Elasticity - : Price Elasticity of Demand

Elasticity –
Elasticity refers to the percentage change that will occur in one variable in response to a 1 percent
increase in another variable. It is denoted by the formula, E y = (%∆X)/(%∆Y). It measures how sensitive
one variable is w.r.t. another1.
Price Elasticity of Demand –

Price elasticity of demand, EP, refers to the percent change in quantity of a good resulting from a 1
percent increase in price. It is denoted by –
Ep =¿ ¿| = |(∆Q/∆P)|*(P/Q)
Where ∆Q = is the QFinal – QInitial and similarly ∆P = PFinal – Pinitial.
P and Q are initial price and quantity respectively or average of P Final and Pinitial and QFinal – QInitial
respectively.
Ep measures the sensitivity of a good demanded w.r.t. price. E P is usually a negative number since the
demand of a good usually reduces with an increase in price for majority of goods. There are various
factors that impact the price elasticity of demand.
If the magnitude of Ep <1, it is considered less elastic, i.e. percentage change in quantity with 1% change
in price is less. The consumers are less sensitive to price changes and the quantity demanded may have
a marginal variance. E.g. salt, vegetables.
If the magnitude of Ep >1, it is considered highly elastic, i.e. percentage change in quantity with 1%
change in price is high. The consumers are very sensitive to price changes and the quantity demanded
will change significantly depending upon price increases or decreases. This may happen if the good has
very close substitutes or is not a necessity. E.g. various brands of instant coffee.
Some of the factors impacting the price elasticity of demand are outline below 23:
1. Nature of the Good –

For sake of simplicity the analysis will be classify the goods into three following parts:
o Necessary Goods – Necessity goods are usually inelastic, i.e., the variance in price
doesn’t impact the consumption or demand of the good. E.g. vegetables, salt,
vegetables etc.
o Comfort Goods – Goods that are considered comfort goods usually have elastic demand
with regards to price. Consumers feel the decision to buy the product can be postpone
or forgo consumption in the short run. Goods such as Room Coolers, 2-wheelers etc.
o Luxury Goods – Luxury goods are usually highly elastic. Goods such as diamonds and
automobiles are highly elastic and their demands varies significantly with price change.
1
Pindyck and Rubenfield, Microeconomics 8th edition
2
https://www.tutor2u.net/economics/reference/factors-affecting-price-elasticity-of-demand
3
http://www.yourarticlelibrary.com/economics/9-major-factors-which-affects-the-elasticity-of-demand-of-a-
commodity-economics/8946
In addition, one must keep income levels in mind of the consumer while classifying the goods in
either category. High-Income level group may consider a good necessary, while a low-income
group may consider the same good a luxury item, and thus would be less price sensitive.
2. Income Levels –
As briefly mentioned above, income levels impact the price elasticity of demand. Usually high-
income level group people are less sensitive to price changes over smaller ranges than low
income group. Eg. Recent surges in onion prices. For around Rs. 5 higher income level group
overlooked the change and continued to consume the quantity at a higher price. The scenario
was different for low income groups.
3. Availability of Substitutes –
Demand for a commodity with large number of substitutes will be more elastic. The reason is
that even a small rise in its prices will induce the buyers to go for its substitutes. For example, in
countries where power is privatized and more than one company can co-exist in an area,
Constellation and Clearview both charge the same price /kWh in Rochester, NY. Even a change in
1 cent will make consumers switch from one to another 4.
However, it works on the assumption that switching costs between the two is zero.
4. Time Period
Price elasticity of demand is always related to time period. Some products are highly elastic in
the short run, while others in the long run.
When habits are difficult to change in the short run goods are less elastic. Eg. increase in oil-
prices will induce some drivers to carpool or change to alternate means of transport, but overall
change in demand will be low in short run. In the long run however, demand may vary as people
either adapt to higher prices or change to electric vehicles.
On the other hand, for durables, short run price elasticity is higher as compared to long run. This
is primarily because people postpone purchasing the good but once they reconcile, the demand
settles at pre-price increase point. Eg. A/C, TVs, Automobiles.
5. Misc. Events –
Macroeconomic factors impact demand price elasticity. For eg. Immediately after or during a
pandemic a surge in Demand of a good may be experienced regardless of the price. These goods
temporarily become inelastic. More of this is covered in the real life example covered later in
the document.
Apart from the factors covered above, there are various others such as price of compliments, budget
constraints, habits etc. that impact demand’s price elasticity.
Consider the example of a cyber-security firm below. The model was constructed with following
assumptions:
 The price points have been scaled down and rounded to the second decimal point.
 Price points are weighted average.
4
https://www.chooseenergy.com/shop/residential/electricity/NY/14020/national-grid-ny-electricity/
 Similarly Q, has been adjusted to the nearest 100’s.
 In order to maintain the confidentiality of the client and technology real names have been kept
out.
 Furthermore, for analysis some time periods have been skipped, while the time column has
been inverted to reflect decline in prices over time.
 Elasticity was calculated by (Final-Initial)/(Initial) for both P and Q rather than taking averages of
two P or Q points.
Background
The company was founded in early 2010’s by 4 American University Graduates. The 4 graduates, One
Indian, One Israeli and two Americans. The company was registered in Tel Aviv, Israel.
Analysis
Product A was launched at price point of 1.4 Currency Units/Q Unit and initially attracted limited users
only. From 1 and 1.15 unit elasticity was reached as the founders reduced prices to attract more
consumers and overcome competitors.
 The demand was inelastic till T4 when price was further reduced. However, in T5 when a major
contract was sold, the owners were further able to reduce prices as various costs had decreased and
more users signed up, showing a highly elastic demand curve.
 T6 onwards when they started to pass on savings to consumers, the demand remained relatively
inelastic.
 However, in T9 two major events occurred around the same time and they were able to enter two
geographies. The events were cyberattacks in Ukraine 5 and India. This prompted various
government agencies and firms in various countries to update cybersecurity systems in a hurry. This
prompted Q to shoot up and weighted average prices to fall. Despite dealing in a highly competitive
5
https://www.sciencedirect.com/science/article/pii/S1040619017300507
market, the company was able to realize higher revenues and thus a high short-run elasticity despite
keeping price almost constant.
 T11 was preceded by another major event that helped the company significantly; when Israel and
India announced various concessions to collaborate and consolidate start-ups 6. This enabled the firm
to expediate registration in India vis-à-vis looking for another headquarter in S-E Asia. This lowered
legal and marketing costs thus enabling a surge in sales in various countries.
 Between T11 and T13 the company tried to stimulate demand by further reducing prices, however,
demand remained fairly inelastic due to availability of substitutes and lack of adapdability in firms in
current markets.
 T14 reflects the contracts acquired in the gulf market, marked by a high Quantity since a firm
registered in India faced less regulatory hurdles than Israel. Furthermore, due to limited competition
in various Gulf countries and higher Per Capita Income (income effect) the company was able to
command a higher price, thus driving the weighted average price up, making the demand curve
inelastic.
 T15 and T16 reflect the growth of competitors thus the Demand Price Elasticity remained low and
failed to attract more orders.
Overall, it is evident from the analysis: the major factors determining Price Elasticity of Demand are:
 Availability of Substitutes
 Short-Term Macroeconomic Factors
 Income
 Firm’s Costs
6
https://www.mea.gov.in/bilateral-documents.htm?
dtl/28593/IndiaIsrael_Joint_Statement_during_the_visit_of_Prime_Minister_to_Israel_July_5_2017

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Elasticity –

Price Elasticity of Demand –

Where ∆Q = is the QFinal – QInitial and similarly ∆P = PFinal – Pinitial.

1. Nature of the Good –

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