Economics Basics: Elasticity

We’ve seen that the demand and supply of goods react to changes in price, and that prices in turn move along with changes in quantity. We’ve also seen that the utility, or satisfaction received from consuming or acquiring goods diminishes with each additional unit consumed. The degree to which demand or supply reacts to a change in price is called elasticity.

Elasticity varies from product to product because some products may be more essential to the consumer than others. Demand for products that are considered necessities is less sensitive to price changes because consumers will still continue buying these products despite price increases. On the other hand, an increase in price of a good or service that is far less of a necessity will deter consumers because the opportunity cost of buying the product will become too high.

A good or service is considered highly elastic if even a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life, or if there are good substitutes. For example, if the price of Coke rises, people may readily switch over to Pepsi. On the other hand, an inelastic good or service is one in which large changes in price produce only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life, such as gasoline.

To determine the elasticity of the supply or demand of something, we can use this simple equation:

If the elasticity is greater than or equal to 1, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

As we saw previously, the demand curve has a negative slope. If a large drop in the quantity demanded is accompanied by only a small increase in price, the demand curve will appear looks flatter, or more horizontal. People would rather stop consuming this product or switch to some alternative rather than pay a higher price. A flatter curve means that the good or service in question is quite elastic.

Meanwhile, inelastic demand can be represented with a much steeper curve: large changes in price barely affect the quantity demanded.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.The elasticity of supply works similarly to that of demand. Remember that the supply curve is upward sloping. If a small change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one. The good in question is inelastic with regard to supply.

Factors Affecting Demand Elasticity

There are three main factors that influence a good’s price elasticity of demand:

1. Availability of Substitutes In general, the more good substitutes there are, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people in this case might not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Necessity As we saw above, if something is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to get to work or drive for any number of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.

3. Time The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

Income Elasticity of Demand

Income elasticity of demand is the amount of income available to spend on goods and services. This also affects demand since it regulates how much people can spend in general. Thus, if the price of a car goes up from $25,000 to $30,000 and income stays the same, the consumer is forced to reduce his or her demand for that car. If there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand: demand will be sensitive to a change in price if there is no change in income. It follows, then, that if there is an increase in income, demand in general tends to increase as well. The degree to which an increase in income will cause an increase in demand is called the “income elasticity of demand,” which can be expressed in the following equation:

If EDy is greater than 1, demand for the item is considered to have a high income elasticity. If EDy is less than 1, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. As an example, consider what some consider a luxury good: vacation travel. Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per year. With this new higher purchasing power, he decides that he can now afford to go on vacation twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is 7, which is highly elastic.

With some goods and services, we may actually notice a decrease in demand as income increases. These cases often involve goods and services considered of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the decrease in going out to fast food restaurants as income increases, which are generally considered to be of lower quality that other dining alternatives. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero. These goods and services are considered necessities and are sometimes referred to as Giffin Goods.

Another anomaly in elasticity occurs when the demand for something increases as its price rises. We’ve learned that if the price of something goes up, people will demand less – but certain luxury or status items may be demanded because they are expensive. For example, designer label clothing or accessories or luxury car brands signal status and prestige. A work of art, a personal chef, or a diamond ring all may be in high demand precisely because they are expensive. These types of goods are referred to as Veblen Goods.