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Elastic Demand

What Is Elastic Demand

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Elastic Demand

A perfectly elastic demand curve is horizontal because a imperceptible change in price will create an infinite change in demand.

Definition: Elastic demand means that consumers buy a lot more products or services in response to a price change. There are two other types of demand elasticity, which measures how much the quantity purchased changes when the price does. They are:

  1. Inelastic demand, which is when the quantity demanded changes less than the price does.
  2. Unit elastic demand, which is when the quantity demanded changes the same percent that the price does.

 

Elasticity of demand is measured by dividing the percentage change of the quantity demanded by the percentage change of the price. The easiest example is unit elastic demand. That's when the quantity demanded changes the exact same percent as the change in price. Therefore, the ratio is one.

To illustrate, say the quantity demanded increased 5% in response to a price drop of 5%. The ratio is .05/.05 = 1. You'll notice that the price was a negative move, while the quantity was a positive move. However, since everyone knows that demand moves inversely to price, the minus signs is ignored.

Elastic demand is when the percent change in the quantity demanded is greater than the percent change in price. This makes the ratio more than one. For example, say the the quantity demanded rose 10% when the price fell 5%. The ratio is .1/.05 = 2.

Perfectly elastic demand would occur when the quantity demanded skyrockets to infinity when the price dropped any amount. This, of course, could not happen in real life. However, it illustrates the concept -- that elastic demand has a ratio of anything more than one.

Inelastic demand is when the quantity demanded rises by a lower percentage than the price drop. For example, if the quantity rose 2% when the price was lowered 5%. The ratio is .02/.05 = .4, or less than one.

Elastic Demand Curve

The demand curve is an easy way to determine if the demand is elastic. The quantity demanded will change much more than the price. As a result, the curve will look more low and flat than the unit elastic curve, which is a diagonal. The more elastic the demand, the flatter the curve. If it's perfectly elastic, then it will be a horizontal line. That's because the quantity demanded will skyrocket to infinity at any little drop in price. On the other hand, it will drop to zero at any little increase in price.

Of course, in real life there is nothing that has perfectly elastic demand. However, many commodities approach that situation because they are highly competitive, and price is pretty much the only thing that matters. Say two stores are selling identical ounces of gold. One sells it for $1,800 an ounce, while the one next door sells it for $1,799 an ounce. No one will buy the more expensive gold, while the less expensive dealer will sell as much as he has.

Example of Elastic Demand

A good example of elastic demand is housing. True, people need to live somewhere, but they have many choices: townhome, condo, apartment or live with friends or family. However, demand for housing in 2006 was artificially stimulated by low-cost mortgages. Even though home sale prices rose, the cost of qualifying for a mortgage was dramatically lowered. Interest rates plummeted because new types of exotic loans were invented. Interest rates on adjustable rate loans were lower than those for fixed-rate loans. Then, when interest rates started to rise, banks created interest-only loans, and even negative amortization loans. These loans were actually more expensive in the long run, but they had low monthly fees in the short run. In addition, many families who didn't think they could ever be a homeowner were told they could qualify for loans. As a result, demand skyrocketed, creating an asset bubble.

When the bubble crashed, prices dropped. However, the demand curve had shifted. High unemployment combined with foreclosures and bankruptcies meant income was much lower. When the housing market turned, many people lost their homes, and some had to move back in with relatives. As a result, the average national home price fell 28%, more than during the Great Depression. Even then, the quantity of homes bought were much lower. That's because another determinant of demand, expectations, had also shifted. People expected prices to continue to drop because of the record number of foreclosures that kept prices low. It wasn't until June 2012 that prices started to rise in some states, and demand started to return.

Clothing also has elastic demand. True, people have to wear clothes, but there are many choices of what kind of clothing, and how much to spend. Stores offered sales, and as a result clothing prices dropped to maintain demand. Small stores that couldn't offer huge discounts went out of business. During the Great Recession, they were replaced by second-hand stores that offered quality used clothing at steeply discounted prices. Article updated February 25, 2014.

 

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