Determinants of Price Elasticity of Demand
Given the significance of price elasticity of demand, it is important to know how responsive demand is to price changes. For our gas station operator considering a price increase, it would matter a good deal if the elasticity was -.5 rather than -2. As we will see in the section on revenue, if the elasticity were -.5, then the price hike would raise total revenue while if it were -2, the price hike would lower revenues. In one case the strategy is a win - in the other it is a loss.
The bad news is that it is not easy to estimate elasticity of demand. The good news is that there are some rules of thumb that we can use to get a handle on elasticity.
Availability of substitutes affects price elasticity of demand. In general we will find demand becomes more responsive as the number of substitutes increases. If we were to look at the demand for Hood milk we would expect it to be elastic since there are many substitutes for Hood milk. When we look at the demand for milk, however, we may expect to find demand to be less responsive since there are not many very close substitutes to milk - unless you see soda or juice as a good substitute.
This would be where we would see the influence of loyalty. When a firm successfully creates brand loyalty what it is doing is effectively reducing the availability of substitutes in the minds of buyers. Because the buyers no longer believe the other products are close substitutes, the increase in price is less likely to lower demand for the product.
Size matters. Price elasticity of demand is also likely to be smaller when your total expenditure on the item is small - when it is a small ticket item. For example, if the price of paper clips rose substantially it is unlikely that you would reduce your demand since total expenditures on paper clips is still very small and the change would have virtually no impact on your total budget.
There is also the question of durability. If you have an item that is durable, you would expect demand to be more responsive to price changes. When an item is durable you will not need to buy it if the price rises because you can put off your purchase and still receive the benefits from your previous purchase. If the price of garden tools rose, you could use your old tools because they are durable, but if the price of milk rose, it is unlikely that you will be able to get by with using milk that you bought last month.
Time matters. If you give people longer to adjust their behavior, they will be able to make larger adjustments. For example, if the price of gas rises rapidly then your initial reaction is likely to be minimal. You will still buy the same amount of gas because your driving habits will not have changed. If you are given a longer period to adjust, however, you may find that you buy a new, more gas efficient car which will lower your demand for gas. The generalization to be drawn from this is that elasticity increases with the time horizon.
Here is where habit enters the picture. Because habits are slow to break, a change in price is not likely to have a large immediate impact on demand. If you give people a chance to adjust, however, they may very well be able to 'break' their habits and thus we could expect a larger response to the price change in the long-run.
When we switch to supply, we can expect that time horizon will have a significant effect on the price elasticity of supply. For example, if the price of rentals increased in the Kingston area in September as URI students returned to school, you would expect to see little increase in the supply of rental housing since the housing stock is fixed in the short-term. By next Fall, however, if landlords believed that the price increases were going to last and they could make money on new construction, then the supply of housing would tend to increase as a result of the new construction. The same would be true if the price of gasoline rose rapidly and consumers drove up the price of small, gas efficient cars. In the short-term the auto companies could not shift assembly lines to produce the small cars so supply would tend to be inelastic. Once there was enough time to shift the assembly lines, the supply increase associated with the price increase would be greater and supply elasticity would be higher.
Now that you have the determinants of price elasticity of demand, let's look at a problem similar to question 4 in the review quiz.
For which of the following products do you expect to see the lowest price elasticity of demand?
To answer this we need to return to the discussion of the determinants of demand elasticity. Automobiles and homes would, all other things equal, tend to have higher elasticities because they are big ticket items. If the price went up it would have a potentially big impact on your expenses so you might be 'persuaded' by the price increase to cut back on your purchases. The same would be true of leather jackets. Demand for homes and autos would also tend to be more responsive because they are both durable, and maybe the same could be said of leather jackets. This would tend to make demand for these items more responsive to price changes because you could continue to use what you have if the price went up - you could forestall consumption. The winner in terms of inelasticity would be socks, a small ticket item on which people probably do not even check the price.