The Concept of Price Elasticity
The concept of price elasticity is important when considering the relationship between price and demand. If a product is inelastic, it is unlikely to change its price if demand increases. For example, insulin is a very inelastic good, meaning that a rise in price will not significantly affect its demand. Conversely, if a product’s price decreases, people will not hold out for a lower price.
Price elasticity is the degree to which the price of a good or service changes when the quantity of it increases. A transit authority, for instance, might increase the price of a bus from $0.10 to $0.20, and the total revenue would decrease from $42,000 to $32,000, respectively. As a result, the price elasticity of this service is -0.20 in the short-run, but -0.50 in the long-run.
Price elasticity can be affected by many factors. First, it can depend on the characteristics of customers. The more diverse the potential customer base, the more varied the demands they will have. Second, price elasticity can be affected by changes in people’s beliefs, such as the trend towards eco-friendly products.
The lower the price elasticity, the less elastic the product’s price. For example, food in general is inelastic, but specific foods may be more elastic. The most elastic goods are those that consumers perceive as necessities. As such, the price elasticity of addictive goods is relatively low. Thus, it’s imperative to find the right price for such products to attract the right consumers.
As a rule of thumb, elasticity of demand is a measure of how much a change in a product or service changes the quantity a consumer is willing to pay. For example, if a consumer is spending a small percentage of his income on a single product, a price change will have little effect on the price of that product. However, when that proportion of income is larger, the consumer is more elastic over a longer period. It’s also a good indicator of whether a product or service is truly unique.
In the long run, price changes affect the quantity demanded by consumers. When a price is increased, total revenue will rise, and if it decreases, total revenue will decrease. The effect of a price increase is more dramatic for products that consumers purchase on a regular basis. This is important because changes in price may lead to a change in demand, which affects total revenue.
Prices elasticities can also be influenced by the introduction of new products into a market. There are different models that account for price elasticity. In the Lancaster (1979) style model, consumers prefer an ideal product variety. The market space is finite, and entry drives the price elasticity of demand up. Similarly, Melitz and Ottaviano (2008) model features linear demand with a choke price. This model demonstrates how entry and exit affects the slope and intercept of a demand curve.