What determines the value of an elasticity

Overview

Demand for a habit-forming or addictive product typically price inelastic, spare capacity make supply more price elastic and ability to hold stocks make supply more price elastic.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does the number and closeness of available substitutes have such a strong effect on price elasticity of demand?

   Model answer

   Substitutes give consumers somewhere to go when a price rises. If a good has many close substitutes, even a small price rise pushes a large proportion of buyers towards the alternatives, so quantity demanded falls sharply and demand is price elastic. If a good has few or distant substitutes, buyers have little choice but to absorb the price rise, so quantity falls only slightly and demand is inelastic. Closeness matters as much as number: a hundred distant alternatives constrain a seller less than two near-identical ones do.

2. 2

   Why is demand for a necessity generally less price elastic than demand for a luxury?

   Model answer

   A necessity is something a household regards as essential and continues to buy across a wide range of prices - domestic heating, basic foodstuffs, prescription items. Buyers cannot simply do without it, so quantity demanded falls very little when price rises and demand is inelastic. A luxury is postponable: a household can delay a new sofa or skip a holiday without hardship. When its price rises, buyers can and do walk away, so quantity demanded falls proportionately more and demand is elastic. What counts as a necessity varies between households and over time.

3. 3

   How does the share of a household's income that a purchase takes up affect price elasticity of demand?

   Model answer

   The larger the share of income the purchase absorbs, the more elastic demand tends to be, because the price change matters enough to be worth reacting to. A 10% rise in the price of a new car is hundreds of pounds and prompts serious shopping around or postponement. A 10% rise in the price of a box of matches is trivial, so buyers barely notice and demand is very inelastic. This is why cheap, frequently bought small items often show inelastic demand even when substitutes exist.

4. 4

   Why is demand for a habit-forming or addictive product typically price inelastic?

   Model answer

   Habit and addiction weaken the consumer's ability or willingness to substitute away. The purchase is not being reconsidered afresh each time, so a price rise does not trigger the search for alternatives that ordinary goods face, and consumption falls by proportionately less than the price rose. Demand for such products is therefore inelastic, particularly in the short run. Over longer periods the value tends to rise in modulus, because sustained high prices, better substitutes and cessation support allow some consumers to reduce or quit.

5. 5

   Why is demand for a good usually more price elastic in the long run than in the short run?

   Model answer

   Adjustment takes time. Immediately after a price rise, consumers may not know about it, may be locked into a contract, or may own equipment that ties them to the product - a gas boiler, a petrol car, a particular software system. Over a longer period they can search out alternatives, change their habits, replace the equipment and reorganise their lives around a substitute. Each of those responses adds to the eventual fall in quantity demanded, so the same price rise produces a larger percentage change in quantity and demand looks more elastic.

6. 6

   Why is demand for petrol as a whole less price elastic than demand for petrol from one particular chain of filling stations?

   Model answer

   Because the market has been defined more narrowly in the second case. If all petrol becomes dearer, motorists have few real alternatives in the short run and must largely keep buying, so demand is inelastic. If only one chain raises its price, motorists can drive to a competitor a mile away and buy an identical product, so a large proportion switch and demand for that chain's petrol is highly elastic. The broader the definition of the market, the fewer substitutes lie outside it and the more inelastic demand becomes.

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