Price Elasticity Compared

Definition

Price elasticity of demand refers to the measure of how responsive the quantity demanded of a good is to a change in its price, first introduced by Alfred Marshall in 1890.

How It Works

The price elasticity of demand is calculated as the percentage change in quantity demanded in response to a 1% change in price, with elastic goods having an elasticity greater than 1, indicating a significant response to price changes, and inelastic goods having an elasticity less than 1, indicating a relatively small response. According to Ricardo's comparative advantage model, 1817, countries should export goods for which they have a lower opportunity cost, which can lead to increased trade and economic efficiency. For instance, Boeing produces ~800 aircraft annually (Boeing annual report), and a change in aircraft prices can significantly affect the quantity demanded, as airlines and other buyers are sensitive to price changes.

The price elasticity of demand is influenced by several factors, including the availability of substitutes, the necessity of the good, and the income level of the buyers. For example, luxury goods such as diamonds have a high elasticity, as buyers can easily substitute them with other luxury goods or postpone their purchase, whereas essential goods like food have a low elasticity, as buyers are less responsive to price changes. The cross-price elasticity of demand measures the response of the quantity demanded of one good to a change in the price of another good, and can be used to identify complementary or substitute goods.

The price elasticity of supply is also an important concept, as it measures the responsiveness of the quantity supplied of a good to a change in its price. According to the law of supply, an increase in price leads to an increase in the quantity supplied, as producers are incentivized to produce more at higher prices. However, the price elasticity of supply can vary depending on the industry and the production costs, with some industries having a more elastic supply curve than others. For instance, the supply of agricultural products is often inelastic in the short run, as farmers cannot quickly adjust their production in response to price changes.

Key Components

• Substitutes: Availability of substitutes affects the elasticity of demand, with more substitutes leading to higher elasticity, as buyers can easily switch to alternative products.
• Income level: The income level of buyers affects their responsiveness to price changes, with higher-income buyers being less responsive to price changes for essential goods.
• Necessity of the good: Essential goods tend to have lower elasticity, as buyers are less responsive to price changes, whereas luxury goods have higher elasticity.
• Time period: The elasticity of demand can vary depending on the time period, with short-run elasticity often being lower than long-run elasticity, as buyers may take time to adjust to price changes.
• Production costs: The elasticity of supply is affected by production costs, with industries having lower production costs tend to have a more elastic supply curve.
• Market structure: The market structure, such as monopoly or perfect competition, can influence the elasticity of demand and supply, with monopolies often having more inelastic demand curves.

Common Misconceptions

Myth: Price elasticity of demand is always constant — Fact: Elasticity can vary depending on the price level, with higher prices leading to higher elasticity, as seen in the demand for luxury goods.

Myth: All essential goods have low elasticity — Fact: Some essential goods, such as healthcare services, can have high elasticity, as buyers may respond to price changes by postponing or forgoing treatment.

Myth: Price elasticity of supply is always high — Fact: The supply of some goods, such as agricultural products, can be inelastic in the short run, as producers cannot quickly adjust their production in response to price changes.

Myth: Cross-price elasticity is only relevant for complementary goods — Fact: Cross-price elasticity can also be used to identify substitute goods, such as Coca-Cola and Pepsi, which have a high cross-price elasticity.

In Practice

In the United States, the demand for gasoline is relatively inelastic, with an elasticity of around 0.3, as drivers are less responsive to price changes, according to the US Energy Information Administration. However, the supply of gasoline is more elastic, as refineries can adjust their production in response to price changes. In 2020, the COVID-19 pandemic led to a significant decrease in gasoline demand, with prices falling by over 30% in some areas, resulting in a decrease in production by refineries, such as ExxonMobil, which reduced its production by ~20% (ExxonMobil annual report). The price elasticity of demand for gasoline can vary depending on the region and the time period, with some studies suggesting that the elasticity is higher in the long run, as drivers can adjust their behavior and purchase more fuel-efficient vehicles in response to sustained price changes.