Part 4. What Everybody Ought to Know about Economics
Elasticity? What does that have to do with economics?
In this series, I will be teaching from Economics, 3rd Edition by Professor Timothy Taylor. I am providing the link so that you can take the course yourself. I found it quite enjoyable.
In Lecture 5, Professor Taylor covers what economists call elasticity. I learned about elasticity in the MBA program. I don’t remember understanding it. I’ll try to understand and explain it.
When we talk about supply and demand curves, the curves really are curves and not straight lines. I will continue to use straight lines in this post. A change in price of 1% probably does not cause a quantity change in either demand or supply of 1%. Elasticity is computed by dividing the percentage change in quantity by the percentage change in price.
Compare buying a new car to buying a new bicycle. A change in price of $500 might not affect the demand or supply of cars. It might affect both demand and supply of bicycles. So, rather than look at the dollar values, we look at percentages. If a car or bicycle goes up 100% in price, that is double. The car may have gone up by tens of thousands of dollars and the bicycle might have gone up hundreds of dollars. We can compare the elasticity of each of them by comparing percentage changes.
Elastic demand is when elasticity is greater than 1. A change in price produces a larger change in quantity demanded. Inelastic demand is when a change in price produces a smaller change in demand. If the percentage change in quantity/percentage change in price equals 1, it is called Unitary Elasticity of Demand.
I have found an easy way to look at it. If buyers can stretch and take other options, demand is elastic. Quantity demanded can change a lot with price changes. If buyers must buy, demand is inelastic. Quantity demanded does not change much with price changes.
Look at the following elastic and inelastic demand lines. The quantity demanded on the inelastic line hardly changes when price changes. Buyers don’t have an option. No matter what price they must buy. Medications and food are two examples.
An example of elastic demand would be something you don’t have to buy. A new car might be an example. You could buy many substitutes. If you feel price is too high, you buy something else, or you don’t buy anything. So, demand quickly falls with price increase. Or, a supplier can decrease price and increase demand.
Think about supply similarly. If suppliers have options as to how much to supply, supply is elastic. Supply can change a lot with price. For example, if the price of a manufactured good goes up, a supplier might add another shift of workers to increase supply.
If suppliers don’t have much option, supply is inelastic. In the short term, supply will stay about the same with changes in price. For example, a farmer can’t harvest a different crop for months so change in quantity takes time
In short hand:
%change in quantity demanded/%change in price > 1 = Elastic Demand
%change in quantity demanded/%change in price < 1 = Inelastic Demand
%change in quantity supply/%change in price > 1 = Elastic Supply
%change in quantity supply/%change in price < 1 = Inelastic Supply
Practical applications:
If demand is inelastic, suppliers can pass along changes in cost over the short run. Over the long run, buyers may find options. On the other hand, supply may be inelastic in the short run. Prices may go up and suppliers can’t produce more quantity. In the long run, suppliers have time to increase capacity.
Think about tariffs. Tariffs may cause increase in prices. If demand is elastic, we expect to see the quantity purchased go down. If demand is inelastic, we expect to see quantity demanded stay the same. Increase in price means that local sources may produce more. That may not happen in the short run. For example, Intalco (an aluminum plant near me) has not been operational for many years. When I moved here, it employed about 200 people. I doubt that it would take too long to get it running again, if the price was right. Makes me wonder how many other plants could be rejuvenated quickly.