We can change our dependence on certain goods and services so that we don’t take too high a knock when their prices fluctuate.
Life is about making choices. As rational beings, we tend to make the choices that benefit our wealth and well-being. But some options and choices have to be made on our behalf — especially when it comes to the provision and regulation of commonly used goods and services in an economy. The prices of government-regulated products such as fuel, alcohol, and cigarettes are examples.
How we react to the price change (whether an increase or decrease) is referred to in economics as elasticity.
It is a general term for a ratio of change and scientifically attempts to capture people’s sensitivity to price movements. It is the percentage change in the quantity demanded (or supplied) of a good or service brought about by a percentage change in the price of that good or service.
A 10% increase in the price of bread, for example, resulting in a decrease in the quantity demanded by 8%, means that the price elasticity of demand for bread is 0,8.
The ratio is expressed as a number between negative infinity and infinity, with one being the midpoint. The number has no unit — it is not expressed in centimetres, litres or as a percentage. But that number tells us a great deal. If it is higher than one, the product is said to be elastic: quantity demanded responds strongly to price changes. Anything under one is inelastic: a price change doesn’t affect quantity demanded much.
When a product is said to be unit elastic, it means the change in quantity demanded is equal to the change in price. On the commercial side, the concept becomes more useful and relevant when formulating and studying consumer trends.
It is especially useful to product brand managers who (like any profit-maximizing firm) have to set prices of their goods and service but at the same time watch the level of consumption or sales. Income elasticity of demand measures the responsiveness of the quantity demanded of a good to the change in the income of the people demanding the good.
The degree of elasticity is essential in assessing the impact of price changes on the level of demand or supply and in particular, estimating the effect on the total revenue of the good or service. Generally, the more inelastic the product, the easier it is for firms to maximize profit by increasing its price.
So if you’ve ever wondered why the price of alcohol and cigarettes — what governments refer to as “sin taxes” — always tends to rise, it is merely because they are inelastic products. A person addicted to nicotine will rather cut down on movies so that he or she can still afford a box of smokes, even when the price increases.
Likewise more and more countries, as they industrialize, are becoming heavily reliant on oil. The global dependence on oil was reiterated in the latest Organisation of Petroleum Exporting Countries (Opec) oil outlook, which paints a gloomy picture as the West’s demand for oil is predicted to surpass the available supply in the coming years.
Globally, over the decade 1994-2004, about five times more passenger cars appeared on the road than did commercial vehicles. In South Africa, for instance, commercial vehicle sales for July was up 13% on the same period.
Concurrently, increases in lorry volumes worldwide have been observed. The more inelastic the product is, the easier it is for suppliers — who naturally want to make bigger and bigger profits — to slap consumers with high price increases. At the time of writing in 2007, the oil price once hovered around $73/barrel and threatened to reach a record high of $80*
By using other means of energy (such as oil substitutes, wind, electricity and solar) we could reduce our reliance on the oil – and make it less inelastic. In a country like South Africa, for example, the use of trains for cargo transport would ease the dependence on petrol and diesel-powered commercial vehicles.
*The shift in reliance on oil-based resources has changed since this piece was originally written as the oil price is now at 56.41 per barrel. This is partly due to apparent diminishing reserves and the advent of emerging alternative sources of energy and technology to power motor vehicles and trucks. Tesla recently launched its future truck and alleged fastest production car and has been making grounds to introduce its electric cars and have surpassed the net worth of Ford.
This blog is extracted from a column written as far back as in 2007 for a special project for the Financial Mail (South African finance magazine).