Elasticity

Concept

This is the responsiveness of demand for a product to changes in one of the factors that influence demand. In other words, it measures the change in demand following a change in another variable (such as the price of the product, peoples' incomes, or the advertising of the product).

Price Elasticity of Demand

This is the responsiveness of demand for a product to a change in the price of the product itself (i.e. when the price of the product changes, by how much does demand change?).

Diagram 1 represents a product which has an inelastic demand:

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At a price of P1, quantity Q1 is demanded. An increase in price to P2 results in only a small fall in the quantity demanded to Q2. In other words, the percentage change in quantity demanded is far less than the percentage change in price that brought it about. Products with an inelastic demand curve include fast-moving consumer goods (f.m.c.g) such as bread and milk, and habit-forming goods such as alcohol and tobacco.

Diagram 2 represents a product which has an elastic demand:

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At a price of P1, quantity demanded is Q1. An increase in price to P2 results in a large fall in the quantity demanded to Q2. In other words, the percentage change in quantity demanded is far greater than the percentage change in price that brought it about. Products with an elastic demand curve include luxury goods such as holidays, cars, dishwashers and televisions.

Diagram 3 represents a product which has a perfectly inelastic demand:

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This shows that demand is completely unresponsive to changes in price. In other words, regardless of the change in price, the quantity demanded would stay at Q1.

Diagram 4 represents a product which has a perfectly elastic demand:

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In this case, there is only a demand for the good at the price P1. At any other price, there would be no demand at all. In other words, demand is completely unresponsive to changes in price.

Both diagrams 3 and 4 are theoretical extremes and there are no realistic examples.

The formula for calculating price elasticity of demand:

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Example 1. If the price of product A rises from £ 8 per unit to £ 10 per unit, and the quantity demanded falls from 100 units to 50 units, then the price elasticity of demand for product A is:

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= 2

Example 2. If the price of product B falls from £ 10 per unit to £ 9 per unit, and the quantity demanded rises from 80 units to 84 units, then the price elasticity of demand for product B is:

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= 0.5

  • An answer of zero indicates that demand for the product is perfectly inelastic (see diagram 3).
  • An answer of between zero and one indicates that demand for the product is inelastic (see diagram 1).
  • An answer of one indicates that the demand for the product is unitary elastic.
  • An answer of greater than one but less than infinity indicates that the demand for the product is elastic (see diagram 2).
  • An answer of infinity indicates that the demand for the product is perfectly elastic (see diagram 4).
Income Elasticity of Demand

This is the responsiveness of demand for a product to a change in peoples' incomes (i.e. if a person's income changes, by how much does his / her demand for the product change?).

If an increase in income leads to an increase in demand for the product, then the product is a normal product. If an increase in income leads to a fall in demand for the product, then the product is an inferior product, (e.g. supermarket own-branded products, where an increase in income will often lead to an individual buying less of an own-brand product, and more of an expensive brand).

The formula for calculating income elasticity of demand:

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Example 1. If a person's income rises from £ 200 per week to £ 250 per week, and his demand for product C rises from 10 units to 14 units, then the income elasticity of demand for product C is:

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= 1.6

Example 2. If a person's income falls from £ 400 per week to £ 360 per week, and her demand for product D rises from 100 to 105 units, then the income elasticity of demand for product D is:

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= -0.5

  • A positive answer indicates that the product is a normal product. A high positive answer would suggest that the product is a luxury product.
  • A negative answer indicates that the product is an inferior product. The larger the negative value, the more inferior it is.
  • An answer of zero indicates that changes in income have no effect on the demand for the product (i.e. the product is completely income inelastic).
Advertising Elasticity of Demand

This is the responsiveness of demand for a product to a change in the advertising expenditure used to promote it (i.e. if a business spends more money on the advertising of a product, by how much does the demand for the product change?).

The formula for calculating advertising elasticity of demand:

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Example 1. If a business increased its advertising expenditure on product E from £ 1 million per year to £ 1.2 million per year, and the demand for product E rises from 10 million units to 14 million units, then the advertising elasticity of demand for product E is:

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= +2

Example 2. If a business reduced its advertising expenditure on product F from £ 2 million per year to £ 1.8 million per year, and the demand for product F rises from 1 million units to 1.1 million units, then the advertising elasticity of demand for product F is:

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= - 1

  • A positive answer indicates that the advertising campaign is effective, since either an increase in advertising expenditure leads to a rise in demand for the product, or a decrease in advertising expenditure leads to a fall in demand for the product.
  • A negative answer indicates that the advertising campaign is ineffective, since either an increase in advertising expenditure leads to a fall in demand for the product, or a decrease in advertising expenditure leads to a rise in demand for the product.

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