Determinants of Price Elasticity of Demand

Determinants of Price Elasticity of Demand Definition

The definition of determinants of price elasticity of demand is a set of guidelines that help us understand why the price elasticity of demand behaves the way it does. The elasticity of a good measures how sensitive demand is to changes in the price of a good. The price elasticity of demand measures how much the demand for a good changes in response to the price of the good changing.

Since elasticity is a spectrum with elastic and inelastic on opposite ends, what determines the degree of price elasticity of demand? The four determinants of price elasticity of demand are:

• The availability of close substitutes
• Necessity versus luxury goods
• The definition of the market
• The time horizon

The state of these four determinants helps economists explain the shape of the demand curve for a certain good. Because demand is based on consumer preferences which are shaped by qualitative forces like human emotion, social constructs, and the economic state, it can be difficult to set any firm rules for the demand curve's elasticity.

By having these determinants as guidelines, we can use them to understand why particular circumstances produce a more elastic or inelastic demand curve. Each determinant of price elasticity of demand makes us consider a different perspective from the consumer regarding the choices they make when they are deciding whether or not to continue purchasing a good after the price increases or if they want to buy more if the price falls.

Factors Determining Price Elasticity of Demand

There are many factors determining the price elasticity of demand. The way a consumer's demand reacts to a change in price, be it a decrease or an increase, can be due to a wide range of circumstances.

• Income
• Personal tastes
• Price of complementary goods
• Versatility of the product
• Quality of the good
• Availability of substitute goods

The above-mentioned factors are just a few of the reasons why a consumer's demand curve is more or less elastic. If a person is on a tight budget then they will be more elastic to price changes since a small change could have a big impact on their budget. Some people are brand loyal and refuse to purchase a different brand even if the price rises astronomically. Maybe the price of a good rises but it is so versatile that it has more than one use for a consumer, such as a pickup truck. All of these factors mean something different to every consumer, but they all impact consumer spending patterns and determine their elasticity.

Fig. 1 - Inelastic Demand Curve

Figure 1 above shows an inelastic demand curve where a change in price has little effect on a consumer's demand. If this demand curve was perfectly inelastic it would be vertical.

Fig. 2 - Elastic Demand Curve

Figure 2 above shows us what an elastic demand curve would look like. A small price change has a significant effect on the quantity that is demanded of a good. This is what a consumer's demand curve looks like if they are sensitive to changes in price. If the demand was perfectly elastic, the curve would be horizontal.

Major Determinants of Price Elasticity of Demand

There are four major determinants of price elasticity of demand. Consumers determine what they will spend their income on by looking at which other goods are available to them, if they need the good or if it is a luxury, the type of good they are considering, and the time frame they are planning.

Determinants of Price Elasticity of Demand: Availability of Close Substitutes

The demand is typically more elastic if a good can be easily substituted for another. This means that people are likely to switch to buying a very similar good instead of continuing to buy the good whose price increased. A close substitute would be a BIC ballpoint pen versus a Papermate ballpoint pen. If both pens used to cost the same amount, but BIC decided to raise their price by $0.15, then people would not find it difficult to simply switch over. This would cause a large drop in demand for a relatively small increase in price.

However, if BIC is the only company to produce affordable ballpoint pens, and the next closest product on the market is a fine-tipped marker, then people would be more inelastic. Additionally, if the price of a close substitute fell or increased, people would be quick to switch over to the cheaper good.

The availability of close substitutes is the most important determinant of price elasticity of demand because as long as there are substitutes available, the consumer will gravitate toward the best deal. If one firm raises its price, it will more difficult to compete with other producers.

Determinants of Price Elasticity of Demand: Necessities versus Luxuries

A consumer's elasticity of demand depends on how much they need or want the good. Baby diapers are an example of a necessity and a good with inelastic demand. Diapers are necessary for child rearing; parents must purchase more or less the same amount for their children's health and comfort regardless of if the price rises or falls.

If the good is a luxury good, such as a Burberry or Canada Goose jacket, then people might choose to go with a more cost-effective brand such as Colombia if the luxury brands decide to price their jackets at $1,000, while Colombia uses similar quality materials but only charges $150. People will be more elastic to price fluctuations of luxury goods.

Determinants of Price Elasticity of Demand: Definition of the Market

The definition of the market refers to how broad or narrow the range of goods available is. Is it narrow, meaning the only goods in the market are trench coats? Or is the market broad so that it encompasses all jackets or even all forms of clothing?

If a market is defined as "clothing" then the consumer really has no substitutes to choose from. If the price of clothing goes up, people will still buy clothing, just different kinds or cheaper kinds, but they will still buy clothing, so the demand for clothing won't change much. Thus, the demand for clothing will be more price inelastic.

Now, if the market is defined as trench coats, the consumer has more options to choose from. If the price of a trench coat rises, people may either buy a cheaper trench coat or a different kind of coat, but they will have a choice, but in this case, the demand for trench coats could fall substantially. Thus, the demand for trench coats will be more price elastic.

Determinants of Price Elasticity of Demand: Time Horizon

The time horizon refers to the time in which the consumer must make their purchase. As time goes by, demand tends to become more elastic as consumers have time to react and make adjustments in their lives to account for price changes. For example, if someone relied on public transport for daily commuting, they will be inelastic about a change in the ticket fare over a short period. But, if the fare increases, commuters make other arrangements in the future. They may choose to drive instead, carpool with a friend, or ride their bike if those are options. They simply needed time to react to the change in price. In the short run, consumer demand is more inelastic but, if given time, it becomes more elastic.

Methods to Determine Price Elasticity of Demand

There are two main methods to determine the price elasticity of demand. They are called the point elasticity of demand and the midpoint method. The point elasticity of demand is useful for telling the elasticity of a specific point on the demand curve given that the initial price and quantity and the new price and quantity are known. This results in a different price elasticity at every point depending on the direction of the change since the percent change is calculated using a different base, depending on if the change is an increase or a decrease. The midpoint method takes the midpoint of the two values as the base when calculating the percent change in value. This method is more useful when there are large price changes and it gives us the same elasticity regardless of an increase or decrease in price.

Point Elasticity of Demand

To calculate the price elasticity of demand using the point elasticity of demand method, we need to know how much the price and quantity demanded of the good changed after the price changed.

The formula for point elasticity of demand is:

\[Price \ Elasticity \ of \ Demand=\frac {\frac{New\ Quantity - Old\ Quantity} { Old\ Quantity}} {\frac{{New\ Price - Old\ Price}} { Old\ Price}} \]

Generally, if the price elasticity of demand is less than 1 in magnitude, or absolute value, demand is deemed inelastic or demand is not very responsive to a change in price. If it is greater than 1 in magnitude, as is the case with our example below, demand is considered elastic, or sensitive to changes in price.

Midpoint Method of Price Elasticity Of Demand

The midpoint method of price elasticity of demand is used to calculate the average price elasticity. To use this method, we need two coordinates from the demand curve so that we can calculate their average to calculate the price elasticity of demand. The formula is:

\[Price \ Elasticity \ of \ Demand=\frac {\frac{Q_2 - Q_1} {\frac {Q_2+Q_1} {2}}} {\frac{P_2 - P_1} {\frac {P_2+P_1} {2}}}\]

This formula can be seen as rather complicated but all it is is calculating the percent change in value using the average of the two coordinates.

\(\frac {Q_2 - Q_1}{\frac {Q_2+Q_1} {2}}\) is the new value minus the old value divided by the average (midpoint) between the two points. It is the same principle for the percent change in price. Let's do an example.

Determinants of Price Elasticity of Demand Examples

Let's have a look at some determinants of price elasticity of demand examples. The first example will look at how the availability of close substitutes influences the price elasticity of demand. Say you wanted to buy a professional camera. Only two manufacturers produce professional cameras and they are very different from each other. One is only good for portraits and the other for scenery. They are not very good substitutes for each other. This means that you will still probably buy the camera you want regardless of its price since you do not have any other option. You are inelastic. Now, if many cameras had comparable performance you would be more selective and elastic to changes in price.

An example of elasticity for luxury goods versus necessities would be the demand for toothpaste. A regular tube will cost about $4 to $5. It cleans your teeth, preventing cavities, bad breath, and painful dental work in the future. You will not be very elastic to a change in price for a good that is part of your daily routine and keeps your body healthy. On the other hand, if you buy designer clothes for $500 per pair of slacks, then you will be more elastic to a change in price because it is not a good that you need because you can buy cheaper pants and they will perform the same.

In a narrowly defined market, like ice cream, demand is more elastic because there are close substitutes available. You can choose from hundreds of brands of ice cream. If the market is broadly defined, demand will be inelastic. For example, food. Humans need food and there is no other substitute for food, making it inelastic.

Lastly, elasticity depends on the time horizon. In the short run, people are going to be more inelastic because changes in spending cannot always happen from one day to the next but given time to plan, people can be more flexible. Gasoline-powered cars are the majority of cars on the road, so people are inelastic to fluctuations in the price of gasoline. However, seeing the rising prices in the long run, people may buy more electric vehicles, and the consumption of gasoline will fall. So if given time, the consumer's demand is more elastic.