4.5: Determinants of Elasticity

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Martin Medeiros
Chabot College

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What determines a customer’s sensitivity to changes in the price of a good or service? Well, there are many things.

Think about that time you were on a long car trip. There was probably a time when you were driving through a remote part of the country when low on gasoline. If you were lucky enough to find a gas station, you would have noticed that the price for a gallon was nearly double compared to prices in the last big city you drove through. Even though the price of gasoline has increased by 100%, you will still fill your tank.

What explains your insensitivity to that price increase? The answer is simple: You had no options (unless walking 50 miles to the next town for cheaper gas is an acceptable option). This is a classic example of how a customer’s sensitivity (i.e., price elasticity) changed simply by driving to a new location with fewer options. The lack of options (i.e., substitutes) is just one of many determinants of price elasticity.

Sometimes students get the determinants of demand confused with determinants of price elasticity. To avoid confusion, you need to remember that all determinants of demand have a type of elasticity associated with it. We have been examining just one type of elasticity: price elasticity. Price elasticity shows how sensitive customers are to a change in price – and price is a determinant of demand.

Determinant of Demand: Advertising

Let’s take advertising spending as an example. Advertising is supposed to increase the demand for a good or service. And given the fact that spending on advertising totaled $136.8 billion in 2008*, there are many who feel there is a positive relationship between advertising spending and quantity demanded. But just because there is positive relationship ($\uparrow \text { ad spending } \rightarrow \uparrow Q_{\text {demanded }}$) does not mean that all increases in ad spending is a good idea.

Let’s say the Coca Cola Company launched a new ad campaign that cost $20 million. And let’s also assume that the increase in sales that resulted from this ad campaign was a measly one bottle. Now, does this result follow the positive relationship between advertising and quantity demanded? Yes, because both advertising spending and quantity demand increased. But even though demand increased after the ad campaign, it would be ridiculous to call it a success. This ad campaign failed because cola drinkers are insensitive to advertising spending - in other words, the advertising elasticity for Coke inelastic.

It is very important for business to not only know what determines their customer’s demand; they must also know how sensitive they to changes in these determinants.

Every determinant of demand has an elasticity measure associated with it.

Bottom line: When a business owner knows demand elasticity, he/she knows his/her customer.

*Source: The Nielson Company (http://blog.nielsen.com/nielsenwire/...nd-release.pdf)

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