DETERMINANTS OF PRICE ELASTICITY

Price elasticities can be estimated for many goods and services; Table-3 provides some examples. The short-run elasticities reflect periods of time that are not long enough for the consumer to adjust completely to changes in prices. The long-run values refer to situations where consumers have had more time to adjust. Note the variation in elasticities in Table-3. The long-run demand for foreign travel by U.S. residents is elastic (i.e., ep = |4.10|). In contrast, the long-run demand for water is highly inelastic (i.e., ep = |0.14|). In general, three factors determine the price elasticity of demand. They are: (1) availability of substitutes, (2) proportion of income spent on good or service, and (3) length of time.

Availability of Substitutes: The main determinant of elasticity is the availability of substitutes. Products for which there are good substitutes tend to have higher price elasticity of demand than products for which there are few adequate substitutes. Movies are a good example. Movies are a form of recreation, but there are many alternative recreational activities. When ticket prices at the movie theatre increase, these substitute activities replace movies. Thus, the demand for motion pictures is relatively elastic, as shown in Table-3. Other examples of products with close substitutes and therefore elastic demand would be demand for Maruti cars, subscription to cellular services, demand for air-travel etc.  estimates-of-price-elasticity-determinants

Sources: H. S. Houthakker and L. D. Taylor, Consumer Demand in the United States. Analysis and Projections (Cambridge, Mass.: Harvard University Press, 1970), and I. L. Sweeney, “The Demand for Gasoline: A Vintage Capital Model,” Department of Engineering Economics, Stanford University, 1975.

At the other extreme, consider the short-run demand for electricity. When your local supplier increases prices, consumers have few options. There are not many short-run alternatives to using electricity for cooling and lighting. Hence the short run demand for electricity is relatively inelastic. In the days of the license raj in India, when government was the monopoly provider, demand for telecom services was relatively inelastic since there was no other service provider in the market. Thus, a product with close substitutes tends to have elastic demand; one with no close substitutes tends to have inelastic demand. An important mission for most advertising is to make the consumer perceive that no close substitute exists for the product being advertised, thereby rendering the consumers demand relatively inelastic.

Proportion of Income Spent: Demand tends to be inelastic for goods and services that account for only a small proportion of total expenditures. Consider the demand for salt. 250 grams of salt will meet the needs of the typical household for months and costs only a few rupees. If the price of salt were to double, this change would not have a significant impact on the family’s purchasing power. As a result, price changes have little effect on the household demand for salt. In contrast, demand will tend to be more elastic for goods and services that require a substantial portion of total expenditures. Thus demand for holiday travel and luxury cars take up a considerable portion of the family’s budget and therefore tend to have higher elasticities. The relative necessity of a good also influences elasticity. For example, the demand for insulin is probably very inelastic because it is necessary for diabetics who rely on this drug.

Time Period: Demand is usually more elastic in the long run than in the short run. The explanation is that, given more time, the consumer has more opportunities to adjust to changes in prices. Table-3 indicates that the long-run elasticity for electricity is more than ten times the short-run value.

Price Elasticity and Decision Making

Information about price elasticities can be extremely useful to managers as they contemplate pricing decisions, if demand is inelastic at the current price, a price decrease will result in a decrease in total revenue. Alternatively, reducing the price of a product with elastic demand would cause revenue to increase. The effect on total revenue would be the reverse for a price increase. However, if demand is unitary elastic, price changes will not change total revenues. However, a price reduction is not always the correct strategy when demand is elastic. The decision must also take into account the impact on the firm’s costs and profits. 

As another example of how knowledge of price elasticity may be useful, let’s consider the demand for cigarettes. The price elasticity for cigarettes by age groups has been found to be:

Age Group Price Elasticity

12-17 years – 1.40

20-25 years – 0.89

26-35 years – 0.47

36-74 years – 0.45

These elasticities indicate that young smokers are much more responsive to price than are older smokers. This may be in part related to the fraction of income that goes towards the purchase of cigarettes. It may also reflect the degree to which physical/psychological addiction influences consumption. From the perspective of cigarette sellers, these results suggest that if all sellers increased prices proportionately, the total expenditure on cigarettes by adult smokers would increase. (Recall that when demand is inelastic, price and total revenue move in the same direction). Individual brands would be more price elastic than for the entire product class because each brand has other brands that represent potential substitutes; however, for the product class, there may be few good substitutes.

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