Elasticity of Demand Explained in Plain Terms

When you think of “elasticity,” you probably think of flexibility or the ability of an object to bounce back to its original conditions after some change. The type of elasticity we will discuss in this post is a concept of economics. This concept focuses on studying how the change in one variable affects another variable economically. Elasticity on its own is a vast concept, but we will only be talking about one of its branches.

Our primary focus will be on the topic “Demand elasticity” and we will be covering the following topics today, along with some real-world examples to help you understand them better:

  • What is Elasticity of Demand?
  • Followed by some real-life examples
  • The three important types of demand elasticity 

 

The elasticity of Demand – What is it?

The elasticity of demand is how the demand for a product changes with the change in any of its market variables. Demand is considered elastic when the result of this change is significant in number, and if it is not, the demand is considered inelastic. The values of demand elasticity can be derived by dividing the change in quantity demanded by the change in the other variable.

For instance, if there is a hike in a particular food item’s price, how would it affect its demand? If it happens to be one of the essential ones, people would still have to buy it; otherwise, most people would skip it from their grocery lists. Similarly, if there is an increase in the price of things like electronics, you can postpone buying that product until the price drops again. These examples show how the price of a product increases or decreases its demand. 

Another factor affecting the demand for certain products could be the availability of comparable products in the market. For example, if another brand launches a product just like the one you were about to buy, and that too at a lower price, which product would you go for? Close substitutes can hinder the demand for some products as well. Just like this, if the prices for the relatively expensive brands were to drop, you would opt for them instead of your previous choice.

Let us take the example of gasoline prices. Today almost every country is complaining about the surge in fuel prices. But since everyone is dependent on automobiles to commute, they have to deal with inflation. This proves that gasoline and other fuels’ consumption is price and income inelastic. It may be a shock to some but charging a tesla happens to be 3.6 times cheaper than getting fuel for your car. Due to this, people are opening up to the idea of electric cars. In this case, electric cars seem like an excellent substitute for fuel-powered cars.

Different Types of Elasticity of Demand

There are three important types of demand elasticity. All of these are based on factors that affect the demand for the quantity of a product. 

What is Inertia? | moment of inertia
What is Inertia? | moment of inertia

The three types of elasticity of demand are:

  • Price elasticity of demand (PED)
  • Cross elasticity of demand (XED)
  •  Income elasticity of demand (YED)

Let’s go through each type in detail below:

1.   Price Elasticity of Demand (PED)

PED mainly focuses on how the increase or decrease in the price of a product would affect its demand. This means that if there is an increase in the cost of the product, its demand will go down, whereas if the price were to decrease, more people would want to buy that product. Let us talk about clothes; people often wait for sales to buy clothes because they would much rather buy them at a lower price.

Not only that, but the services you provide could also determine your sales because if you offer good service, people would consider buying your product even if it is expensive.

The response (reaction of people towards the price change) can be calculated through:

Price Elasticity of Demand (PED) = % (change in demand) / % (change in price)

2.   Cross Elasticity of Demand (XED)

When there are many product competitors in the market, you have to calculate the cross elasticity of demand. When you have multiple competitors for your product, you have to make sure that your product is the best in the market to gain your customers’ attention. 

Since people have many options to choose from, any slight variation in your product or other products could change the demand for your product. If you raise the price of your product, the demand for substitute products will rise, whereas if you were to reduce your product’s price, people would most likely buy your product.

You can calculate the response for this through:

Cross Elasticity of Demand (XED) = % (change in demand of X) / % (change in price of Y)

3.   Income Elasticity of Demand (YED)

What is the first question we ask ourselves when we see a price tag? That probably is if we can afford to buy this product or not. Income demand of elasticity is a comparison between the consumer’s salary with the prices of different products. Most of the expensive brands are located in urban areas because the people living there can afford to buy costly products while people in the rural areas with lower incomes cannot. Therefore, becoming a vital business factor before starting our business anywhere, we need to ensure that the people living in that locality can also afford to buy our products. The ability to afford and buy a product show if the product is actually necessary or a basic need

This can be calculated using:

Income Elasticity Demand (YED) = % (change in demand) / % (change in income)

A Quick Summary – And Unitary Elasticity

Sometimes, you might be faced with situations where the demand is neither elastic nor inelastic. In such cases, the relationship will not fall into either elastic or inelastic categories. Well, in these cases, the change in a particular variable and the quantity demanded are pretty much equal. This is called unitary elasticity.

Here’s a quick summary I’ve prepared for you to quickly grab the important details and see which categories the elasticity falls into. So basically, whatever type of demand you are dealing with, it could be either one of these types:

  1. Elastic (when the change in demand is greater than the change in the economic variable)
  2. Perfectly elastic (when there is a high increase or decrease in the response)
  3. Inelastic (when the change in demand is lesser than the change in the economic variable)
  4. Perfectly inelastic (when no change can be seen in the response)
  5. Unitary (when the change in the demand is equivalent to the change in the variable you are dealing with, and the response is equal to 1)

That’s it for today’s article; let’s wrap things up in the following section.

All Things Considered

Throughout the article, we discussed how many factors affect the product. Before starting a business, you need to consider the factors that would eventually affect the sales of your product and not only the product itself. Knowing when to raise the price of your product and when you lower it could benefit you greatly, as well as recognizing the type of people you will be selling your product to and your competitors could also help you. Therefore, it is necessary to keep such economic factors in mind before launching a business.

Emidio Amadebai

As an IT Engineer, who is passionate about learning and sharing. I have worked and learned quite a bit from Data Engineers, Data Analysts, Business Analysts, and Key Decision Makers almost for the past 5 years. Interested in learning more about Data Science and How to leverage it for better decision-making in my business and hopefully help you do the same in yours.

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