sell and hence the supply is inelastic. Length of Production Period: The law of supply assumes that changes in price will produce an immediate effect in the quantity supplied.

This may be theoretically correct. However, this is not possible in reality for many products. Production is a time and resource consuming process. Hence, it cannot be scaled up or down with that much ease. In many cases, the time required for production stretches to many months or even years. Hence, there is a lagging effect on supply. But if it is rapid, a small fall in price will cause only a very small increase in his purchases.

In the former case In the latter case The overriding factor in determining PED is the willingness and ability of consumers after a price change to postpone immediate consumption decisions concerning the good and to search for substitutes "wait and look".

On a graph with both a demand curve and a marginal revenue curve, demand will be elastic at all quantities where marginal revenue is positive.

Demand is unit elastic at the quantity where marginal revenue is zero. Demand is inelastic at every quantity where marginal revenue is negative. A firm considering a price change must know what effect the change in price will have on total revenue.

Revenue is simply the product of unit price times quantity:. Generally any change in price will have two effects: For inelastic goods, because of the inverse nature of the relationship between price and quantity demanded i. But in determining whether to increase or decrease prices, a firm needs to know what the net effect will be. Elasticity provides the answer: The percentage change in total revenue is approximately equal to the percentage change in quantity demanded plus the percentage change in price.

One change will be positive, the other negative. As a result, the relationship between PED and total revenue can be described for any good: Hence, as the accompanying diagram shows, total revenue is maximized at the combination of price and quantity demanded where the elasticity of demand is unitary. It is important to realize that price-elasticity of demand is not necessarily constant over all price ranges.

The linear demand curve in the accompanying diagram illustrates that changes in price also change the elasticity: PEDs, in combination with price elasticity of supply PES , can be used to assess where the incidence or "burden" of a per-unit tax is falling or to predict where it will fall if the tax is imposed. For example, when demand is perfectly inelastic , by definition consumers have no alternative to purchasing the good or service if the price increases, so the quantity demanded would remain constant.

Hence, suppliers can increase the price by the full amount of the tax, and the consumer would end up paying the entirety.

In the opposite case, when demand is perfectly elastic , by definition consumers have an infinite ability to switch to alternatives if the price increases, so they would stop buying the good or service in question completely—quantity demanded would fall to zero. As a result, firms cannot pass on any part of the tax by raising prices, so they would be forced to pay all of it themselves. In practice, demand is likely to be only relatively elastic or relatively inelastic, that is, somewhere between the extreme cases of perfect elasticity or inelasticity.

More generally, then, the higher the elasticity of demand compared to PES, the heavier the burden on producers; conversely, the more inelastic the demand compared to PES, the heavier the burden on consumers.

The general principle is that the party i. Among the most common applications of price elasticity is to determine prices that maximize revenue or profit. If one point elasticity is used to model demand changes over a finite range of prices, elasticity is implicitly assumed constant with respect to price over the finite price range.

The equation defining price elasticity for one product can be rewritten omitting secondary variables as a linear equation. Constant elasticities can predict optimal pricing only by computing point elasticities at several points, to determine the price at which point elasticity equals -1 or, for multiple products, the set of prices at which the point elasticity matrix is the negative identity matrix.

The fundamental equation for one product becomes. Excel models are available that compute constant elasticity, and use non-constant elasticity to estimate prices that optimize revenue or profit for one product [38] or several products. In most situations, revenue-maximizing prices are not profit-maximizing prices. For example, if variable costs per unit are nonzero which they almost always are , then a more complex computation of a similar kind yields prices that generate optimal profits.

In some situations, profit-maximizing prices are not an optimal strategy. For example, where scale economies are large as they often are , capturing market share may be the key to long-term dominance of a market, so maximizing revenue or profit may not be the optimal strategy. Various research methods are used to calculate price elasticities in real life, including analysis of historic sales data, both public and private, and use of present-day surveys of customers' preferences to build up test markets capable of modelling such changes.

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Definition: The Elasticity of Demand is a measure of sensitiveness of demand to the change in the price of the commodity. Determinants of Elasticity of Demand Apart from the price, there are sever Apart from price, there are several factors that influence the elasticity of demand.

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will use the cross elasticity of demand. One possible definition is: companies are in the same industry if the cross elasticity of demand is + or greater. This means that a 10% increase in the price of one product would cause the demand for the other product to rise by 10% or more.

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Price. The law of demand states that when prices rise, the quantity of demand falls. That also means that when prices drop, demand will grow. People base their purchasing decisions on price if all other things are equal. The exact quantity bought for each price level is described in the demand schedule. Whereas, if we were estimating the price elasticity of demand for all cars and time consumers have are the two critical determinants of price elasticity demand.

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• Determinants of Demand • How responsive is Demand to changes in price? in income? in prices of other goods? tastes? • Demographics and demand • Demand and Need SA Topic 2 Housing Demand, Supply and Price D = 1 unit elasticity If demand price is elastic. CHAPTER-4 Elasticity of Demand in any one of demand economist consider three important kinds of elasticity of demand like: (i) Price elasticity of demand The price elasticity of demand attempts to measure the relationship.