Elasticity of Demand

How much does quantity demanded change when price changes? By a lot or by a little? Elasticity can help us understand this question. This video covers determinants of elasticity such as availability of substitutes, time horizon, classification of goods, nature of goods (is it a necessity or a luxury?), and the size of the purchase relative to the consumer’s budget.

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- Today, we begin to discuss elasticity
and its applications. This is going to

take us a few lectures because the
material is a little bit involved and

also, I'm going to be honest, the material
can be a little bit tedious. There's

some formulas that we're going to have to
learn how to use and memorize and so

forth. However, the applications are
really fascinating. Moreover, elasticity

is going to come back again and again.
We're going to use it when we do taxes and

subsidies, we're going to use it again
when we do monopoly. This is just another

one of those foundational concepts that is
going to pay to learn well the first time

we do it. Let's get started. Demand curves
slope down. In other words, when the price

goes up the quantity demanded goes down,
when the price goes down the quantity

demanded goes up. Pretty simple. But how
much does quantity demanded change when

the price changes? When the price goes
down, does the quantity demanded increase

by a lot or by a little? That's the
concept that elasticity is going to help

us to understand. Here's the basic
terminology. A demand curve is said to be

elastic when an increase in price reduces
the quantity demanded by a lot. And

similarly, when a decrease in price
increases the quantity demanded by a lot.

That's an elastic curve. The quantity is
changing a lot in response to the price.

When the same increase in price reduces
the quantity demanded just a little or

when the same decrease in price increases
the quantity demanded just a little, then

the demand curve is said to be inelastic
or less elastic or not elastic. The

elasticity of demand is going to be a
measure of how responsive the quantity

demanded is to a change in the price.
Here's an example. Let's start with this

demand curve which we're going to see is
an inelastic demand curve. Notice that

when the price increases from $40 to $50
that the quantity demanded goes down by

just a little, by five units from 80 units
to 75 units. Now consider the following,

suppose we had a demand curve like this.
This turns out to be an elastic demand

curve. Notice that the same $10 increase
in price now reduces the quantity demanded

from 80 units to 20 units. On the elastic
demand curve, the quantity demanded is

much more responsive to the price than it
is on the inelastic demand curve. On a

demand curve where the quantity demanded
is responsive to the price, that's called

an elastic demand. On a demand curve when
the quantity demanded isn't responsive or

is less responsive to the price, that's an
inelastic demand or a more inelastic

demand, a less elastic demand. Now you may
have noticed on the previous diagrams that

the inelastic curve had the higher slope.
That is it was more vertical while the

elastic curve was the more horizontal
curve. We haven't defined elasticity

technically yet. When we do so, you'll be
able to see that elasticity is not the

same as slope. However, they are related.
For the purposes of this class, if you

follow a simple rule you're going to
be fine. The rule is this, if two linear

demand or supply curves run through a
common point, then at any given quantity

the curve that is flatter, more
horizontal, that's the more elastic curve.

So if you're going to draw two demand
curves which we're going to have to do

many times in this class. Let's say they
run through a common point. The flatter

one is the more elastic curve, that will
work fine for you. What determines whether

a demand curve is more or less elastic?
The key determinant is the availability of

substitutes. As we'll see in a minute, the
more substitutes the more elastic the

curve. We can also give some more specific
examples that are closely related to the

number of substitutes. The time horizon, a
longer time horizon is going to make the

curve more elastic. The category of
product, a broad category is going to be

less elastic. A specific category, more
elastic. Necessities versus luxuries.

Luxuries are going to be more elastic. The
purchase size, bigger purchase sizes are

going to be more elastic. Now I've gone
through those quickly so don't worry if

you haven't followed them all right away.
I'm going to go through them now each in

turn and explain the details. The
availability of substitutes is really the

key determinant of how elastic a demand
curve is. The idea is pretty intuitive. If

there's lots of substitutes for a good
then when the price of that good goes up,

people are going to switch from it, the
good whose price is increased towards the

substitutes. They're going to buy the
substitutes instead. That means that when

a good with lots of substitutes, when the
price of that good goes up, the quantity

demanded is going to go down a lot as
people switch to the substitutes. On the

other hand, if we have a good which has
very few substitutes then consumers are

going to find it harder to adjust when the
price has changed. In particular, if the

price goes up and there are very few
substitutes, consumers aren't going to be

able to switch out of that good into
another good. So the quantity demanded is

going to remain fairly constant.
It's not going to fall a lot when the good

has few substitutes. Let's test your
understanding with some quick examples.

Oil, Brazilian coffee, insulin, Bayer
Aspirin. Which of these goods have an

elastic demand? Which of them have an
inelastic demand? Let's start with oil.

Are there lots of substitutes for oil or
just a few substitutes? Just a few

substitutes, right? So if the price of oil
goes up tomorrow, at that point do we all

stop driving our cars? No, there aren't
very many substitutes at least in the

short run. Few substitutes that means
inelastic demand for oil. What about

Brazilian coffee? Some people love
Brazilian coffee but there's also

Ethiopian coffee, there's Mexican coffee,
there's Guatemalan coffee. Therefore, lots

of substitutes, therefore elastic demand.
Insulin, if you don't get it you're going

to die. Not many substitutes, therefore
inelastic demand. What about Bayer

Aspirin? If you go to Wal-Mart you'll find
Wal-Mart Aspirin. If you go to Target

there's Target Aspirin. All kinds of
generic aspirins. If you understand that

aspirin is aspirin, you'll understand that
there are lots of substitutes. If Bayer

tries to raise the price of its aspirin
too much you'll say, "Forget it. I'm going

to go buy the substitutes." Therefore,
elastic demand. The time horizon

influences the elasticity of demand for a
good. And really this is just an

application of the fact that the
fundamental determinant is substitutes.

Immediately following a price increase
it's going to be difficult to find

substitutes. Therefore, immediately
following a price increase, demand is

likely to be fairly inelastic, but over
time consumers can adjust their behavior

and they can find more substitutes.
For example, if the price of oil goes up

then we know that there are very few
substitutes in the short run. But in the

long run what are some of the things that
people would do if the price of oil stays

permanently higher? We'll drive smaller
cars. They'll switch to mopeds. There's a

lot more mopeds driven in Europe for
example because for decades the price of

oil has been higher in Europe due to
taxes. People have adjusted. In the long

run, people will even adjust how cities
are designed so that more people will live

in apartments closer to where they work if
the price of oil stays high. If the price

of oil is really low, there'll be more
sprawl. People will be more willing to

live far away and have a big lawn if the
price of oil isn't so high. The longer the

time horizon, the more the ability to
adjust. The more substitutes and thus the

more elastic the demand. Another factor
determining the elasticity of demand again

based upon the fundamental question, are
there lots of substitutes or just a few is

what we might call the classification of
the good. The broader the classification,

the less likely consumers will be able to
find a substitute. The narrower the

classification, the more likely consumers
will be able to find a substitute. We've

already seen an example of this. There are
more substitutes for Bayer Aspirin, a

narrow classification, than there are for
aspirin, a wider classification. If the

price of Bayer Aspirin goes up, there are
more substitutes, the generics. If the

price of all aspirin goes up there are
fewer substitutes. Of course there are

still some like ibuprofen and
acetaminophen and so forth. But the

narrower the classification, the more
substitutes, the more elastic the demand.

Another example, the demand for food. A
broad classification is less elastic than

the demand for lettuce, a particular type
of food, a narrow classification.

Therefore the demand for lettuce would be
more elastic than the demand for food. The

nature of the good in the consumer's mind
can also affect the elasticity. In

particular whether the good is thought of
as a necessity or as a luxury. Now don't

take these categories as somehow being out
there in the world. They are more about a

person's tastes. For example, for some
consumers that coffee in the morning is a

necessity. Even if the price of coffee
goes up by a lot, those consumers will

still continue to consume about the same
amount of coffee. Therefore those

consumers will have an inelastic demand.
They'll have an inelastic demand for goods

that they consider to be necessities. The
same good in someone else's mind might be

a luxury. The consumer who occasionally
has a cup of coffee. If the price goes up

then they're going to be more willing to
say, "Nah, I'm going to switch to tea. I'm

going to switch to something else."
Depending upon how consumers regard the

good therefore as a necessity, more
inelastic demand. As a luxury, more

elastic demand. The final determinant is
the size of the purchase relative to a

consumer's budget. If the purchase is
small relative to the budget, then

consumers may not even notice when the
price goes up. And if they don't notice

they're not going to respond with a big
change in the quantity demanded. On the

other hand, if we have a product which is
a large part of the budget, consumers

will notice. Consumers notice when the
price of automobiles goes up, that's a big

purchase. They're going to shop around a
lot. They're going to try and get a big

bargain when the purchase is a large
fraction of their budget. On the other

hand, when the price of toothpicks goes up
by a lot, that's not such a big deal.

Consumers probably won't even notice
whether toothpicks are $0.50 or a $1.

That's a 50% increase in price, but you
probably don't even notice that at the

store.
So small item at least in the short run

more inelastic. Bigger items, the bigger
part of the budget, ones the consumer

notices, more elastic, more price
sensitive. Let's summarize the

determinants of the elasticity of demand.
For less elastic goods, that means fewer

substitutes. Short run, less time to
adjust, necessities, small part of the

budget. Each of these factors makes the
demand curve less elastic. More elastic

demand, that means more substitutes. Long
run, more time to adjust. Luxuries, large

part of the budget. These factors make a
demand curve more elastic. If you have to

memorize these but once you understand
that elasticity means how responsive is

the quantity demanded to a change in the
price, then you'll be able to recreate or

figure out these factors again. That's it
for the elasticity of demand. Next time,

we're going to take a closer look at
technically how do we get a number? How do

we calculate the elasticity of demand?
Given some facts and figures on prices and

quantity demanded, how do we calculate
with the elasticity really is? What's the

number?

- [male] If you want to test yourself,
click Practice questions. Or if you're

ready to move on, just click Next Video.

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