Factors Determining Elasticity of Demand

It is difficult to say whether the demand for a commodity is elastic or inelastic. Whether the demand for a commodity is very elastic or less elastic depends on several factors. The main factors determining elasticity of demand can be explained as follows:
  1. Nature of commodity: The elasticity of demand depends on nature of the commodity. The goods are classified as necessary, comfort and luxury. In general, the demand for necessaries of life such as food grain, salt is inelastic. The increase in price does not reduce demand. In general, the demand for comfort and luxury such as T.V., car, smartphones is elastic. The decrease in price increases the demand for the demand these goods. But necessary and luxury are relative terms. So, for the same commodity, elasticity may differ from person to person. As for example, the demand for car is a necessary to the rich but luxury to the poor. Hence, demand for car may be inelastic for the rich and elastic for the poor.
  2. Existence of substitutes: The existence of substitutes also affects the elasticity of demand. As for example, tea and coffee are substitutes. If the price of tea increases people substitute coffee. So, the demand for tea is elastic. But the demand for the commodities having no substitute such as salt, potato, onion is relatively inelastic.
  3. Number of uses: When the commodities have several uses, the demand for such commodities is elastic. As for example, electricity. If the price of electricity fall, it is put to several uses such as in cooking, pressing clothes, using fan etc. The elasticity of demand may be different in different uses. As for example, the demand for electricity for cable car is inelastic, since it does not have alternative. But for domestic purpose such as for cooking, electricity can be substituted by gas. So, demand is elastic.
  4. Possibility of postponement: When the possibility of postponement of consumption of a commodity exists, the demand is elastic. As for example, the consumption of Coca-cola can be postponed. But in case of consumption of goods, which are urgently needed, demand will be inelastic. The consumption of rice cannot be postponed.
  5. Level of Prices: If the price is too high or too low, the demand for a commodity will be inelastic. In case of expensive goods like T.V., car, camera, phones, demand will be inelastic. This implies that a small change in price, say $100 will not have effect on demand. The demand will be elastic only if the price change is high. Likewise, the demand for low-priced goods such as salt, onion, newspaper is inelastic. A small change in price will not affect demand. Because, all might have already purchased the required quantity.
  6. Proportion of income spent: if the persons spend a small amount in a commodity, a change in its price will not affect demand or demand will be inelastic. As for example, the demand for cheaper goods such as salt, matches is inelastic. But in case of expensive commodity such as car, demand is elastic.
  7. Habit and custom: If the commodities are demanded or account of habit and custom, demand will be less elastic. As for example, the increase in price of cigarettes or wine does not reduce the demand. Likewise, due to custom, the increase in gold price does not reduce the demand for wedding ring.
  8. Consumer’s incomes: Generally, the higher a person’s income the more inelastic will be his demand for commodities. The demand of millionaire for all commodities may be unaffected by any change in price. For most people, however, choice has to be made. Lower the person’s income, the higher the need of choice.
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Measurement of Price Elasticity: Total Outlay Method

In general, elasticity of demand means price elasticity. The concept of price elasticity is widely used in demand analysis. There are three methods of measuring price elasticity – total outlay method, point method and arc method. Here we concentrate only on total outlay method.

Total Outlay Method or Expenditure Method


In total outlay method, we see the change in expenditure as a result of change in price. Then on the basis of change in expenditure, we say whether the elasticity is equal to unity or greater than unity or less than unity. This can be illustrated by the help of schedule and figures.

1. Elasticity of Demand Equal to Unity (Ed = 1)

If the change in price does not change the total expenditure, the elasticity of demand is said to be equal to unity. In the table, the price falls from $10 to $9 to $8, but the total expenditure (PQ) remains unaltered at $10,000. So, the elasticity of demand is equal to unity.

Demand Schedule with Different Elasticities
Elastic Demand
Unit Elastic Demand
Inelastic Demand
P
Q
PQ (TE)
P
Q
PQ (TE)
P
Q
PQ (TE)
$10
$9
$8
1,000
2,000
3,000
10,000
18,000
24,000
10
9
8
1,000
1,111
1,250
10,000
10,000
10,000
10
9
8
1,000
1,050
1,100
10,000
9,450
8,800
Adapted from Watson & Getz: Price Theory & Its Uses

The unitary elastic demand can be illustrated by the help of a figure below.

Unitary Elastic Demand

In the figure, at initial price OP, quantity demanded is OM and total outlay (PXQ) is equal to rectangle OMRP. When the price falls to OP1, quantity demanded increases to OM1, and total expenditure is equal to rectangle OM1R1P1. The total expenditure falls by the area marked (-) and rises by the area marked (+). The area (-) is equal to area (+). So, the spending remains unaltered. In other words, new total expenditure OM1R1P1 = initial total expenditure OMRP. So, elasticity of demand is equal to unity. When the demand curve is rectangular hyperbola, the elasticity of demand on all points of it is equal to unity.

2. Elasticity of Demand Greater than Unity (Ed > 1)

If the total expenditure increases with fall in price, elasticity of demand is said to be greater than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure increases from $10,000 to $18,000 to $24,000. So, the elasticity of demand is greater than unity. This can be illustrated by the help of following figure.

Greater Than Unity

In the figure, the total expenditure at price OP is equal to rectangle OMRP. When price falls to OP1, the total expenditure increases to the rectangle OM1R1P1. The total expenditure falls by area marked (-), but rises by the area marked (+). The area (+) exceeds the area (-). The total spending increases. Hence, the elasticity of demand is greater than unity.

3. Elasticity of Demand Less than Unity (Ed < 1)

If the total expenditure falls with fall in price, the elasticity of demand is said to be less than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure falls from $10,000 to 9,450 to $8,800. Hence, elasticity of demand is less than unity. This can be illustrated by the help of a figure below.

Less Than Unity

As shown in the figure, when price is OP, the total expenditure is equal to rectangle OMRP. When price falls to OP1, the total expenditure falls to the rectangle OM1R1P1. The total expenditure falls by the area marked (-) but rises by the area marked (+). The area (+) is smaller than the area (-). The total expenditure falls. Hence, elasticity of demand is less than unity.
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Cross Elasticity of Demand: Proportionate change in demand with change in price

Cross Elasticity of Demand


Some goods are related to each other. So a fall in the price of a commodity causes change in the demand for other commodity. As for example, demand for tea is related to the price of substitute, coffee. When the price of coffee increases, the demand for tea increases. Hence, cross elasticity of demand means the responsiveness of quantity demanded of a commodity to the change in price of other commodity. The cross elasticity of demand is defined as the percentage in the quantity demand of good x resulting from a 2 percent change in the price of good y.
According to C. E. Ferguson, “Cross elasticity is the proportionate change in the quantity demanded of good x divided by the proportionate change in the price of y.”
The formula to calculate cross elasticity is,

Cross Elasticity = Proportionate change in quantity demanded of x/Proportionate change in price of y

Symbolically, Ec = Δqx/Δpy x Py/Qx

The concept of cross elasticity can be illustrated by the help of a numerical example. Suppose that x and y are two substitute goods. Suppose when the initial price of y is $4.50, the initial quantity of x is 60kg. Now when the price of y increases to $5, the quantity demanded of x increases to 70kg. The cross elasticity is calculated as,

Ec = Δqx/Δpy x Py/Qx 
= 10/5.0 x 4.5/60 = 3/2 = 1.5

1.5 coefficient shows that the cross elasticity is positive.

Types of Cross Elasticity


The goods may be either substitutes or complements. So the cross elasticity is of two types as follows:

1. Positive Cross Elasticity (Ec > 1)

When two goods are substitutes of each other, the cross elasticity is positive. As for example, tea and coffee. The increase in price of one commodity leads to an increase in quantity demanded of other commodity. Because, people substitute one commodity for other.

Positive Cross Elasticity

In the figure, demand curve DD shows positive cross elasticity. Because, with the increase in price X from OP to OP1, demand for Y has increased from OM to OM1.

2. Negative Cross Elasticity (Ec < 0)

When two goods are complements, cross elasticity is negative. As for example, shoe and shoelaces. The increase in price of one commodity causes fall in the quantity demanded of other commodity.

Negative Cross Elasticity

In the figure, demand curve DD shows negative cross elasticity. Because due to the increase in price of X from OP to OP1, demand for Y has declined from OM to OM1.

When the goods are not related to each other, the cross elasticity is zero. As for example, book and coat. The change in price of one does not affect the demand for other. Hence, the demand curve will be a vertical straight line. But this is not counted as cross elasticity.
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Income Elasticity of Demand: Proportionate change in quantity demanded per change in income

Income Elasticity of Demand


The income elasticity measures the responsiveness in quantity demanded to the change in income. In other words, it measures by how much the quantity demanded changes with change in income. The income elasticity of demand is defined to be the percentage change in quantity demanded resulting from a 1 percent change in consumer’s income.

According to C. E. Ferguson, “Income elasticity of demand is the proportionate change in quantity demanded divided by proportionate change in income.”

The formula to measure income elasticity is,

Income elasticity = Proportionate change in quantity demanded/Proportionate change in income

Symbolically, 
Ey = Δq/Δy  x   y/q

Where, y denotes income

The concept of elasticity of income can be illustrated by the help of an example. Suppose that when the income is $100, demand is 25 units. Now suppose that the income increase to $150. As a result of its demand increases to 30 units. The elasticity of income is calculated as,

Ey = Δq/Δy  x   y/q 
= 5/50 x 100/25 = 2/5

The coefficient 2/5 shows that the demand is inelastic.

Types of Income Elasticity

There are three types of income elasticity in practice. They are:

1. Positive income elasticity (Ey > 0)

If the demand for the commodity increases with increase in income elasticity is said to be positive. For most commodities increase in income lead to increases in quantity demanded. Such goods are called normal goods. Normal goods have positive income elasticities.

2. Negative Income Elasticity (Ey < 0)

If the demand decreases in income, income elasticity is said to be negative. Inferior goods such as cheap foods have negative income elasticities.

3. Zero Income Elasticity (Ey = 0)

The boundary between positive and negative income elasticity is zero income elasticity. If the demand for the commodity does not change with the increase in income, income elasticity is said to be zero. This happens in case of neutral goods such as salt, matches etc.

These three types of income elasticity have been shown in a single diagram below:

Types of Income Elasticity

In the figure, demand curves show zero, positive and negative income elasticity. Good A has zero income elasticity. Good B is a normal good with a positive income elasticity. Good C is an inferior good with a negative income elasticity.

It should, however, be noticed that a good does not have to be in the same category at all levels of income. The same good may have zero income elasticity at very low level of income; positive elasticity at higher level of income and negative income elasticity at very high level of income.

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