Capital Markets Efficiency

Elastic and Inelastic Markets

Elastic Markets

Supply changes as a result of consumer demand, where price and quantity are inversely related, in an elastic market.

The price elasticity of demand is the measure of how responsive the quantity demanded of an item is to changes in the price of that item. The price elasticity of demand will show that price and quantity demanded are inversely related. The less expensive an item, the more consumers will buy. The more expensive an item, the less demand there is for that product.

To calculate this ratio, the percentage change in quantity demanded is divided by the percentage change in the price. In an elastic market, the quantity demanded of an item is responsive to changes in price. The greater the proportional disparity, the more elastic the marketplace. For example, if every 10 percent decrease in the price of an aspirin tablet results in a 20 percent increase in demand, the demand for that product is elastic because the ratio of demand increase to price changes is 2/1. Elastic demand occurs when a small change in price is paired with a large change in quantity demanded. Demand elasticity is calculated by dividing the percentage change of quantity demanded by the percentage change in price.

A market structure in which demand is perfectly elastic is a perfect competition marketplace. Such a market usually contains a large number of competitors selling identical products that are easy to sell. Aspirin is a good example of an elastic product. Most consumers will purchase aspirin from whatever vendor provides it at the lowest price, as it is comparable to the other products in the marketplace.

Elastic and Inelastic Market Demand Curves

Elastic markets and inelastic markets measure how responsive the quantity demanded is to fluctuations in the price of an item.

Inelastic Markets

Supply does not change as a result of demand in an inelastic market.

In the world economy, price and quantity demanded are in general inversely related to one another. If an item is less expensive, more units of that item are purchased. Conversely, if the item is more expensive, fewer units are sold. Thus, businesses aim to find the perfect price at which profits and revenues are maximized. In an inelastic market, the quantity demanded is minimally responsive to changes in price, and the smaller the proportional disparity between price change and demand, the more inelastic the marketplace.

The concept holds true for necessary goods and services for which there are few good substitutes. For example, gasoline is a market that is very inelastic in demand. Consumers have to purchase gasoline to be able to drive. For many people, driving is a necessity for work and other important aspects of their lives. Even when the price of gasoline rises significantly, demand for the product does not decrease very much. There are no easy alternative fuel sources if a person owns a gas-powered vehicle. Also, public transportation and access to other viable options may be limited. People are, therefore, willing to buy gasoline even at relatively high prices. Such a marketplace demonstrates very inelastic demand.

Unit elastic demand occurs when the percentage change in the quantity demanded is equal to the percentage change in the price for a product. For example, Widget Inc. sells bags of potato chips for $1 each and knows that, at that price, there is demand for 20,000 units monthly. If there is unit elastic demand for the potato chips, then Widget Inc. knows that if it doubles the price of the chips to $2 per bag, demand will be cut in half and only 10,000 bags of chips will sell each month. If Widget Inc. does the opposite and reduces the price in half to $0.50 per bag, demand will double to 40,000 units monthly. In all scenarios, the revenue will be the same because there is unit elastic demand for the product and the amount demanded by the consumer will move in harmony with the price of the offering.

A marketplace with these characteristics is equally balanced between elastic and inelastic demand. Total revenue measures price times quantity sold. Businesses seek to determine at what price to sell goods in order to maximize revenue. In an efficient market, after accounting for costs, this is what leads to profit maximization. Profit maximization is the determination of the best price and output level that results in the greatest profit. Businesses seek to maximize profits by determining the best price point at which to sell their goods.Businesses thus need to know the elasticity of their marketplace. In elastic markets, companies have to be responsive to price changes that reduce demand. However, in an inelastic market, businesses mostly concern themselves with the prices their competitors are charging, as they know that overall market demand will not change much as prices increase. In addition to gasoline, other examples of inelastic markets include goods such as cigarettes, prescription medicines, and fees for toll roads. All of these are examples of items consumers often deem necessary and for which there are few alternatives.

Impact of Elasticity Changes in Securities Markets

Securities prices are governed by the elasticity of the market on which they are sold.

The price elasticity of supply examines how responsive businesses are to the production of an item in relation to changes in the price of that item. This measurement along with the price elasticity of demand dictates how price changes can affect elasticities of supply and demand. Changes in the price of an item in a marketplace can thus influence both consumer behavior regarding purchasing choices and business behavior regarding production levels. In particular, the changes in supply and demand in an elastic market will affect changes in securities prices that trade in that market, as changes in supply and demand will affect how much of a good can be sold and what prices will affect profitability margins. Certain factors dictate how elastic a marketplace is relative to both supply and demand.

In a marketplace where consumers have diverse preferences for goods that can be easily substituted and the commodity is considered to be a luxury rather than a necessity, consumers tend to have higher incomes, and the market will be more elastic with regard to demand as prices fluctuate. Similarly, in a market with many close alternatives, lots of competition among sellers, few barriers to market entry, and available manufacturing and distribution channels, supply will be more elastic in response to changes in price. This is because when consumers have options for a product or service, they will exercise choice in response to price changes more easily; producers of those goods will change price and production levels to meet the consumer preferences. This influences securities prices in highly elastic markets, as revenues and profit margins will swing with the changes in consumer and producer behavior, which in turn respond to price changes in the underlying product.

Conversely, there can be marketplaces that are less elastic with regard to supply and demand. For example, the marketplace may be less elastic if consumers have rigid preferences for goods, there are limited or no acceptable substitutes for the goods, the product is viewed as a necessity, and buyers have less disposable income with which to move into other markets. The demand will be less elastic and less sensitive to price variations. For suppliers, if there are few close substitutes, there will be less competition. If production or harvest limits the goods in that marketplace and/or there are difficulties in increasing production or distribution channels, production of the item will remain somewhat steady despite price changes in that market. This can also influence securities prices in inelastic markets, as production costs will be relatively stable regardless of price. Profit margins will be based more on independent factors outside of the control of the producers, and stock prices will vary accordingly.