The law of demand explains only the direction of change in quantity demanded, not how much the quantity demanded changes as a result of price changes. In different cases, the quantity demanded reacts differently to changes in the commodity’s price. The study of price elasticity of demand is centred on this topic.
What is the elasticity of demand?
Many factors influence the demand for a commodity, including its price, the price of related goods, the buyer’s income, tastes and preferences, and so on. The term ‘elasticity’ refers to the degree of response. Demand elasticity refers to how responsive demand is. Changes in price, the price of related goods, income, and other factors all influence demand for a commodity.
Price elasticity of demand
The concept of price elasticity of demand describes how a change in price affects the quantity demanded. Because of the law of demand, it is calculated as the percentage change in quantity demanded divided by the percentage change in price.
Price Elasticity of Demand (PED) = % change in quantity demanded / % change in price
The greater the price elasticity of demand, the more responsive is the quantity demanded to price changes. The good is said to have elastic demand if the price elasticity of demand is greater than one. Demand is perfectly elastic when the quantity demanded falls to zero as the price rises. When the price of an elastic good rises, there is a quantity effect, in which fewer units are sold, lowering revenue.
The lower the demand elasticity, the less responsive the quantity demanded is to price changes. The good is said to have inelastic demand if the price elasticity of demand is less than one. Demand is described as perfectly inelastic when the quantity demanded does not respond to a change in price. Increased revenues will result from raising the price of an inelastic good because each unit will be sold at a higher price.
When a change in price is accompanied by a proportional change in the quantity demanded, the good is said to be unit elastic. This indicates that if the price changes by X percent, the quantity demanded changes by X percent. As a result, if the demand price elasticity equals one, the good is unit elastic. When a good has a unit elastic demand, the quantity and price effects cancel each other out.
Factors affecting price elasticity of demand
- Total number of substitutes
If a product has several substitutes or brands, the elasticity of demand for that product will be high because consumers will switch from one brand to another based on price changes. Chocolates, for example, are an excellent example of substitutes. Chocolates are available in a variety of brands for consumers to choose from.
- Product price in relation to earnings
When a person spends a small percentage of their available income on a good, their price elasticity of demand is low. As a result, a change in the price of a good has very little impact on the consumer’s willingness to buy it. When a good accounts for a significant portion of a consumer’s income, the consumer is said to have a more elastic demand.
- Substitution costs
In some cases, switching from one brand to another can have a significant impact. For example, if a cable service has a deposit lock-in period, an existing customer cannot switch to another service, even if it is cheaper, without losing the deposit. As a result, demand is inelastic.
- Loyalty to a brand
Consumers can be devoted to a particular brand. In such cases, a change in the product’s price has no impact on the demand for that product. As a result of brand loyalty, demand is inelastic.
The amount of time that has passed since a price change.
Consumers are more elastic over longer periods of time because they will find acceptable and less expensive substitutes after a price increase of a good.
Relationship between total expenditure and the price elasticity of demand
The price of a good and the quantity of that good that is demanded are inversely proportional. As a result, the change in expenditure is determined by the responsiveness of demand to price changes, or price elasticity of demand. The following scenarios are possible:
Elasticity is less than one (ed < 1): When a commodity’s demand is less than unit elastic, a decrease in price causes a decrease in total expenditure, while an increase in price causes a rise in total expenditure. (The price of the commodity moves in the same direction as the total expenditure.)
The elasticity is more than one (ed >1): When demand for a commodity is more than unit elastic, a decrease in price leads to an increase in total expenditure, while a decrease in price leads to a decrease in total expenditure on the commodity. The price of the commodity moves in the opposite direction of total expenditure.
The elasticity is one (ed = 1): When a commodity’s demand is unit elastic, the total amount spent on the commodity does not change in response to price changes.
The degree to which demand for a commodity responds to price changes is known as price elasticity of demand. The availability of close substitutes, the nature of the commodity, its share in total expenditure, the level of price, the level of income, and other factors all influence the price elasticity of demand for a commodity.