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, while necessities are generally inelastic. A narrow market definition increases elasticity, and demand becomes more elastic in the long run as consumers adapt to price changes. 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, particularly in relation to economic concepts like demand curves and consumer surplus.

Determinants of Price Elasticity of Demand

Now let's discuss what causes different products to have different elasticities of demand. 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 close substitutes. 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 wouldn't buy more apples, but you'd buy oranges instead, or something like that, right? The idea that you're more affected by the 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 maybe 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 aren't really too many choices for your power bill, so when there aren't so many options, it's going to be less elastic. The price goes up and the quantity demanded isn’t 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. So luxury items tend to have a more elastic demand. Alright, and these should all be a little bit intuitive as well, right? You could imagine that something that you need, you're going to be pretty inelastic, you’re going to kind of 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 anyway, 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. Alright, let's go on to the next one. Definition of the market. So 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 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. Cool. Another one here, the time. So 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 really, the long run is 5 years, it's not something so clear cut, it's just like how long will it take to adapt to these changes. So in the short run, we don't have enough time to adapt. So 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 is 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, right, 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 got 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 or something like that. 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¢, it's not 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. So that is the determinants of price elasticity of demand. Let's move on.

Here’s what students ask on this topic:

What are the determinants of price elasticity of demand?

The determinants of price elasticity of demand include:

• Availability of close substitutes: More substitutes lead to more elastic demand.
• Necessities vs. luxuries: Necessities are inelastic, while luxuries are more elastic.
• Definition of the market: Narrowly defined markets have more elastic demand.
• Time horizon: Demand is more elastic in the long run as consumers adapt to price changes.
• Share of a consumer's budget: Products that take up a larger share of the budget have more elastic demand.

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, leading to a significant drop in the quantity demanded for apples. Conversely, if there are few or no substitutes, such as with utilities, the demand is inelastic because consumers have fewer alternatives.

Why are necessities generally inelastic in terms of price elasticity of demand?

Necessities are generally inelastic because consumers need them regardless of price changes. For example, food and basic utilities are essential for daily life, so even if their prices increase, the quantity demanded does not decrease significantly. This inelasticity occurs because consumers prioritize these essential goods and services over others, making them less sensitive to price changes compared to luxury items, which are more elastic as they are not essential and can be foregone if prices rise.

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 a 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 if the price of apples increases. In contrast, a broadly defined market, like the market for fruit in general, has less elastic demand because consumers are still buying fruit, even if they switch from apples to oranges. Thus, the elasticity depends on the specificity of the market definition.

Why is demand more elastic in the long run compared to the short run?

Demand is more elastic in the long run compared to the short run because consumers have more time to adjust their behavior and find alternatives. In the short run, consumers are often constrained by existing habits, contracts, or lack of immediate alternatives. For example, if gasoline prices rise, consumers may still need to use their cars in the short run. However, in the long run, they can adapt by buying more fuel-efficient vehicles, using public transportation, or carpooling, making their demand for gasoline more elastic over time.