Price Elasticity of Demand

Economics

The concept is proportion of income devoted to a good typically applies to discussions about the price elasticity of demand. The basic concept of price elasticity of demand is that it is relational to the percentage change in the price of a good. But the proportion of income devoted to a good will have an impact on the elasticity. The best way to illustrate this is by comparing two different products.

A person pays rent, and they like to buy a coffee every morning. If their rent is $1,000 per month and the coffee is $2 per day (so $40 per month). The price of each increases by 10%. The percentage price increase is the same, but the rent is a much larger proportion of income. So the increase in the price of rent is $100, and the increase in the price of coffee is $4. The consumer is going to be much more conscious of the rent increase. That extra $100 may spur a decision to move, where the extra $4 is unlikely to spur a change in coffee consumption -- especially when it is 20 cents per day. If the person's income is $3,000, then the $100 represents 3.3% of that. The coffee increase is 0.13%, so a much smaller proportion, and a figure much less likely to draw a response from the consumer.

What this shows is that the greater the proportion of income that a good is, the higher the price elasticity of demand should be for that good. Consumers are simply more sensitive to what are larger dollar value changes in price; the percentage change does not matter much when the proportion of income is vastly different.

E1. If these figures are taken on aggregate to deliver a statistically-significant sample, this would work as follows. For every 100 people, an additional $100 in rent would be worth moving over. This is $1,200 per year, and the place just isn't worth it. Moving is a nuisance, so not everybody is going to move over $100, but let's say that 30 people out of 100 move. This is 30% of the total sample size. The price elasticity of demand is therefore:

% D / ? $% P

-30% / 10% = -3

So the demand for housing is reverse elastic by a factor of 3. For every 1% of change in the price of rent, there will be a 3% change in demand.

With coffee, the change is less pronounced. Say 5 people are put off by the change in the price of coffee, and substitute it with something else. Maybe they brew their own coffee at home; maybe they get it at a cheaper place. It doesn't matter what the substitute is. Five people out of one hundred have taken the price increase as a sign that they need to stop going to that shop. The price elasticity of demand for coffee is therefore:

% D / ? $% P

-5% / 10% = -0.5

This means that for every 1% change in the price of coffee, there will be a 0.5% change in the demand for coffee. Coffee in this instance would be an inelastic product. It is certainly going to have a lower degree of elasticity than rent.

It should be noted, however, that elasticity is not always a flat curve. These elasticities are just the slope at this point in the curve. At lower levels of change, rent might not have much elasticity at all, because there is a cost associated with moving. Any change in rent that is lower than the cost of moving should not result in a move unless the person genuinely cannot afford the new rental rate. The same thing occurs with coffee. Coffee is inelastic when the price change is relatively minor. If the price of coffee doubled, however, elasticity would be much higher. Even though the proportion of income would not be that much different, consumers will find that if the price of coffee at their usual place is way out of line with the other coffee shops in the area, their price sensitivity will probably increase.

F. There are also differences in price sensitivity over the short run and long run. The price of rent is a good example. In the short run, a person might not freak out immediately when their rent is raised. They might have a lot of good reasons not to move, and thus may accept that they are uncomfortable with the higher rent in the short run. Maybe the costs of moving are high. Maybe they need to consider the other people who live in the household. A good example would be if rent increased in October. A parent might hesitate to move and force their kids to change schools once the year has started. But there could be a lot of reasons why someone's consumption pattern might not change immediately. With some commodities, a person might wait to see if a price change sticks before making a decision. With rent, they know it won't come back down but other factors might cause a delayed decision.