4 important concepts of Elasticity made simple

4 Elasticity Concepts in 5 Minutes

Elasticity is a very basic economics concept. It's used in many economics studies. When you complete this page, you'll be able to grasp it & use it in your answers in such a way that professors, interviewers would love to listen:

Elasticity is how flexible demand/supply is in response
to a change in price (or other variable).

1) Price Elasticity of Demand (PED): 

What does it means? It simply means if you change price of a product how'll demand for it will behave.

Suppose you are CEO of a company you would try to figure out how much change in price of your product will increase its demand or sales!

If you're CEO of some luxury stuffs co. then probably reducing price won't help you much. Because if it's not pricey then its not luxury. Isn't it?

Price In-elastic Demand: Apple iPhone 5C 

PED, price elasticity demand, economics, rbi grade b, sbi po, ibps,
iPhone 5C pic by flickr janitor

Apple launched both iPhone 5S (high end) & 5C (ridiculed as C for cheap) According to some reports iPhone 5C sales were not impressive. And some intellectuals are criticizing Apple for venturing into low-cost mobiles as their price & cult-culture is what separates it from others. May be that's why the legendary Steve Jobs never actually gave any thought of making "cheaper mobiles".

So we would say demand of iPhone 5C is price inelastic! Demand is not responding to change in pricing. Another way to see it: if price were reduced by 40%, demand increased by may be 2-3% - that's what we call price in-elasticity.

Price elastic Demand: Burgers

Take another case: What if you are CEO of McDonald? Reduce price or not. Well, here is some piece of news, reduce price & increase sales. So when you reduce prices by say 25% & demand increase by say 40% then we say Burger sales (demand) are price elastic!

Now lets see another easy concept.

2) Income Elasticity of Demand (YED):

(letter 'I' is for Investment, so Y for income).

What does it means? It simply means if you change real Income levels how'll Demand behave.

Normal Goods & Inferior Goods

With increase in real income demand for 'normal goods' increase. More money with people they'll spend it.

However there are some goods whose demand will decrease with increasing income for e.g. bus tickets because people will take taxis, cars etc. such goods are called 'Inferior goods'.

Luxury goods are more income elastic than necessities. Because people will buy luxuries with rise in income!

Consider this: When your income goes up, what would you do? Buy Apple iPhone - 5S of course, eat out with friends in expensive restaurants, go for holidays... and so on. You are creating more demand by spending more, because now your income is more.

What if your income goes down? Probably you'll eat at home, prefer low-cost types of mobiles, take public transport instead of taxis etc.

Here's a study to understand these concepts better - don't go into too much details just read Executive summary only. But before that read this Elasticity part 2. Here's excerpt:

"An average income elasticity of 1.65 is estimated for inbound tourism. A 1% increase in GDP (Income)... would lead to an increase in tourism expenditure in the UK of 1.65%."

That's roughly to say that if you raise income by 1%, Britishers tourism expenditure increase by 1.65%. So hotel-room demands are income elastic!

YED, income elasticity demand, economics, rbi grade b, sbi po, ibps,
Jumeriah Hotel by flickr adteasdale

3) Cross Elasticity of Demand (XED):

 is a measure which shows how much demand of a good will change in response to change in price of another good.

Coke & Pepsi are 2 subtitute goods. If coke reduce it's price, Pepsi sales will be affected.

Tea & Chai-Masala are 2 pretty strong compliments ;). Tea & Sugar can be said as good compliments.

4) Price Elasticity of Supply (PES):

What does it means? It simply means if you change prices of a good how'll (& how quickly) supply behave.

Now suppose you are an Onion supplier!

Should I tell you more? I don't think so if you are in India. When prices increase, you would rush to book max profit. You'll increase supply & sell more & more...

PES tells us how quickly suppliers are able to react to the price change. If suppliers are able to react quickly we say the supply is price elastic.

So Onion supply is price elastic.

Supply is said to be price inelastic when suppliers are not able to increase supply when price is high. Similarly they are not able to restrict supply when price goes down.

Suppose you're Onion farmer, what would you do when prices shoots up. Actually you can't do anything because onion corps are ready in 5 months. By the time your fields are ready prices would come down.

A very important concept in it is: Commodities like Agricultural produce, Mining are price inelastic.

But if seen over a longer period of time then even commodities are elastic. If Basmati rice fetch good price for farmers, then over a longer period of time, farmers will produce more of it!