Economists use elasticity of demand to gauge how responsive consumers are to changes in price and income, but investors can also use elasticity of demand to help make more informed investing decisions.
The challenge is wrapping your head around the difference between elasticity and inelasticity of demand.
Elasticity of demand measures how much the demand for a product or service changes relative to changes in price or consumers’ incomes. The difference between elasticity and inelasticity of demand is the proportion of this change. If the demand changes by more than the change in price or income, it has elastic demand. If demand changes by less than the change in price or income, it has inelastic demand. When demand changes by the same amount as price or income, the good or service has unit elastic demand.
To illustrate an example of elastic demand, say the price of a good increases by 1% and the demand for it decreases by 2%. Since demand changed by more than price, the good has elastic demand. If, on the other hand, the price increases by 1% and demand decreases by 0.5%, the good has inelastic demand. If both price and demand change by 1%, the good has unit elastic demand.
Another way to think of elasticity of demand is like a rubber band. A good with elastic demand has a softer rubber band — so when prices pull on it, the “demand band” more readily stretches in response. With inelastic demand, demand is more resilient to changes in price and less likely to get pulled one way or the other.
Of course, price isn’t the only thing that can pull on demand. There are three types of elasticity of demand, each with different pulls.
The Three Types of Elasticity of Demand
Risa Kumazawa, associate professor of economics at Duquesne University in Pittsburgh, says there are three demand elasticities that economists use to analyze consumer behavior: price elasticity of demand, cross price elasticity of demand and income elasticity of demand.
Price elasticity of demand measures how much a good or service’s demand changes when its own price changes. It’s calculated by dividing the percentage change in quantity demanded for a good by the percentage change in its price. If the price for corporate bonds increases by 5% and demand for corporate bonds decreases by 10%, the price elasticity of demand for corporate bonds is two (10% divided by 5%) and demand for corporate bonds is said to be elastic. If the price elasticity of demand for corporate bonds was less than one, which would happen if demand changed by less than the 5% change in price, corporate bonds would have an inelastic demand.
But what happens to the demand for other bonds if the price for corporate bonds increases? To answer this, economists look at the cross price elasticity of demand.
“The cross price elasticity of demand is calculated as the percentage change in quantity demanded for a good divided by the percentage change in the price of a related good, either a substitute or complement,” Kumazawa says.
If the price of running shoes increases 5% and the quantity demanded for flip-flops increases 10%, the cross price elasticity of demand is two (10% divided by 5%). This implies consumers must be purchasing either running shoes or flip-flops, so the two are substitutes for each other.
If the price of running shoes increases 5% and the quantity demanded for shoelaces decreases 10%, the price elasticity of demand is negative two (-10% divided by 5%). This shows that the two are being consumed together: When consumers buy fewer running shoes, they also need fewer shoelaces. The two goods are complementary.
The third type of elasticity of demand is income elasticity of demand. This measures how much demand for a good or service changes when consumers’ incomes change. Here, the sign differs on whether the good is a normal good, which consumers buy more of when their income increases, or an inferior good, such as secondhand clothes, which consumers buy more of when their income has decreased, Kumazawa says.
If consumers’ income increases 5% and the quantity demanded for sneakers increases 10%, sneakers are normal goods. If consumers’ income increases 5% and the quantity demanded for sneakers decreases10%, sneakers are inferior goods.
What Impacts Elasticity of Demand?
There are several factors that can affect elasticity of demand.
For instance, the more close substitutes there are in the market, the more elastic a good’s demand, says Giacomo Santangelo, a senior economics lecturer at Fordham University and term professor at the Stillman School of Business at Seton Hall University. If the price of a good changes, and you do not have to buy it, you’ll buy a substitute good, thus reducing demand for the good, he says.
This is why cartels and monopolies impact the elasticity of demand for a good or service. “Since there are no competitors, logical pricing would be to keep raising prices until demand goes from inelastic to elastic,” says Jim Glenn, faculty member in Walden University’s DBA program. “That is, raise prices up to the point where the next marginal price increase, say 5%, leads to a 6% drop in demand.”
The larger the portion of a consumer’s income they spends on the good also impacts elasticity of demand. Goods on which consumer’s spend a larger portion of their income have more elastic demand, Santangelo says. Hence why demand for higher-priced luxury goods are more elastic than lower-priced items.
Time is another factor that can impact elasticity of demand. “The more time you have to make your purchase decision given the change in price, the more elastic the demand,” Santangelo says. For example, a good that can be stored, will be elastic. “If the good is perishable, and one must purchase it soon, it will be less elastic,” he says.
Natural disasters can also impact demand. “Natural disasters affect supply and demand simultaneously, and thus prices,” Glenn says. For example, “The recent fires in California have increased the cost of milled lumber by over 20%, thus making houses and other items made of wood 20% more expensive overnight.”
Why Should Investors Care About Elasticity of Demand?
Knowing if the companies you invest in are producing a good that is elastic or inelastic allows you to estimate what will happen to the firm should prices for its product rise or fall.
“In general, if a good has elastic demand, firms increase revenue by decreasing price since the increase in quantity sold is larger than the decrease in price,” Santangelo says. “If a good has inelastic demand, firms increase revenue by raising prices since people will not change the quantity they purchase significantly when the price increases.”
Elasticity of demand also determines what will happen to a firm’s revenue throughout the business cycle, Santangelo says. “Firms producing goods with elastic demand will ‘feel’ more of the market cycles.”
If you want to invest in a company that can still generate revenue even when the economy isn’t doing well, you need a company that has inelastic demand.
“While these companies tend not to have spectacular growth, the sale of their products tends to remain steady,” Santangelo says. Clorox Co. (ticker: CLX) is a perfect example of this: People still need to clean during a recession. Compare Clorox’s demand to that for luxury brands like Christian Dior (CHDRF), and you can see the impact of elasticity of demand in action.
“Investors should pay attention to elasticity of demand because they will want to be invested in companies that have pricing power and a sustainable competitive advantage,” Glenn says. He tells investors to target industries that have the following characteristics:
— High financial, legal or political barriers to entry.
— Few or no substitute products available.
— Bargaining power with suppliers, such as Walmart (WMT).
— No need to negotiate with buyers on pricing.
“When making investing decisions, look for companies that have a dominant and unassailable market position and can sustain advantages over long periods,” he says. “To evaluate the potential of relatively young companies, ask yourself whether there are obvious and cheaper substitutes or if the product or service is a fad or megatrend.”
The Difference Between Elastic and Inelastic Demand
To recap, the key differences between elasticity and inelasticity of demand are as follows:
— Goods with elastic demand experience greater proportionate changes in demand when price or income changes.
— Goods with inelastic demand have smaller proportionate changes in their demand when price or income changes.
— Inelastic goods are more likely to continue producing revenue during down markets or recessions as demand for their goods won’t change.
— Companies that produce goods with elastic demand can increase revenue by lowering price. Firms that produce goods with inelastic demand can increase revenue by raising their price.
— Goods or services that have natural substitutes have more elastic demand. Goods or services for which there is no easy substitute have inelastic demand.
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