Elasticity is a term that was initially developed by known economic scholar called Alfred Marshall, and has been since used in measuring the relationship that exists between product price and its quantity demanded. It typically followed the law of demand that states that the lower the price of goods and services, the higher the quantity that will be demanded of such goods and services i.e. it primarily explains only the actual directions of changes in the demand for the commodity, but not really explaining the extent of that change. A further development on these lapses led to the concept of elasticity of demands.
In practical term, elasticity means the act of responsiveness. Meanwhile, elasticity of demand has been theoretically defined as the responsiveness of the actual quantity demanded of a product to the change in its actual price. Elasticity of demand could be defined as the measure of the degree of responsiveness of the quantity demanded to any small change in its price.
Factors that Determine Elasticity of Demand
Below are the important factors that directly or indirectly influence the degree of demand to any small change in price:
- Nature of the commodity: Elasticity has been argued has primarily depending on if the actual commodity to be demanded is a basic necessity, a comfort or a luxury. This is because goods that fall under the basic necessities of life have been categorized as having inelastic demand, while those comforts and luxuries goods are categorized under the elastic demand.
- Availability of the substitutes of goods or services: Goods or services with available substitutes have been theoretically and practically argued and established as having elastic demand and those goods and services that are without available substitutes normally have inelastic demand. Good examples of these goods are coffee and tea that serve as substitutes to each other. They are substitutes because a change in the price of tea might make people to switch over to buying coffee. Alternatively, an increase in the price of coffee may also make people shift to buying tea. But a good example of inelastic good is salt because it has no substitute.
- Uses and/or applications of the goods or services: The usage of goods or services may affect its elasticity either elastic or inelastic. Good example is electricity, any decrease in its price will eventually led to consumers ability to make more use and further establishing electricity as having elastic demand curve.
- Consumers proportion of the income that is spent on the commodity: Practically we have noticed that the consumers can spend only a very small percentage of its income in buying such goods. Good example is salt and matches that normally take a very small percentage of consumers’ income, making them having inelastic demand curve.
- The prices of goods: Generally speaking, cheap goods and services normally have inelastic demand curve, while the expensive goods normally have elastic demand curve.
- Income of the consumers: Scholarly arguments have shown that the rich or high income earners normally have inelastic demand curves for their goods and services, while the poor or lower income earners normally have elastic demand curve. This is because he rich and high income earners will buy the goods and services at every levels of its prices, whereas the poor or lower income earners tends to change along the quantity of their consumptions due to changes in price.
- Time period: Evidence has shown that elasticity of demand would better occur in the long run production of the goods or services than at the short run. This is primarily because in the long run production and supply processes, the consumers could adjust to their individual demands by switching or trying cheaper substitutes. Industry evidence has shown that productions of the cheaper substitutes are only possible only at the long run operational processes.
- Income and Wealth Distribution in the society: The presence of unequal distributions of the national income would the demand for the goods and services to be relatively inelastic. Most advance countries that allow even distributions of their income and wealth will make possible elastic demand for its commodity.
Types of Elasticity of Demand
Below are the three types of elasticity:
1. Price Elasticity of Demand
Price elasticity of demand has been defined as the actual degree of responsiveness of the quantity that is demanded of a good or services in response to the changes in its actual price i.e. price elasticity of demand primarily measures how much of a change in actual price of any good that affects the demand for these goods or services, leaving all other factors to be constant. To calculate price elasticity, there is need to divide the proportionate of change in the quantity that is demanded by the proportion of change in the price.
Price Elasticity of Demand= % change in quantity demanded / % change in price
2. Income Elasticity of Demand
Income elasticity of demand has been argued as measuring how much of a change in consumers’ income that affects the demand for such goods or services if its price and all other factors remained constant. Below is the formula for calculating income elasticity of demand:
Income Elasticity of Demand= % change in quantity demanded / % change in Income
As divided into three, Zero income elasticity shows that a change in the consumers’ income will have no significant effect on the quantity that is demanded of such goods. Good examples are salts, matches and cigarettes. Next is negative income elasticity that shows that an increase in the incomes of consumers will lead to the decrease in the quantity that is demanded of such goods. This situation mostly occurs in inferior goods. Last is positive income elasticity that means an increase in the incomes of consumers will lead to the increase in quantity that is demanded of such goods.
3. Cross Elasticity of Demand
Cross elasticity of demand measures the actual change in the demand for commodity A due to the change in the price of commodity B.
Cross Elasticity of Demand = % change in the quantity that is demanded of commodity A / % change in the price of commodity B
The above formula indicates that if the goods or services that have substitutes and cross elasticity are positive i.e. as above any increase in price of commodity X will finally result in the increase in sales of commodity Y.
Importance Elasticity of Demand
As evident above, the concept of elasticity of demand has been playing a vital role in the decision making processes of the business world, especially as it relate to fixing commodity prices with the aim of making larger profits. Good example is if the cost of production tends to be increasing the company will want to pass this rising cost to the consumers through raising the price of the commodity. Practical examples have also shown that some companies do change their commodity price even without any visible change in the actual cost of their productions. But practically, whether the raising price is following any rise in the cost of production or otherwise has proved to be beneficial depends on the following situations:
- The actual price elasticity of the demand for such goods or services, i.e. the percentage change is subject to how high or low the proportionate changes in its actual demand relate to the percentage change in commodity price.
- The price elasticity of the demand is also very relevant for business in determining the value of their substitute, this is because when the commodity price increases the actual demand for the product substitutes also increases automatically even if the products prices generally remained unchanged.
Businessmen are also able to know that increasing the price of their goods would only be beneficial if:
- The demand for their products is less elastic
- The demand for their product’s substitutes is also much less elastic.
- Finally, the usefulness of elasticity of demand also stands in its ability established the required quantitative relationships that exist between the quantity demanded of a product and its price or any other determinants of demand.