The Existence of Substitutes
If consumers can substitute easily, switching from one product to another without losing any value or quality, the prod-
uct will be elastic. Consumers will purchase a substitute rather than the original product because of the lower price.
For example, some movie theaters offer price discounts to teenagers. More substitutes may be available to teenagers
than to other consumers, so movie theaters offer these discounts as an incentive to lure them to the movies.
In contrast, people who are on prescription medication have no substitutes. No substitutes means inelasticity. The fewer
options there are, the higher the degree of price control and inelasticity for producers.
When few close substitutes for a product are available, the price elasticity of demand for that product is low. It is for
this reason that firms attempt to create brand names and customer loyalties. A lower price elasticity of demand enables
a firm to increase its prices without a decrease in sales.
Product Importance Relative to Budget
Consider the monetary values of a vacation in Europe and a new car. Any small percentage change will require a signif-
icant portion of income. As a result, a one-percent change in the price of the vacation or the car may delay the purchase
of either one. Toilet paper, on the other hand, accounts for such a small portion of an income that a 1 percent change in
its price will have no impact on consumption. Although the demand for the vacation or the car is a lot more elastic than
the demand for toilet paper, consumption of anything is relative to the budget of the consumer.
The Time Period
The time allowed for a consumer to respond to a price change is crucial when determining elasticity. If we consider an
hour or two, chances are the product will be closer to inelastic than elastic because of the lack of time consumers have
to respond to a price change. If we are talking about a year or longer, then the demand for products will tend to be more
elastic in comparison. Consumers for one reason or another may take a while to react to a price change. Additional
time allows consumers to alter their behavior based on economic cycles, recent purchases, and even the ability of
finding close substitutes. If you go to the mall and see a pair of shoes you really like but realize they may be out
of your price range, chances are you will continue to search for the same shoe at a lower price or find a pair that are
very similar.
Price Cross-Elasticity of Demand
Price cross-elasticity of demand measures the correlation between goods and their substitutes or complements. To derive
the price cross-elasticity of demand, you take the percentage change in the quantity demanded for one good and divide it
by the percentage change in the price of a related good:
Price cross elasticity Percentage change in Y
Percentage change in quantity for X
-=When price cross-elasticity is positive, the goods are deemed substitutes, and when the price cross-elasticity is negative,
the goods are complements. If a one-percent increase in the price of cereal leads to a five-percent increase in quantity
demanded of oatmeal, then oatmeal and cereal are substitutes. If a one-percent rise in the price of cereal leads to a
5 percent decrease in oatmeal, then the two goods are complements.
Knowing competitors’ pricing and marketing strategies is crucial for a firm. Firms can estimate the impact of their price
changes in relation to their substituted or complemented good. This allows firms to set more effective prices using a
formula that can tell just how closely related the two goods are.
Elasticities