Elasticity of Demand - The Economic Lowdown Podcast Series
How elastic are rubber bands? There's more than one way to answer this question. The word "elasticity" is commonly used to describe things that have a stretchy quality to them. You might try to answer the question by stretching a rubber band across your finger and shooting it across the room. To an economist, however, elasticity can have a whole other meaning. Learn more in this episode of The Economic Lowdown.
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The word “elasticity” is commonly used to describe things that have a stretchy quality to them. Rubber bands are elastic and have a stretchy quality to them. But just how elastic are rubber bands?
One way to answer that question is by stretching a rubber band across your finger and shooting it across the room. However, to an economist, the elasticity or stretchiness, of rubber bands can have a whole other meaning. The economist would likely refer to how much the quantity of rubber bands demanded changes—or how much it stretches—when the price of rubber bands changes. Specifically, the economist would be referring to something called the price elasticity of demand and probably wouldn’t be too focused on the elastic quality that propels a rubber band off your finger: unless you hit the economist with the rubber band.
The law of demand tells us that when the price of a good or service rises, consumers tend to buy less of it. Likewise, when the price of a good or service falls, consumers tend to buy more of it. However, the law of demand does not tell us how much more or less consumers tend to buy. For some goods, the quantity demanded stretches a lot when the price changes: for others, not so much.
That’s where the price elasticity of demand comes in. It is a measure of how sensitive, or responsive, consumers are to a change in price. For any given good or service, the price elasticity of demand measures how much the quantity demanded by consumers responds to a change in the price of that good or service.
So a good that is price elastic has a very stretchy quantity response when there is a change in price. In economic terms, the quantity demanded of that good changes a lot when there is a change in the price of that good.
What do I mean by “changes a lot”? Well, if the percent change in the quantity demanded is greater than the percent change in the price, economists label the demand for the good as elastic.
For example, if the price of a good increases by 10 percent and the quantity demanded of that good decreases by 20 percent, that good is said to have elastic demand. The quantity demanded has stretched a lot relative to the change in price. In such a case, consumers are considered sensitive, or responsive, to a change in the price of that good.
On the other hand, a good that is inelastic does not have very stretchy demand. In economic terms, the quantity demanded does not change a lot when the price changes. What do I mean by “does not change a lot”? If the percent change in quantity demanded is less than the percent change in price, economists label the demand for the good as inelastic.
So, if the price of a good increases by 10 percent and the quantity demanded decreases by only 5 percent, that good is said to have inelastic demand. The quantity demanded does not stretch much relative to the change in price. In this case, consumers are not considered very sensitive, or responsive, to a change in the price of that good.
There’s another possible combination. If the percent change in a good’s price is offset by an equal percent change in the quantity demanded, economists would label the demand for that good as unit elastic. So if a price of a good increases by 20 percent and the quantity demanded decreases by 20 percent, the demand for that good is considered unit elastic.
Pop Quiz Time! Let’s see how well you do at determining if the good is elastic or inelastic.
- The price of black Nike Air Jordan shoes increases by 10% and the quantity demanded decreases by 20%. Are black Nike Air Jordan shoes elastic or inelastic? – Elastic.
- If the price of natural gas increases by 10% and the quantity demanded decreases by 5%. Is natural gas elastic or inelastic? - Inelastic
But why is a certain brand of shoe more elastic than natural gas? Several factors can influence whether a good or service is elastic or inelastic. Let’s discuss the four primary factors of elasticity of demand:
The first factor of elasticity of demand is whether the good is considered a necessity or a luxury. Necessities are more inelastic than luxuries. So, if you consider the natural gas that runs your furnace and heats your home in the winter a necessity, you will likely keep buying approximately the same amount even if the price goes up. You may turn the thermostat down a little lower, but you will likely reduce the quantity you demand by a smaller percentage than the percent increase in the price. As it turns out, other consumers react in a similar way. In economic terms, the demand for natural gas in the winter tends to be relatively price inelastic.
But what about cowboy boots? For me, cowboy boots are not a necessity. So, if the price of cowboy boots were to rise, the quantity I demand would fall. In fact, the quantity I demand would fall a lot. If others behaved similarly, we might assume the demand for cowboy boots is relatively price elastic. When the price goes up, the quantity demanded goes down a lot.
A second factor is the portion of your income you give up to buy something. Anything you purchase takes a portion of your income. It may be a small portion or a large portion.
Say that for dinner you regularly eat steak, followed by an after dinner mint. While you consider both an essential part of a good meal, one important difference is the price relative to your grocery budget. Steak tends to be much more expensive than mints.
In fact, if the price of steak and mints both doubled in price, you’d likely continue to buy mints, but perhaps choose something else as your main course. The demand for steak tends to be more price elastic than the demand for after dinner mints.
The third factor of price elasticity is the availability of close substitutes. A good with few close substitutes tends to be more inelastic than those with many substitutes. Why?
Well, when the price of that good rises, you may start looking for substitutes to purchase to avoid paying the higher price. The more substitutes there are, the less likely you—and other people—are to buy the good at the higher price. When thinking about price changes, it’s important to distinguish between a change in the price of a specific product and a change in the price of a product category.
For example, consider shoes in general, a product category. If the price of shoes rises—that is, all shoes cost more—there are few substitutes for shoes so you, and most other consumers—will likely still buy shoes in spite of the price increase. Using economic terms, consumers will not be very sensitive, or responsive, to price changes—so the demand for shoes will likely be price inelastic. It will stay relatively the same.
However, consider the price of a specific good within the category—say black Nike Air Jordan basketball shoes. For example imagine the price of black Nike Air Jordan basketball shoes were to increase. Because there are many substitutes—perhaps 60 or more—you will likely be more sensitive, or responsive, to a change in the price of that specific shoe. In economic terms, consumers will likely be very sensitive, or responsive, to a change in the price of this specific good. So, demand for this specific shoe will likely be more price elastic than for shoes as a category.
A fourth factor of price elasticity is time. All goods tend to be more elastic in the long-run than in the short run. Why?
Time allows people to find substitutes. So, if the price of gasoline were to increase, in the short-run you would likely decrease the quantity you demand, but only slightly. You would still likely have the same commute to work or school and the same car as you had before the price increase. Realistically, it could be hard to quickly reduce the quantity of gas you use.
However, as time passed, if gas prices stayed high, you might find a car pool or buy a more fuel-efficient car. So, while it might be difficult to adjust consumption of certain goods immediately when prices increase, with time, you —and many others—are likely to find other options.
Now let’s see if you can identify whether a good is likely to be elastic or inelastic and which factor of elasticity is likely to have the biggest effect.
- Frizzy Cola, a type of carbonated beverage. – Elastic demand because there are many substitutes for Frizzy Cola—a specific brand of soda pop.
- An expensive meal at a restaurant. – This could be elastic demand because of the portion of your income you give up.
- Auto Repair – Inelastic demand— because it could be a necessity if you rely on your automobile to get around.
So, how did you do? Elasticity can sometimes be tricky to understand. But there are some people who might find it especially important to understand the elasticity of demand.
Can you guess who they are?
Business people and policymakers. Knowing whether a good is likely to be price elastic or price inelastic could help guide business decisions about price changes and government decisions about taxes. Here’s how.
If you owned a business, it would be useful to know how a change in the price of the good you sell would influence the amount of money you bring in, which is your revenue. Your revenue is calculated by multiplying the amount of a good sold by the price charged for that good.
Imagine you own a firm that sells widgets. If demand for widgets is relatively price elastic and you decide to increase the price by 10 percent, you could expect the quantity you sell to decrease by more than 10 percent, which means your revenue would decrease. In this case, by increasing your price, you’d bring in less money. But if demand for widgets is relatively price inelastic, and you decide to increase the price by 10 percent, you could expect the quantity demanded to fall—due to the law of demand. But since the demand is relatively inelastic, the quantity demanded would fall by less than 10 percent, which means your revenue would increase. By increasing the price, you’d bring in more money.
For policymakers, understanding the price elasticity of demand may help them consider consequences when designing tax policy. For example, consider cigarettes—a good that state and local governments frequently tax. Demand for cigarettes tends to be price inelastic. When the price of an inelastic good increases, consumers generally don’t reduce their consumption by very much, relatively speaking.
When government increases the tax on cigarettes, the relative increase in price is greater than the decrease in quantity sold, so tax revenues increase. However, if a good is price elastic, an increase in the tax on that good would likely reduce the quantity of the good consumers demand by a greater percentage than the price increase.
Tax revenues would likely fall.
Well, snap! We’re out of time. I hope you feel a little stretched by this experience. Thanks for listening.
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