Definition of Terms
Elasticity of demand: The elasticity of demand measures the degree of change in the quantity demanded after a change in any one of the factors affecting demand (Gregory, 2011).
Cross-price elasticity: This is the measure of degree of responsiveness of quantity demanded of one good due to change in price of another good (William et.al, 2011). In the case of complimentary goods, the cut in price of one of the goods raises the demand of the other good. For substitutes, an increase in price of one good will lead to an increase in demand of the other good.
Income elasticity: The income elasticity of demand measures the degree of change of quantity demanded of a commodity due to change in income (Gregory, 2011). In the case of inferior goods, the demand decreases as income rises. In the case of a normal good which is a necessity, the demand does not fall or rise with the change in income.
Explanations of the coefficients of each of the three terms.
The coefficient of elasticity of demand captures the percentage change in quantity demanded due to a unit change in a factor affecting demand e.g. income or prices. It is calculated using the formula.
The negative value indicates the law of demand.
The coefficient of cross-price elasticity captures the percentage change in quantity demanded due to a unit change in price of another good. It is given as,
A negative or positive coefficient indicates goods are cross to substitutes or compliments. Zero coefficients indicate goods are not related.
The coefficient of income elasticity of demand captures the percentage change in quantity demanded due to a unit change in income.
The positive or negative coefficient indicates the demand changes with change in income.
Contrast of the terms defined above
If the coefficient of price elasticity is high, it means that demand will change by a high percentage after a change in price. For example, if it is greater than one then demand is elastic and a unit change in price causes demand to change by more than one percent.
If the coefficient of cross price elasticity is high, it means the demand of one good will respond more to a change in price of another good. For example, if cross price elasticity of two goods is more than one, a unit change in price of one good will lead to a higher percentage change in demand of the other good (William et.al, 2011).
If the coefficient of income elasticity is high, it means demand will respond to a change in income. For example, if income elasticity is more than one then demand will increase by more than one percent if income is increased by one percent.
How factors affect the elasticity of demand
Availability of substitutes; where there is availability of close substitute to a product, the demand of the good tends to be more price elastic because of availability of choice to the consumer. If the price of one good is increased, the consumer switches to the substitute (William et.al, 2011).
Share of consumer income devoted to a good; If the share of income devoted to a good is high, the demand for the commodity responds less proportionately to changes in price and demand tends to be less elastic (Gregory, 2011). If the share devoted to the commodity is small, the demand is more elastic
Consumer’s time horizon; elasticity of demand of a product tends to be more elastic in the long run than in the short term (William et.al, 2011). This is because, in the long run, consumers have more time to adjust their consumption behavior, for instance by finding substitutes to a product.
Examples of determinants
Cross substitutes such as butter and margarine have high elasticity of demand. An increase in price of butter forces consumers to demand less of butter and more of margarine (William et.al, 2011). This shows that availability of a substitute to butter makes it respond quickly to price changes, increasing its elasticity.
Poor citizens devote a huge share of their income to food hence a change in the price of food would not cause a change in demand for food to the poor (Gregory, 2011). This is because food is necessary.
A person accustomed to driving to the work would not change from driving to work in the short term due to increase in fuel prices, but in the long run, he would find it necessary to look for cheaper means of transport. This shows that demand is negative in the long run.
Perfectly inelastic and perfectly elastic demand
Demand is perfectly inelastic if changes in price have no effect on quantity demanded (William et.al, 2011).
Quantity demanded
Demand is perfectly elastic if consumers are willing to buy all they can get at a certain price but the demand changes to zero if price changes (Gregory, 2011).
Explanations for the relationship between total revenue and elasticity of demand
The demand is elastic from 1-5 units along the demand curve. A price decrease would increase quantity demanded by a higher percentage and therefore increase revenue.
The demand is inelastic from unit 5-9 along the demand curve. A decrease in price decreases the demanded to fall by more than proportionate decreasing revenue.
The demand is unit-elastic at unit 5 on the demand curve. At these points, the revenue is maximum. A change in price does not cause a change in demand and therefore revenue is constant.
References
Gregory N (2011). Principles of economics. Mason, OH: Thomson south western
William, J, et.al (2011). Economics: principles and policy. Mason, OH. Cengage Learning
