Price Elasticity of Demand
Categories: Econ
When we’re talking “elasticity” in economics, we’re talking about how responsive one thing is to something else.
What if your brother snapped your arm with a rubber band? If you reacted wildly, you’re very responsive to the change, which means you’re elastic to being rubber-band-snapped. If you remain as stoic as a monk (unmoving and unreactive), you’re inelastic to being rubber-band-snapped.
With the elasticity of supply and demand, we’re measuring the change in quantity as a response to a change in price. The price elasticity of demand asks, “if price changes by x%, how does the quantity demanded change?” In the technical sense, price elasticity of demand is the percent change in quantity demanded divided by the percent change in price.
Even in the monkey kingdom we can measure the elasticity of demand. For instance, there was a time when a monkey could buy one banana for three back scratches...a high price. But now a monkey can get one banana for the price of one back scratch, much cheaper than before. In fact, it’s 200% cheaper. Since the price of bananas changed, how did the quantity of bananas demanded in the monkey kingdom...change? Well, since bananas are cheaper now than they were before (and since monkeys looooove bananas), the demand for bananas increased. Which means the demand for bananas moves down the demand curve to a higher quantity and a lower price.
But...how many more bananas were demanded, exactly? If the quantity of bananas demanded didn’t increase that much, even with such a drastic price reduction, then the monkeys would have inelastic demand for bananas. That’s when the price change looks a lot bigger than the quantity change. When price elasticity of demand is less than one, the good is considered to have “inelastic demand.” If instead the monkeys went bananas for bananas, demanding many, many bananas in response to the price drop, it would be considered relatively elastic demand. When price elasticity of demand is greater than one, the good is considered to have “elastic demand.”
If we think back to the elasticity of demand equation, this makes sense. “How much quantity changed” is on the top, and “how much price changed” is on the bottom. When quantity changes more than price, our equation is top-heavy, which means it’ll be larger than one. When quantity changes less than price, the equation is bottom-heavy, which means the elasticity is less than one. When consumers will buy a lot more of something if the price drops, or a lot less of something when the price rises, that good has elastic demand. When consumers keep buying a similar amount of the good, even if the price changes, that good has inelastic demand.
Let’s take a look at elasticity of supply, from the banana-supplier perspective. The price elasticity of supply asks, “if price changes by x%, how does the quantity supplied change?” The price elasticity of supply is the percent change in quantity supplied divided by the percent change in price. The higher the price that banana suppliers can sell their bananas for, the more bananas they’ll want to sell. The lower the price of the bananas, the fewer they’ll want to sell.
If we take our same case, where banana prices decreased 200%, how does that affect quantity of bananas supplied? Well, first of all, why would the price of bananas decrease? If producers are “price takers,” it means their prices depend on consumer demand for their goods. In this case, a drop in the demand for bananas by consumers would lead to a drop in prices.
So how does a drop in consumer demand change the quantity supplied? If the banana producers were elastic, it means there’s a large drop in bananas supplied compared to the price drop. Remember, the more elastic something is, the more drastic the response. As with elasticity of demand, a good’s supply is considered elastic if the elasticity is bigger than one. If banana producers were relatively inelastic to a drop in price, then the quantity shrunk a small amount compared to the price drop. Inelastic supply means the price elasticity of the good is less than one, just as with inelastic demand.
Okay, so you might be wondering why some goods are more elastic and why some are more inelastic. The price elasticity of demand can change when prices change, when income changes, and when substitute goods are available. The effect of when prices and income changes is similar, since they both change your buying power in the market.
Substitute goods are...a bit different. Say the price of bananas dropped 200% because a substitute good became available on the market: plantains. Plantains are no bananas, but they’re similar enough to be cutting into the banana market. When substitute goods cut into another good’s market, that good’s demand drops, causing a price drop. For consumers, it’s a change in how much cash is in your pocket, and your alternative options on the market. What about for suppliers? The price elasticity of supply is largely dependent on their production constraints. In other words, “how much control do suppliers have in raising supply?” Because sometimes...they don’t too much.
For instance, if there was a hurricane that wiped out a slice of the usual supply of bananas, banana supply will be lower, and there’s nothing suppliers can really do about it. When supply can’t be increased in response to an increase in demand, the supply elasticity is inelastic. Another good example of inelastic supply is parking. There are just some days when there’s a high demand for parking, yet supply does not rise to meet that demand. You can’t just get out your asphalt paving truck and throw down ten new spots to accommodate that line of Teslas forming at the garage entrance.
Both of these cases are examples of limited production capacity. Other factors that can affect the price elasticity of supply? Firm stockpiling, whether it’s easy for firms to switch up their production process, and how long it takes firms to produce the goods. There wouldn’t be a banana shortage if we could get bananas to grow like bamboo. Like monkeys, we’re sensitive to change...price change, that is. Whether you’re a consumer or a producer, you have a measurable elasticity deep down inside of you, telling you how to respond to price changes. All you have to do is put down your banana for a second and...listen.