3.1.3 Elasticity
Helpful prior knowledge and learning objectives
Helpful prior learning:
Section 1.1.1 The economy and you, which explains what an economy is and how it is relevant to students’ lives
Section 1.1.2 The embedded economy, which explains the relationship between the economy and society and Earth’s systems
Section 1.3.6 Households, markets, state and commons, which explains four provisioning institutions in the economy and their interconnection
Section 3.1.1 The market as a system, which describes market parts and their relationships, and the connection between the household and the rest of the economy.
Section 3.1.2 Demand and supply, which explains the factors affecting supply and demand and the dynamic relationships and feedback between supply, demand and prices.
Section S.1 Systems thinking, which explains what a system is and why systems thinking is useful. (coming soon)
Learning objectives:
describe the concept of elasticity in the context of price elasticity of demand and supply, cross-price elasticity of demand, and income elasticity of demand
describe the relationship between price elasticity of demand and market power, and its significance for producers, consumers and the state
analyse the factors that impact price elasticity of demand
The 2022 Russian invasion of Ukraine shocked global markets. Prices of many commodities, especially natural gas (Figure 1), more than doubled. Europe, heavily dependent on Russian gas, faced major supply disruptions. Wheat exports from Russia and Ukraine were also affected, causing a spike in bread prices in countries like Egypt, which relies on these sources for over 80% of its wheat.
When supply decreases, producers gain more market power and may raise prices, especially for essential goods like fuel and food. This section explores the concept of elasticity to help us understand the power dynamics first introduced in the previous Section 3.1.2.
Figure 1. Price of natural gas (US$) on the NYMEX from August 2019 to August 2024
(Credit: Google Finance)
Figure 2. Some countries, like Egypt, are very dependent on wheat imports from Ukraine.
(Credit: MM, CC BY-SA 2.0)
What is elasticity?
Elasticity measures how much the quantity demanded or supplied of a product changes in response to some factor. Imagine a rubber band (Figure 3). Some are very stretchy, easily extending when pulled—these are elastic. Others are stiff, stretching only slightly under force—these are inelastic.
Demand and supply can also be elastic or inelastic. When demand or supply is elastic, consumers or producers react strongly to some factor that affects them; demand or supply stretches, or changes a lot. These factors include price and non-price factors discussed in Section 3.1.2.
Figure 3. How stretchy is demand or supply in response to some factor that affects it?
(Credit: laogooli, CC BY SA 2.0)
Economists mainly focus on price and income when studying elasticity. The most common elasticities are:
Price elasticity of demand (PED): measures how a price change affects the quantity demanded.
Price elasticity of supply (PES): measures how a price change affects the quantity supplied.
Cross-price elasticity of demand (XED): measures how a price change in one good affects the quantity demanded for a substitute product or complementary product.
Income elasticity of demand (YED): measures how changes in income affect demand for a product.
Figure 4 shows these elasticities (highlighted) in relationship to the factors affecting demand and supply from Section 3.1.2.
This section focuses on price elasticity of demand, revealing the power dynamics between producers and consumers, a key theme in Topic 3.
Figure 4. Common elasticities calculated by economists, formulas highlighted and relevant factors in bold
What is price elasticity of demand and what can it tell us about market power?
Price elasticity of demand (PED) measures how much the quantity demanded of a product changes when its price changes. If a price increase, say 100%, leads to a proportionally smaller decrease in demand, like 10%, demand is inelastic. We calculate price elasticity of demand by dividing the percent change in quantity demanded by the percent change in price:
PED = (%ΔQd) / (%ΔP) = -10% / 100% = -0.10
This means that for every 1% increase in price, there is just a 0.10% drop in demand; demand is inelastic, inflexible.
If a price change, say a price increase of 20% for movie tickets, causes a relatively larger change in quantity demanded, like a decrease of 25%, then demand is elastic. This is calculated:
PED = (%ΔQd) / (%ΔP) = -25% / 20% = -1.25
This means that for every 1% increase in price of movie tickets, quantity demanded decreases by 1.25%, and demand is therefore elastic, flexible. Note that regardless of the situation, PED is always negative because the relationship between price and quantity demanded is inverse. However, PED is usually given as a positive number, because the number has no significance for interpreting its meaning.
The more inelastic the demand, the more power producers have; the more elastic, the more power consumers have (Figure 5).
Figure 5. The more inelastic demand is, the more market power the producer has to raise prices. Consumers have more power when their demand for a product is elastic.
What factors impact the price elasticity of demand?
Several factors influence price elasticity of demand, affecting the market power of producers and consumers:
availability of substitutes: if close substitutes are available, demand is more elastic. Consumers can easily switch to a cheaper option if prices rise. For example, if one brand of rice becomes more expensive, consumers may choose a less expensive brand if there are many alternatives (Figure 6).
necessity of the good: demand for essential products is often inelastic. For instance, during natural disasters, clean water is often in short supply. People selling water may raise prices and people have no choice but to pay if they want to survive. The more necessary a product, the more inelastic demand is likely to be.
Figure 6. If the price of one brand of rice increases, people may be able to buy another lower priced substitute, making demand more elastic
(Credit: Chris Devers, CC BY-NC-ND 2.0)
price as a proportion of income: expensive products that take up a large part of consumers’ incomes tend to have more elastic demand. For example, if car prices rise, there is likely to be a large decline in purchases, because cars are already very expensive for people to buy.
time delay: the longer consumers have to adjust to price changes, the more elastic demand becomes. If petrol prices rise today, people might not change their driving habits immediately. But over time, they might switch to fuel-efficient cars or public transport, increasing elasticity.
These conditions affecting elasticity are not fixed. Economic actors can influence them.
For example, some businesses grow to dominate a market, with a large market share. This reduces substitutes and the business gains power to raise prices (Section 3.2.4). States, however, can use antitrust laws to prevent businesses from gaining too much market power (Section 3.4.5).
Economic narratives also impact power and social norms in the economy. Economic narratives (Section 3.2.2) are the stories we tell about how the economy works, how we should study the economy and participate in it. For example, if we start our economics courses with the story that resources are scarce and human needs and wants are unlimited, we set ourselves up to expect that producers/sellers naturally have more power in market exchanges. This story can shape how we think about market power and what we might do about it.
What is the significance of price elasticity of demand for producers, consumers and the state?
Producers, consumers/households, and the state need to be aware of price elasticity of demand in their decision-making.
Producers
Price elasticity of demand affects whether a price change will increase a business’s total revenue, the amount of money earned from selling the product. If a business raises the price of a product with inelastic demand, revenue will increase because consumers will reduce their purchases by a smaller percentage than the price increase.
Producers must also consider the ethical implications (Section 3.1.2) of using market power to raise prices, especially for essential goods, like water after a natural disaster mentioned earlier in the text. Exploiting such situations for profit is known as price gouging and is illegal in some places.
Figure 7. A protestor highlighting the high prices for essential drugs charged by pharmaceutical companies
(Credit: Elvert Barnes, CC BY-SA 2.0)
On the other hand, if demand is elastic, raising the product price will decrease revenue because so many buyers will stop purchasing it. To increase revenue when demand is elastic, businesses should lower prices, as the quantity demanded will rise by a larger percentage than the price drop. However, businesses are often reluctant to do this because it can lead to price wars with competitors. This is why gaining market and pricing power is so attractive for businesses (Section 3.2.4).
Consumers/households
Consumers experience the effects of price elasticity in their everyday purchases. When demand is inelastic, like petrol for car owners, they may have little choice but to pay higher prices. However, when demand is elastic, consumers can switch products or stop buying them if prices rise.
It's important for consumers to recognize situations where demand might be inelastic so they can avoid them. By maintaining choice and flexibility in transportation, energy, food, and other essentials, they can avoid being trapped by higher prices.
Figure 8. Keeping transportation options flexible if possible, can help avoid being harmed by high prices and inelastic demand
(Credit: Picryl)
The state
The state must consider price elasticity of demand when taxing products, as it affects tax revenue, changes in behaviour, and who actually pays the tax
For products with inelastic demand, like cigarettes, a tax generates high revenue for the state because higher prices from the tax don’t significantly reduce purchases, at least in the short term. This makes the tax effective for raising revenue, but less effective for changing behaviour, like reducing smoking. The opposite is true if the taxed product has elastic demand.
When demand is inelastic, producers often pass most or all of the tax to consumers/households through higher prices, so they are disproportionately affected by such taxes. This can cause public unrest, as seen in the 2018-19 yellow vest protests in France (Figure 9), where a proposed petrol tax increase sparked widespread anger, particularly among low- and middle-income households, and rural households who have fewer transportation choices.
Figure 9. The gilet jaunes protesters demanding a just economic transition
(Credit: Thomon, CC BY-SA 4.0)
States also need to monitor how changing economic conditions influence elasticity, especially in essential human needs. It's crucial for states to prevent increases in market power that could make demand more inelastic in areas like food, water, housing, and mobility. This often requires the state to support or provide affordable or free alternatives to market-based essential goods and services.
Activity 3.1.3
Concept: Power
Skills: Thinking skills (transfer, critical thinking)
Time: 15 minutes each
Type: Individual, pairs, group
Option 1: Practise calculating elasticities
What is the PED if the price of a product increases from S$2 000 to S$2 500 and quantity demanded declines by 10%? Hint: you first have to calculate the percentage change in price - here’s a reminder.
What does that number tell you about the demand for the product?
With this price elasticity of demand, if a producer/seller wants to increase their revenue, would they increase or decrease the price? Why?
Why is a business’s pricing decision an ethical issue?
Show/hide solution
%ΔP = ((P2-P1) / P1) x 100 = ((S$2 500 - S$2 000) / S$2 000) x 100 = 25%
PED = - 10% / 25% = - 0.4 or 0.4
Demand is inelastic because the value is between 0 and 1, meaning demand is relatively unresponsive to a price change.
When the demand for a product is inelastic, raising the price of the product will earn the business more revenue. This is because the relative decline in quantity demanded is smaller than the increase in price.
Business pricing is an ethical issue particularly in conditions of inelastic demand. Businesses have power in these cases to raise prices, but must consider the impact on human wellbeing and needs. It is a choice to use market power to increase prices and maximise profits, and businesses must consider the social implications of doing so.
2. Research on cigarette taxes shows that price increases in cigarettes (usually due to taxes) have a larger impact on reducing youth smoking than reducing adult smoking. Use what you learned in this section about the factors affecting elasticity of demand to explain why this is the case.
Option 2: Reflection - thinking about the impact of language on economic relationships
Mainstream economics often describes the human relationships and decisions in market transactions in mechanistic terms. Elasticity is one example.
Given what you know about markets, elasticity, and power and what you know about economics more broadly at this point, consider/discuss the following question:
To what extent might this mechanistic use of language hide the human relationships and decisions in market interactions? Who benefits from the public thinking that markets operate mechanistically rather than through human relationships and decisions?
Option 3: Reflection - thinking about economic narratives
Most economics courses define economics as the study of how scarce resources are allocated among unlimited human needs and wants. This course defines economics differently, as the study and practice of how we organise ourselves to meet human needs and wants in the planetary ‘household’. There is no mention of scarcity or unlimited human needs and wants.
Given what you know about markets, elasticity, and power and what you know about economics more broadly at this point, consider/discuss the following question:
Who benefits from the story, or narrative, that resources are scarce and human needs and wants are unlimited? What does this story have to do with market power?
Ideas for longer activities and projects are listed in Subtopic 3.5 Taking action
Checking for understanding
Further exploration
Price elasticity of demand - a Tutor2U video for A-level Economics about price elasticity of demand, with a focus on UK examples. The video covers key definitions, calculations and the factors affecting PED. Difficulty level: easy
Fuel protests gripping more than 90 countries - A BBC news article about the widespread fuel protests around the world in 2022. What was causing these and how does price elasticity of demand help us understand why fuel prices are so important to people? Difficulty level: easy
Sellers Inflation - video from the Institute for New Economic Thinking where University of Amherst (USA) professor Isabella Weber explains how narratives about rising costs of production for firms can make buyers more willing to pay higher prices. This enables sellers to pass along all of their cost increases to consumers, and perhaps raise prices and profits even further, a form of value extraction. Difficulty level: medium
Justice - an excerpt from the book Justice by political philosopher Michael Sandel where he discusses the ethics of price gouging. Price gouging is when sellers charge very high prices for essential products at moments when people’s demand becomes very inelastic, such as demand for bottled water after a hurricane. Other moral limits of markets are discussed in Section 3.2.5. Difficulty level: medium
Sources
Blink, J., & Dornton, I. (2020). Economics: Course Companion. Oxford: Oxford University Press.
The CORE Econ Team (2023). The Economy 2.0: Microeconomics. Unit 7. https://www.core-econ.org/the-economy/microeconomics/07-firm-and-customers-01-winning-brands.html
The CORE Econ Team (2023). The Economy 2.0: Microeconomics. Unit 8. https://www.core-econ.org/the-economy/microeconomics/08-supply-demand-01-american-civil-war.html
Kognity (2022). IB DP Economics HL FE2024. Stockholm: Kognity.
Terminology
Link to Quizlet interactive flashcards and terminology games for Section 3.1.3 Elasticity
market: a system where people buy and sell goods and services for a price.
price: an amount that must be paid to access a good or service; can be money or some other medium of exchange
commodity: something that can be bought and sold, often, though not always referring to raw materials
supply: the quantity of a product that producers are willing and able to supply at various prices
export: send products to another country for sale
market power: the ability of a firm to influence the price of their product in a market, as well as other market conditions
elasticity: a measure of how much the quantity demanded or supplied of a product changes in response to some facto
power: the ability to influence events or the behaviour of other people
elastic: when consumers or producers react strongly to some factor that affects them
inelastic (demand or supply): when consumers or producers do not react strongly to some factor that affects them
demand: the quantity of a product that consumers are willing and able to purchase at various prices
price elasticity of demand (PED): a measure of how a price change affects the quantity demanded
price elasticity of supply (PES): a measure of how a price change affects the quantity supplied
cross-price elasticity of demand (XED): a measure of how a price change in one good affects the quantity demanded for a substitute product or complementary product
substitute product: a product that serves the same purpose as another product in the market
complement product: a product that is used with or whose demand is positively related to another product
income elasticity of demand (YED): a measure of how an income change affects the quantity demanded of a good (normal good or inferior good)
income: money received from work or investments
market share: the portion of a market controlled by a particular business or product
antitrust law: a law that encourages competition by limiting the market power of any particular firm
economic narrative: the stories we tell about how the economy works, how we should study the economy and participate in it
worldview: an all-inclusive outlook on the world held by an individual or group, and through which they make sense of reality and gain knowledge
norm: a social rule for accepted and expected behaviour, can be stated or unstated
scarcity: when there is not enough of something
household: a system where people living together care for each other and do domestic work, often termed the 'core economy'
state: a system that provides essential public services, and also governs and regulates other economic institutions
revenue: the money earned from selling a product
price gouging: increasing the prices of goods, services, or commodities to a level much higher than is considered reasonable
price war: a form of market competition in which businesses within an industry aggressively cut prices
tax: payment from individuals or organisations to the government, used to provide public infrastructure and services
tax revenue: money collected by a government from individuals and organisations used for public spending and investment