Elasticities: Quantifying Supply & Demand

Now that we have established a solid understanding of supply and demand, it is possible to make some basic predictions about market prices and quantities. It is now necessary to delve into a more advanced topic known as elasticities of supply and demand to better quantify these predictions.

Elasticity of supply and demand is a measurement of quantity sensitivity to price changes. Elasticity explains change in quantity supplied or demanded as a result of a price change. Another way to think of elasticity is the supply and demand curves' slope. There are elastic (gradual slope) and inelastic (steep slope) curves. An elastic curve is when a small change in price creates a large change in quantity. The supply curve drawn below goes up in price by $10, but increases in quantity by 20. It is an elastic curve because its percent change in quantity is greater than its percent change in price. The demand curve, as illustrated below, is an inelastic curve. With the exact same change in price, there is only a small change in quantity demanded. The percent change in quantity demanded is smaller than the percent change in price.

Factors that effect elasticity of supply:

• Marginal Production- If it is difficult to increase production of a good then the curve is inelastic and if it is easy to produce more then the curve is more elastic. Hand-made antiques would be an example of a more inelastic good in comparison to toothpicks made quickly through machines. 
• Source of Supply- If a good is already maximizing the global supply of resources then it is very inelastic, where as a product using only a small portion of raw materials can increase production and is more elastic.
• Time Horizon- Over a short period of time, supply curves are more inelastic as it must produce goods with existing capital and infrastructure. In a long run market scenario, companies can expand their production and the product becomes more elastic. 

Factors that effect elasticity of demand:

• Substitutes- The fewer substitutes that exist to replace a good, the more inelastic the demand curve. If there are more options and goods to choose from, the curve is elastic. 
• Scope of Product- The demand for an entire category of a product such as blue jeans is more inelastic than the market for designer blue jeans.
• Necessities vs. Luxuries- The demand for life essentials is significantly more inelastic than the demand for life's luxuries.
• Size of Budget- For those items that are a small part of your budget, your demand for them is largely more inelastic than purchases that consume more of your income.

Elasticity of demand has a very useful application to business. It helps determine total revenues and prices. Total revenues= Price x Quantity. If a business is aware of their good having inelastic demand, they know they can charge a higher price and only lose a few buyers and increase their net revenues. The opposite is true for a businessman with elastic buyers. Other important applications to elasticities will be unpacked in my explanations of taxes and subsidies.

Competition Between Sellers: Corrects Surpluses, Lowers Prices

The opposite of a market shortage is a market surplus. A surplus is when the quantity supplied at a given price is greater than the quantity demanded. In the diagram below, imagine that the model represents the market for generic watches. For simple illustration purposes, we will set the price higher than equilibrium on the original curves to create a surplus. The surplus is caused by a shift in either the supply or demand curve.

Let us say that the price of watches is at $50. At the price of $50, 25 consumers demand watches and sellers supply 75 watches. This results in 50 leftover watches that are produced by sellers that are unwanted by consumers. Similarly to shortages, there is a self-correcting mechanism to resolve surpluses known as competition between sellers.

In order for a seller to ensure a sale of his products to consumers, the seller must compete for the business of consumers against his competitors. The way in which sellers do so is by giving consumers the best value through lower prices or higher qualities. In the event that sellers are producing similar products, producers must lower prices as much as possible. The lowering of prices reduces the number of goods, or watches, supplied and increases the quantity demanded by consumers. In this market, a $30 price will result in market equilibrium at which point the downward pressures of seller competition balances with the upward pressures of consumer competition.

It is important to take away from both shortages and surpluses that the problem is not with the market, as the market is the solution. As you can see, the market does have its own ways of correcting itself towards equilibrium. One must understand that it is not the consumers versus the wealth capitalists, but rather consumers competing amongst one another that lead to price increases. At the same time it is competition between sellers that results in a lower price. Remember that shortages and surpluses are often a problem with pricing. Also keep in mind the complexities of markets with all the buying and selling and levels of production and how that it is impossible for anyone to centrally plan a perfect equilibrium at all times. What we can be sure of is that despite both shortage and surplus, markets will correct and return to equilibrium.

Also, watch this learnliberty.org video to learn about marginal value, a very important economic principle. Learn how a bottle of water can be worth more than diamonds.