What is Elasticity?
Elasticity measures how sensitive a buyer or seller is to changes in the prices of goods or services – The more elastic something is, the more a consumer or producer is expected to shift their behavior due to a change in price.
Elasticity is a microeconomics concept that describes the relationship between price, supply, and demand. To calculate it, you take the percentage change in the price of a good and divide it by the percentage change in quantity of that good, whether that be the amount bought or sold. That brings us to the two most common types – the price elasticity of demand and the price elasticity of supply. Demand elasticity describes the behavior of consumers, such as whether they’ll continue to buy coffee if its price skyrockets. Conversely, supply elasticity refers to the behavior of producers of goods and services – like whether a pizza joint will make more pies if the price of them increases. The more elastic consumer demand is for a product, the likelier it is that buyers will change their habits when the price changes (i.e. they’ll buy less). On the flip side, for more inelastic products, buyers are less likely to switch their habits based on a price change (i.e. they won’t reduce how much they buy). We can generally say that the more competitive a market is, the more elastic it is. Elasticity is influenced by factors such as the availability of similar products, the necessity of a product, and the level of brand loyalty.
Suppose Stan opens a new BBQ food truck as a lunch spot in town. He knows that there’s a lot of competition in the food truck industry, and Stan wants to be sure that he can effectively compete with other local trucks. So, as he’s developing the menu, Stan decides to set his prices reasonably close to nearby food trucks in the hopes that he won’t push potential customers away. He knows customers could easily walk down the block to the burger truck, and he doesn’t want to lose out on that business. Because of the elasticity of the food industry, Stan knows that an increase in his prices could lead customers to head to his competitor down the street instead.
Elasticity is like a rubber band…
We’ve all experienced the difference between a really stretchy rubber band and a heavy duty one that requires a ton of muscle to get it to flex the tiniest bit. You can think of the stretchy rubber band as an elastic good and the heavy duty one as inelastic. The stretchy rubber band easily moves, like an elastic good. The more elastic a good is, the more easily its demand will change based on the slightest change in price. However, the more inelastic the good, the more resistant the demand will be to change based on a shift in price – like the heavy duty rubber band that’s really hard to stretch.
Economists use elasticity to measure both the proportional change in the supply or demand for a product given a change in its price.
Price elasticity of demand (aka PED) measures how sensitive the market (i.e. consumers like me and you) is to changes in the price of a good, such as gasoline. In other words, if you increase the product’s price, will people buy less of it or continue to purchase at the same levels they do now?
The more elastic the demand for a particular product is, the more likely people are to alter their buying habits based on a shift in price. Take a pint of ice cream, for example. If you’re in the store and see that the price of the brand you usually buy has, for whatever reason, jumped to $50 per pint, there’s a good chance you’re going to choose something else. This means that it is an elastic good – The increase in the price causes many people to stop buying it.
The opposite of elastic is inelastic. An inelastic product is one where people don’t change the amount they buy based on a change in the price of the product. A classic example of this is insulin. It’s a medicine that some people cannot live without, and there are no good substitutes in the market today. Given that, a hike in its price is highly unlikely to cause people to stop buying it in the same amount that they typically do.
In rare cases, the amount demanded of a product increases as the price increases – This is called a Veblen good. The most common examples of this are luxury goods that are exclusive and have appeal as a status symbol (e.g., Rolex watches or Gucci loafers).
There is also something called a Giffen good. This is a product that consumers buy more of as the price rises and less of as the price falls. These products are also rare, and often limited to poor communities. For example, if the price of your basic foods like rice increases, then you can no longer afford to purchase a more expensive alternative food, like red meat. This, in turn, causes you to end up buying more rice because it’s the only thing you are now able to afford. Both Veblen and Giffen goods defy the traditional laws of demand.
PED is sometimes referred to as own-price elasticity of demand – This is because it’s the elasticity of demand based on changes to the good’s own price (get it?).
There is also something called cross-price elasticity. This measures the elasticity for product A based on the change in price of product B. Let’s take a real-world example. How much does the demand for frozen yogurt (product A) change when the price of ice cream (product B) increases? The more that the demand for frozen yogurt increases, the more elastic the cross-price demand – This product is called a substitute. Let’s look at another example. Say that an increase in the price of fuel caused the demand for, say, tires to decrease. This relationship indicates that tires are a complement to fuel – That is, the demand for one product decreases due to the price increase of another product.
Elasticity is most commonly used to measure the price elasticity of demand, and it’s in that context you’ll most often hear and read about it. But it can be used to measure the sensitivity of supply to a change in price, as well. Price elasticity of supply (aka PES) measures by how much the number of products supplied will change with a shift in the price of that product.
The more elastic the supply of a product, the more likely sellers are to change the amount of the product they’re offerings when the market price of a good changes. Consider a publishing company that produces romance novels. They see that mystery novels have really taken off and that the market price has gone up. Since it’s pretty easy for that company to start publishing mystery novels, they boost the production of those, which makes this supply elastic.
On the other hand, let’s look at the example of an auto mechanic. If the market price of car repairs goes down, it’s quite unrealistic that the mechanic would start offering a different service instead or reduce the amount of cars they repair. The employees are trained mechanics and the equipment in the shop is used to service cars only. They can’t easily adapt to a new service. That makes their supply inelastic.
The price elasticity of demand and supply for a product can be calculated in the same exact way. It is the output of the percentage change in price divided by the percentage change in quantity of a good. The resulting number tells you how elastic a product is. The formula looks like this:
% change in quantity ÷ % change in price = Elasticity
Since the above is expressed in percentage change, let’s break the actual calculation down a little further. The expanded formula looks like:
((New Quantity / Old Quantity) - 1) ÷ ((New Price / Old Price) - 1) = Elasticity
A result higher than one means the demand or supply is elastic. A result of less than one indicates that the demand or supply is inelastic. When analyzing elasticity, most economists tend to ignore whether the number is positive or negative, and simply quote the number as an absolute value. That’s the approach we’ll take here.
According to the law of supply, an increase in the market price for a product will usually result in an increase in the supply of that product. Except for the less usual products that have inelastic supply, we can typically expect the elasticity of supply to be greater than one.
The same trend exists for product demand. The law of demand tells us that, as the price of a good increases, the demand for that good will decrease. Similarly, we can expect a decrease in the price of a good to trigger an increase in the demand. Most products are elastic, so we would usually expect the elasticity to be greater than 1.
Let’s look at an example of the calculation in action. Let’s say the price of a pair of shoes increases from $50 to $55. Therefore, there was a 10% increase in the price (($55 / $50) - 1) = 0.1). Now imagine that, after the price increase, the number of pairs of shoes people purchased the following month was lower than the norm. Usually, the store sells 200 pairs of shoes and, this month, they only sold 120 pairs. There was a 40% decrease in the demand for the shoes ((120 / 200) - 1) = -0.4).
Using the formula for elasticity, we can determine the elasticity of demand:
((120 / 200) - 1) ÷ (($55 / $50) - 1)
-0.4 / .1 = -4
So, the elasticity of demand for the shoes is 4 (remember, we’re using absolute value), which means the demand for them is elastic. It’s quite possible that the shoe store has competition and they are getting the business that the store is losing from its boost in price.
There are five different levels of elasticity that you may hear used when discussing the topic.
Perfect elasticity: If the elasticity calculation results in infinity (e=∞), then the product is considered to be perfectly elastic. This is the extreme version of elasticity where even the smallest change in the price of a product results in an incalculably large change in the demand. It’s highly unlikely to happen in real life, as there would almost certainly be people who would still buy the product.
Perfect inelasticity: If elasticity is zero (e=0), a good is considered to be perfectly inelastic. Perfectly inelastic demand occurs when a change in the price of a product has zero impact on the demand. If the price goes up, the demand doesn’t change at all. One example of a product that is close to perfectly inelastic are some parts of healthcare. If you or a family member is sick, you’re probably going to seek care regardless of recent changes in prices, especially if it’s a sickness that mandates medical attention.
Relative elasticity: When elasticity is greater than one but less than infinity (1<e<∞), the product is said to be relatively elastic. Elastic demand occurs when the change in a product’s demand is greater than the change in the product’s price. The larger the number, the more disproportionate the demand swing is as compared to the price change. One example of elastic demand is in the clothing industry. There are so many clothing brands available that if the price of one goes up, many people will shop elsewhere. However, there will still be plenty of people (e.g., brand loyalists) unswayed by the price change – That is why it’s not perfectly elastic.
Relative inelasticity: When elasticity is less than one but greater than zero (0<e<1), the product is relatively inelastic. In this case, the demand for a product changes at a slower rate than the price of the product changes — A change in price doesn’t have a significant impact on demand. The closer to zero the number is, the less a change in price will change the quantity demanded. One example of inelastic demand is gasoline. When the price of gas goes up, most of us still buy gas. However, a small percentage of people might seek out other means of transportation or buy a more fuel-efficient vehicle.
Unitary elasticity: When elasticity is equal to one (e=1), it is considered neutral elasticity (aka unitary). This neutral elasticity means that any change in supply or demand for a product is directly proportional to the change in price. That is, if the price increases by 5%, then demand will decrease by exactly 5%. Products that have close to unitary elasticity are home appliances and electronics.
Several factors might influence the elasticity of a particular product. The factors differ depending on whether we’re talking about the price elasticity of demand or price elasticity of supply, so we’ll cover those separately.
Demand elasticity varies from one product to another. Some products continue to sell at the same rate no matter how much they increase in price, while others have demand that is incredibly sensitive to price.
A few determining factors include:
Availability of substitute or complementary goods: There are many products that have multiple close substitutes, like potato chips. It’s possible that you’re likely to buy the cheapest version on the shelf and will happily change brands if the one you usually purchase increases in price. Or maybe you’ll buy pretzels, a complementary good, instead. The more substitutes there are for a given good or service, the more elastic it tends to be.
Proportion of income consumed: Elasticity of a product can be affected by how big a chunk of their budget the product uses. Expenses that eat up a large percentage of someone’s monthly income, such as rent, might be more elastic. If rent goes up, they very well may be looking for a new apartment.
Degree of necessity: Another factor that determines a product’s elasticity is the necessity of the product. Consider the example of prescription medications. If your child has an illness that requires a particular medicine, a change in the price isn’t likely to deter you. Even if it causes financial stress, you will still buy the medication – That makes this good relatively inelastic.
Breadth of definition of a good: The more specific the product, the more likely there is to be elasticity in it’s demand. For example, someone buying tomato sauce might be easily convinced to buy a different brand if the price of one goes up. The brand itself is elastic. But, chances are, that person is still going to buy food if the price of everything goes up, so the industry is inelastic.
Duration of price change: The shorter the amount of time a price changes for, the less likely people are to change their habits. If you go to the gas station and see that the price of gas has gone up, you’re likely to still buy gas. But people are more likely to change their habits over the long-run, such as by finding ways to use less gas by switching modes of transportation.
Brand loyalty: Brand loyalty also plays a role in demand elasticity. There are certain brands that people are so loyal to that, no matter how much the price increases, they’ll still buy it. Think about Apple and the iPhone. Every iPhone that comes out is more expensive than the prior and, yet, people still buy them on the first day they’re available every time.
The degree to which a good or service has an elastic supply depends, in part, on the following:
Availability of raw materials: Let’s say a company uses a specific kind of screen to produce its electronic widget. The market price for the widget has increased, but there’s only a finite number of screens available for the producer to purchase, so the company can’t increase its supply to the market – That makes this inelastic.
Time to respond: It’s also possible that some companies just can’t produce more of a product than they already are in the short run. It might be a result of limited space in their warehouse, limited employees, inadequate machinery, or simply limited time. For a product that takes a lot of time and money to produce, a company might not be able to increase its supply at the drop of a hat – That creates an inelastic supply.
Level of competition: Finally, if there are low barriers to entry for new companies, an increase in price of a good would typically result in new suppliers entering the market and increasing the overall product supply, resulting in higher elasticity. But, when barriers to entry are significant, it’s not easy for new entrants gain foothold, which results in relative inelasticity.
Complexity of production: Some products are a lot more complex than others to produce. For example, a pharmaceutical company must spend years on the research, development, and production of a new drug. The supply is relatively inelastic, as they’re unlikely to just stop producing it if the price decreases. Other products and services that require less time and skilled labor to produce might have a more elastic supply, meaning a company may abandon it if the price dips too low.
Mobility of equipment and labor: The elasticity of the supply of a particular industry depends on how mobile the equipment and the labor are. For example, can the equipment used to create one product easily be used to create another? Can the labor serving one purpose serve another? The more mobile these factors are, the more elastic the supply. More mobile companies and industries can adapt faster to a change in price and are, therefore, more elastic.
What is Scarcity?
What is the Law of Supply?
What is the Law of Demand?
What is Income?
What is Profit?
What is Revenue?
What is the Cost of Goods Sold?
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