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Understanding Markets
Elasticity
Identifying the Determinants of Elasticity
Page 1 of 2
The elasticity of demand is the responsiveness of the quantity demanded to changes in the price of the good. We’ve
discussed how to calculate the elasticity of demand, and we’ve also discussed the relationship between elasticity of
demand and total revenue. One question remains. What determines the elasticity of demand for a particular product?
What determines whether the demand for a product is elastic, that is, very responsive to changes in the price of the
product or whether it’s relatively inelastic? That is, a large change in the price of the product may not produce a
sizeable change in the quantity demanded. What’s the difference between goods with elastic demand and goods with
inelastic demand?
The first, and probably most important determinant of the elasticity of demand is the available of close substitutes,
products that have a lot of close substitutes are likely to have more elastic demand. For example, if one airline
decides to raise the price of its tickets, customers can switch to another airline and fly perhaps to the same
destination. The availability of substitutes makes the demand for a particular airline ticket relatively elastic. The
demand for a particular kind of soda might also be elastic. If one company raises the price of its soft drinks,
customers may switch to another comparable drink.
Elasticity of demand often follows from the availability of close substitutes. The more substitutes are available, the
more elastic the demand for the product is likely to be. The more close substitutes, the more price responsive.
Products that are inelastic in demand are likely to be those that have no close substitutes available, or few good close
substitutes. For example, the demand for insulin to treat diabetes is usually viewed as inelastic. Whatever the price
of insulin is, a diabetic is likely to pay it rather than do without because there are no good substitutes. However, even
insulin is not a perfectly inelastic good. As the price of diabetic treatment goes higher and higher, some people who
suffer from diabetes may look to alternative ways of managing their condition. They may choose to exercise more
rigorously or watch their diet more closely as opposed to paying higher and higher prices for the medicine.
It’s difficult to come up with any product that’s going to be completely unresponsive, any product that has no
substitutes at all available. Even though you need gasoline to make your car go, it may be that if the price of gasoline
gets high enough, you will stop driving your car altogether and use mass transportation or walk or simply make fewer
trips. The point I’m trying to make is this: if there are few close substitutes available for a product, the demand for that
product is likely to be unresponsive to changes in the price of the good. When there are few close substitutes, people
have to buy that product, and their demand for the product is unresponsive or inelastic. On the other hand, the more
close substitutes there are available, the more likely you are to get elastic demand, that is, highly price-responsive
quantity demanded.
The second determinant of the elasticity of demand is time. The more time you have during which to search for
substitutes, the more likely your demand will be elastic. Suppose I’m building a house and I think I need lumber for
framing my house and finishing it. If the price of lumber goes way up and I have to make a decision now, I’m likely to
just swallow the extra cost and finish my house with lumber. But if I have two or three months to make a decision, two
or three months to search for a substitute, then I’m more likely to hold out and look for a possible alternative. During
those months producers may convince me that steel framing is a very good substitute for lumber. As lumber prices
rise, producers will begin to offer customers alternatives.
Alternatives don’t come on line quickly, so the more time you have to get an alternative, the more likely you are to find
an acceptable substitute, and the more price-responsive your demand for lumber will be. That is, the more time you
have for making a decision, the more likely you are to find a good substitute, and therefore, the more price-responsive
your demand will be.
The third determinant of the elasticity of demand is the percentage of your budget that is spent on the good in
question. If you consider your elasticity of demand for bubble gum, your demand for bubble gum is probably relatively
inelastic. That is, when the price of bubble gum goes up from two cents apiece to a nickel apiece, you probably don’t
change the quantity that you consume during a week. Your demand for bubble gum is inelastic because bubble gum
is not a big percentage of your budget. You may not even look at the price tag when you purchase gumballs.
On the other hand, if you consider your demand for housing, your housing cost is such a large percentage of your
budget that if your apartment rent were to go up by 20 percent, you may have to look for another place to live or take
in a roommate. Because housing occupies a large chunk of your budget, your quantity demanded will be responsive
to a given percentage change in price.
Understanding Markets
Elasticity
Identifying the Determinants of Elasticity
Page 2 of 2
Well, as a quick summary then, your demand for a product is likely to be more elastic if there are close substitutes
available, if you have lots of time over which to search for substitutes, and if the product in question occupies a big
chunk of your budget, so that price changes really require you to make some kind of adjustment. On the other hand,
your demand for a particular product is likely to be inelastic or non-price-responsive if there are not good substitutes
available, if you have to act quickly and don’t have time to search for substitutes, and finally, if the good in question
occupies a small chunk of your budget so that you don’t have to change your behavior when the price changes.
These three factors are likely to influence whether the demand for a product will be inelastic or elastic, and as you
know, once you know which it is, you can say how a change in price will affect total revenue raised in that market.
Inelastic demand means that lower prices shrink total revenue. Elastic demand means that lower prices increase total
revenue.