What Factors Determine the Price Elasticity of Demand?

Investors in private ambulance companies believe that the price elasticity of demand for an ambulance ride is low for two important reasons. First, in many if not most cases, an ambulance ride is a medical necessity. Second, in an emergency there really is no substitute for the standard of care that an ambulance provides. And even among ambulances there are typically no substitutes because in any given geographical area there is usually only one ambulance provider. (The exceptions are very densely populated areas, but even in those locations an ambulance dispatcher is unlikely to give you a choice of ambulance providers with an accompanying price list.)

In general there are four main factors that determine elasticity: whether a good is a necessity or luxury, the availability of close substitutes, the share of income a consumer spends on the good, and how much time has elapsed since a change in price. We’ll briefly examine each of these factors.

Whether the Good Is a Necessity or a Luxury As our opening story illustrates, the price elasticity of demand tends to be low if a good is something you must have, like a life-saving ambulance ride to the hospital. The price elasticity of demand tends to be high if the good is a luxury—something you can easily live without. For example, most people would consider a 110 inch high-definition TV a luxury—nice to have, but something they can live without. Therefore, the price elasticity of demand for it will be much higher than for a life-saving ambulance ride to the hospital.

The Availability of Close Substitutes As we just noted, the price elasticity of demand tends to be low if there are no close substitutes or if they are very difficult to obtain. In contrast, the price elasticity of demand tends to be high if there are other readily available goods that consumers regard as similar and would be willing to consume instead. For example, most consumers believe that there are fairly close substitutes to their favorite brand of breakfast cereal. As a result, if the maker of a particular brand of breakfast cereal raised the price significantly, that maker is likely to lose much—if not all—of its sales to other brands for which the price has not risen.

Share of Income Spent on the Good Consider a good that some people consume frequently, such as gasoline—say, for a long commute to and from work every day. For these consumers, spending on gasoline will typically absorb a significant share of their income. As a result, when the price of gasoline goes up, these consumers are likely to be very responsive to the price change and have a higher elasticity of demand. Why? Because when the good absorbs a significant share of these consumers’ income, it is worth their time and effort to find a way to reduce their demand when the price goes up—such as switching to car-pooling instead of driving alone. In contrast, people who consume gasoline infrequently—for example, people who walk to work or take the bus—will have a low share of income spent on gasoline and therefore a lower elasticity of demand.

Time Elapsed Since Price Change In general, the price elasticity of demand tends to increase as consumers have more time to adjust. This means that the long-run price elasticity of demand is often higher than the short-run elasticity.

CARLSON©2006 Milwaukee Journal Sentinel. Reprinted with permission of UNIVERSAL UCLICK.

A good illustration is the changes in Americans’ behavior over the past decade in response to higher gasoline prices. In 1998, a gallon of gasoline was only about $1. Over the years, however, gasoline prices steadily rose, so that by 2014 a gallon of gas cost from $3.50 to $4.00 in much of the United States. Over time, however, people changed their habits and choices in ways that enabled them to gradually reduce their gasoline consumption. In a recent survey, 53% of responders said they had made major life changes in order to cope with higher gas prices—changes such as driving less, getting a more fuel-efficient car, and using other modes of transportation like buses or bicycles. Some even moved to a more convenient location to save gas. These changes are reflected in the data on American gasoline consumption: the trend line of consumption fluctuated until about 2003, then took a nosedive. So by 2013, Americans were purchasing 30 million gallons of gasoline a day on average, less than half of the 64 million they purchased in 2003. This confirms that the long-run price elasticity of demand for gasoline was indeed much larger than the short-run elasticity.

ECONOMICS in Action: Responding to Your Tuition Bill

Responding to Your Tuition Bill

College costs more than ever—and not just because of inflation. Tuition has been rising faster than the overall cost of living for years. But does rising tuition keep people from going to college? Two studies found that the answer depends on the type of college. Both studies assessed how responsive the decision to go to college is to a change in tuition.

A 1988 study found that a 3% increase in tuition led to an approximately 2% fall in the number of students enrolled at four-year institutions, giving a price elasticity of demand of 0.67 (2%/3%). In the case of two-year institutions, the study found a significantly higher response: a 3% increase in tuition led to a 2.7% fall in enrollments, giving a price elasticity of demand of 0.9. In other words, the enrollment decision for students at two-year colleges was significantly more responsive to price than for students at four-year colleges. The result: students at two-year colleges are more likely to forgo getting a degree because of tuition costs than students at four-year colleges.

Students at two-year schools are more responsive to the price of tuition than students at four-year schools.
Wavebreakmedia/Shutterstock

A 1999 study confirmed this pattern. In comparison to four-year colleges, it found that two-year college enrollment rates were significantly more responsive to changes in state financial aid (a decline in aid leading to a decline in enrollments), a predictable effect given these students’ greater sensitivity to the cost of tuition. Another piece of evidence suggests that students at two-year colleges are more likely to be paying their own way and making a trade-off between attending college versus working: the study found that enrollments at two-year colleges are much more responsive to changes in the unemployment rate (an increase in the unemployment rate leading to an increase in enrollments) than enrollments at four-year colleges. So is the cost of tuition a barrier to getting a college degree in the United States? Yes, but more so for students at two-year colleges than for students at four-year colleges.

In response to decreased state funding, many public colleges and universities have been experimenting with changes to their tuition schedule in order to increase revenue. A 2012 study found that in-state college freshmen were significantly more responsive to the cost of tuition than freshmen from out-of-state. In-state freshmen were found to have a measured elasticity of demand of 1.8; the elasticity of demand for out-of state freshmen was statistically insignificant (that is, virtually zero). Perhaps out-of-state applicants are less price sensitive because they have higher incomes.

Not surprisingly, many public colleges and universities have found that raising the tuition for enrollments of out-of-state students has boosted revenues.

Quick Review

  • Demand is perfectly inelastic if it is completely unresponsive to price. It is perfectly elastic if it is infinitely responsive to price.

  • Demand is elastic if the price elasticity of demand is greater than 1. It is inelastic if the price elasticity of demand is less than 1. It is unit-elastic if the price elasticity of demand is exactly 1.

  • When demand is elastic, the quantity effect of a price increase dominates the price effect and total revenue falls. When demand is inelastic, the quantity effect is dominated by the price effect and total revenue rises.

  • Because the price elasticity of demand can change along the demand curve, economists refer to a particular point on the demand curve when speaking of “the” price elasticity of demand.

  • Ready availability of close substitutes makes demand for a good more elastic, as does a longer length of time elapsed since the price change. Demand for a necessity is less elastic, and demand for a luxury good is more elastic. Demand tends to be inelastic for goods that absorb a small share of a consumer’s income and elastic for goods that absorb a large share of income.

6-2

  1. Question 6.4

    For each case, choose the condition that characterizes demand: elastic demand, inelastic demand, or unit-elastic demand.

    1. Total revenue decreases when price increases.

    2. The additional revenue generated by an increase in quantity sold is exactly offset by revenue lost from the fall in price received per unit.

    3. Total revenue falls when output increases.

    4. Producers in an industry find they can increase their total revenues by coordinating a reduction in industry output.

  2. Question 6.5

    For the following goods, what is the elasticity of demand? Explain. What is the shape of the demand curve?

    1. Demand for a blood transfusion by an accident victim

    2. Demand by students for green erasers

Solutions appear at back of book.