Elasticity of Supply and Demand: What Is It and How Does Relate to Price Movement
If you talk about elasticity, most people will imagine stretching and something like a rubber band. But we also have a concept named elasticity in economics. In this post, I’m going to give you a simple definition of this elasticity of supply and demand, so you can see how it relates to price movement in any market.
Note: If you’re not quite familiar with it, you should read our guide to the law of supply and demand first.
What Is Elasticity in Economics?
Elasticity in economics, measures the sensitivity of one variable against another. Its formula is the percent of change in one variable or economic factor divided by the percent of change in another. So when we talk about the elasticity of supply or the elasticity of demand, we’re actually talking about how much any price change can affect the quantity of supply or demand.
Elasticity of Supply and Demand
Elasticity of supply can be calculated using this formula: Percentage of change in quantity of supply / percentage of change in price.
Similarly, for elasticity of demand: Percentage of change in quantity of demand / percentage of change in price.
Let’s make it clear with a few simple examples:
1. We have only one shoe maker in a city and he produces only one kind of shoe. In this market, when he raises the price 10 percent, the quantity of demand for his shoes go down by 5 percent.
2. In the same city, we have a t-shirt importer that sells everything at the same price. When the price of t-shirts goes down by 10 percent, he imports 20 percent less product, meaning the quantity of supply decreases by 20 percent.
3. And finally, we have a farmer who grows and sells potatoes for a living. When he raises the price of potatoes by 10 percent, people buy 10 percent less and when the price goes down by 10 percent, he brings 10 percent less product to the market.
What’s the elasticity in these examples?
In the first one, the elasticity of demand is 10 divided by 5, which equals 2.
In the second one, the elasticity of supply is 10 divided by 20, which equals 0.5.
And in the third one, the elasticity of supply and the elasticity of demand are both 10 divided by 10, which equals 1.
So What Does This Mean?
– When elasticity is more than 1, the quantity of supply or demand changes more than the price, percentage-wise. In these cases, you can say that the supply or demand is elastic.
– When elasticity is less than 1, the quantity of supply or demand changes less than the price, percentage-wise. In these cases, you can say that the supply or demand is inelastic.
– When elasticity is exactly 1, the change in quantity of supply or demand equals the change in price, percentage wise. In these cases, you can say that we have unitary elasticity.
This means that elasticity can tell us how much the quantity of demand or supply will change if the price changes. Or it can tell us about how much the price will move if we have the amount of change in the quantity of supply and demand.
Note: In the long term (several years to several decades), supply and demand will usually be elastic. Even if they are inelastic in the short run.
Why Is This Important?
The units of measurement and the currencies are different in different places. But because elasticity uses percentage, it gives us a framework to compare every market everywhere.
Elasticity also gives us another thing to consider when making financial decisions. For example, things that have inelastic supply or demand can be very good investments. Because in case of inelastic demand, you can raise the price of goods or services more easily and to better results in terms of profit and in case of inelastic supply, you maybe dealing with something that’s relatively scarce and therefore valuable.
So if you want to start a business or choose the right price for your goods or services, you really need to think about the elasticity of supply and demand in your target market. Governments and people who support them also need to think about elasticity when making financial policies.
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***Last Updated on 30 March 2022 by Hamed Derakhshani (Guy with a Wallet)