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Elasticity

Elasticity

Author: Kate Eskra
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Compare elasticity coefficients of different types of goods.

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Tutorial

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is on elasticity. As always, my key terms are in red. And my examples are in green.

So in this tutorial, I'll define elasticity for you, three different types-- own price, cross-price, and income. We'll talk about the difference between elastic, inelastic, and unit elastic. And finally, I'll be giving you examples along the way of each of these types of goods or services.

So you already know the laws of supply and demand, which are as the prices go up, consumers buy less, but producers want to supply more. As prices fall, consumers buy more, and producers supply less. But in this tutorial, we'll be talking about just how much more or less. Is it the same for every good?

Elasticity then is the measurement of the change in quantity demanded or supplied which looks at the sensitivity of one variable to characteristics of another variable. So the idea here is, just how much do people respond by buying or supplying more or less when something else changes, like the price of the good itself, the price of a good related to something, or people's income? And the answer is, it really depends on the good or service-- so how necessary something is, whether there are close substitutes, how expensive, or if something is addictive can impact the elasticity of a good.

So let's hear some examples. This is an extreme example of elasticity. This is perfectly inelastic demand. I'm going to talk about demand because I think that's a little easier to understand. But this could certainly be talked about with supply as well.

This, though, is perfectly inelastic demand for a life-saving medicine. Notice that no matter what the price, people are buying the exact same quantity. People therefore are not responsive at all to a price change because a life-saving medicine is a necessity. And there are no substitutes.

So the way that I remembered it when I first learned about elasticity is the more straight up and down something is, it looks like an I. And I tried to think about something that was very inelastic. Insulin would be very inelastic. So that works out nicely.

OK. But most things in the world are not perfectly inelastic. But there are things like gasoline that are relatively inelastic. This is not straight up and down. It's not completely vertical because people certainly do change their behavior somewhat as the price of gasoline goes up.

But notice how the price can change pretty significantly, and people don't change their quantity demanded by very much. And that's because most people view gasoline-- at least in the short term-- as a necessity. So the idea here is the more vertical the curve, the more inelastic the demand or the supply for something is.

Now we go to the other end of the spectrum. And that would be perfectly elastic. I'm using the example of a hot dog stand here that is 1 of 200 stands in, let's say, a baseball stadium. They're selling an identical product. And they're all charging $5 for that identical hot dog.

If one hot dog stand out of 200 decided to raise price up to, let's say, $6, no one would shop there. No one would purchase a hot dog. So the quantity demanded in theory, according to this curve, would drop to zero.

That's what straight across demand would imply. This is perfectly elastic. And the way I think about it is if you put that top on, it looks like an E. So it's elastic.

But again, not many things are perfectly elastic in the world. So I'm giving you an example here of something that's just relatively elastic, which would be the demand for a specific brand of something. So demand for a specific type of apples, like Gala apples, would be pretty elastic.

It's not completely horizontal because they could certainly raise price a little bit. And you'd have some people who really just prefer Gala apples who still buy them. But a lot of people would change their mind. So notice how quantity is what's changing a whole lot compared to price because there are so many substitutes for Gala apples. The idea is the more horizontal the curve, the more elastic it's going to be.

Then we have unit elastic. Chicken is the example I came up with. And let's just say that somewhere along this curve, the price of chicken rises by 10%. And people buy exactly 10% less chicken. That means that the proportion of how much people respond is exactly identical to the percentage change in price. So people's response is proportional to the percentage change in price.

We've been talking here in these examples about own-price elasticity, which is elasticity of either demand or supply when we're looking at the price of a good itself changing. But with this, we're keeping all other variables and goods separate.

So here's an example that we'll run through. Is bottled water at the zoo elastic or inelastic in demand? I just made these numbers up. Let's say the zoo was selling bottled water for $2. And they were selling 500 bottles of water a day. They raise price to $4. And now their quantity demanded drops down to 400. OK.

So the equation that you need to be aware of for elasticity is the percentage change in quantity-- how much people respond-- divided by the percentage change in price. Keep in mind that for demand, this will always be negative because the relationship between quantity and price is negative. They move in opposite directions. For supply, it will always be positive because those two things move in the same direction.

So for right now, all we're concerned about is absolute value for own-price elasticity. What I'm doing here is I'm just looking at two points along the demand curve for water at the zoo. So again, here was the equation. And absolute value for here is what matters.

OK. So what do we do with this? What does that number mean? Well, when we look at elasticity coefficient for own-price elasticity, a coefficient greater than 1 indicates that demand would be elastic because that would suggest that the numerator responds more than the denominator. So people change their buying habits by more than the percentage change in price.

With inelastic demand, that's a coefficient less than 1 because people are not as responsive to the change in price. Unit elastic is when the two change proportionately.

OK. Now we need to talk about cross-price elasticity. And that's change of demand or supply that occurs due to a change in the price of something else, some substitute or compliment. I'm using Nike and Adidas. And here we're looking at what's going to happen to the quantity of Nike not when the price of Nike changes, but when the price of Adidas changes.

So the price of Adidas is going up from 100 to 130. And the quantity of Nike shoes are going up from 200 to 240. So if you calculated it, you would get a cross-price elasticity of 1.09. But again, what does this tell us?

Well, here, it does matter what direction these things are moving. It does matter. We're not just looking at absolute value. Because if the coefficient is positive, like it was here, that means that the two goods are substitutes. If it's negative, the two goods are compliments. You would buy them together.

So in this case, with a positive 1.09, Nike and Adidas, like you could expect, must be substitutes since it's a positive coefficient. And that should make sense. When Adidas raises prices, that goes up. The quantity that people are buying of Nike also goes up. So you would get a positive coefficient.

Income elasticity is the last kind of elasticity we need to look at. And that's an economic measure of change in relation to income and demand for normal, inferior, and luxury goods. So again, sticking with Nike, if we now change our incomes, will we buy more or less Nike apparel?

So if Tom's income goes up, he buys more Nike, from two to three pair a year. We can do the calculations here. There's his demand curve. But instead of looking at what happens when the price changes, we're looking at what happens when someone's income changes.

So if we do the calculations, we see that we get an elasticity coefficient of a positive 0.6. Again, the coefficient does matter in terms of the sign. It's not just absolute value. So that positive 0.6 tells us that the good is a normal good. If the coefficient would be negative, the good would be inferior.

Let me define that for you. A normal good is a good where we buy more of them as our income goes up. So another example of that would be vacations. Notice how when your income is $40,000, you go on no vacations. When your income is $80,000, you go on three vacations in a year.

So let's look at what the coefficient is. The coefficient, if you plug the numbers in, would be a positive 3. That would indicate that they're a normal good.

But they're also considered a luxury good. Because when coefficients are greater than 1, that means that our consumption of them increases by a greater percentage than the income increase. So a luxury good is a good that offers better quality and features which is consumed when income rises.

Finally we have generic cereal. And generic cereal is an example of an inferior good because you can see that as our income goes up, we don't buy them as much anymore or at all. So our coefficient is negative. That's an inferior good. So an inferior good is one where our demand decreases as income goes up.

This is what we talked about in this tutorial today. Thanks so much for listening. Have a great day.

Terms to Know
Cross-Price Elasticity

Change of demand (supply) that occurs due to change in price of substitutes or complements.

Elasticity

Measurement of change in quantity demanded (supplied) which indicates the sensitivity of one variable to characteristics of another variable or income.

Income Elasticity

An economic measure of change in relation to income and demand for normal, inferior, and luxury goods.

Inferior Goods

Goods for which demand decreases as income increases.

Luxury Goods

A good that offers better quality and features which is consumed when income rises.

Normal Goods

Goods for which demand increases as income increases.

Own-Price Elasticity

Elasticity of demand (supply) when the price of a good changes, keeping all other variables and goods separate.