At 99 cents, you might impulse buy a bottle of Coke.
At $1.09, you might still grab that drink off the shelf if it's near the register.
At $1.19, perhaps you'd spend the money on a particularly hot day.
At $1.29, you might get uncomfortable about spending this much on the war against enamel.
At $1.39, you're out. Nothing will convince you to buy that bottle of Coke.
You've just experienced elasticity of demand.
What Is Elasticity of Demand?
Elasticity of demand is when external factors such as price and environment influence how much of a product consumers buy. You see it in your day to day life more often than you might realize. Consider, for example, the last time you went grocery shopping and saw the sale items completely sold out. This is elastic demand in action.
High elasticity of demand indicates that consumers respond easily to external factors when buying a given product. Take our grocery example from above; a small price drop on chicken drumsticks might lead to a surge in consumption. Or consider umbrellas, a highly elastic market based on weather conditions. When it rains, people buy them. On a nice day, they buy very few.
Most consumer products tend to have moderate to high elasticity.
Low elasticity of demand indicates that consumers tend to buy a product regardless of changes to price or external factors. Gasoline is a classic example of a low-elasticity product. Workers and travelers need to drive, so as prices go up, people tend to cut spending in other areas, rather than buy less gas. As a unique necessity, there aren't many factors that will convince people to change their gas-buying habits.
Unit elastic demand is when a change in price has a 1:1 relationship to change in consumption. That is, for every 1% you change the price, consumption also changes by 1%. Few, if any, products demonstrate true unit elasticity.
What Drives Demand?
Price is the most common influencer of demand, typically with an inverse correlation. As prices rise, consumer interest tends to fall and vice versa. This is known as "price elasticity of demand." (It is worth noting that at times price can influence other demand factors. For example, within the liquor industry price can drive consumer perception of quality, leading to a reversal of the normal relationship in which consumers actually prefer a brand more as its price goes up.)
While price elasticity is a major element of total demand elasticity, many factors can drive consumer habits. These are often cited as either the five or the six determinants of demand. Typically these are:
Price of product: As the price of a product rises, consumption tends to fall. As the price of a product falls, consumption tends to rise.
Consumer income: As consumer income rises, consumption does too. As consumer income falls, so does consumption.
Consumer preferences: This is perhaps the broadest, most ambiguous determinant category. It refers to how much consumers want a given product, and can be driven by perception, advertising, environmental factors and anything else that will make a product more or less popular (a can of Coke on a hot day, an umbrella on a rainy one and so on).
Ease and price of substitution: For any given product, as availability of a substitute rises and the price of that substitute falls, consumption of the product will decline. Essentially, as consumers can more easily and cheaply replace a product, consumption of that product will decline. This is sometimes known as cross-elasticity.
Anticipated price: If consumers think the price of a product will go up in the future, demand will go up. If consumer think the price of a product will decline in the future, they will tend to wait on any purchases.
Market segment: Elasticity is also highly determined by consumer profile. For example, high-wealth consumers will generally be very inelastic according to price, while urban consumers may have high cross-elasticity due to their access to a crowded marketplace.
As we touched on above, "high elasticity" means that consumers tend to respond easily to one of the factors listed above. As a general rule, luxury products, brand-driven and fungible goods, and entertainment tend to have higher elasticity.
For example, a brand-driven product will tend to have high elasticity by substitution. This means that consumers can easily replace this product with a comparable one. A good example is paper towels. There is little practical difference between paper towel products, so most consumer purchases are driven by brand loyalty; someone who purchases Bounty will tend to continue doing so. However, if a competing brand of paper towels drops their price, consumers will quickly switch to the competitor because the products are easily substituted.
This is also a factor in how retail stores schedule their sales. When consumers know that a sale is coming up, they tend to stop buying in anticipation of lower prices. So retailers often won't announce their upcoming sales. On the other hand, during that sale a retailer will typically publish when the discount ends. This will drive consumers to buy more of a product, in anticipation of higher prices.
With a highly elastic product, this sales model will prove effective. With an inelastic or "low elasticity" product, it will not. Consumers will continue to buy it in steady numbers regardless of how they think future prices will move.
Low elasticity means that consumers don't change their buying habits easily regardless of the factors listed above. A product could get more expensive or external conditions could change and consumers will still buy the product in steady numbers. Low elasticity of demand is typically associated with necessities, products related to health and safety and irreplaceable goods.
In addition to gasoline, listed above, cigarettes are a classic example of an inelastic product. Many smokers are driven by physical habit. This means they will continue to buy cigarettes even as prices go up or shopping gets inconvenient. Few, if any, external factors will change how much someone with a nicotine habit wants to smoke, and many states take advantage of this through lucrative taxes.
Health care is another inelastic market.
Patients have very little discretion in how much health care they consume. If you have a broken bone, you must have it fixed. If you are sick, you need the appropriate medicine. As a result, price and market conditions have very little impact on how much health care people buy. Consumers will go into debt and bankruptcy because, ultimately, this is a physically coercive market: You consume more health care or suffer pain, illness and possibly death. This leads to high inelasticity.
What Is Artificial Inelasticity?
Managing elasticity is a critical factor to good policymaking, and many (if not most) economic policy is structured around influencing demand in the market place.
For example, consider the Federal Reserve changing interest rates. The goal of an interest rate shift is to either encourage or discourage borrowing and, by extension, business spending. The key factor underlying this is price elasticity of capital. In essence, how much will consumption of capital (borrowing) change based on changes in price?
Many other government policies are built around creating or restricting artificial inelasticity.
Through the patent and copyright system, for example, the government artificially creates a highly inelastic substitution market. Without these laws, people could easily copy the work of scientists and artists, creating an almost infinitely elastic marketplace. Without copyright laws, someone could simply transcribe John Grisham's latest novel word for word, charge $1 for it and create immediate cross-elasticity.
Intellectual property laws exist to stop that. They make it impossible to compete through pure price and substitution, forcing other authors to compete for consumer preference. (In other words, by writing a better book.)
The antitrust system, on the other hand, is an example of regulation away from artificial inelasticity. Monopolies allow a company to eliminate all substitution competition by making themselves the only product on the shelf. By breaking up these monopolies, the government enforces competition and by extension this form of consumer elasticity.
It is important to note that a product can have varying degrees of elasticity along different factors of demand. Something which is highly elastic by consumer preference might also be very inelastic by price and vice versa.
For example, novels are a good example of a product that has varying degrees of elasticity by factor. As an entertainment product, a consumers will tend to quickly lose interest in a paperback the more expensive it gets. This product has high price elasticity.
Yet this also tends to be a highly unique product. A fan of John Grisham will not simply substitute his latest thriller for a space opera, regardless of price difference between the two. This product has very low substitution elasticity.
High elasticity is a single-factor question. If any one factor can cause people to buy less of the product, then it has higher elasticity. Low elasticity is a net-factor question. If, all things considered, no demand factor will significantly change consumption, then this is a low elasticity product.