THE DETERMINANTS OF PRICE ELASTICITY

What determines whether the price elasticity of demand for a good is high (say, -5) or low (say, -0,5)? Ultimately the answer must be sought in consumer tastes. If it is considered socially essential to own a television, higher television prices may have little effect on quantity demanded. If televisions are considered a frivolous luxury, the demand elasticity will be much higher. Psychologists and sociologists may be able to explain more fully than economists why tastes are as they are. Nevertheless, as economists, we can identify some considerations likely to affect consumer responses to changes in the price of a good. The most important consideration is the ease with which consumers can substitute another good that fulfils approximately the same function.

Consider two extreme cases. Suppose first that the price of all cigarettes is raised 1 per cent, perhaps because the cigarette tax has been raised. Do you expect the quantity of cigarettes demanded to fall by 5 per cent or by 0,5 per cent? Probably the latter. People who can easily quit smoking have already done so. A few smokers may try to cut down but this effect is unlikely to be large. In contrast, suppose the price of one particular brand of cigarettes is increased by 1 per cent, all other brand prices remaining unchanged. We should now expect a much larger quantity response from buyers. With so many other brands available at unchanged prices, consumers will switch away from the more expensive brand to other brands that basically fulfil the same function of nicotine provision. For a particular cigarette brand the demand elasticity could be quite high.

Ease of substitution implies a high demand elasticity for a particular good. In fact, our example suggests a general rule. The more narrowly we define a commodity (a particular brand of cigarettes rather than cigarettes in general, or oil rather than energy as a whole), the larger will be the price elasticity of demand.

MEASURING PRICE ELASTICITIES

To illustrate these general principles we report estimates of price elasticities of demand in Table 4.3. The table confirms that the demand for general categories of basic commodities, such as fuel, food, or even household durable goods, is inelastic. As a category, only services such as haircuts, the theatre, and sauna bath, have an elastic demand. Households simply do not have much scope to alter the broad pattern of their purchases.

In contrast, there is a much wider variation in the demand elasticities for narrower definitions of commodities. Even then, the demand for some commodities, such as dairy produce, is very inelastic. However, particular kinds of services such as entertainment and catering have a much more elastic demand. Small changes in the relative price of restaurant meals and theatre tickets may lead households to switch in large numbers between eating out and going to the theatre, whereas the demand for getting out of the house on a Saturday evening may be relatively insensitive to the price of all Saturday night activities taken as a whole.

TABLE 4-3. Estimates of Price Elasticities of Demand in the UK

You have read the text. Check your understanding.

1) At what numerical quantities of the price elasticity is demand elastic or inelastic?

2) When do economists say that demand is unit - elastic?

3) What is the key piece of information which is required in setting prices?

4) What determines whether the price elasticity of demand for a good is high or low?

5) For what categories of commodities is demand usually inelastic?

6) What is the most important consideration which affects consumer responses to changes in the price of a good?

7) What is the demand elasticity for narrower definitions of commodities?

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