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Determinants of price elasticity of demand

AP Micro: MKT‑3 (EU), MKT‑3.E (LO), MKT‑3.E.3 (EK), MKT‑3.E.4 (EK)

Video transcript

- [Instructor] In other videos we have already started talking about the price elasticity of demand, and what we're gonna do in this video is think about the factors that might drive the price elasticity of demand in a given market to be more or less elastic. So one could say that we're gonna think about the determinants of the price elasticity of demand. Now before we even talk about those determinants or those factors, let's just give ourselves a little bit of a review of what an elastic or an inelastic market might look like. So let me draw my price and quantity axes that we are pretty familiar with at this point. So quantity on the horizontal axis, price on the vertical axis, and remember, price elasticity of demand is percent change in quantity for given percent change in price. So a high elasticity would say that you have a large percent change in quantity for a given percent change in price, so high elasticity would look something like this, it would be a flatter demand curve. So this might look something like that, so I'll write that as high, high elasticity elasticity. And low elasticity would be that your percentage in quantity does not change much depending on your percent change in price. So low elasticity, the closer and closer we get to a vertical curve, the lower our elasticity, so low elasticity would look something like that. A low elasticity demand curve. Low elasticity. Elasticity. In other videos we even think about a perfectly inelastic market in which case you would have a vertical demand curve. But let's now think about the factors that might lead us to be closer to the high elasticity case or closer to the low elasticity case. So the factors that economists will generally point to are substitutes, timeframe, income share, whether the market we're talking about is about a luxury or necessity, and the narrowness of a market. So let's start with substitutes. So let's imagine first a world where there are many substitutes for the good or service that we're talking about. Many substitutes. And we can think of examples in our heads for markets of goods or services where there are many substitutes, let's say it's the market for Fuji apples. Well, the other substitutes are the other types of apples out there, McIntosh apples and Red Delicious apples, and all of those, and so for a given percent change in price, would you expect the percent change in quantity demanded of Fuji apples to change dramatically? Well if there are many substitutes, and only the Fuji apples, say, get a lot more expensive, then people will go to the substitutes, they're more likely to go the the Red Delicious, or the McIntosh apples, so when you have many substitutes, that tends to lead to more elasticity. More elasticity. People quantity, I guess you could say, would be very sensitive to price. And you could go the other way around if you have few substitutes. Few substitutes. Well, then, even if the price changes a little bit, or even if it changes a lot, people say well I don't know what I could substitute that with, so they might still buy a reasonably similar quantity, so this would be less, less elastic. Less elastic. Now what about timeframe, how does that affect elasticity? Well, imagine that you are selling umbrellas and it is raining right now. So for thinking about a short timeframe, while it is raining, then you could probably raise the prices on umbrellas a good bit, and assuming you have good foot traffic, a lot of people are probably going to be willing to pay that price, and so in a short timeframe, in a short, short timeframe, things tend to be less elastic. Less elastic. But over a longer timeframe, so longer timeframe, people might say, hey you're trying to really rip me off with those umbrellas and take advantage of me, I can go someplace else and find umbrellas, I could go online or whatever else, and so there, people tend to be more sensitive to price on the longer timeframe, they can find their substitutes, going back to the previous determinant, and so things tend to be more elastic. So once again, you could view elasticity as how sensitive quantity is to price. So next, income share. So let's first think about something that makes up a very small percentage of your income, say bubble gum, and let's say bubble gum right now is 25 cents, and if it were to go to 50 cents, that would likely reduce the quantity demanded, but it might not be so significant because going from 25 cents to 50 cents isn't gonna make a big difference for most people's pocket books. So in general, the lower the income share, lower share of income, the less elastic, the less elastic that market is going to be. But imagine something that is a high share of income. So let's say we're talking about, let me just write here, so high share, high share of income, so let's say we're talking about an automobile, and if people are already spending 20% or 30% of their income on that automobile and that automobile were to double, the cost of that versus the gum ball drop, the bubble gum, well then people just wouldn't even be able to demand the same quantities that they were able to before because their income just can't support it, they have other things to spend that money on, that extra money because their incomes just can't support it, so they will be highly sensitive to changes in price. So high sensitivity to changes in price, more elastic. Now what about luxuries versus necessities? Let's start with necessities. If this is something that you absolutely need, then even if the price were to go up a good bit, as long as you can still afford it, you might still go for that thing. So for example, let's say there's some medicine, let's say you're a diabetic and you need insulin, if you don't get insulin, really bad things are going to happen. If they were to raise the price of insulin by 20, 30, 40%, assuming that you could still afford it, you would still buy the same quantity because you need that insulin, and so if something is a necessity, necessity, you're gonna be less price sensitive, the quantity is going to be less sensitive to price, and so you're going to be less elastic, but if something's a luxury, if we're talking about you know, gold tiaras, and the price of gold were to go up dramatically, well then a lot of people will say, I might not need that gold tiara anymore, it's really not gonna make a big difference in my life. So, in general, luxuries, luxury will be associated with more elasticity. Now there could be exceptions, if something isn't kind of the ultra luxury category, and if maybe the price were to go up, maybe the people buying it, it's a very low share of their income, and maybe it's a brand that, at least the people buying it feel that there's no substitute for it, well then maybe it might not be as sensitive, but we're talking about in broad generalities. Now the last factor that is sometimes talked about is the narrowness of the market. Now what are we talking about here? So, for example, we could be talking about the market, market for apples, or you could talk about the market, market for food. Which of these markets, they're kind of both describing food, but which one is more narrow? Yes, apples are a subset of all food. And so, if we're talking about the market for apples, the narrower situation, so if we're talking about the narrower, narrower market, you tend to have more substitutes. So if the price of apples go up, people say well maybe I'm gonna go buy some pears, or bananas, or something else instead of the apples, and so you're gonna be more, quantity will be more sensitive to changes in price, and so you're gonna have more elasticity, but if you have a broader definition of your market, the market for food, well now the food looks a lot more like it's a necessity, there are very few substitutes for food, if I stop eating food, well I, it's not like I can eat, you know, change or just live off of air, or whatever else, there's really no substitutes for food, it is an absolute necessity. So the broader the market definition, so the broader the market, we tend to be dealing with a less elastic, less price elasticity of demand.