Value Investing – Elasticity in Economics (Lesson 22)
One of the terms synonymous with the field of economics is ‘Elasticity’. The term refers to the change in either the demand or supply (the other terms synonymous with economics) curve when there is a change in the price. In general, if the price increases a little for consumer goods and the consumers decrease their consumption in significant volume, the goods are considered elastic. Think of it like a rubber band, if there is a lot of change in the rubber band’s tension with very little price change, then the item is elastic (it stretches more) in nature.
On the flip side, if there is a significant price change for a particular good and the demand doesn’t change or changes very little, then the item is considered inelastic or stiff in nature. Based on this model, you should deduce that those needed goods such as housing, food and transportation will have very little change in consumption no matter what happens to the price. The current gas premium (Winter of 2021 – 2022) with the price increase is a perfect example. Consumers might drive a little less, but overall consumption of gas is going to remain relatively flat. Therefore, gasoline is generally considered inelastic. To prove this, will you greatly modify your current driving habit if gas increases to $5 per gallon. It is unlikely because you still have to go to work, you still have to shuffle the kids around and you still need to use the vehicle for your day to day needs. However, you may decrease your discretionary driving, such as planning a trip and so on. But overall, your driving habits will vary little due to the increase or decrease in fuel prices. Again, fuel is a need and therefore considered more inelastic than elastic.
On the flip side of all this are wants in life. If your local restaurant increased their price for a meal $2, you’ll think twice about going. Odds are that in the aggregate, the entire clientele will eat at the restaurant a lot less often than current rates. This is because there are substitutes for this particular item; eating at home, converting to fast food and so on.
A fascinating side note to this relates to the sales of McDonald’s fast food back in 2009 when the economy was in recession. They actually went up! Why? Folks traded their traditional going out and sitting down meals for fast food that had not changed price. This was an acceptable substitute with the decrease in discretionary spendable dollars for the consumer. The consumer had less money to spend and reoriented the spending habits related to elastic items. The ultimate losers were the national chains of sit down restaurants.
Elasticity affects both demand and supply related to both types of consumer goods and services. The following sections will explain this in more detail. If the above summary explanation is satisfactory, then you may only need to come back to this article for reference as needed. If you desire to gain a higher level of understanding, then please read on.
Elasticity – Demand and Supply Related to Needs and Wants
In general, for the consumer, there are two groups of consumer goods and services. These are needs and wants. The following chart is as basic outline of these two groups:
Needs Wants
Housing Entertainment
Transportation Recreation
Food Dining Out
Medical Care Dental Cleanings
Utilities Cell Phones
Look at the want in dental cleaning. The dental industry through education and marketing, have almost turned dental cleaning into a need and not a want. But the reality is; it’s a want. There are alternatives to a dental cleaning from your local dentist including more aggressive behavior with your toothbrush, increase frequency of using floss and modification to the diet to cut back on acidic foods. But by getting the consumer to believe it is a need (get it done every six months) they are able to have the consumer spend money on this service.
There is demand for each of the needs and wants and of course supply available for these goods and services. To understand elasticity is to understand what happens to the curve as the price of the item or the supply related to the item changes. Let’s find out.
Elastic Demand and Supply
Remember, basically for an item to be elastic in nature; it must flex or stretch like a rubber band if the demand or the supply changes significantly with any price change. In general you see this with more wants than needs. Let’s start out with entertainment. Suppose you own a movie theater and you decide to change the movie ticket price from $11 to $9 for current releases. What do you think will happen? No doubt about it, there will be more customers coming to your theater. This is pretty much a given. Entertainment is a want and if the price decreases, there will be more patronage. If the price increases, then the consumer will consider other alternatives especially Netflix or using their in-house cable to watch movies.
Suppose that current $11 a ticket increases to $12 a ticket, but patronage has no change. Then the profit margins for your theater increases. Other business opportunists decide to get into the business. Now another set of theaters open up about 5 miles away in the next town. Now, suddenly there is more supply of entertainment. This is an example of the supply side acting in an elastic manner. The supply of the goods or services increases with a little change in price.
If either the supply of the item or the demand for the item changes dramatically with a price change, then the item is considered elastic in nature.
Inelastic Demand and Supply
For needs, the basic response is an inelastic change exists in demand with a price change. Above, fuel for your car was used as one example. But, let’s use food as another example. In this case, we are not going to use one particular item because often people can substitute one item with a less expensive item if the price increases. Let’s use the whole grocery cart for the week of household food.
Suppose that the grocery cart of food suddenly increases from $165 to $175 for the same group of items. In general will the shopper change their habit? Odds are that they will not. They may look for alternatives to lower the price but let’s just assume that the cart contains pure basic foods such as the lowest cost loaves of bread, no pre-made items and no luxury foods such as sodas or alcohol. The meats come from large quantities of the lowest costs meats on sale each week. Naturally the consumer has no choice but to pay the price of $175. Here the price can go up several times but the demand will change very little in proportion. The demand line (volume or quantity of food purchased) changes very little as the price increases or decreases. This illustrates inelastic demand as the price changes. That is for needs, as the price changes, the overall demand does not. This holds true for all the needs related to goods and services. If you broke your arm, it doesn’t matter whether the doctor charges $400 or $800, you are going to pay the price to get the arm fixed.
Now think about inelastic supply. In this situation, the basic principle is that the producer will not change his production with any dramatic change in price. Let’s review a couple of examples:
Cruise Ships – in this industry there is a set amount of supply. As a particular week gets closer on the calendar, the price per cabin can decrease dramatically but the number of cabins on the cruise liner doesn’t change at all.
Nuclear Energy – this is another interesting example. To make nuclear power, the reactor runs at full speed, there is no variable control knob that basically allows the plant to produce only ½ the energy or 90%. In effect, the plant was either ‘ON’ or ‘OFF’; no in-between. Therefore, the producer is unaffected by the change in price. To produce more energy if the price increases warranted such a step would require a significant investment of time and money. In addition, the producer would need to recruit qualified technicians and operators which is difficult to do.
Education – how many new colleges have you seen in the last five years? There haven’t been any new universities opening up over the last 10 years and we all know tuition has increased several percent per year over the last 20 years. This is a good example of price increasing with no change in supply.
Cigarettes – do you believe the consumption of this item changes with price? Highly unlikely because those members of our society that smoke will not consume more or less no matter what happens with the price of a carton of cigarettes. Do you think for one minute that if the price of a pack of smokes were cut in half that there will be a sudden increase in the number of smokers thus requiring greater production to meet that demand? Now, there may be a run on the cigarettes if there is a sudden decrease in price but that is in response to the belief that the price will go back to normal in the near future.
Do you notice any common traits associated with the above? Well, one characteristic is the difficulty of increasing or decreasing the supply related to a price change. Many of the supply issues relate to the high investment barrier to add an additional line of production or build another ship or airplane.
A related article on this site addresses the business principle of absolute dollars. The key for any high initial cost to create supply with very little variable costs warrants selling the supply for any value obtainable to put the maximum number of dollars into the bank account.
Elasticity – Other Issues
Although the above seems relatively simple to understand, it does get a lot more complicated. In economics there are many outside factors that affect decisions every day. Politics, availability of capital, consumer habits and our social interactions greatly impact demand and the correlating supply of goods and services. To complicate this further, economists use variances of elasticity and in-elasticity. For example extreme ends of the curve include ‘Perfectly Elastic or Inelastic’ which means the demand or supply is completely unaffected by the change in price. Think of chemotherapy for a cancer patient. The price for the treatment can change 10 fold in either direction and the demand will not change at all.
Other terms include:
- Coefficient of Elasticity
- Unit Elasticity
- Factors Affecting Demand Elasticity – Substitutes, Time and Availability of Income
The point of all this is that this is a science and it involves actuarial calculations (law of large numbers). For you as a small business owner, you need to understand the principle of elasticity. As the price changes (up or down), what happens to the demand or the supply? If no change in either, it is considered inelastic. Think of the rubber band, it doesn’t change shape with the price change, therefore it is inelastic. On the other hand, if the supply or demand changes some to a significant amount then it is considered elastic, i.e. the rubber band stretches.
Use this thinking to assist you in your decision models as an owner of your business. Act on Knowledge.