Definition of elasticity of demand: How sensitive demand for a product is to a change in price.

What is elasticity of demand?

Elasticity of demand is a very interesting economics principle you’ll see included in all good economics books, which I hope you’ll find easy to grasp, as it can be demonstrated with real-life examples.

As we discussed in our definition of demand, price is perhaps the largest single factor which helps us predict demand for a product. At a higher price, fewer consumers will make the decision to buy. At a very low price, even relatively indifferent consumers might be tempted into making a purchase.

This summarises the directionality of the relationship, i.e. the downward slope of a demand curve. Elasticity of demand helps us appreciate how steep that curve is.

Products with high elasticity of demand experience sharp increases or decreases in the quantity demanded when relatively small changes are made to the price.

Products with a low elasticity, also known as inelastic products, experience little change in demand when prices change.

Why are some products elastic and others inelastic?

It’s more helpful to think of the consumer as being flexible or inflexible on price, rather than the product itself having elastic properties. After all, it’s the decision making going on in the consumers’ brain which results in the behaviour we describe as elasticity.

The simple answer is that consumers simply want some products a lot more than others.

Water, food, shelter and security are basic human needs for survival. As a result, there is no maximum price a human would pay to obtain these goods and services, beyond the limit of affordability.

Products which provide these needs, particularly in a monopolistic environment where there is only one supplier, are therefore very inelastic. Even if water prices triple – consumers would have little choice but to continue to use their taps in similar quantities to yesterday.

Naturally, a surge in price will lead to consumers being more cautious about usage and would cut-back on frivolous use, so demand would still fall, but only to a limited extent.

In contrast, cake decorations are not very essential. They’re an inedible, aesthetical improvement to a luxury item. It’s safe to say that no consumer will feel they desperately ‘need’ to buy cake decorations at any price.

Therefore if the prices of cake decorations tripled overnight, consumers may potentially stop buying them altogether. They would begin to make up a very large proportion of the cost of a decorated cake. Undecorated cakes would become very attractive alternatives on shop shelves, as they would be priced much lower.

Therefore it’s possible that if prices rise enough, demand could collapse.

Elasticity works both ways

In the examples above, I demonstrated the way demand reacts to an increase in price. Inelastic demand results in a moderate reduction, whereas elastic demand sees a much sharper drop.

The same applies the other way around. When prices fall, inelastic demand results in a muted rise in uptake, whereas elastic demand results in demand sky rocketing.

Consider this:

How much additional water would you use if water prices halved?

Compare your answer to:

How frequently would you eat out at restaurants if all meals & drinks became half their current price?

If you’re like me, you wouldn’t find yourself taking an extra shower per day just because my budget now allows it. Whereas I can imagine that halving the price of eating out would encourage a lot of households to do so more often.

How is the phrase elasticity of demand measured?

The elasticity of demand is measured by a coefficient (Ep). This calculates the % change in the quantity of a good or service demanded resulting from a percentage change in its price.

A coefficient of 1 means that a 10% increase in price results in a 10% decrease in demand. > 1 means a price is elastic, and < 1 means it is inelastic.

How does the definition of elasticity of demand relate to investing?

The definition of elasticity of demand is useful to understand when considering the business model and microeconomic environment in which a company operates within.

Investment courses and investing books will explain that you should perform adequate research on a company before you invest.

You should, as a general rule, always perform a review of the financial statements of a company, and review its markets, its dominance in the industry, and many other factors. This should be done before you buy shares from your stockbroker or through any other channel than a financial adviser.

Elasticity of demand is a factor which can protect a business during a downturn. If a product has relatively inelastic demand, then a business can maintain or even increase income by increasing the price of its product.

Because the % change in demand would be lower than the % increase in price, the business would generate higher turnover after the price change. This is a useful characteristic which could help identify what are known as ‘defensive stocks’ – shares or bonds which outperform the rest of the market during tough times.