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The Concept of Price of Elasticity of Demand

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The Concept of Price of Elasticity of Demand

Businesses know that they face demand curves, but rarely do they know
what these curves look like. Yet sometimes a business needs to have a
good idea of what part of a demand curve looks like if it is to make
good decisions. If Pepsi Coca raises its prices by ten percent, what
will happen to its revenues? The answer depends on how consumers will
respond. Will they cut back purchases a little or a lot? This question
of how responsive consumers are to price changes involves the economic
concept of price elasticity. Therefore the first aim of this essay is
to outline the concept of the price elasticity of demand. It will be
focused on 3 aspects, first, definition of the price elasticity of
demand, second, elastic versus inelastic, and finally some factors
influencing the price elasticity of demand will be interpreted. Also
in this essay, it will be discussed that the price elasticity of
demand in health care market.

The price elasticity of demand measures the responsiveness of quantity
demanded to change in price, with all other factors held constant.

The price elasticity of demand, Ed is defined as the magnitude of:

Proportionate change in quantity demanded

……………………………………………………….

Proportionate change in price

Since the quantity demanded decreases when the price increases, this
ratio is negative; however, the absolute value usually is taken and Ed
is reported as a positive number.

Because the calculation uses proportionate changes, the result is a
unitless number and dons not depend on the units in which the price
and quantity are expressed.

As an example, if a 2% increase in price resulted in a 1% decrease in
quantity demanded, the price elasticity of demand would be equal to
approximately 0.5. It is not exactly 0.5 because of the specific
definition for elasticity uses the average of the initial and final
values when calculating percentage change. When the elasticity is
calculated over a certain arc or section of the demand curve, it is
referred to as the arc elasticity and is defined as the magnitude
(absolute value) of the following:

Q2- Q1

…………………

(Q1+Q2) / 2

……………………………….

P2 - P1

……………………..

(P1+P2) / 2

where

Q1 = Initial quantity
Q2 = Final quantity
P1 = Initial price
P2 = Final price

The average values for quantity and price are used so that the
elasticity will be the same whether calculated going from lower price
to higher price or from higher price to lower price. For example,
going from $8 to $10 is a 25% increase in price, but going from $10 to
$8 is only a 20% decrease in price. This asymmetry is eliminated by
using the average price as the basis for the percentage change in both
cases.

An elasticity coefficient of 2 shows that consumers respond a great
deal to a change in price. If, on the other hand, a 10% change in
price causes only a 5% change in sales, the elasticity coefficient
will be only 1/2. Economists would say in this case that demand is
inelastic. Demand is inelastic whenever the elasticity coefficient is
less than one. When it is greater than one, economists say that demand
is elastic.

Finally, the price elasticity of demand can be influenced by following
factors:

* Availability of substitutes: the greater the number of substitute
products, the greater the elasticity.

* Degree of necessity or luxury: luxury products tend to have
greater elasticity than necessities. Some products that initially
have a low degree of necessity are habit forming and can become
"necessities" to some consumers.

* Proportion of income required by the item: products requiring a
larger portion of the consumer's income tend to have greater
elasticity.

* Time period considered: elasticity tends to be greater over the
long run because consumers have more time to adjust their behavior
to price changes.

* Permanent or temporary price change: a one-day sale will result in
a different response than a permanent price decrease of the same
magnitude.

* Price points: decreasing the price from $2.00 to $1.99 may result
in greater increase in quantity demanded than decreasing it from
$1.99 to $1.98.

Now to better understand the price elasticity of demand that the
demand of health care market is a good example.

Individuals make choices about medical care. They decide when to visit
a doctor when they feel sick, whether to go ahead with an operation,
whether to immunize their children, and how often to have checkups.
The process of making such decisions can be complicated, because it
may involve accumulating advice from friends, physicians, and others,
weighing potential risks and benefits, and foregoing other types of
consumption that could be financed with the resources used to purchase
medical care. This chapter presents some simple tools for describing
these choices and making empirical estimates of the effects of certain
factors, such as prices, incomes, and health status.

Despite a wide variety of empirical methods and data sources, the
demand for health care is consistently found to be price inelastic.

Although the range of price elasticity estimates is relatively wide,
it tends to center on –0.17, meaning that a 1 percent increase in the
price of health care will lead to a 0.17 percent reduction in health
care expenditures. The price-induced changes in demand for health care
can in large part be attributed to changes in the probability of
accessing any care rather than to changes in the number of visits once
care has been accessed. In addition, the studies consistently find
lower levels of demand elasticity at lower levels of cost-sharing.

The demand for health is also found to be income inelastic. The
estimates of income elasticity of demand are in the range of 0 to 0.2.
The positive sign of the elasticity measure indicates that as income
increases, the demand for health care services also increases. The
magnitude of the elasticity, however, suggests that the demand
response is relatively small. Studies based on long time series data
tend to report higher income elasticities. The difference in estimates
across time frames is due to the incorporation of the effects of
changes in medical technology in studies that use long time series of
data.

Although the price elasticity of demand for medical care in general is
relatively low, certain types of care are found to be somewhat more
price sensitive. Preventive care and pharmacy benefits are among those
medical services with larger price elasticities. The finding that the
demand for preventive care is more price sensitive than the demand for
other types of care is not surprising. The number of available
substitutes for a product is a major determinant of demand elasticity.
In the case of preventive care, a number of goods and services could
possibly serve as substitutes. As a result, when the price of care
increases, consumers are able to substitute away from preventive care
toward other goods and services that promote health such as
nutritional supplements and healthy foods. In addition, preventive
medical services may be seen more as a luxury than a necessity and,
thus, may be put off when the price of such care increases. Further,
the opportunity cost of obtaining preventive care is much higher than
it is when the patient is sick, particularly if the illness keeps the
individual out of work. It is also likely, that since the benefits of
preventive care accrue in the long-term, they are heavily discounted.

To conclude this essay that the elasticity of demand is a measure of
the responsiveness of product demand to changes in one of its
determinants. The demand determinants for which elasticity measures
are typically computed are the price of the good or service, the
income of the consumer, and the prices of related goods or services.
Elasticity measures are particularly useful because they focus on the
relative magnitudes of changes rather than the absolute. As such,
elasticity measures are free of units of measurement. This
characteristic makes them particularly useful for comparing demand
responses across products, countries, and individuals. Also in this
essay, in order to better understand the price elasticity of demand,
the health care market has been made as a example in discussed ether
it is a inelasticity of elasticity.

References:

G. J. (1988), “Health status and the demand for health,” Journal

of Health Economics 7:151–163.

Cook, M. & Farquharson, C., (1998), Business Economics, Chapter 6

Hardwick, P., et al, (1999) 5th Ed, An Introduction to Modern
Economics, Chapter3

[www.duke.edu/~dbr1/Health/mba_schedule.html]

“The Health Care Market”

20th March 2005

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