## 05 August 2012

### Day 58: Elasticity - How Far Can we Stretch our Customers? - Part 1

In previous blog-posts the concepts of supply and demand were discussed and it was explained how economists use supply and demand curves to predict how the quantity demanded and supplied of goods will change when their prices change. However, so far we've only been able to predict in which direction the quantity demanded for a good or services will change if the price of the good/service changes, or in which direction the quantity supplied will change if the price of the good/service changes (will it go up or will it go down). But to make more accurate predictions, economists require to know by how much the quantity demanded/supplied will change by a certain change in price. In order to do this, a new concept must be introduced, namely: Elasticity.

Elasticity basically measures responsiveness. It is possible that if a price goes down slightly, that the quantity demanded will barely change - in this case we speak of a low level of responsiveness. But it is also possible that if a price goes down slightly, that the quantity demanded will significantly increase - in this case we speak of a high level of responsiveness.

So - with elasticity we're looking at a relation between an action and a reaction - where, the change in price is the action and the change in the quantity demanded/supplied is the reaction.

To calculate elasticity, (take a breath, it's going to be a little technical now - don't worry, it'll soon be over) we divide the percentage change in the reaction by the percentage change in the action. Because two percentages are divided by each other - we end up with simply a number (not a percentage) and this number is referred to as the 'elasticity coefficient'.

Let's make this more tangible by discussing the Price Elasticity of Demand.

#### The Price Elasticity of Demand

With the price elasticity of demand, the change in price is the action and the change in quantity demanded is the reaction. We know from previous discussions that if the price of a good goes up, the quantity demanded will generally go down (when something becomes more expensive, less people are willing and able to pay the higher price). And - when the price of a good goes down, the quantity demanded generally goes up (when something becomes cheaper, more people are willing and able to pay the lower price). The price elasticity of demand will thus help us assess by how much the quantity demanded of a good goes up or down in response to a change in price.

To calculate the price elasticity of demand, we divide the percentage change in quantity demanded (the reaction) by the percentage change in price (the action). Let's say - the price of petrol goes up by 10%. In response, the quantity demanded of petrol will go down as less people will be willing and able to pay the higher price. But, since many people are currently dependent on petrol to for instance drive to work, it will for many make sense to just pay the higher price, rather than looking for alternative ways to go to work that might take up more time or that are simply not available. Therefore, let's say that the quantity demanded will only go down with only 1%.

The price elasticity of demand for petrol is then calculated as follows: 1% (percentage change in quantity of petrol demanded ) / 10% (percentage change in the price of petrol) = 0.1

Because 0.1 lies between 0 and 1- this result indicates to us that the price elasticity of demand is 'inelastic'. In other words: Even if the price of petrol goes up by quite a large percentage, in comparison, the quantity demanded will not go down by much.

Demand is inelastic when a change in price will cause a smaller change in quantity demanded.

Demand is elastic when a change in price will cause a bigger change in quantity demanded. In case of elastic demand, the elasticity coefficient will be above 1.

Goods with an inelastic price elasticity of demand are often goods that people need, like basic necessities (eg. basic foodstuffs, electricity, water, petrol, etc.), as well as goods that are addictive (eg. tobacco, alcohol, drugs). With basic necessities, a person often simply doesn't have the choice not to pay the higher price. Therefore, if a person knows that the good they are providing/selling is a good with inelastic demand - they can take advantage of the situation by raising the prices as high as possible, because they know people will still pay for it; it's either paying up or endangering one's life. With addictive goods, the same logic is used, because even though prices of these goods are high, the addiction will motivate individuals to keep on purchasing the good, even if they have to sacrifice a lot of money for it.

Goods with an elastic price elasticity of demand are generally luxury goods - meaning: goods that are not necessary for one's survival, such as books, holiday resorts, fast cars, etc. If the price of a luxury goods goes up, many people will be willing to sacrifice having this good in order to have more money available. Or in other words: the price will be a big factor in deciding to acquire luxury goods, whereas with basic necessities - the goods must be purchased de facto and the decision to buy the good is therefore less dependent on the price.

Other points that play a role in determining the price elasticity of demand are:

1. Substitution possibilities
The amount of substitutes available will also play a role int he price elasticity of demand. If there are many substitutes for a product, then instead of paying a higher price, people will simply turn to a cheaper substitute. However, if there are no or only very little substitutes, then people are inclined to keep on buying the same product even if the price rises.

2. The degree of complementarity of the product

The degree of complementarity of a product refers to the tendency of people to use this product together with other products. For instance, you use batteries with appliances - you use salt to spice your food, etc. For goods with a high degree of complementarity (that are often used together with other goods) the price elasticity of demand will tend to be low (inelastic). And the other way around for goods that are used individually.

4. The proportion of income spent on the product

The larger the proportion of income spent on a product, the higher the price elasticity of demand will be (elastic).

One can see that having insight in the price elasticity of demand of the good one is selling gives the seller the opportunity to make the biggest profit possible - and one doesn't have to know much economics to do this, simply considering the points above and assessing what type of product one is selling in relation to these categories will aid a person in milking their customers to give them as much of their money as possible.

We discussed here the price elasticity of demand - the same principle of elasticity can be applied in relation to:
• The income elasticity of demand (how will the demand for a good change with a change in the income of households?)
• The price elasticity of supply (how will supply for a good change with a change in the price of the good?)
• The cross elasticity of demand (how will the demand for a good change if the price of a related good changes? Eg: how will the demand for coffee change if the price for tea changes?)