Demand elasticity measures how demand for goods or services changes relative to changes in other variables. Many factors determine the demand elasticity for a good or service, such as the price level, the type of good or service, the availability of a substitute, and consumer income.
Key Takeaways
- Factors that determine the demand elasticity for a product include price levels, the type of product or service, income levels, and the availability of substitutes.
- Luxury items are highly elastic.
- Goods with many available alternates are elastic because, as the price of the good rises, consumers shift to substitute items.
- As consumer incomes increase, demand for products increases.
Price Levels
The price level of an item affects the demand for a good or service. A good or service may be categorized as a luxury item or a necessity to a consumer. When a good or service is a luxury good, the demand is highly price-elastic compared to a necessary good. Essential goods, such as food, are generally price-inelastic because consumers continue to buy food even if the price changes.
The price elasticity of demand is calculated by dividing the percent change in the quantity demanded of a good or service by the percent change in its price level.
PEd=%ChangeinPrice%ChangeinQty
Luxury goods have a high price elasticity of demand because they are sensitive to price changes.
Substitutes
The availability of alternatives or substitute goods can affect demand elasticity. Hence, the demand for goods or services with many substitutes is highly price elastic. An increase in the price levels of goods causes consumers to buy substitutes. The demand for soda or wash detergent is highly price-elastic because of the number of substitutes. If the price rises, consumers can opt to buy the cheaper substitute.
The demand elasticity of goods with close substitutes is measured by dividing the percent change of the quantity demanded of one product by the percent change in the price of a substitute product. This formula is also known as the cross elasticity of demand.
Ec=Q1B+Q2BP1A+P2A⋅ΔPAΔQB
Income
Consumer income plays a role in the demand elasticity of goods and services. The income elasticity of demand is used to measure the sensitivity of a change in the quantity demanded relative to a change in consumers' incomes. Different types of goods are affected by income levels.
Inferior goods, such as generic products, have a negative income elasticity of demand because the quantity demanded for generic products tends to fall as consumers' incomes increase.
When Is a Good Determined to Be Inelastic?
When demand for a good or service remains consistent regardless of economic changes, a good or service is referred to as inelastic.
What Is the Substitution Effect?
The substitution effect is the relative decrease in demand for a product caused by consumers switching to cheaper alternatives when its price rises.
What are Examples of Inferior Goods?
The term "inferior good" refers to affordability, rather than the quality of a good. Generic labeled food products or public transportation are considered examples of inferior goods. Demand for inferior goods decreases as a consumer's income increases and consumers will be likely to choose more costly substitutes.
The Bottom Line
Changing price levels, the type of product or service, income levels, and the availability of substitutes all affect the demand for goods and services. Demand for luxury items such as cars or electronics tends to be highly elastic as demand often changes due to changes in income and availability of less expensive substitutes. Demand for necessities such as food or medicine tends to be inelastic since demand remains consistent with economic changes.
