Determinants of Price Elasticity of Demand

Have you ever wondered why some products' prices can go up without affecting their sales, while others see a huge drop in demand with just a slight increase in price? The secret lies in the price elasticity of demand which tells us how sensitive consumers are to changes in price! In this article, we'll explore the factors that determine the price elasticity of demand and provide examples of these determinants of price elasticity to help you understand the concept.

Determinants of Price Elasticity of Demand Determinants of Price Elasticity of Demand

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    Get ready to learn everything you need to know about the determinants of price elasticity of demand including the major determinants of price elasticity of demand, and the methods used to determine the price elasticity of demand!

    Determinants of Price Elasticity of Demand Definition

    The definition of determinants of price elasticity of demand is a set of guidelines that help us understand why the price elasticity of demand behaves the way it does. The elasticity of a good measures how sensitive demand is to changes in the price of a good. The price elasticity of demand measures how much the demand for a good changes in response to the price of the good changing.

    Elasticity is the responsiveness or sensitivity of a consumer's demand for a good to changes in the price of the good.

    The price elasticity of demand measures the change in the quantity demanded of a good in response to a change in the price of the good.

    Since elasticity is a spectrum with elastic and inelastic on opposite ends, what determines the degree of price elasticity of demand? The four determinants of price elasticity of demand are:

    • The availability of close substitutes
    • Necessity versus luxury goods
    • The definition of the market
    • The time horizon

    The state of these four determinants helps economists explain the shape of the demand curve for a certain good. Because demand is based on consumer preferences which are shaped by qualitative forces like human emotion, social constructs, and the economic state, it can be difficult to set any firm rules for the demand curve's elasticity.

    By having these determinants as guidelines, we can use them to understand why particular circumstances produce a more elastic or inelastic demand curve. Each determinant of price elasticity of demand makes us consider a different perspective from the consumer regarding the choices they make when they are deciding whether or not to continue purchasing a good after the price increases or if they want to buy more if the price falls.

    In this explanation, we are learning about what determines the price elasticity of demand, but if you want to learn more about what it is or how to calculate it, check out these other explanations too:

    - Price Elasticity of Demand

    - Price Elasticity of Demand Calculation

    Factors Determining Price Elasticity of Demand

    There are many factors determining the price elasticity of demand. The way a consumer's demand reacts to a change in price, be it a decrease or an increase, can be due to a wide range of circumstances.

    • Income
    • Personal tastes
    • Price of complementary goods
    • Versatility of the product
    • Quality of the good
    • Availability of substitute goods

    The above-mentioned factors are just a few of the reasons why a consumer's demand curve is more or less elastic. If a person is on a tight budget then they will be more elastic to price changes since a small change could have a big impact on their budget. Some people are brand loyal and refuse to purchase a different brand even if the price rises astronomically. Maybe the price of a good rises but it is so versatile that it has more than one use for a consumer, such as a pickup truck. All of these factors mean something different to every consumer, but they all impact consumer spending patterns and determine their elasticity.

    Determinants of Price Elasticity of Demand graph of an inelastic demand curve StudySmarterFig. 1 - Inelastic Demand Curve

    Figure 1 above shows an inelastic demand curve where a change in price has little effect on a consumer's demand. If this demand curve was perfectly inelastic it would be vertical.

    Determinants of Price Elasticity of Demand graph of an elastic demand curve StudySmarterFig. 2 - Elastic Demand Curve

    Figure 2 above shows us what an elastic demand curve would look like. A small price change has a significant effect on the quantity that is demanded of a good. This is what a consumer's demand curve looks like if they are sensitive to changes in price. If the demand was perfectly elastic, the curve would be horizontal.

    Major Determinants of Price Elasticity of Demand

    There are four major determinants of price elasticity of demand. Consumers determine what they will spend their income on by looking at which other goods are available to them, if they need the good or if it is a luxury, the type of good they are considering, and the time frame they are planning.

    Determinants of Price Elasticity of Demand: Availability of Close Substitutes

    The demand is typically more elastic if a good can be easily substituted for another. This means that people are likely to switch to buying a very similar good instead of continuing to buy the good whose price increased. A close substitute would be a BIC ballpoint pen versus a Papermate ballpoint pen. If both pens used to cost the same amount, but BIC decided to raise their price by $0.15, then people would not find it difficult to simply switch over. This would cause a large drop in demand for a relatively small increase in price.

    However, if BIC is the only company to produce affordable ballpoint pens, and the next closest product on the market is a fine-tipped marker, then people would be more inelastic. Additionally, if the price of a close substitute fell or increased, people would be quick to switch over to the cheaper good.

    The availability of close substitutes is the most important determinant of price elasticity of demand because as long as there are substitutes available, the consumer will gravitate toward the best deal. If one firm raises its price, it will more difficult to compete with other producers.

    Determinants of Price Elasticity of Demand: Necessities versus Luxuries

    A consumer's elasticity of demand depends on how much they need or want the good. Baby diapers are an example of a necessity and a good with inelastic demand. Diapers are necessary for child rearing; parents must purchase more or less the same amount for their children's health and comfort regardless of if the price rises or falls.

    If the good is a luxury good, such as a Burberry or Canada Goose jacket, then people might choose to go with a more cost-effective brand such as Colombia if the luxury brands decide to price their jackets at $1,000, while Colombia uses similar quality materials but only charges $150. People will be more elastic to price fluctuations of luxury goods.

    Determinants of Price Elasticity of Demand: Definition of the Market

    The definition of the market refers to how broad or narrow the range of goods available is. Is it narrow, meaning the only goods in the market are trench coats? Or is the market broad so that it encompasses all jackets or even all forms of clothing?

    If a market is defined as "clothing" then the consumer really has no substitutes to choose from. If the price of clothing goes up, people will still buy clothing, just different kinds or cheaper kinds, but they will still buy clothing, so the demand for clothing won't change much. Thus, the demand for clothing will be more price inelastic.

    Now, if the market is defined as trench coats, the consumer has more options to choose from. If the price of a trench coat rises, people may either buy a cheaper trench coat or a different kind of coat, but they will have a choice, but in this case, the demand for trench coats could fall substantially. Thus, the demand for trench coats will be more price elastic.

    Determinants of Price Elasticity of Demand: Time Horizon

    The time horizon refers to the time in which the consumer must make their purchase. As time goes by, demand tends to become more elastic as consumers have time to react and make adjustments in their lives to account for price changes. For example, if someone relied on public transport for daily commuting, they will be inelastic about a change in the ticket fare over a short period. But, if the fare increases, commuters make other arrangements in the future. They may choose to drive instead, carpool with a friend, or ride their bike if those are options. They simply needed time to react to the change in price. In the short run, consumer demand is more inelastic but, if given time, it becomes more elastic.

    Methods to Determine Price Elasticity of Demand

    There are two main methods to determine the price elasticity of demand. They are called the point elasticity of demand and the midpoint method. The point elasticity of demand is useful for telling the elasticity of a specific point on the demand curve given that the initial price and quantity and the new price and quantity are known. This results in a different price elasticity at every point depending on the direction of the change since the percent change is calculated using a different base, depending on if the change is an increase or a decrease. The midpoint method takes the midpoint of the two values as the base when calculating the percent change in value. This method is more useful when there are large price changes and it gives us the same elasticity regardless of an increase or decrease in price.

    Point Elasticity of Demand

    To calculate the price elasticity of demand using the point elasticity of demand method, we need to know how much the price and quantity demanded of the good changed after the price changed.

    The formula for point elasticity of demand is:

    \[Price \ Elasticity \ of \ Demand=\frac {\frac{New\ Quantity - Old\ Quantity} { Old\ Quantity}} {\frac{{New\ Price - Old\ Price}} { Old\ Price}} \]

    Generally, if the price elasticity of demand is less than 1 in magnitude, or absolute value, demand is deemed inelastic or demand is not very responsive to a change in price. If it is greater than 1 in magnitude, as is the case with our example below, demand is considered elastic, or sensitive to changes in price.

    Julie's favorite granola bars cost $10 per box. She would buy 4 boxes at a time to last her until her next grocery trip. Then, they went on sale for $7.50 and Julie immediately bought 6 boxes. Calculate Julie's price elasticity of demand.

    \(Price \ Elasticity \ of \ Demand=\frac {\frac{6 - 4} {4}} {\frac{{$7.50 - $10}} { $10}}\)

    \(Price \ Elasticity \ of \ Demand= \frac {0.5}{-0.25}\)

    Notice, at this step above, we have the percent change in quantity divided by the percent change in price.

    \(Price \ Elasticity \ of \ Demand= -2\)

    Julie's demand is elastic to a decrease in price because the price elasticity of demand is greater than 1 in magnitude.

    Since the change in quantity demanded and the change in price have an inverse relationship, one value will be negative and the other positive. This means that elasticity is usually a negative number. But, when calculating elasticity, economists traditionally disregard this minus sign and use absolute values for price elasticities instead.

    Midpoint Method of Price Elasticity Of Demand

    The midpoint method of price elasticity of demand is used to calculate the average price elasticity. To use this method, we need two coordinates from the demand curve so that we can calculate their average to calculate the price elasticity of demand. The formula is:

    \[Price \ Elasticity \ of \ Demand=\frac {\frac{Q_2 - Q_1} {\frac {Q_2+Q_1} {2}}} {\frac{P_2 - P_1} {\frac {P_2+P_1} {2}}}\]

    This formula can be seen as rather complicated but all it is is calculating the percent change in value using the average of the two coordinates.

    \(\frac {Q_2 - Q_1}{\frac {Q_2+Q_1} {2}}\) is the new value minus the old value divided by the average (midpoint) between the two points. It is the same principle for the percent change in price. Let's do an example.

    Fred has to buy wipes for his baby. 1 packet costs $7. He buys 20 packets per month. Suddenly, the price per packet increases to $10. Now, Fred only buys 18 packets. Calculate Fred's price elasticity of demand.

    The coordinates would be (20,$7), (18,$10),

    \(Price \ Elasticity \ of \ Demand=\frac {\frac{18 - 20} {\frac {18+20} {2}}} {\frac{$10 - $7} {\frac {$10+$7} {2}}}\)

    \(Price \ Elasticity \ of \ Demand=\frac {\frac{-2} {19}} {\frac{$3} { $8.50}}\)

    \(Price \ Elasticity \ of \ Demand=\frac {-0.11} {0.35}\)

    \(Price \ Elasticity \ of \ Demand=-0.31\)

    Since Fred's price elasticity of demand is less than 1 in magnitude, his demand for baby wipes is rather inelastic, so his consumption does not change very much regardless of price.

    Determinants of Price Elasticity of Demand Examples

    Let's have a look at some determinants of price elasticity of demand examples. The first example will look at how the availability of close substitutes influences the price elasticity of demand. Say you wanted to buy a professional camera. Only two manufacturers produce professional cameras and they are very different from each other. One is only good for portraits and the other for scenery. They are not very good substitutes for each other. This means that you will still probably buy the camera you want regardless of its price since you do not have any other option. You are inelastic. Now, if many cameras had comparable performance you would be more selective and elastic to changes in price.

    An example of elasticity for luxury goods versus necessities would be the demand for toothpaste. A regular tube will cost about $4 to $5. It cleans your teeth, preventing cavities, bad breath, and painful dental work in the future. You will not be very elastic to a change in price for a good that is part of your daily routine and keeps your body healthy. On the other hand, if you buy designer clothes for $500 per pair of slacks, then you will be more elastic to a change in price because it is not a good that you need because you can buy cheaper pants and they will perform the same.

    In a narrowly defined market, like ice cream, demand is more elastic because there are close substitutes available. You can choose from hundreds of brands of ice cream. If the market is broadly defined, demand will be inelastic. For example, food. Humans need food and there is no other substitute for food, making it inelastic.

    Lastly, elasticity depends on the time horizon. In the short run, people are going to be more inelastic because changes in spending cannot always happen from one day to the next but given time to plan, people can be more flexible. Gasoline-powered cars are the majority of cars on the road, so people are inelastic to fluctuations in the price of gasoline. However, seeing the rising prices in the long run, people may buy more electric vehicles, and the consumption of gasoline will fall. So if given time, the consumer's demand is more elastic.

    Determinants of Price Elasticity of Demand - Key takeaways

    • The price elasticity of demand measures how much the quantity demanded of a good changes in response to a change in its price.
    • If someone's demand is elastic to changes in price, then a small change in price will result in a larger change in quantity. If it is inelastic to a change in price, then a large change in price will only affect demand a little bit.
    • There are four main determinants of price elasticity of demand.
    • The midpoint and point elasticity methods are both useful ways to calculate the price elasticity of demand depending on the circumstance.
    • A consumer's price elasticity depends on multiple factors and changes depending on the individual's preferences.
    Frequently Asked Questions about Determinants of Price Elasticity of Demand

    What are the determinants of price elasticity of demand?

    The determinants of price elasticity of demand are the availability of close substitutes, necessity versus luxury goods, the definition of the market, and the time horizon.

    What factors determine price elasticity of demand?

    There are many factors that can help determine the price elasticity of demand. Some of them are the availability of close substitutes, necessity versus luxury goods, the definition of the market, the time horizon, income, personal tastes, versatility of the product, and the quality of the goods. 

    What are the factors affecting price elasticity?

    Some factors affecting price elasticity are the other options available, time, luxury, preferences, what is included in the market, quality, and usefulness of the good. 

    What is the most important determinant of price elasticity of demand?

    The most important determinant of price elasticity of demand is the availability of substitutes.

    How to determine price elasticity of demand?

    To determine the price elasticity of demand there are two methods: the midpoint method and the point elasticity method. Both calculate the percent change in the quantity of a good divided by the percent change in price. 

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