THE PRICE ELASTICITY OF DEMAND DEPENDS ON FOUR MAIN FACTORS
- The closeness of substitutes
- The proportion of income spent on the goods
- The time elapsed since a price change
- Nature of the good
- The closeness of substitutes: The closer the substitute for a good or service, the more elastic is the demand for it. For example, salt is hardly having any substitutes in out like, whereas different brands of soaps are good substitutes, so that the demand for these goods is elastic.
In everyday language, we call some goods, such as food and housing necessities and the other goods, such as exotic vacations, luxuries. Necessities are goods that have poor substitutes and that are crucial for out well-being, so generally they have inelastic demand. Luxuries are goods that usually have many substitutes and have elastic demands.
The degrees of substitutability between two goods also depend on how narrowly (or broadly) we define them. For example, even though oil does not have a close substitute, a different type of oil is a close substitute of each other. Saudi Arabian Light, a particular type of oil is a close substitute for Alaskan North Slope, another particular type of oil. If you happen to be economic adviser to Saudi Arabia, you will not contemplate a unilateral price increase. Even though Saudi Arabian Light has some unique characteristics, other oils can easily substitute for it, and moist buyers will be sensitive to its price relative to the prices of other types of oil. So the demand for Saudi Arabian Light is highly elastic.
This example, which distinguishes between oil in general and different types of oil, applies to many other goods and services. The closeness of the substitutes for good also depends on some other factors discussed below.
2. Proportion of income spent of the good: Other things remaining the same, the higher the proportions of income spent on a good. The more elastic is the demand for it. If only a small fraction of income is spent on a good. Then a change in its price has little impact on the consumer’s overall budget. In contrast even a small rise in the price of a good that commands a large part of the consumer’s budget includes the consumer to male a radical reappraisal of expenditures.
To appreciate the importance of the proportion of income spent on a good, consider your own elasticity of demand for textbooks and potato chips. If the price of textbooks doubles (i.e. it increases 100 percent), there will be a big decrease in the quantity of textbooks bought. There will be an increase in sharing illegal photocopying. If the price of a packet of potato chips doubles also a 100 percent increase, there will be almost no change in the quantity of packets demanded. Let us discuss the reason for this difference. Textbooks take a large proportion of your budget while potato chips occupy a tiny portion. None of us will like the increase in the price of either of the two, but you will hardly notice the effects of the increased price of potato chips, while the increased price of the textbooks puts your budget under severe strain.
3 Time elapsed since price change: The greater the time lapse since a price change, the more elastic is the demand. When a price changes, consumers often continue to buy similar quantities of a good for while. But gives enough time, they find acceptable and less costly substitutes. As this process of substitution occurs, the quantity purchase of an item that has become more expensive gradually declines. That is, given more time, it is possible to find more effective substitutes for a good or service whose price has increased. It is also possible to find more uses for good whose price has decreased.
To describe the effect of time on demand, we distinguish between two time frames
- Short run demand
- Long run demand
Short run demand describes the response of buyers to a change in the price of a good before sufficient time has elapsed for all possible substitutions to be made. Long run demand describes the response of buyers to a change in the price after sufficient time has elapsed for all the possible substitutions to be made.
For example, within a period of a month there may be little that we as drivers can do to reach to an increase in the oil prices. However, over several years we can seek out more fuel-efficient vehicles and buy them to replace our older ones. We can also move closer to our place of work. Also over a period of several years more substitutes are developed for goods whose prices go up. For example, a sharp permanent increase in the price of petrol might lead to be development of substitute fuel.
4. Nature of the good: In general, it is seen that luxury items are price elastic whereas necessary items are price inelastic. This is because, changes in the price level affects the necessary goods comparatively less to the luxury goods.