With the number in hand (Price Elasticity of Demand), the next question is why some goods have elastic demand and others inelastic. The answer comes back to substitutes (Substitutes and Complements).
Key idea
Demand is more elastic when there are close substitutes, when the good is a luxury rather than a necessity, when it takes a large share of the budget, when buyers have more time to adjust, and when the market is narrowly defined (one brand of cereal rather than food). Elasticity is not the slope: along a straight-line demand curve, demand is elastic at high prices and inelastic at low prices.
Why it works
All five come back to one question: how easily can buyers do without? With good substitutes, a price rise sends buyers elsewhere. A luxury can be skipped; insulin can't. A 10% rise in rent hurts more than a 10% rise in salt, so people search harder for alternatives. Over time, people find new options: buy a smaller car, move closer to work. As for the line: high on a demand curve, quantity is small, so a few units lost is a big percent; price is large, so a \$1 change is a small percent. The ratio is big. Low on the line, the reverse holds.
Worked example: Which is more elastic?
For each pair, which has the more elastic demand? (a) Gasoline over one week, or over five years. (b) One brand of bottled water, or water in general. (c) Insulin, or concert tickets.
- (a) Five years: there is time to buy a more efficient car, carpool or move.
- (b) One brand: other brands are close substitutes.
- (c) Concert tickets: a luxury with many alternatives; insulin is a necessity with no close substitute.
Answer: Gasoline over five years; one brand of water; concert tickets.
Worked example: Two points on one line
Demand is $Q_d = 20 - 2P$. Is demand elastic or inelastic between \$8 and \$9? Between \$2 and \$3?
- \$8 to \$9: quantities 4 and 2. $\%\Delta Q = \tfrac{2}{3} \approx 67\%$; $\%\Delta P = \tfrac{1}{8.5} \approx 12\%$. $E_d \approx 5.7$: elastic.
- \$2 to \$3: quantities 16 and 14. $\%\Delta Q = \tfrac{2}{15} \approx 13\%$; $\%\Delta P = \tfrac{1}{2.5} = 40\%$. $E_d \approx 0.33$: inelastic.
- Same slope, very different elasticities.
Answer: Elastic near the top (about 5.7); inelastic near the bottom (about 0.33).
Common mistake
Judging elasticity by how steep a graph looks. Steepness depends on the units on the axes, and on a straight line the elasticity changes from point to point even though the slope never does. Check: compute percent changes, or remember the rule of thumb for a straight line: above the midpoint elastic, below it inelastic.