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Look at These Prices!

What Determines Elasticity?

Either consciously or subconsciously, the issue of elasticity surfaces for consumers and producers in many everyday, real-world situations. Let's examine some of these situations and the main factors that determine the degree of elasticity of demand. These factors are:

  • Availability of substitutes
  • Short-run versus long-run
  • Percentage of income spent on the product

Availability of Substitutes

Overall demand for gasoline—at least in the United States—is generally considered relatively inelastic. Americans own cars and trucks, and the country is large and laced with highways. Americans need gasoline because there are few substitutes for it. In fact, the only real substitutes are public transportation, which is not always available, and the electric car, which is still a relatively new technology.

However, any individual consumer's demand for gasoline can be elastic or inelastic, depending on their access to a substitute. Suppose the price of gasoline were to double over the next two months. If you commute from a suburb into New York City or another city with good public transportation, you could start taking the bus or train to work and dramatically reduce your demand for gasoline. Your demand for gasoline is relatively elastic.

On the other hand, if you commute from your home in one suburb to an office campus in a distant suburb, your transportation options may be quite limited. You need gasoline, and therefore your demand for it is relatively inelastic.

If there are few substitutes for a product, the demand for it is relatively inelastic. That means that the price can change, but the quantity demanded doesn't change very much in response.

Short-Run Versus Long-Run

The long-run and a short-run demand for many goods and services can differ substantially, and that affects elasticity.

In our gasoline example, a driver whose demand for gas is inelastic in the short-run may have elastic demand in the long run. She may find a job or start a business closer to home, or start a home-based business. She might buy a more fuel efficient car, or—in an instance of substitution—buy an electric car when her vehicle needs replacement.

For most products and services, long-run demand is far more elastic than short-run demand. As a fossil fuel with a finite supply, gasoline itself will be unavailable in the long run. Over the long run, people can make any of a number of adjustments that will alter their demand for a good.

In the short run, however, inelasticity tends to prevail, relative to the long run.

Percentage of Income

EconoTip

If you produce or sell anything, or work for an outfit that does, you should have some idea of the elasticity of demand for your product or service. When the economy takes a downturn and people cut back their spending, can they cut back on your product or service? If you work for a hospital or a liquor store, you have little to worry about. People who need medical services or a drink aren't worried about what it costs—their demand is relatively inelastic.

On the other hand, if you work in a travel agency or fine restaurant, you may want to keep a Plan B handy. In general, inessentials or highly discretionary expenses have a higher elasticity of demand. If people can do without something, when times get tough they will.

The higher the percentage of income that a product or service consumes, the higher the elasticity. The lower the percentage of income, the lower the elasticity. For example, if the price of Tic Tacs goes up by 10 percent I doubt that many consumers of the mints would alter their demand for them. It's partly because the percentage increase would occur on a small base price relative to other common purchases, such as food, clothing, and gasoline. But it's also because the money spent on mints is a tiny percentage of most people's incomes.

Demand for items purchased with a small percentage of people's incomes is fairly inelastic. Price changes don't have a big effect on the quantity demanded. By that same token, cutting the price would probably do little to stimulate demand.

Things that people spend a higher percentage of their incomes on, such as cars, have higher elasticity of demand. People will consistently seek out the best deal on a new car or buy a used car because the price represents a relatively high percentage of most people's incomes. Some people never buy a new car, only used ones. Meanwhile, few people are shopping for the best deal on Tic Tacs (or are willing to accept used ones).

Elasticity is worth knowing about because, first, it explains a lot of consumer behavior and, second, it lays the groundwork for understanding other aspects of consumer purchase decisions.

book cover

Excerpted from The Complete Idiot's Guide to Economics © 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

To order this book direct from the publisher, visit the Penguin USA website or call 1-800-253-6476. You can also purchase this book at Amazon.com and Barnes & Noble.


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