Kasar Jamil

151BE

A good economist is not just interested in calculating numbers. The number is a

means to an end; in the case of price elasticity of demand (PED) it is used to see
how sensitive the demand for a good is to price change. This essay explains the
concept of elasticity of demand with graphical and numerical examples
distinguishing between elastic and inelastic demand, along with explanations of
income elasticity of demand, cross price elasticity of demand and their effects
over time within the construction industry.
To understand price elasticity of demand it is imperative to have a basic
knowledge of the relationship between demand and supply. The law of demand
states that the higher the price of a product, the fewer consumers will demand
that product. In turn, supply is the quantity of a product sellers wish to sell at a
possible price (Investopedia 2008). The relationship between demand and supply
is shown in the graph below:

The graph shows as supply

for a product increases, then
demand for the product
decreases. The equilibrium is
the point at which the
quantity supplied equals the
quantity demanded.

Price elasticity of demand can be defined as the percentage change in quantity

demanded to the percentage change in price. The higher the price elasticity, the
more sensitive consumers are to price changes. Very high price elasticity
suggests that when the price of a good goes up, consumers will buy a great deal
less of it and when the price of that good goes down, consumers will buy a great
deal more. Very low price elasticity implies just the opposite, that changes in
price have little influence on demand (About.com: Economics (2008). It can be
written as:
% Change in Quantity Demanded
% Change in Price
Price elasticity of demand is categorised into two parts; elastic and inelastic
demand.
Elastic demand is when the PED is more negative than -1. This is when the
percentage change in quantity demanded exceeds the change in price. Inelastic
demand is when the price elasticity lies between -1 and 0. This is when the
percentage change in quantity demanded is smaller than the change in price.
Price change of a product has a very different impact demand depending on
whether demand is elastic or inelastic. What determines the price elasticity is the
ease at which consumers can substitute another good.

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Let us now look at distinguishing between elastic and inelastic price elastcity of
demand. The graph below is showing inelastic demand:

The perfectly inelastic graph

illustrates the effect of
change of price of a product
has on demand. If the price of
a product changes, it has
very little effect on quantity
demanded.

Renewed prices have a negligible impact on the quantity demanded as there is

not a good substitute available. For example, take the graph as showing the
impact of price change on drinking water which has good inelastic characteristics
in that people will pay anything for it (high or low prices) with relatively equal
quantity demanded (Begg, Fischer, Dornbusch 2003: 47). Below is a numerical
example showing price inelasticty:
Price Of Insulation

Month 1
50.00

Month 2
55.00

Quantity Sold

105 Tonnes

100 Tonnes

Total Revenue

5250.00

5500.00

PED =
Q X P1 = -5 X 50 = - 0.476
is Inelastic
P
Q1
5
105

Difference (
P = 5

Q =-5

PED < -1 Therefore PED

Alternatively, with elastic demand, the same increase or decrease in price has a
big impact on demand as there are many substitutes for this product available.
For example, a product which is highly elastic is sugar. This is because as the
price of sugar increases, there are many substitutes available that the consumer
can switch to (Begg, Fischer, Dornbusch 2003: 47).

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151BE

The elastic graph illustrates

the effect of change of price
of a product has on demand.
If the price of a product
changes, it has a big impact
on the quantity demanded.

The numerical example below demonstrates price elasticity:

Price Of Insulation

Month 1
50.00

Month 2
55.00

Quantity Sold

35 Tonnes

30 Tonnes

Total Revenue

1750.00

1650.00

PED =
is Elastic

Q X P1 = -5 X 50 = - 1.429
P

Q1

Difference (
P = 5

Q =-5

PED > -1 Therefore PED

35

The concept of elasticity also includes income elasticity of demand (YED) which
helps us to predict the pattern of consumer demand as the economy grows and
people get richer (Begg, Fischer, Dornbusch 2003: 47). Income elasticity of
demand for a good is the percentage change in quantity demanded divided by
the corresponding percentage change in come:
% Change in Quantity Demanded
% Change in Consumer Income
The greater the consumer income, the greater the consumer spends on products
which increases demand of certain goods and decreases demand of others.
These goods are categorized into normal, inferior, essential and luxury goods
which all have different impacts on demand when there is a change in income as
shown below:

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-A normal good has a positive

YED meaning that an
increase in income leads to
an increase in quantity
demanded e.g. dairy produce
-An inferior good has a
negative YED meaning an
increase in come leads to a
fall in quantity demanded
e.g. coal.
-A luxury good has a YED
greater than 1 e.g. wine.
Elasticity of demand is also of great use to the construction industry. When
looking at housing, if prices of houses are too high, consumers are unable to
afford them and demand declines causing supply to decline. As stated above,
income elasticity of demand helps to predict consumer demand when people get
richer and their incomes increase. The construction industry can use this
information in terms of demand and supply of housing. Privately owned housing
is a normal good for most people. As average living standards rise, the total
demand for housing expands, as does the demand for more expensive properties
as people look to move up market (Tutor2u Limited n.d.). This will increase the
work and demand for construction companies as incomes are greater and people
are now willing to buy bigger and new houses, which will increase long run profits
of construction industries.
Looking at the applications of elasticity in construction, we must also refer to
cross-price elasticity. The cross-price elasticity tells us the effect on the quantity
demanded of the good X when the price of good Y is changed (Begg, Fischer,
Dornbusch 2003: 48). It is shown and calculated as:
% Change in Quantity Demanded of X
% Change in Price of Y
The cross-price elasticity for products that are substitutes for one another is
positive. For example, suppose good X is carpet and good Y is laminate flooring.
An increase in the price of laminate flooring raises the demand for carpet.
Alternatively, the cross-price elasticity for products that complement one another
is negative. For example bricks and mortar. We expect a rise in the price of bricks
to reduce the demand for mortar as they complement each other.
In the construction industry, cross price elasticity can be used in terms of renting
or buying a house. Rents are paid monthly or yearly for a property which is
owned by another. If rent prices are low, consumers would find it easier to rent
for lower cost than buy a house. The cross price elasticity
between
and
Low rents
wouldrenting
see
buying a house is high for rent if only renting is cheaper
than buying
a house,
construction
companies
therefore the cross price elasticity for houses is low as more people would prefer
without work
aspaying
there would
to rent than buy. However if rents are raised and consumers
were
lots of
be
people
renting
rather than
money to rent then in the long run they would be better off buying (Tutor2u
buying,
however
rents
Limited n.d.). Cross-price elasticity now favours buying
a house
as inifthe
long run
bills for renting would add up to total sum needed to
buy a house
increased
then the same
companies would have to
increase supply to meet
demand as illustrated by the
graph.

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151BE

Other factors would also be taken into account when using price elasticity in
housing. These would include interest rates which would affect whether
consumers can get a mortgage and in turn have an effect on demand for houses
(Tutor2u Limited n.d.). Expectations of future prices would also have an effect on
demand. For example, if there is a prediction that house prices will increase,
consumers will be encouraged to buy now, which would increase demand for
houses.
Elasticity of demand changes over time, as already touched on above within the
housing market. For example, cross-price elasticity favours buying a house over
renting in the long run as the bills for renting would add up to the total sum
needed to buy a house. However, in the short run, the consumer would save
more money by renting.
When looking at the elasticity of PC machines, you can see the change over time
due to availability of substitutes. PC machines were originally price inelastic and
held their value as there was a limited choice available to the consumer having a
negligible effect on demand. However, at the present time PC machines are
highly elastic as there is much more competition in the market, giving consumers
a wide range of substitutes to choose from.
In more detail, you can see the short and long term effects of elasticity of
demand when looking at energy prices for example. In the short term, the
consumer would struggle with an increase in energy prices, unless they could
rearrange their lifestyle to reduce the amount of energy they use by using a
substitute for energy. A short term solution may be to add insulation, which is a
substitute for energy consumption in a current home. A long term solution to the
same problem may be for the consumer to purchase a more energy efficient
house or one in a warmer climate (Hoag, Hoag 2007:108)
In conclusion, the concept of price elasticity of demand can be applied to a
variety of different problems in which one wants to know the expected change in
quantity demanded given a contemplated change in price. Price elasticises of
demand are useful in calculating the price rise required to eliminate excess
demand (shortage) or the price fall to eliminate excess supply (surplus). Knowing
the elasticity of demand helps us to understand why some markets exhibit
volatile quantities but stable prices, while other markets exhibit volatile prices
but stable quantities (Begg, Fischer, Dornbusch 2003: 48). Identifying whether
the elasticity is elastic or inelastic is the first step towards calculating the price

Kasar Jamil

151BE

elasticity of demand. Take housing in construction for example, demand for

housing is indeed price elastic, though not perfectly elastic as new families
always require new homes. As the house prices rise, demand for larger homes
fall and shift to smaller houses/ apartments and some people defer buying new
homes and continue with rented accommodation (FunQA.com 2007). This
information is of great use to construction companies in predicting whether to
increase or decrease supply of houses.

List of References
Begg, D, Fischer, S, Dornbusch, R (2003)
7th edn. ed. By Partridge, J Economics. Maidenhead: McGraw-Hill
Education
Hoag, A.J, Hoag J.H, (2006)
4th edn. Introductory Economics: World Scientific
Tutor2u Limited (n.d.) Tutor2u demand and supply from housing [online]
Available from
<http://tutor2u.net/economics/content/topics/housing/housing_demand
_supply.htm> [30 October 2008]
About.com: Economics (2008) Price Elasticity of Demand [online]

Kasar Jamil

151BE

Available from
<http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm>
[2 November 2008]
Investopedia (2008) Economics Basics: Demand and Supply [online]
Available from
<http://www.investopedia.com/university/economics/economics4.asp>
[2 November 2008]
NetMBA Business and Knowledge Centre (2007) Price Elasticity of Demand
[online]
Available from
<http://www.netmba.com/econ/micro/demand/elasticity/price/>
[2 November 2008]
Affordable Housing Institute (2008) [online]
Available from
<http://affordablehousinginstitute.org/blogs/us/2006/03/housing
Demand.html> [2 November 2008]
FunQA.com (2007) Price elasticity for housing demand [online]
Available from <http://www.funqa.com/economics/822-economics3.html>
[2 November 2008]