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The Determinants of Price Elasticity of Demand

Price Elasticity of Demand

Price elasticity of demand is an economic concept that describes how responsive the quantity demanded of a good or service is to changes in the price of that good or service.  If we know what the demand curve for a good or service looks like (or part thereof), we can use a mathematical formula to get a specific value for price elasticity of demand.  In some cases, however, this is not logistically feasible, so it's helpful to have some general rules of thumb about price elasticity of demand to fall back on.

 Let's examine some of these rules.

Necessities Versus Luxuries

In general, demand for goods that are considered luxuries tends to be more elastic than demand for goods that are considered necessities.  This makes intuitive sense mainly because, if a good is a necessity, an individual doesn't really have the option of a large decrease in quantity demanded when the price of the good increases, even if the price increase is large.  On the other hand, if a good is a luxury, an individual can more easily do without the good and therefore has more flexibility to change her purchasing habits in response to a price change.

For example, crucial medications would likely count as necessities whereas lifestyle medications fit more into the category of luxuries, so we can expect the crucial medications to have lower elasticity of demand (or, equivalently, are more inelastic) than the lifestyle medications.

Availability of Close Substitutes

The availability of close substitutes for a good affects the price elasticity of demand for that good.  If a good has more close substitutes available, consumers have more flexibility to switch among products without losing much utility from consumption.  Therefore, goods with more close substitutes tend to have higher elasticity of demand (i.e. are more elastic) than goods for which there are few close substitutes available.

For example, the demand for orange juice is likely more elastic (i.e. less inelastic) than the demand for milk, since there are a number of close substitutes for orange juice- grapefruit juice, apple juice, and so on- whereas there aren't as many obviously good substitutes for milk.

Specificity of a Good

Price elasticity of demand also depends on how specifically a good is defined.  In general, the more broadly a good is defined, the lower the price elasticity of demand.  This observation is actually closely related to the previous point- when a good is defined more broadly, there are fewer close substitutes for the good, whereas a narrowly defined good tends to have more close substitutes.

For example, when considering the elasticity of a narrowly defined good such as a Ford Focus versus a more broadly defined good such as a car, it is most likely the case that the demand for the Ford Focus will be more elastic than the demand for cars overall.

 This is due to the fact that it's relatively easy to switch consumption from a Ford Focus to another type of similar car than it is to switch away from consuming a car entirely.

Share of Budget

Price elasticity of demand depends to some degree on the share of a consumer's budget that the good represents.  Specifically, consumers tend to behave more elastically (i.e. have higher price elasticity of demand) regarding items that comprise a large share of their budget than they do when considering goods that comprise a smaller share of their budget.  It might seem like this is equivalent to saying that consumers behave more elastically when considering goods with higher prices, but this need not be the case.

For example, a consumer's price elasticity of demand for truffle oil is likely lower than a consumer's demand for olive oil- even though the truffle oil is generally sold at a higher price point, consumers don't use as much truffle oil as they do olive oil, so it likely comprises a smaller share of the consumer's budget.  Similarly, a parent's price elasticity of demand for diapers is likely pretty high since, even though each individual diaper or package of diapers don't have a high price tag, parents consume so many of them that the can end up comprising a fairly large share of the parent's budget.

Lastly, the price elasticity of demand for an item is affected by the time horizon over which demand is calculated.  Because consumers generally have more flexibility over longer time horizons, it stands to reason that elasticity tends to be larger over longer time horizons than over shorter time horizons.

For example, a consumer's demand for gasoline over the next month is likely more inelastic (i.e.

less elastic) than the consumer's demand for gasoline over the next year simply because, in the short term, the consumer is stuck using a particular car, having a particular job, living in a particular place, and so on, whereas over longer time horizons the consumer has more ability to change her consumption patterns (by buying a different car, moving closer to work, etc.) in order to avoid consuming as much gasoline when the price increases.

It's important to note that these rules are all written in terms of relative elasticity and inelasticity- in other words, they don't allow us to determine whether a good is elastic or inelastic in an absolute sense, just where pairs of goods fall relative to one another.  For example, even when two goods are both inelastic in an absolute sense (i.e. have price elasticity of demand less than 1 in magnitude), one can still be more inelastic than the other (i.e.

have an elasticity closer to zero in magnitude).

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