Updated June 18, 2020 Robinhood Learn Democratize Finance For All. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more. Definition: 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. Example 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. 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. Ready to start investing? Sign up for Robinhood and get stock on us. Certain limitations apply New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC. Tell me more…
What are the different types of elasticity?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 demandPrice 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. Price elasticity of supplyElasticity 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. How is elasticity calculated?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. What are the different levels of elasticity?There are five different levels of elasticity that you may hear used when discussing the topic.
What factors affect elasticity?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.
Price elasticity of demandDemand 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:
Price elasticity of supplyThe degree to which a good or service has an elastic supply depends, in part, on the following:
Ready to start investing? Sign up for Robinhood and get stock on us. Certain limitations apply New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC. Related ArticlesYou May Also LikeWhat does it mean when price elasticity is negative 1?Minus one is usually taken as a critical cut-off point with lower values (that is less than one) being inelastic and higher values (that is greater than one) being elastic. If demand is inelastic a price increase will increase total revenues while if demand is elastic, a price increase will decrease revenues.
What does the value of price elasticity of mean?The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
What does it mean if elasticity is greater than 1?Elasticity of Demand by Price
If the price elasticity of demand is greater than 1, it is deemed elastic. That is, demand for the product is sensitive to an increase in price.
What does it mean if elasticity of demand is 1?If the number is equal to 1, elasticity of demand is unitary. In other words, quantity changes at the same rate as price.
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