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Elasticity of Demand and Supply

As we have seen in my previous blog posts, economics can be difficult to understand precisely because it depends, in large part, on consumer behavior. Elasticity is particularly dependent on consumer behavior.

We know a change in price is accompanied by a change in quantity demanded and therefore a change in supply. Under most circumstances, simply knowing the direction of such changes (i.e., whether a change in price yields an increase or decrease in quantity demanded) is sufficient. But there are other times when it is important to know not only the direction of the change but its magnitude as well. Economists use the concept of elasticity to measure the change in magnitude.

Elasticity simply measures how sensitive we are to changes in price. If price matters very little, changes in price will have small impacts on our willingness to purchase an item. However, if price matters greatly, changes in price will have a large impact on our willingness to purchase an item.

The Elasticity calculation ranges between one and negative one (but for expediency’s sake we are only interested in the absolute value of the elasticity). If the elasticity is less than one, we say demand is inelastic. That is a big change in price elicits very little influence on the quantity demanded. When elasticity equals exactly one, the demand is said to be unit elastic. This occurs when the percent change in price causes the exact same percent change in quantity demanded. If a price change creates no change whatsoever in quantity demanded, we say consumer demand for that product is perfectly inelastic. When elasticity is greater than one, consumer demand for that product is said to be elastic. This means a change in price causes the consumer to change his or her spending habits. Now, every once in a great while, the consumer’s demand for an item changes consumption from zero to all they can get. When that happens, demand is said to be perfectly elastic.

There are different types of elasticities. The price elasticity of demand (which we talked about above) is the consumer’s sensitivity to a product’s price change. It is measured by taking the percent change in quantity demanded divided by the percent change in price.

The cross price elasticity of demand measures how sensitive consumer purchases are to a price change of some other product. Here is where it gets a little more complicated. The cross price elasticity of demand depends on whether consumers see a product as a substitute or complementary good. A substitute good is any good that can be replaced by something else. For example, Coca Cola for Pepsi or vice versa (Coke and Pepsi purists, please forgive me) or cookies for cake. The former is termed a perfect substitute, the latter an imperfect substitute. The cross price elasticity of demand for substitute goods is positive. Thus if the price of one item goes up, the sales of the other rises as well.

A complementary good is one that is usually consumed with another; for example, peanut butter and jelly. When there is a fall in the price of peanut butter, for example, we expect to see more peanut butter bought leading to an expansion in the market demand for jelly since they are consumed together. Because peanut butter and jelly are complements, the cross price elasticity of demand is negative. Please note: the stronger the relationship between two products, the higher the coefficient of cross price elasticity of demand.

The Income Elasticity of Demand measures the degree to which a consumer responds to a change in their incomes by buying more or less of a particular good. Now let’s get a little bit more complicated…the income elasticity of demand depends on whether consumers see the good as a normal or inferior good. A normal good is one for which quantity demanded increases as income increases. Most goods are normal goods. Normal goods have a positive elasticity coefficient. An inferior good is one where the quantity demanded decreases as income increases. Inferior goods are those for which there are close substitutes but the substitute is only purchased with positive changes in income. Inferior goods have a negative elasticity coefficient.

The Elasticity of demand is based on four major factors that can affect how well and how quickly consumers can adjust to price changes. Those four factors are: availability of substitutes, importance of the good to the consumer’s budget, the amount of time available to find more substitute goods, and the relative necessity of the good to the consumer.

The more close substitutes there are for a good, the more elastic its demand. If a good has many close substitutes, consumers can switch back and forth between them whenever the price changes.

Consumers are not very concerned about goods that they typically do not spend a lot of their income on. Their quantity demanded tends to be inelastic for such goods. The price changes of goods that they spend a large portion of their budgets on have much more significant effects; quantity demanded for such goods tend to be more elastic.

When consumers have time to adjust to price changes, it becomes easier for them to find substitutes for a good; they can rearrange their consumption patterns and therefore demand tends to be more elastic the longer the time available to adjust to price changes.

The price elasticity of supply is measured by taking the percentage change in quantity supplied divided by the percent change in demand. The price elasticity of supply should be positive. Elasticity of supply depends partly on the time available for firms to adjust to market price changes. There are long-run and short-run scenarios that impact the elasticity of supply.

In the long run, firms can make all sorts of adjustments so elasticity is elastic. In the short run, firms are restricted by capital goods (time, equipment, supplies, etc.) and cannot easily adjust production. Price elasticity of supply in the short run tends to be inelastic for these reasons.

Perfectly inelastic supply occurs when supply cannot change at all no matter how high or low the prices go. This occurs when you have to build a building for example. It takes time to erect a building regardless of the price of the materials needed.