When it comes to the economy, there are many factors that contribute to the economic change; however, demand, supply, and production are its three primary factors of it. If any fluctuations are observed in either of these, it translates to a significant change in the economy, that is ultimately reflected in the GDP of the nation. Out of these three, demand is something that is exclusively controlled by the consumers. Therefore, determining the range of demand is essential, which is carried out by the elasticity of demand.
What is the Elasticity of Demand?
The demand for certain goods and prices is subject to change depending on various factors. Either the demand can be increased significantly or lowered to the point of companies going out of business. The elasticity of demand can be observed in day-to-day life, take a sale in the supermarket, for example, people rush to purchase specific items at a reduced price, which they may have never bought in the first place. Elasticity measures the amount of change in specific good or service in relation to the change in its related commodities. There are three major types of elasticity of demand; Price Elasticity of Demand, Income Elasticity of Demand, and Cross-Price Elasticity of Demand.
1. Price Elasticity of Demand
This type of elasticity of demand measures the degree of change in the demand for a certain product in relation to its price. This is one of the most largely observed types of elasticity of demand. Usually, the demand for a specific product increases when its price is reduced, and its demand plummets when the price is increased. Moreover, the elasticity of a product is affected if a substitute is available for that specific product. Interestingly, if substitutes are not of the same quality, the product becomes inelastic despite the changes in price. There are three types of price elasticity of demand.
- Perfectly elastic demand: In this, the price remains constant; however, a change in demand is observed.
- Perfectly inelastic demand: When the demand remains constant despite the change in prices, it is called perfectly inelastic demand.
- Relatively elastic demand: In this, a significant change in demand is observed despite a slight change in the price.
- Relatively inelastic demand: This is the opposite of the relative elastic demand, as it occurs when minor changes arise in demand because of the price change.
- Unitary elastic demand: In this, the change in demand is equal to the change in price.
2. Income Elasticity of Demand
Similar to the price elasticity of demand, this type of elasticity of demand measures the change in demand for a product in relation to the change in income of the public. To calculate the income elasticity of demand, the change in the quantity of demand is divided by the percentage change in the income. Usually, the increased income results in an increased demand; however, there are times when demand can become inelastic for similar factors as price elasticity of demand.
3. Cross-Price Elasticity of Demand
Interestingly, cross-price elasticity of demand follows a similar pattern to price elasticity of demand; however, in this, the demand for one product changes when a price change is observed in another product. Moreover, the products that cause a change in demand for other products can either be complements or substitutes. A small or even negative percentage in cross-price elasticity means that the product complements while an increase in it denotes that the products are substitutes.
Applications of The Elasticity of Demand
When the state is planning to introduce new taxes and tax policies, the price elasticity of demand is thoroughly analyzed. By determining the demand for a certain product, the government can impose a higher tax on the product to generate revenue; however, if the public reacts negatively to the tax raise, the demand decreases, resulting in the state having to reduce the tax. Therefore, a clear change in demand in relation to the product’s price (tax in this case) can be observed. This concept also applies to services. Similarly, if the state wishes to promote the consumption of a certain product or service, the taxes can be reduced to raise the demand. The best example of taxes depending on the demand is the raised tax on alcohol and cigarettes.
2. Pricing Decisions
Although it may seem like setting a price for a product is based on the production and labor cost, a large determining factor in pricing decisions is the demand for the product. A company must analyze at what price their substitutes and complements are being sold. Additionally, seeing trends of how the demand of their competitors changed based on price change is also taken into consideration. The price elasticity of demand helps the industries to determine the price of their product in relation to many variables.
3. Creating Monopoly
Based on the trends, it is observed that the demand for a product increases when the price is reduced, therefore, companies begin to sell their product at a significantly lower price than the competitors to create a monopoly. This gives rise to cross-price elasticity of demand. Perhaps the best example of this is Google Photos. Dropbox used to be the go-to cloud service that was in high demand; however, it was a paid service. Google introduced its cloud services that offered free services to users that purchased their mobile devices, this created a monopoly, as the demand for Google Photos skyrocketed, and other manufacturers had no choice but to leave the market.
4. Determining Quality of Products
Interestingly, the production quality of products is not accounted for in this aspect. Instead, the quality of the product is determined by the income elasticity of the demand. If the demand for a certain product rises with a rise in income, it is considered a normal quality product. Take gold, for example, its demand always increases with a hike in income. On the other hand, if the demand for the product declines with an increase in income, it is considered an inferior product. For instance, a decline in sales of margarine when income increases.
5. Price Discrimination
Different prices of products and services can be charged to different consumers based on the demand, especially for essential services. Take the example of electricity, it is required for both domestic and industrial use; however, electricity supplied to households is significantly expensive compared to industrial supply. This is because the industries can opt for other power sources, and to retain them as consumers, electricity-producing companies offer them the electricity at a lower price.
6. Forecasting Production
The elasticity of demand is also quite useful for industries when it comes to determining the amount of production. Moreover, it also allows the companies to determine which product must be discontinued. It should be noted that the research department is equally important in this application, as analyzing the market trends for a product is essential. This saves resources for the company, as they don’t accidentally produce more than they can sell. Ford Motor Company is the best example of this, as it used to be a car manufacturing company. Now, seeing the demand of the consumer, they discontinued their entire car line-up. Instead, they are focused on producing SUVs, based on the demand.
7. Trade Cycles
The elasticity of demand is a great way to understand if an economy is experiencing an expansion or a recession. This is because consumers purchase more during an expansion, increasing the demand for a product, which benefits both the consumer and the seller. As for the recession, the demand for all products drops. The United States Oil Crisis is a great example of this, as people were facing a lack of funds, and the demand for even essentials such as food was reduced because of unemployment. During the roaring twenties, people were buying products, which were not even used because of increased income.
As long as the value of a currency remains stable, the import of products remains relatively inelastic; however, once a currency devaluates, the price of the products that are being imported, suddenly increases exponentially. This results in a plunging demand for the product. For example, the demand for mandarin oranges in India is met by imports, therefore, a devaluation of the Indian Rupee will result in decreased demand for this fruit. Devaluation not only applies to the elasticity of demand for products but also includes the international trade of commodities.
9. Brand Migration
A majority of people prefer to purchase products from one brand over the other, as they consider a specific brand offers superior products to others; however, once the prices of that specific brand are increased or its products are altered against the will of the consumers, a trend of brand migration is observed. In this, the demand for once popular brands plummets exponentially. For instance, once the automobile manufacturer, Porsche, removed the manual transmission from their sports car, their customers quickly started shifting to other brands.
10. Paid Services
Unlike products, services can be a little complex to be placed in the spectrum of elastic and inelastic demand; however, the freedom of the customer to choose among different services is an indication of its elasticity. Moreover, these can either be online or offline. The entire hotel industry can be considered an elasticity of demand because if a certain hotel is charging more than the competitors, then, its demand will decrease quickly. Likewise, a travel agency charging more for the same tour package as others are likely to face a plunge in its demand.