What Makes Demand Stretch or Snap?
The Core Determinants of Elasticity
Price Elasticity of Demand is calculated using the formula: $PED = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Price}$. But what makes this percentage high or low? Why do we eagerly stop buying one product when its price rises but barely change our habits for another? The answer lies in several key factors that act behind the scenes.
| Determinant | Effect on PED | Simple Example |
|---|---|---|
| Availability of Substitutes | More substitutes = More Elastic demand. If a close alternative exists, consumers can easily switch. | Butter vs. margarine. If butter's price doubles, many will buy margarine instead. |
| Proportion of Income | Larger share of income = More Elastic demand. A price change has a bigger impact on your budget. | Salt is very inelastic—it's cheap. A car is very elastic—it's expensive and a price cut can trigger many sales. |
| Necessity vs. Luxury | Necessities are Inelastic. Luxuries are Elastic. You can't easily give up needs, but you can postpone wants. | Insulin for a diabetic (inelastic) vs. a cruise vacation (elastic). |
| Habit & Addiction | Strong habit/addiction = Inelastic demand. Consumers are less sensitive to price changes. | Cigarettes for a smoker or your favorite brand of soda you buy every week. |
| Time Period | Longer time = More Elastic demand. People need time to find substitutes or adjust habits. | If gas prices spike, you still fill your tank today (inelastic). Over a year, you might buy an electric bike or move closer to work (elastic). |
A Closer Look at Each Factor
Let's dive deeper into each determinant with more detailed examples to see how they work in real life.
1. Substitutes: The Power of Choice
This is the most important factor. The more readily available and similar a substitute good is, the more elastic the demand will be. Think of brands within a product category. If the price of Brand A potato chips rises by 20%, and Brand B chips are right next to them on the shelf, most people will switch to Brand B. The demand for Brand A chips is therefore highly elastic. In contrast, if you need a specific medicine that has no generic equivalent, you will likely pay the higher price because there is no close substitute. Demand is inelastic.
2. Income Share: The Budget Impact Test
Goods that take up a large portion of a consumer's budget tend to have more elastic demand. Why? Because a price change forces a significant decision. If the price of a $30,000 car drops by 10% (saving $3,000), that's a big deal that might convince many new buyers. If the price of a $1 pencil drops by 10% (saving 10 cents), you probably won't buy ten times as many pencils. The demand for pencils is inelastic relative to price because it's a trivial part of your spending.
3. Necessity, Luxury, and Habit
These three are often intertwined. Necessities like basic food, water, and housing have inelastic demand. You need them to survive, so you'll pay what you must. Luxuries, like designer clothes or fancy restaurants, are elastic – if prices go up, you can simply do without.
Habit or brand loyalty can make demand for a luxury item more inelastic. For instance, a person might be willing to pay a high premium for their favorite brand of coffee every morning out of habit, even though cheaper coffee exists. Addictive goods like tobacco or certain drugs present an extreme case. Despite being non-essential and expensive, their demand is highly inelastic because addiction overrides price sensitivity. This is why governments often tax them heavily – they know consumption won't fall much, generating significant tax revenue.
4. The Role of Time: Short Run vs. Long Run
Time is a critical, often overlooked, determinant. In the short run, demand for many goods is inelastic because consumers and producers are "locked in" to their current behavior. If your home heating uses natural gas and the price doubles in a month, you can't immediately install solar panels or a new furnace. You'll pay the higher price. In the long run, you have time to adapt: you can insulate your home, switch to a different heat source, or move. Thus, long-run demand is almost always more elastic than short-run demand.
Consider gasoline. A price hike won't immediately change how much you drive to school or work. But over several years, it influences the cars people buy (more fuel-efficient or electric), where they live, and public transportation use. The long-run demand elasticity for gasoline is much higher than the short-run.
Case Study: The Smartphone Market
Let's apply all these determinants to a real-world example: smartphones. Imagine the price of the latest model from a major brand (like Apple's iPhone or Samsung's Galaxy) increases by 25%. How would demand react?
- Substitutes: Many close substitutes exist! Other Android phones, previous models, or different brands offer similar features. This makes demand for a specific model highly elastic.
- Income Share: A smartphone is a significant purchase for most people, often costing hundreds of dollars. This large budget share also contributes to elastic demand; a price increase will cause many to delay purchase or choose a cheaper option.
- Necessity vs. Luxury: While a basic phone might be a necessity for communication, a high-end smartphone with premium features is a luxury for many. This adds to its elasticity.
- Habit & Brand Loyalty: This factor works in the opposite direction! Strong brand loyalty and being accustomed to a specific operating system (iOS vs. Android) can make demand more inelastic. A loyal customer might grumble but still pay the higher price.
- Time Period: In the short run, a loyal customer might buy the expensive new phone anyway. In the long run, if prices keep rising, even loyal customers might reconsider their brand choice or switch to holding onto their old phone longer. Again, demand becomes more elastic over time.
The overall PED for a specific high-end smartphone is likely elastic ($PED > 1$), because the factors of substitutes, income share, and luxury status outweigh the habit factor for most consumers. This is why companies compete fiercely on features and marketing to build brand loyalty—they are trying to make demand for their product less elastic so they can have more control over pricing.
Important Questions
Q1: Can a good be both a necessity and have elastic demand?
Yes, but it depends on the definition. Water is a biological necessity, so demand for water itself is perfectly inelastic. However, demand for bottled water from a specific brand is highly elastic because tap water is a perfect and almost free substitute. The "necessity" characteristic applies to the broad category, while elasticity is determined at the specific product/brand level where substitutes exist.
Q2: How does understanding PED help a business set prices?
If a business sells a product with very inelastic demand (e.g., a unique medicine), it can raise prices significantly without losing many customers, increasing its total revenue. If it sells a product with very elastic demand (e.g., a common brand of cereal), raising prices would cause many customers to switch brands, drastically reducing sales. For elastic goods, businesses often compete on price or use sales/promotions to attract customers.
Q3: Why is the time factor so important for environmental policies, like a tax on gasoline?
Policymakers know that the short-run demand for gasoline is inelastic. A new gas tax will immediately generate substantial revenue and have only a small effect on driving habits, which might be unpopular. However, the long-run goal is to reduce consumption for environmental reasons. Over time, as demand becomes more elastic, the higher price will encourage people to switch to electric vehicles, use public transport, or live closer to work, thereby achieving the policy's environmental objective. The time factor explains why the full effect of such policies takes years to materialize.
Footnote
[1] PED (Price Elasticity of Demand): A measure of the responsiveness of the quantity demanded of a good to a change in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. If $PED > 1$, demand is elastic; if $PED < 1$, demand is inelastic; if $PED = 1$, demand is unit elastic.