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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- [Alex] 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
what the elasticity really is?

What's the number?

- [Narrator] 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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