ELASTICITY

We already know that changes of price produce responds in supply and demand. The law of demand describe an inverse relationship while the law of supply describes a direct relationship between the quantity and the price. But this relationships are not always proportional. Different markets will respond differently to changes. Elasticity helps us describe this degree of responsiveness.

The most important is the price elasticity.

Price elasticity of demand

Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded.  The formula for calculating price elasticity of demand is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably.  If quantity demanded changes proportionately, then the value of PED is 1, which is called ‘unit elasticity’.

PED can also be:

• Perfectly elastic where any very small change in price results in a very large change in the quantity demanded. Products that fall in this category are mostly “pure commodities”.
• Relatively elastic where small changes in price cause large changes in quantity demanded (the result of the formula is greater than 1). 
• Relatively inelastic where large changes in price cause small changes in demand (the number is less than 1). Petrol is a good example here because most people need it, so even when prices go up, demand doesn’t change greatly. 
• Perfectly inelastic where the quantity demanded does not change when the price changes. Products in this category are things consumers absolutely need and there are no other options from which to obtain them. This is indeed the situation where a monopoly firm would absolutely thrive because they can charge any price and people will still buy their products.

Thus a crucial information for marketers would be, not so much the actual number, but rather the category they fall in. It is mandatory that they know how people will react to price changes, and more importantly, to what level of change will they react the most.

Determinants 

Availability of substitute goods 

The more and closer the substitutes available, the higher the elasticity is likely to be, as people will have more options to choose from.

Breadth of definition of a good
The broader the definition of a good (or service), the lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high elasticity of demand if a significant number of substitutes are available, whereas food in general would have an extremely low elasticity of demand because no substitutes exist.

Percentage of income
The higher the percentage of the consumer's income that the product's price represents, the higher the elasticity tends to be, as people will pay more attention when purchasing the good because of its cost.  

Necessity
The more necessary a good is, the lower the elasticity, as people will attempt to buy it no matter the price.

Duration
For most goods, the longer a price change holds, the higher the elasticity is likely to be, as more and more consumers find they have the time and inclination to search for substitutes.

Brand loyalty
An attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand.

Who pays
Where the purchaser does not directly pay for the good they consume, such as with corporate expense accounts, demand is likely to be more inelastic.

Price elasticity of supply

Price elasticity of supply (PES) depicts the degree of responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. The following equation can be used to calculate PES:

Price Elasticity of Supply = % Change in Quantity Supplied / % Change in Price

While the coefficient for PES is positive in value, it may range from 0, perfectly inelastic, to infinite, perfectly elastic.

Extreme cases 

There are three extreme cases of PES.

• Perfectly elastic, where supply is infinite at any one price.
• Perfectly inelastic, where only one quantity can be supplied.
• Unit elasticity, which graphically is shown as a linear supply curve coming from the origin.

Determinants

Availability of raw materials

For example, availability may cap the amount of gold that can be produced in a country regardless of price. 

Length and complexity of production

Much depends on the complexity of the production process.

Mobility of factors

If the factors of production are easily available and if a producer producing one good can switch their resources and put it towards the creation of a product in demand, then it can be said that the PES is relatively elastic. The inverse applies to this, to make it relatively inelastic.

Time to respond

The more time a producer has to respond to price changes the more elastic the supply. Supply is normally more elastic in the long run than in the short run for produced goods, since it is generally assumed that in the long run all factors of production can be utilized to increase supply, whereas in the short run only labour can be increased, and even then, changes may be prohibitively costly. 

Inventories

A producer who has a supply of goods or available storage capacity can quickly increase supply to market.

The importance of elasticity for firms

Elasticity is typically defined in terms of changes in total revenue since that is of primary importance to firms. For managers, a key point int the discussions of demand is how changes in price(and specifically raising of prices) will affect the quantity demanded. It is important to know the extent to which the price can be increased in order to obtain more total revenue. With elastic demand, an increase in price will lead to a decrease in total revenue whereas, with inelastic demand an increase in price will lead to an increase in total revenue. It is important for managers to understand the price elasticity of their products in order to set prices appropriately to maximize firm profits.