Elasticity

July 27, 2023
10 MIN READ
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An economic variable's elasticity is its reactivity to a shift in another economic factor. Price elasticity of demand, cross-price elasticity of need, and income elasticity of demand are the three main types of elasticity. The price elasticity of demand is influenced by four variables: the availability of alternatives, whether or not the commodity is a luxury, the percentage of earnings spent on the good, and the length of time since the price fluctuation. A positive income elasticity indicates that the good is normal. A defective product has a negative income elasticity.

What is elasticity?

The degree to which one economic component responds to changes in another is measured by a concept known as "elasticity." For instance, shifts in supply or demand may cause prices to fluctuate, and changes in demand can also cause shifts in income. Demand is considered inelastic, with a coefficient of elasticity of less than 1.0, if it remains constant despite price changes. Products like apparel and technology are examples of elastic goods, whereas food and medicine are inelastic goods. The degree to which one product's demand shifts in response to a change in the price of a related item is defined as the cross elasticity of that demand.

The concept of elasticity

If the elasticity value is more than 1, it indicates that consumer demand responds more than proportionately to a shift in the price for the commodity in question. Demand is inelastic if the demand elasticity is less than 1.0.

Customers' purchasing behavior is said to be inelastic if it does not alter much in response to changes in the price paid by those customers. If the elasticity value is zero, then the demand for the good or service is said to be perfectly inelastic, and the price does not affect it. There are almost certainly no real-world instances of perfectly inelastic products. Consumers would be forced to pay whatever price manufacturers and distributors set for their goods and services if this were the case. Air and water, which no one owns or manages, are the closest things to a fully inelastic good.

Quantity changes in response to changes in the price of an item or service are measured using the economic concept of elasticity. The elasticity of demand is the extent to which the quantity demanded of a good or service shifts in response to variations in its price. On the other hand, price insensitivity in demand for a product indicates inelastic demand.

Insulin is a good illustration of a highly inelastic product. Demand for insulin to treat diabetes is so high that price hikes do not impact sales. Price cuts have little effect on demand since most people who require insulin are not waiting for prices to drop before buying.

Very elastic products are on the opposite end of the spectrum. For instance, the demand for spa services is very elastic since they are a luxury rather than a need; when the cost of spa visits rises, consumers will be less likely to use them. On the other hand, if the price of spa services were to drop, demand would rise significantly.

Classifications of elasticity

i.       Demand elasticity

Demand for a product or service is affected by several variables, including price, income, and individual taste. The demand for a product or service responds to the abovementioned changes. The quantity required may be shown to be influenced by price changes using the concept of price elasticity of demand. Because of the law of demand, the elasticity of demand is often negative when calculated as the percentage change in the quantity requested over the percentage change in price.

Unless the product in question is a Giffen item, a higher price will result in a lower quantity desired, as the law of demand states. The quotient's negative sign is often omitted. The greater the price elasticity of demand, the more sensitive the demand quantity is to changes in price. Elastic demand is present in the market for a product when the price elasticity of demand is more significant than one. Demand is considered completely elastic if and only if the desired amount decreases to zero as the price increases. If the cost of an elastic product increases, fewer goods will be purchased, and less money will be made.

The less sensitive the quantity required is to a change in price, the lower the price elasticity of demand. Goods are said to have inelastic demand when their price elasticity of demand is less than 1. Demand is perfectly inelastic when there is no relationship between the price and the amount required. Increasing the price of an inelastic good result in more money since people are willing to pay more.

A product is considered unit elastic if its demand shifts in tandem with a shift in its price. Meaning that a percentage change in price leads to a percentage change in demand. Therefore, a good is said to be unit elastic if and only if the price elasticity of demand is equal to one. If a product's demand is perfectly price elastic, then any impact on supply will be balanced by any impact on demand.

ii.     Income elasticity

A product's income elasticity of demand is the proportion by which a consumer's willingness to buy a product responds to changes in the money available. Economists may determine the responsiveness of the amount required to changes in income by computing the income elasticity of demand for an item or service.

A normal good is one for which the quantity sought at a given price rises in line with a rise in income if the income elasticity of demand is positive. An inferior product has a negative income elasticity of demand, which means that as income rises, less of the commodity is wanted at a given price. Goods are said to be income elastic if their demand increases faster than their price as income increases. International trips or second residences are examples of luxury goods.

Goods are considered income inelastic if their income elasticity of demand is more than zero but less than one. It means that as income grows, demand for these products increases, though at a slower pace.

iii.    Cross elasticity

The concept of cross-price elasticity of demand captures how much one good's demand shifts in response to a shift in the price of another. Quantity A's percentage change divided by the other variable's percentage change in cost yields this value. The positive cross-price elasticity of demand indicates a substitution relationship between two items. Good A and Good B are alternatives to one another. The demand for good A increases if good B becomes more expensive.

If, on the other hand, products A and B were complements, then a rise in the price of item B would lead to falling demand for good A. The result may be inferred from the formula for the cross-price elasticity of demand. It is worth emphasizing that cross-price demand elasticity is a metric with no inherent units.

iv.    Supply price elasticity

The market response of the supply of an item or service to a fluctuation in its price is quantified by its price elasticity of supply. When the price of an item goes higher, the supply of that good goes up, according to standard economic theory. When the cost of a product drops, supply tends to go down.

Influencing aspects of demand elasticity

The following primary variables affect the price elasticity of demand for an item;

·       Availability of alternatives

The greater the availability of satisfactory alternatives, the more elastic the market's demand will be. If the cost of a cup of coffee doubled, for instance, people would switch to drinking strong tea in the morning instead. Because people would switch to other beverages, such as tea, if the price of coffee rises even little, we say that coffee is elastic.

Caffeine may have few viable replacements; thus, if the cost of caffeine itself rises, coffee and tea consumption may not change much. In this situation, most individuals probably would not give up their morning coffee, no matter how much money was offered. Caffeine is, thus, an example of a product with low elastic properties. Even if individual products within an industry may be elastic owing to the presence of replacements, industries as a whole are often not. In general, diamonds and other rare commodities are inelastic since there are few suitable alternatives on the market.

·       The necessity of a product

From the instance above, we saw that individuals would continue to pay higher costs for necessities like food, shelter, and comfort even if they had to do without. There are a variety of reasons why individuals need transportation, such as for work or commuting. Therefore, consumers will still need to fill up their tanks whether the price of petrol drops to $2 per gallon or $3 per gallon.

·        Time

Time is the third primary consideration. For instance, a person with a nicotine addiction and few alternatives will likely keep smoking daily even if the price per pack doubles. Since a little shift in price is unlikely to result in a noticeable shift in demand, we may say that tobacco is price inelastic. But suppose the smoker discovers they cannot afford the additional $2 per day and gradually gives up the habit. In that case, the price of cigarettes becomes elastic in the long term for that customer.

·       The percentage of funds spent on the product

Demand price elasticity is low when consumers spend just a tiny portion of their money on a product. As a result, there is minimal effect on consumers' willingness to buy a product due to price changes. However, a consumer's demand is more elastic when a product takes up a smaller percentage of the consumer's disposable money.

The relevance of price elasticity in economic decision-making

Knowing whether its products or services are elastic is crucial to a company's success. To survive, firms with high elasticity must provide low prices to compete with rivals, leading to a large volume of sales. However, inelastic firms may charge whatever they want for their products and services since they are considered necessities.

Customer retention rates are also affected by factors other than price, such as the elasticity of the product or service. Business owners generally want to move items with "inelastic demand," meaning consumers will keep buying the product or service even if the price increases.

Applications of elasticity

In economics, elasticity may be used in a wide variety of contexts. In particular, knowing about elasticity is crucial to comprehending how supply and demand react in a market.

Governments and businesses alike may benefit from a deeper understanding of elasticity. Businesses may use elasticity to account for the impact of raw material price changes on their bottom line.

The idea of elasticity may be used as a price strategy tool in business. On the contrary, a business owner must determine whether or not lowering prices would increase product demand and prevent a loss. On the other hand, businesses must evaluate whether raising prices and decreasing output increases profits. The explanation is that it is lucrative for businesses to lower prices and wait for demand to grow if it is elastic enough. However, if the pricing is inelastic, it is beneficial to reduce output and allow prices to increase because consumers will be unable to substitute other goods or services for the ones they are forced to buy. Though businesses should not allow their product prices to grow over the inelasticity threshold, if they do, price elasticity will kick in, and the product's demand will inevitably fall.

The principle is crucial for governments to use taxes. If the government is considering raising taxes on products, it may utilize elasticity to determine whether or not this would be a good idea. When governments place higher taxes on items, they often see a corresponding drop in demand. A tax rise would not affect the demand for inelastic items, while the demand for elastic goods may be. Elasticity may be used to analyze the necessity for government action beyond only taxes.

The government also must provide widespread access to these necessities. The government steps in by establishing price controls to make sure these items are at least somewhat accessible to the general public.

Conclusion

Elasticity indicates how sensitive a variable is to changes in other variables—or just one factor. This sensitivity is most frequently expressed as a change in the amount requested to shifts in other parameters, such as price. Price elasticity is the extent to which people, customers, or producers adjust their demand or the amount provided due to price or income changes in commerce and economics. It is mainly used to measure the shift in customer demand caused by fluctuating an item or service price.