Determinants of Price Elasticity of Demand - Online Tutor, Practice Problems & Exam Prep

Price elasticity of demand varies based on several determinants. Close substitutes lead to more elastic demand, as consumers can easily switch products. Necessities tend to be inelastic, while luxuries are more elastic. A narrow market definition increases elasticity, and over time, consumers can adapt to price changes, making long-run demand more elastic. Additionally, products that consume a larger share of a consumer's budget exhibit greater elasticity. Understanding these factors is crucial for analyzing consumer behavior and market dynamics.

Determinants of Price Elasticity of Demand

Now let's discuss what causes different products to have different elasticities of demand. So, you can imagine that the price elasticity of demand for say a pack of gum is going to be different than for a house or a pizza, or anything for that matter, right? So what causes the price elasticity to be what it is? We're going to discuss these determinants, which are things that determine the price elasticity. The first one, and probably the most important one, is the availability of close substitutes, right? So when a product has a lot of close substitutes, it's going to have a more elastic demand, okay, and that kind of makes sense, right? Because if a price change happens and there are a lot of substitutes, say in the fruit market, right? If the price of apples goes up, you would not buy more apples; you'd buy oranges instead or something like that right? The idea that you're more affected by price. The quantity demanded is going to shift a lot in markets where there are a lot of close substitutes. Somewhere where there are not close substitutes, something like utilities, right? Your utility bill, if they change the rate of your electricity, there's not much you can do about it right. You're kind of stuck with that company. There are not too many choices for your power bill, so when there are not so many options, it's going to be less elastic. The price goes up and the quantity demanded is not going to change as much as that price change, right? As compared to close substitutes, something like, let's say apples and oranges, right? Where a price goes up of apples and you're going to buy oranges instead, right? That's what's going to happen and the quantity demand of apples is going to drop a lot compared to that price change. So it's going to be more elastic in that sense.

The next one is necessities versus luxuries. Luxury items tend to have more elastic demand. You could imagine that something that you need, you're going to be pretty inelastic, you're going to buy it whether the price goes up. Something like food, right? If the price of food goes up, you're probably still going to buy food because you need it, right? The quantity demanded isn't going to shift as much as the price there as compared to a luxury item. Maybe something specific like caviar, right? This luxury food or something like that, when the price goes up of caviar, you're probably going to buy less of it because you were only buying it because it was a luxury item, right? So when the price goes up for these luxury items, you didn't need it, you'll be like, well you know maybe I shouldn't spend my money there, I'll spend it on something else. So luxury items tend to have more elastic demand in that same sense.

Let's go on to the next one. Definition of the market. When we define the market narrowly, you're going to have more elastic demand. So what does that mean to have a narrow market definition versus a wide market definition? A narrow market definition could be something like apples, the market for apples compared to a wide market definition which could be the market for fruit in general, right? So you could imagine that apples are going to have a more elastic demand than fruit. Just like in our previous example, if the price of apples went up, you might buy an orange instead right? So the demand for apples might have changed quite a bit, but for fruit in general, you're still buying fruit, right? You just substituted an apple for an orange, so in the fruit market, we defined it wider, right? There wasn't a change there as compared to in the apple market where when the price went up for apples you went to something else. So it's just an interesting thing to note that how we define the market is going to define the elasticity as well.

Another one here, the time period. What is the short run and the long run? We think of the long run as, you know, the amount of time that it takes to adapt to these price changes. It's not something so clear-cut, it's just how long will it take to adapt to these changes. So in the short run, we don't have enough time to adapt. I think a good example for the short run and the long run, I'm going to say gasoline, right? In the short run, let's say the price of gas starts going up a lot, right? You still have your car, you're kind of dependent on gas, you're not really going to be able to change your demand. Your demand's going to be pretty inelastic for gas in the short run, but if those prices stay high you're going to start thinking of alternatives, right? You might sell your car and buy a hybrid, or maybe buy a bicycle, right? You're going to change your demand in the long run so that you don't need the gas as much. So in the long run, your demand for gas is going to be more elastic because you can change what you need, right. You can change how you demand stuff, but in the short run, you're kind of stuck, you're dependent, you have to get to work, get to school, you have your car, but over time, right, you could find out the bus schedules or whatever, buy a hybrid, etc. So in the long run, you're going to have more elastic demand. You're going to be able to change out how you demand stuff.

And last but not least, we've got the share of a consumer's budget. Items using up a large share of a consumer's budget have more elastic demand. So, you can imagine something that has a small share of your budget, something like, say a pack of gum. You know if you chew gum all the time and gum's 50¢ for a pack and now gum went up to 60¢, you're going to be like, oh, that sucks, but you'll probably still buy the gum, right? 50¢, 60¢ isn't a big deal to you, compared to something like a house, right? When you're in the market for a house and you're looking for something that costs $100,000 and now prices have been rising and they're $150,000 that's going to make a much bigger difference to you right. So the share of the budget is another one there.

Cool. That is the determinants of price elasticity of demand. Let's move on.

Here’s what students ask on this topic:

What are the main determinants of price elasticity of demand?

The main determinants of price elasticity of demand include the availability of close substitutes, the necessity versus luxury nature of the product, the definition of the market, the time period considered (short run vs. long run), and the share of the consumer's budget that the product consumes. Products with many close substitutes tend to have more elastic demand. Necessities are generally inelastic, while luxuries are more elastic. A narrowly defined market increases elasticity. Over time, consumers can adapt to price changes, making long-run demand more elastic. Lastly, products that take up a larger share of a consumer's budget exhibit greater elasticity.

How does the availability of close substitutes affect price elasticity of demand?

The availability of close substitutes significantly affects the price elasticity of demand. When a product has many close substitutes, its demand is more elastic. This is because consumers can easily switch to a substitute if the price of the product increases. For example, if the price of apples rises, consumers might buy oranges instead. Conversely, if there are few or no substitutes, the demand is inelastic. For instance, utilities like electricity have few substitutes, so a price increase does not significantly reduce the quantity demanded.

Why are necessities generally more inelastic compared to luxuries?

Necessities are generally more inelastic because consumers need them regardless of price changes. For example, food and basic utilities are necessities; even if their prices rise, people will still purchase them because they are essential for daily living. On the other hand, luxuries are more elastic because they are not essential. If the price of a luxury item like caviar increases, consumers can easily reduce their consumption or stop buying it altogether, as it is not a necessity.

How does the definition of the market influence price elasticity of demand?

The definition of the market influences price elasticity of demand by determining how narrowly or broadly the market is defined. A narrowly defined market, such as the market for apples, tends to have more elastic demand because consumers can easily switch to other fruits like oranges if the price of apples increases. In contrast, a broadly defined market, such as the market for fruit in general, has more inelastic demand because consumers are less likely to stop buying fruit altogether; they will just switch between different types of fruit.

What is the difference between short-run and long-run price elasticity of demand?

The difference between short-run and long-run price elasticity of demand lies in the time consumers have to adjust to price changes. In the short run, demand is generally more inelastic because consumers do not have enough time to find alternatives or change their consumption habits. For example, if the price of gasoline rises, consumers still need to use their cars and cannot immediately switch to other modes of transportation. In the long run, demand becomes more elastic as consumers have time to adapt, such as by buying more fuel-efficient cars or using public transportation.