Price Elasticity of Demand: Classification and Determinants

1. The Spectrum of Elasticity: Classifying Demand

In the last lesson, you learned that because of the law of demand, price elasticity is always negative. By convention, economists use the absolute value, $|E_d|$, to classify elasticity. This avoids confusion and makes interpretation more straightforward.

Demand can be categorized into five types along a spectrum from perfectly responsive to completely unresponsive.

| Classification | Absolute Value of Elasticity $|E_d|$ | Interpretation |
| :--- | :--- | :--- |
| Perfectly Elastic | $|E_d|=\infty$ | The percentage change in quantity demanded is infinite for any price change. A tiny price increase causes demand to fall to zero. |
| Elastic | $|E_d|>1$ | The percentage change in quantity demanded is greater than the percentage change in price. |
| Unit Elastic | $|E_d|=1$ | The percentage change in quantity demanded is equal to the percentage change in price. |
| Inelastic | $|E_d|<1$ | The percentage change in quantity demanded is less than the percentage change in price. |
| Perfectly Inelastic | $|E_d|=0$ | The quantity demanded does not change at all, regardless of the change in price. |

A great way to solidify these concepts is to visualize them. The shape of the demand curve is directly related to its elasticity.

To hear a clear explanation of these graphical representations, please watch the following short video.

The key takeaway is that a steeper demand curve implies more inelastic demand, while a flatter (or shallower) demand curve implies more elastic demand.

2. The Determinants of Price Elasticity of Demand

Now we move to the core of today's lesson: understanding the factors that make demand for a product more or less elastic. Why is the demand for table salt highly inelastic, while the demand for a specific brand of running shoes is highly elastic?

Several factors determine a product's price elasticity of demand. A very useful mnemonic for remembering these for the exam is SPLAT.

The following video provides an excellent and comprehensive overview of these determinants.

Let's break down each component of the SPLAT framework:

S – Substitutes (Availability of)
This is the single most important determinant.

• More Substitutes → More Elastic Demand: If a product has many close substitutes, consumers can easily switch away from it if its price rises. Think of one brand of soda; if Coca-Cola becomes more expensive, you can easily buy Pepsi or another brand.
• Fewer Substitutes → More Inelastic Demand: If a product has few or no close substitutes, consumers have little choice but to pay the higher price. A life-saving pharmaceutical drug is a classic example.

P – Percentage of Income
This refers to the proportion of a consumer's budget spent on the good.

• Large Percentage → More Elastic Demand: Consumers are more sensitive to price changes for expensive items that take up a large part of their income, such as cars or housing. A 10% increase in the price of a car is a significant amount of money, causing buyers to reconsider or delay the purchase.
• Small Percentage → More Inelastic Demand: Consumers are less sensitive to price changes for inexpensive items. A 10% increase in the price of a pack of gum is only a few cents, and it's unlikely to significantly change the quantity people buy.

L – Luxury vs. Necessity

• Luxury → More Elastic Demand: Luxuries are goods that are not essential. If the price of a luxury item like a designer handbag goes up, consumers can easily forego the purchase.
• Necessity → More Inelastic Demand: Necessities are goods required for daily living, like basic food, electricity, or gasoline for commuting. Even if prices rise, consumers must continue to buy them, so demand is inelastic.

A – Addictive/Habit-Forming

• Addictive → More Inelastic Demand: Goods that are addictive or habit-forming, such as cigarettes or coffee, tend to have very inelastic demand. Consumers will continue to purchase them even if the price increases significantly.

T – Time Horizon
This refers to the period over which consumers can adjust to a price change.

• Longer Time Horizon → More Elastic Demand: Over time, consumers have more opportunities to find substitutes and change their behavior. If gasoline prices skyrocket, in the short run, most people have to keep driving their current cars. In the long run, they might buy a more fuel-efficient vehicle, switch to an electric car, or move closer to their workplace.
• Shorter Time Horizon → More Inelastic Demand: In the immediate term, options are limited, making demand less elastic.

For a concise written summary of these factors, please review the following resource.

3. Check Your Understanding

Let's apply these concepts to a typical CFA exam-style question.

Question: The demand for a product is most likely to be more price elastic if:

A) the good is a necessity.
B) a large portion of a consumer's income is spent on the good.
C) the time frame for a purchase decision is short.

Take a moment to reason through the options using the SPLAT framework before reading the solution.

Solution:

Let's analyze each option:

• A) If a good is a necessity, consumers must buy it regardless of price, which leads to inelastic demand.
• B) If a good accounts for a large percentage of income, consumers will be very sensitive to its price, leading to elastic demand.
• C) A short time frame gives consumers less opportunity to find substitutes or adjust their behavior, leading to inelastic demand.

Therefore, the correct answer is B.

Conclusion

In this lesson, we deepened our understanding of price elasticity. We moved from simply calculating a number to interpreting its meaning and understanding the economic factors that drive it.

Key Takeaways:

• Demand is classified into five categories based on the absolute value of its price elasticity: perfectly inelastic, inelastic, unit elastic, elastic, and perfectly elastic.
• The graphical representation of a demand curve reflects its elasticity: vertical for perfectly inelastic, horizontal for perfectly elastic, and steeper curves for more inelastic demand.
• The determinants of price elasticity can be remembered with the acronym SPLAT:
  • Substitutes (the most important factor)
  • Percentage of income
  • Luxury vs. Necessity
  • Addictive nature
  • Time horizon

Preview of the Next Lesson:

Now that you can determine whether demand is elastic or inelastic, we can explore one of the most practical applications of this concept: its relationship with total revenue. In the next lesson, you will learn how a price change affects a firm's total revenue and see that the outcome depends entirely on the price elasticity of demand. This is a critical link between economic theory and business strategy that is frequently tested on the CFA exam.