What it means
Elasticity measures how sensitive buying behaviour is to price. When demand is elastic, a small price rise causes a large fall in the amount sold.
When demand is inelastic, the opposite is true, and customers barely react. Goods tend to have inelastic demand when they are necessities, have few substitutes or take up a small part of the buyer's budget.
Examples include basic medicines, electricity, petrol in the short term and salt. A customer who needs a prescription will usually pay a higher price rather than go without.
The consequence for revenue is important. If demand is inelastic, raising the price increases total revenue, because the fall in sales volume is smaller than the rise in price.
Companies with inelastic demand therefore have more pricing power, meaning they can lift prices without losing many customers. Time and choice change the picture.
Demand that is inelastic in the short run can become more elastic over months or years as people find alternatives, such as insulating their homes or buying more efficient cars. A price rise that works this year may encourage competitors or substitutes to enter next year.
Inelastic supply is the mirror image: producers cannot easily increase output when prices rise. Farm land, rare minerals and the number of seats in a stadium are examples.
When demand rises and supply is inelastic, prices can jump sharply, which is why housing in popular cities and tickets to major events become so expensive. Governments pay attention to inelastic goods when setting taxes.
A tax on a product with inelastic demand raises plenty of revenue because buyers do not cut back much, which is why fuel and tobacco are commonly taxed, though the burden falls heavily on those buyers.
In practice
Real-world examples.
Example
A pharmaceutical company sells a medicine with no close substitutes. It raises the price by 8% and sales volume falls by only 2%. Total revenue rises, which confirms demand is inelastic. The company's finance team records the result for future pricing decisions.
Example
A utility company supplies electricity to homes. Customers need power regardless of price, so even a 15% increase in tariffs reduces consumption only slightly. The regulator therefore reviews and limits rate rises, since the supplier could otherwise charge far more than is fair.
Example
A farmer grows wheat, and a poor harvest across the region reduces total supply by 20%. Because people still need bread, demand barely changes and the price of wheat rises sharply. Farmers with a crop to sell earn good returns that year, while those who lost their harvest do not benefit.
Formula
Calculation
Price elasticity of demand = % change in quantity demanded / % change in price
Suppose a water company raises its price by 10% and the volume sold falls by 4%. The elasticity is -4% / 10% = -0.4. Because the absolute value, 0.4, is less than 1, demand is inelastic.
Check the revenue effect. Before the rise, 100,000 units sold at $20 gives revenue of 100,000 x 20 = $2,000,000. After the rise the price is 20 x 1.10 = $22 and the volume is 100,000 x 0.96 = 96,000, so revenue is 96,000 x 22 = $2,112,000, an increase of $112,000.Case study
Seen in the real world.
Lumen Power Partners is a fictional energy retailer with 400,000 household customers. Its finance team wanted to know whether a 6% price rise would increase income.
Past data suggested that a 6% rise would lead to a 1.8% fall in volume, giving an elasticity of about -0.3. With annual sales of $480,000,000, revenue after the rise would be 480,000,000 x 1.06 x 0.982 = about $499,642,000, a gain of about $19,642,000.
In this illustrative case the company decided on a smaller rise of 4%, because it expected the regulator and the public to react badly to a bigger one. It also introduced a help scheme for low-income households, accepting a small cost to protect its reputation. The finance team monitored volumes each month to check that the elasticity estimate held.
Watch out
Common mistakes.
- Assuming inelastic means customers do not respond at all, when it means they respond less than proportionally.
- Believing demand stays inelastic forever, when alternatives such as solar panels or more efficient appliances can appear over time.
- Raising prices on every product on the assumption that all demand is inelastic, which can drive away customers of items with many substitutes.
Questions
People also ask.
What does an elasticity of -0.4 mean?
It means that a 10% rise in price leads to about a 4% fall in quantity demanded.
Which goods usually have inelastic demand?
Necessities, goods with no close substitutes and items that cost little relative to income.
Why do firms like inelastic demand?
Because they can raise prices and increase revenue without losing many customers, although regulators and public opinion may limit how far they can go.
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