Why We Splurge When Times Are Good

By Stephan Abraham AAA

Economics is not an absolute science. Unlike the more empirical fields of physics or chemistry, economics deals with a lot of human factors that are at times unquantifiable. Economists often try to best forecast or predict the likelihood of an event occurring based upon the given data at a moment in time. One example of this forecasting is the concept of price elasticity of demand. Price elasticity of demand is a more formal way of stating the following: when the price of a good or service changes by a certain percentage, what is the corresponding percentage change in the quantity demanded of that particular good or service. Let's further examine these different types of elasticity and figure out if the concept of price elasticity is something you can relate to on a daily basis. (For a background reading, see Economics Basics Tutorial.)

Perfectly Elastic Demand
Imagine you are shopping online for an airplane ticket to New York City. There are at least 20 flights from your town to New York City and all of them have the same price except for one. Let's assume everything about all 20 flights is identical: same in-flight meals, the same departing and arriving times, and they all offer free baggage check-in. Airline Bumpy Ride is charging $30 more for its flights because management wants to test the competitive landscape of the airline industry and gauge what happens to their business if they raise prices $30 across the board on all flights to NYC. How many people would pay the additional $30 to Bumpy Ride?

Most rational individuals would not pay a penny more for a Bumpy Ride flight. Given the variety of airlines to choose from and the identical value propositions, demand is said to be perfectly elastic in this scenario: the quantity demanded of airplane tickets from Bumpy Ride will drop to near zero with any increase in price. Economists call this perfectly price elasticity of demand. This is illustrated in Figure 1 below.

Figure 1: Perfectly Elastic Demand

Relatively Elastic Demand
Relatively elastic demand simply means that the quantity demanded of a good or service will be impacted by a price change in that good or service. Typically, a good or service is said to have high price elasticity when many substitutes for that good exists. As you walk down your grocery store aisle and look for a bag of pure sugar, you notice sugar as well as many other sugar substitutes. Assume the price of pure sugar increases tomorrow from $2-3 per bag. How many of you are willing to pay $3 for a bag of sugar when there are plentiful sugar substitutes? Most people would shift their preferences from sugar to sugar substitutes, thereby reducing their quantity demanded of pure sugar. Most economists would agree and therefore consider sugar the classic, highly elastic good. Figure 2 below illustrates the considerable reduction in the amount of sugar demanded as its price increases. (For more, read Understanding Supply-Side Economics.)

Figure 2: Relatively Elastic Demand

Perfectly Inelastic Demand
In theory, perfectly inelastic demand means that regardless of price, the quantity demanded for a good or service remains constant. Think about that; is there good or service that you would pay any amount for? Very few come to mind, so thinking outside of the box may help us here. Most people with a terminal illness would pay any amount for a known cure for their disease. Drug addicts are willing to pay practically any price for the substance they are addicted to. Most people would pay any price for water. However, bottled water would be relatively price elastic since tap water is in plentiful supply and is practically free. Figure 3 below illustrates perfectly inelastic demand. (Check out The History Of Economic Thought for more.)

Figure 3: Perfectly Inelastic Demand

Relatively Inelastic Demand
One example of a good that is considered relatively price inelastic is gasoline. Business and consumers alike need gas to thrive in this economy. Despite the movement towards alternative fuels, most of us are dependent upon gasoline in our daily lives and are neither likely nor capable of switching to alternate fuels as a practical substitute. If gasoline prices increased 30% tomorrow, would you not go to work? Most people are going to reluctantly pay the higher price out of necessity. Of course, there are exceptions. During the oil and gas bubble of 2008, prices soared to a national average of around $4.25 a gallon and people changed their behavior by demanding less. Some economists felt this demand shift contributed to the severe recession that followed in late 2008 and 2009. In a normal market, gas is a relatively inelastic product as Figure 4 below illustrates.

Figure 3: Relatively Inelastic Demand

Conclusion
Price elasticity of demand is how economists try to measure demand sensitivity as a result of price changes for a given product. This measurement can be useful in predicting consumer behavior as well as forecasting major events like recession or recovery. As consumers, we make these decisions that economists measure on a daily basis. If the price of a good increases and we can live without it or many substitutes exists, then we consume less of it or maybe none at all. Water, medicine and gasoline, however, are necessities that despite price increases we will still demand in great quantities.

Most of us also tend to splurge on nicer things when times are good and cut back on the luxuries during recessions or bouts of unemployment. Your behavior and thought processes around your purchases and consumption decisions help form the basis for this concept called price elasticity of demand. (To learn more, check out our Microeconomics Tutorial.)

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