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Demand Elasticity

Elasticity measures how sensitive consumers are to price change.

  • Demand is elastic when a change in price causes a large change in demand.
  • Demand is inelastic when a change in price causes a small change in demand.
  • Demand is unit elastic when a change in price causes a proportional change in demand.

Study the elasticity chart below and notice that in the left hand column is labeled the Determinants of Elasticity. These five determinants or factors will help determine whether the product is elastic or inelastic. The second column gives you some examples of products.

Determinants of Elasticity and Examples
Determinants of Elasticity Examples
Is the product a luxury or a necessity?
  • If it is a luxury, the demand for the product is elastic.
  • If the demand for the product is a necessity, the product is inelastic.
  • Yachts and European vacations are luxuries.
  • Insulin for a diabetic, gasoline when your tank is empty, and chocolate to someone with a sweet tooth are necessities.
What is the time horizon? Do you need the product immediately?
  • If you do, the demand for the product is inelastic. You will pay whatever it takes.
  • If you can wait, however, the demand for the product is elastic. You can shop around for the best price.
  • Demand for prom dresses in August is elastic, and so is gas if you have a half of a tank and you live in a big city with a lot of stations.
  • Demand is inelastic for a parent who needs diapers for their baby or an addicted smoker is out of cigarettes.
Does the purchase comprise a large or small part of your income?
  • If the amount is large, the demand for the product is elastic.
  • If the amount is small, the demand for the product is inelastic.
  • A car is expensive and is a large part of a person's income. People therefore shop around and are responsive to a change in price. Therefore, it's elastic.
  • A product like a single piece of gum or a container of salt costs very little. We will buy these items without regard to price. Therefore, it's inelastic.
Are there close substitutes?
  • If yes, the product is elastic.
  • If not the product is inelastic.
  • Coke vs Pepsi are substitutes to some people. So are pork and chicken. So are cookies and cake.
  • Products such as insulin and gasoline (both mentioned above) have no adequate close substitutes currently.
  • One interesting view to consider is that some religions prohibit the eating of certain foods. For example, when pork is on sale for pennies a pound, a person of Jewish faith will not buy the meat regardless of the bargain because it is against their religion.
How big is the market?
  • If the market is big, the demand for the product is elastic.
  • If not, the demand for the product is inelastic.
  • If you need a gallon of milk in a big city, your market is large and you can shop for the best bargain (elastic).
  • If you need a gallon of milk in a small town with only one grocery store, you will buy the milk regardless of the price (inelastic).
  • Another example: Hot dogs at a baseball park and popcorn at a movie theater cost more because the market is small.

Download a copy of the Determinants of Elasticity and Examples chart for your notes here.

Beyond the Elasticity Chart: The Total Expenditures Test

Charts are helpful to determine elasticity, but are not exact. Indeed, a product as simple as a hot dog can be both elastic (hamburger is a close substitute) and inelastic (at a ballpark). Because the business owner and government entity needs to know the exact elasticity, a total receipts test or total revenue test is used and a calculation is derived.

The formula is: Price × Quantity = Total Receipts (Revenue)

For example, selling 20 items (quantity) at $2.00 each (price) equals $40.00 (total receipts or total revenue). $2.00 × 20 items sold = $40.00

Elasticity Chart Using Total Receipts Test
Situation Observation Business Owner Application Government Entity Application
Price Increases ↑
Total Receipts Increases ↑		 Arrow in the same direction. Product is inelastic. If you sell an inelastic product and want to make more money, raise your price.
If Harvard wants more money, the trustees just need to raise tuition. It works! 		Raise taxes on inelastic products such as cigarettes and alcohol; these are known as "sin" taxes. Raise taxes on gasoline. All of these "extra" taxes are known as "excise" taxes.
Price Decreases ↓
Total Receipts Decreases ↓		 Arrow in the same direction. Product is inelastic. If you sell an inelastic product and drop your price, you will lose money.
If you sell a one-in-a-kind product, don't lower your price!		 Don't drop the extra taxes on inelastic products or the revenue will fall.
Price Increases ↑
Total Receipts Decreases ↓		 Arrow in the opposite directions. Product is elastic. If you sell an elastic product and raise your price, people will stop buying your product. Do not tax elastic products. People will buy the substitute.
Price Decreases ↓
Total Receipts Increases ↑		 Arrow in the opposite directions. Product is elastic. If you sell an elastic product and you lower your price, people will buy your product and you will make more money. Consumers are responding to the price break and are buying more. Everyone is happy. If Congress taxed less on certain items, we would buy more of that item. Tax less on the interest earned on investing in the stock market, and more people would invest in the stock market, example.

Download a copy of Elasticity Chart Using Total Receipts Test chart for your notes here.

Graphing Demand

The Demand Curve

Notice the demand curve slopes downward. This shows that people are normally willing to buy less of a product at a high price and more at a low price. According to the law of demand, quantity demanded and price move in opposite directions.

graph of a demand curve
A demand curve. The quantity demanded is on the x-axis and the price is on the y-axis. When price is high, the quantity demanded is low. As price decreases, demand increases. See larger version of demand curve graph.

Change in Quantity Demanded

Change in the quantity demanded due to a price change occurs ALONG the demand curve. In other words, when the price of a good is changed, the quantity demanded changes but you do not change the demand.

graph of a demand curve
A demand curve. The quantity demanded is on the x-axis and the price is on the y-axis. When price is high, the quantity demanded is low. As price decreases, demand increases.

Look at the graph below.

  • At $5, the quantity demanded of a product is 2.
  • A decrease in the price of the product to $4 will lead to an increase in the quantity demanded of the product from 2 to 4.
A demand curve. The quantity demanded is on the x-axis and the price is on the y-axis. When price is high, the quantity demanded is low. As price decreases, demand increases. A dotted line shows that at $5 price, the quantity demanded is 2 and another dotted line shows that at a price of $4, the quantity demanded is 4.
See larger version of annotated demand curve graph here.

To learn more about the demand curve, watch the Demand Curve (5:06) video below.

Open Demand Curve in a new tab

Non-price Determinants

In the last lesson, we talked about several factors that may go beyond changing the quantity demanded but instead will change the entire demand for a good/product/service. These factors (or non-price determinants) are:

  • Change in income
  • Change in taste
  • A price change in a related product (either because it is a substitute or complement)
  • Consumer expectations
  • The number of buyers

Look at the graph below. When a change in demand for the good takes place, the entire demand curve shifts. For example, suppose that consumer income increases. As a result, the demand for a product at all prices will increase.

graph of demand curve shift up
In this demand curve shift, the quantity demanded is on the x-axis and the price is on the y-axis. When price is high, the quantity demanded is low. As price decreases, demand increases, making this a line that runs downward from left to right. In the original line, at a price of $6, the quantity demanded is 0; at $4, the quantity demanded is 4; at $3, the quantity demanded is 6; at $2 the quantity demanded is 8. In the shifted line, the quantity demanded at $6 is 4; at $4 the quantity demanded is 7; at $3 the quantity demanded is 9; at $2 the quantity demanded is 11, The shifted line is moved to the right on the graph. See larger version of the demand curve graph shifting right.

Demand may also decrease due to changes in factors other than price. For example, if public taste changes, making a product undesirable, a decrease in demand for that product will occur. See the graph below.

In this demand curve shift, the quantity demanded is on the x-axis and the price is on the y-axis. When price is high, the quantity demanded is low. As price decreases, demand increases, making this a line that runs downward from left to right. In the original line, at a price of $6, the quantity demanded is 0; at $4, the quantity demanded is 4; at $3, the quantity demanded is 6; at $2 the quantity demanded is 8. In the shifted line, the quantity demanded at $6 is 0; at $4 the quantity demanded is 2; at $3 the quantity demanded is 4; at $2 the quantity demanded is 6. The entire line is shifted to the left. See larger version of demand curve graph shifting left.

Demand Graph Scenario #1

Look at the graph below. Assume a nation is experiencing a severe drought with no sign of relief in the near future. What will happen to the demand curve for umbrellas? (Note: D1 is the original demand curve.)

This is a demand curve showing shifts in demand. D1 is the original demand line. It contains two points - A, which represents a higher price and lower demand and B, which represents lower price and higher demand. Line D2 shows an increase in demand- in other words, a higher quantity demanded for a given price. This line is above D1. Line D3 represents a decrease in demand, or a lower quantity demanded for a given price. It is below line D1.

Select one:

  1. A to B
  2. B to A
  3. D1 to D2
  4. D1 to D3
  5. No Change

Answer: d. D1 to D3

Explanation: The drought is a non-price determinant, so there is not just a change in quantity demanded, but instead the demand decreases causing a shift in the graph.

Demand Graph Scenario #2

Look at the graph below. To help sell umbrellas, stores offer a 50% discount. What will happen to the demand curve for umbrellas? (Note: D1 is the original demand curve.)

This is a demand curve showing shifts in demand. D1 is the original demand line. It contains two points - A, which represents a higher price and lower demand and B, which represents lower price and higher demand. Line D2 shows an increase in demand- in other words, a higher quantity demanded for a given price. This line is above D1. Line D3 represents a decrease in demand, or a lower quantity demanded for a given price. It is below line D1.

Select one:

  1. A to B
  2. B to A
  3. D1 to D2
  4. D1 to D3
  5. No Change

Answer: a. A to B

Explanation: Remember, a change in the quantity demanded due to a price change occurs ALONG the demand curve. So, the price of umbrellas was lowered in order to sell a higher quantity of umbrellas. Therefore, the best choice is A to B.