Elasticity is a vital concept in economics and finance. It basically tells about the impact of a change in one variable because of a change in another. Or in other words, it is the sensitivity or responsiveness of one variable due to a change in the other variable. In business or economics, when we talk about elasticity, we usually mean the elasticity of demand, i.e., how demand changes due to changes in other variables, such as income, price, and more. So, let’s take a look at how does elasticity works.
Before we detail how does elasticity works, it is important to know that a product or service could either be elastic or inelastic to another variable. We call a product to be elastic if its demand changes more than the change in the other variable. For instance, if the price changes by 2%, but the demand changes by, say, 3%. In contrast, if the demand changes less than the change in the other variable, we call the product to be inelastic.
How Does Elasticity of Demand Work?
We can mathematically measure elasticity, and this numeric value helps to understand the strength and weaknesses of two variables. Depending on the value of elasticity, we can classify the relationship between the variables as elastic or inelastic.
For instance, if the value of elasticity is more than 1, it means a variable change more than proportionally to the change in the other variable.
On the other hand, an elasticity of less than 1 means the variable responds less than proportionally to the change in the other variable. When the elasticity value is less than 1, we call the relation inelastic. Such a relationship implies that if the price of a product rise or drops, the demand doesn’t change much.
When the elasticity value is 0, the relation between the variable is said to be ‘perfectly’ inelastic. It means one variable has no impact on the other variable. Or, there will be no change in demand, irrespective of the change in price.
In the real world, possibly there aren’t any examples of a perfectly inelastic product or service. If there were any such product or service, then the supplier would be able to charge any price for it. Insulin is very near to being perfectly inelastic. For diabetic patients, this medicine is so important that a rise in price has little impact on its demand.
If the value of elasticity is 1, we call the relation to unit elastic. It means a change in one variable results in a change in demand in the same proportion.
Then there are highly elastic products as well. The demand for such products or services changes drastically due to the change in price. Suppose a luxury brand announces a big discount, then it is very likely that its demand will shoot up drastically.
Formula and Example
Calculating elasticity is pretty straightforward, and there is a simple formula for it. The formula is:
= Percentage change in demand/ Percentage change in price (or any other variable)
We can also use the same formula to calculate the elasticity of supply.
Let’s take a simple example to understand the calculation. Suppose Apple drops the price of its latest iPhone by 25% for two months. During the same period, demand for the iPhone rises by 35%.
To get the elasticity, we just need to put the values in the formula:
Elasticity = 35%/25% = 1.4
It implies that the iPhone is relatively elastic as its demand changes more than the change in price.
How Elasticity of Supply Works?
The elasticity of Supply works similarly to the elasticity of demand. We can also measure the elasticity of supply, similar to how we measure the elasticity of demand.
Formula to calculate the elasticity of supply is:
Elasticity of supply = % Change in Supply / % Change in Price (or any other variable)
A point to note is that the elasticity of supply is always positive. It is due to the fact that supply is directly proportional to a change in price. It means that the supply would either rise or remain the same with the rise in the market price. Now let’s talk about how different supply elasticity works.
Perfect inelastic supply is when the price has no impact on the quantity supplied. Or when the PES (price elasticity of supply) is zero. Products that have limited supply are usually perfectly inelastic. For example, we can’t increase the number of paintings from deceased artists regardless of price. Bitcoins also have a limited supply, and there is no way to increase their supply.
Relatively inelastic supply is when the % change in supply changes less than the % change in price. Its value is between 0 and 1. Similarly, the supply is said to be unit elastic when the supply change by the same % as the other variable, such as price. In the case of unit elasticity, the value of PES is 1.
The supply is said to be relatively elastic when the supply changes more than the % change in the other variable. Any product that is easy to make usually has a relatively elastic supply. For instance, the raw materials to make toys are easily available, so it is easy to ramp up its production and supply if there is an increase in its prices.
In the case of a perfectly elastic supply, the supply is unlimited at a given price. But at any other price, the supply will be zero. There are no such real-life examples where even a minor change in price (or any other variable) discourages suppliers from selling even a single unit.
Mainly it is the price that affects the elasticity of supply. Apart from price, there are a few other factors that affect the elasticity of supply. In reality, these factors contribute to price elasticity. These factors are capacity of a supplier to push up or down the production, the current inventory of products or raw materials, as well as the time it takes to produce a product.
Talking about how inventory impacts the elasticity of supply, the more the inventory, the lower the responsiveness of the consumer. Or, the more elasticity of supply, the more keen a user will be to buy the product. Understanding the elasticity of supply can assist the management in developing excitement for a new product.
The release of every new iPhone is an excellent example of this. On every release of a new iPhone, most buyers want to buy it on the release day, knowing very well that there is limited stock. Thus, they are even ready to pay extra for it.
How Does Elasticity Work for Different Goods?
Detailed below is how does elasticity work for different types of goods:
Giffen Goods – these are inferior goods that are an exception to the law of demand. The demand for such products rises with the rise in price. Bread, wheat, and rice are a few examples of such goods. Such goods are price inelastic. However, the income impact on such products is more than the price elasticity. This is because consumer shifts to better products as their income increases.
Essential and Non-essential Goods – essential goods are necessary products, such as food, beverages, and certain household products. Such products have a low price elasticity of demand because consumers will always need them. In contrast, non-essential or luxury products have a high-income elasticity of demand. Non-essential products aren’t necessary, and consumers usually spend on them if they have extra money or income, such as jewelry and electronics.