Elasticity is a term used in economics to describe how price changes affect the amount of goods sold. It is commonly used by business owners as a way to determine how to price their products. Elasticity can also give insight to consumer behavior. For consumers, understanding elasticity can also be helpful as it can help them understand what influences price changes and the effects price changes may have.
How Elasticity Works
Elasticity is driven by the principles of supply and demand.
How elastic a product, service, or price is often depends on how many alternative options there are. When there are multiple alternative options for a product or service, the demand is usually elastic, or is sensitive to price changes.
Elasticity vs Inelasticity
When prices for a staple food like eggs go up, people are still likely to buy them. In other words, people usually still buy eggs even if the price goes up. That is because the demand for eggs is relatively inelastic. The same could apply to a basic necessity like gasoline.
On the other hand, if a brand name cereal went from $4.50 to $6.50, consumers might immediately subsitute for the generic brand. Reason being, it’s not a core need and people can easily switch to store-brand cereals if the price goes up. This means demand is relatively elastic.
Elasticity of Supply
When the amount of a product supplied shifts significantly due to market prices, it is an example of relatively elastic supply. For instance, if the price of kale were to suddenly increase, new farmers may respond by planting kale and creating more supply in the market. However, because there would be an increase in the number of farmers supplying kale, consumers would have more options to choose from, and that could eventually drive the price of kale down until it reaches a new equilibrium.
Income Elasticity of Demand
As the name suggests, this type of elasticity describes how the demand of products fluctuates when consumers experience income changes. For instance, sometimes when consumers begin earning more or have more disposable cash, they may indulge in more luxury products or services. Likewise, a decrease in income could lead to cutting down on luxury items and services.
Elasticity of Demand
Changes in price can have a direct impact on the amount demanded. The more sensitive the amount demanded is to price changes, the more elastic the demand is. Using the cereal reference above, when the price of cereal increases, it’s possible that the amount demanded could take a nosedive, making the demand for the cereal elastic.
However, take a product with a steady demand like a classic Chanel handbag, which has a consistent price increase. Because its demand is inelastic, when prices for the bags go up, loyal customers are still willing to pay top dollar.
Elasticity is an important concept for investors to understand because it can give insight to whether a company can increase prices and still be profitable. That, in turn, can give investors an idea about a company’s growth potential.
