Understanding Elasticity in Finance: Concepts and Real-World Examples

What Is Elasticity?

Elasticity is an economic concept that shows the responsiveness of one variable to changes in another. It is used in business to measure changes in demand with respect to price changes. Price elasticity of demand refers to the degree to which individuals, consumers, or producers change their demand or the amount supplied in response to price or income changes. Types of elasticity include demand, income, cross, and price elasticity of supply.

For example, spa days are considered to be highly elastic because they aren’t a necessity. If there is an increase in the price, the number of trips will decline, which will lessen the need for such services.

Understanding the Mechanics of Elasticity

For elastic products, a price drop leads to higher demand, while a price rise causes lower demand. Spa days, for example, are highly elastic because they aren’t a necessary good; an increase in the price of trips to the spa will lead to a greater decline in the demand for such services. Conversely, a decrease in the price will lead to a greater than proportional increase in demand for spa treatments.

When a good is inelastic, there is little change in the quantity demanded even when the price of the good changes. For example, insulin is a highly inelastic product. People with diabetes need insulin so much that price hikes barely affect their demand. Price decreases also do not affect the quantity demanded; most of those who need insulin aren’t holding out for a lower price.

When prices for elastic goods fall, firms often cut back on the supply. If the market price goes up, firms are likely to increase the number of goods they are willing to sell.

Exploring Different Types of Elasticity

Elasticity of Demand

The quantity demanded of a good or service depends on multiple factors, such as price, income, and preference. Whenever there is a change in these variables, it causes a change in the quantity demanded of the good or service.

Price elasticity of demand is an economic measure of the sensitivity of demand relative to a change in price. It is a measure of the change in the quantity demanded due to the change in the price of a good or service.

Income Elasticity

Income elasticity of demand refers to the sensitivity of the quantity demanded to changes in the real income of consumers, keeping all other things constant. The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income.

Cross Elasticity

The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price of another good changes. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good.

Examining Price Elasticity of Supply

Price elasticity of supply measures the responsiveness of the supply of a good or service after a change in its market price. According to basic economic theory, the supply of a good will increase when its price rises. Conversely, the supply of a good will decrease when its price decreases.

Key Factors Influencing Demand Elasticity

There are three main factors that influence price elasticity of demand.

Availability of Substitutes

In general, the more good substitutes there are, the more elastic the demand for a good will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeinated beverage with a cup of caffeinated tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea than coffee.

However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people, in this case, might not willingly give up their morning cup of caffeine, no matter the price. Therefore, it can be assumed that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic.

Necessity

If a good or service is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to use transportation, usually cars, to get to work. Therefore, even if the price of gas doubles (or triples), people will still need to fill up their tanks.

Time

The third influential factor is time. For instance, if the price of cigarettes goes up to $8 per pack, consumers with very few available substitutes will most likely continue buying their daily cigarettes. This means that tobacco is an inelastic good; the price change will not have a significant influence on the quantity demanded (in part, due to the addictive nature of nicotine). However, if a person who smokes cigarettes finds that they cannot afford to spend the extra $8 per day and begins to reduce their tobacco consumption over a period of time, the price of cigarettes for that consumer becomes elastic in the long run.

Why Price Elasticity Matters for Businesses

Knowing if a company’s goods or services are elastic is key to its success. Companies with high elasticity ultimately compete with other businesses on price and are required to have a high volume of sales transactions to remain solvent. Inelastic firms can set higher prices because their goods are necessary for consumers.

Elasticity also impacts how well a company retains its customers. Businesses often strive to sell goods or services that have inelastic demand; doing so means that customers will remain loyal and continue to purchase the good or service even in the face of a price increase.

Examples of Elasticity

Consumers encounter many real-world examples of elasticity daily. Uber’s surge pricing is a modern example of price elasticity. Uber uses a “surge-pricing” algorithm when there is an above-average number of users requesting rides in the same geographic area. The company applies a price multiplier, which allows Uber to raise prices in real time, according to demand.

The COVID-19 pandemic affected price elasticity in several industries. Outbreaks of COVID-19 cases in meat processing facilities across the U.S., in addition to the slowdown in international trade, led to a domestic meat shortage. This caused import prices to rise 16% in May 2020, the largest increase on record since 1993.

The oil industry was also impacted by the COVID-19 pandemic. Although oil is generally very inelastic, because of a historic drop in global demand for oil during March and April, along with increased supply and a shortage of storage space, on April 20, 2020, crude petroleum traded at a negative price in the futures market. In response to this dramatic drop in demand, OPEC+ members elected to cut production by 9.7 million barrels per day through the end of June, the largest production cut in history.

The Bottom Line

Elasticity measures the sensitivity of one economic variable to changes in another. Understanding elasticity is crucial for understanding market dynamics. Price elasticity of demand illustrates how demand responds to price changes and distinguishes between elastic and inelastic goods. Elastic goods, like clothing and electronics, experience significant demand changes with price shifts. In contrast, inelastic goods, such as caffeine and gasoline, maintain demand despite price fluctuations. This is often due to necessity or lack of substitutes.

Real-world examples of elasticity include Uber’s surge pricing and the pandemic’s impact on oil and meat. Businesses need to understand elasticity to strategize pricing, maintain customer loyalty, and ensure financial sustainability.