Introduction
People purchase goods and services according to their abilities and needs. Given the scarcity of resources, consumers are usually compelled to make choices not only on the type of commodities to buy, but also on the quantity of the commodities to purchase. The general law of demand states that consumers are likely to reduce their quantities of consumption in case prices increase.
Nevertheless, the law is not specific in explaining whether quantity demanded will be reduced by a higher or a lower margin in response to increase in price. Moreover, there are other factors that affect demand besides price. This problem is solved by the concept of elasticity of demand.
Elasticity of demand informs people on the direction of change in demand resulting from not only a change in other factors, but also the magnitude of the change.
Price Elasticity of Demand
Sensitivity of demand to changes in price varies from one commodity to another and it is measured by price elasticity of demand. In this regard, price elasticity of demand is defined as the percentage change in demand for a given commodity due to unit change in price of the commodity (Taylor, 2006).
Demand of most goods decreases when prices increase because they become relatively expensive. However, for goods which people buy because they belong to a certain class, increase in prices usually leads to increase in demand.
Demand of a given commodity can either be inelastic, elastic or unitary elastic as far as price elasticity of demand is concerned. Inelastic demand is when a huge change in price causes small changes in demand. This type of demand is usually exhibited by those commodities that consumers cannot do without, for example food.
In case of increase in price of these commodities, consumers reduce consumption of other unnecessary commodities to sustain consumption of necessities. On the other hand, elastic demand refers to a situation where demand of a commodity changes by a larger percentage than the percentage change in price (Mankiw, 2011).
Commodities that people can do without exhibit elastic demand because people will reduce quantities purchased or even stop buying the commodity immediately the price increases. Lastly, the demand can be unitary elastic. This means that percentage change in demand is equal to percentage change in price.
Cross elasticity of Demand
Demand of one commodity is usually dependent on the price of other commodities. In this regard, if price of one commodity rises, quantity demanded of another commodity can increase or decrease depending on whether the commodities in question are substitutes or complements.
Cross elasticity of demand is the measure of how dependent demand of a given commodity is on price of another commodity. Cross elasticity of demand can either be positive or negative depending on whether the goods are substitutes or compliments (Mankiw, 2011).
Complimentary goods must be used together thus decrease in price of one commodity automatically affects demand of the other commodity. Cross elasticity of demand of these commodities is negative. This is because when price of one commodity increases, it leads to a decrease in the quantity demanded of the commodity thus decreasing the quantity demanded of the complementary commodity.
On the other hand, cross elasticity of demand for substitutes is usually greater than zero. An example of substitute commodities is tea and coffee. If the price of tea increases, people will reduce the quantity of tea they take and instead increase the quantity of coffee they consume (Landsburg, 2010).
Nevertheless, whether the magnitude of the elasticity will be more than or less than one depends on whether the commodities are perfect substitutes or not.
Income Elasticity of Demand
Consumers can only purchase the quantities that their disposable income can afford. As a result, income levels are highly influential when dealing with changes in demand for any given commodity. Income elasticity of demand refers to the percentage change in quantity demanded of a commodity arising from change in income levels of people, assuming that other factors are held constant.
On the same note, it is important to note that different groups of commodities respond differently to changes in income. In this regard, taking into consideration whether a given commodity is an inferior or a normal good, income elasticity of demand can either be positive or negative (Taylor, 2006).
As far as inferior goods are concerned, demand decreases as income increases. This is so because people buy luxurious commodities according to their economic and social status. Therefore, people usually change their demand of luxurious commodities as often as their income changes. Moreover, there are very many substitutes to inferior goods that a consumer may take in case of any change.
On the other hand, demand of normal goods increase with the increase in the levels of income. In addition, people really do not have much of a choice on whether they will consume normal goods or not. Consequently, income elasticity of demand is positive for normal goods. However, for normal goods which are necessities, the income elasticity of demand is positive but less than one (Landsburg, 2010).
Effects of Substitutes on Elasticity
Consumers have perfect information concerning the products they want to consume. Moreover, consumers take into consideration all the available opportunities before making any decision. Furthermore, if a commodity becomes more costly either due to increase in price or decrease in income, consumers will compare what they will spend on substitute commodities and choose a cheaper option (Taylor, 2006).
Let us take an example of coffee and tea. These two commodities serve exactly the same purpose all other factors held constant. If the price of coffee increases making it more expensive compared to tea, consumers will reduce their consumption of coffee.
Assuming consumers had no other commodity to use in place of coffee; they would slightly reduce the quantity of coffee consumed but still adjust their budgets to accommodate the changes.
However, since they can still take tea without being affected in any way, consumers will quickly replace coffee with tea in their budgets thus highly reducing the quantity of coffee demanded. Consequently, since substitutes increase the options that consumers have when price and/or income changes, they increase elasticity of demand.
Proportion of income Devoted to Goods and Elasticity
It should be noted that elasticity of demand is also dependent on the proportion of income that people spend on a given commodity. Demand of goods which consume higher percentages of income is usually elastic (Mankiw, 2011). Demand of salt will be less elastic compared to that of computers for any typical consumer given that salt consumes a very low proportion of the budget.
Assume the income of a consumer is $1000 per month and the price of sugar is $3 per kilogram while that of a refrigerator is $300. Assume also that prices of both commodities increase by 25%. The new price of sugar will be $3.75 per kilogram while that of refrigerator will become $375.
It can be seen that price of refrigerator increases significantly by $75 compared to that of sugar which increases by only $0.75. In this regard, equal percentage increase in price of two commodities causes different effects on the budget depending on the proportion of income spent on the commodity. Consequently, demand of refrigerator will be more elastic compared to that of sugar.
Customer’s Reaction to Huge Increases in Price
As a rule of thumb, consumers will always react to increases in price by reducing their demand. However, in the short run people do not have very many options. Some are very busy and cannot get time to go around and see if there are other substitutes.
Therefore, there are some other people who will be compelled not to alter their demand in the short run despite increases in price. However, in the long run, people will have had enough time to look for substitutes and also adjust their budgets. As a result, demand will reduce further. Therefore, demand is highly elastic in the long run compared to the short run (Taylor, 2006).
Elasticity and Total Revenue
From the graph, demand is elastic when prices are between 50 and 80. Here, an increase in prices will cause more than proportionate decrease in quantity demanded thus causing reduction in total revenue. When the price is between 40 and 50 units, the elasticity of demand is equal to one.
As a result, percentage change in price causes equal but opposite percentage change in quantity of goods demanded. Consequently, increase in price will leave total revenue unchanged. On the other hand, when price ranges between 0 and 40 units, a demand is inelastic. In this scenario, any increase in price causes less than proportionate decrease in quantity demanded leading to increased total revenue (Landsburg, 2010).
References
Landsburg, S. (2010). Price Theory & Applications. Stanford: Cengage Learning.
Mankiw, N. G. (2011). Principles of Economics. Stanford: Cengage Learning.
Taylor, J. (2006). Principles of Macroeconomics. Stanford: Cengage learning.