Image Source: Sudden demand surges or supply chains snarls will drive prices up quickly. Businesses face two issues when this happens, First, when a price rises sharply, how long will it take for increased supply and reduced demand to nudge prices back down? The second challenge is how a company can take advantage of its own products enjoying that price hike. That will be the subject for another article; this one is about how to guess how long the price will stay high.Elasticity is the economic term for the key concept. Textbooks define the “price elasticity of supply” as the percentage change in the quantity of a product supplied divided by the percentage change in price. So if a 10% price increase leads to a 15% increase in quantity supplied, we say the elasticity is 1.5 (which is 15 divided by 10). That will be the first concept to ponder. The next issue is price elasticity of demand: how much will the quantity demanded drop because of the higher price. (Elasticity is also defined for income effects on demand.)Three years ago a vivid example of supply elasticity played out in labor markets. Finding workers became very difficult in 2021 and 2022, leading to wage increases and hiring bonuses. But company leaders worried that the tight market might prove temporary. The length of the tight labor market was important because of business choices in the face of difficulty hiring at old wage rates. A company might purchase expensive equipment to take the place of workers they couldn’t find. Or the company might outsource some functions to a location where labor is more abundant, such as India or the Philippines. These possibilities make more sense for a long-lasting crunch than a short-lived one. The wrong choice could prove quite expensive.In the labor market, higher wage offers (and easier job search) would increase the quantity of labor supplied. People with flexibility to work or not work include early retirees, mothers with school-age children, students and other people working part-time by choice. When they see opportunities to work with very little job search and attractive wages, they offer their services.Demand reduction reinforces the great supply. Other employers may respond to higher wage demands by using more equipment or outsourcing or even downsizing. That is good for the businesses that are still trying to hire. No one would doubt that higher wage rates would set the stage for supply and demand changes that would ease the labor shortage. The important question is how long would it take, and how big the eventual change would be.This process plays out for goods and services both. Oil prices have fluctuated widely. When OPEC limited supply, common projections called for permanently rising energy prices. But fracking was developed by scientists and implemented by entrepreneurs lured to the field by those high prices. Car buyers took gasoline mileage into account when shopping for new wheels, lowering demand. Oil prices plummeted.Here are some general rules for estimating the elasticities of both supply and demand.
Elasticities Are Higher Than Most People Guess
The most common first guesses about adjustment to higher prices underestimate the eventual changes. This seems true of both industry experts and outside observers. People making decisions become imaginative when faced with actual challenges that cost money.
Elasticities Rise Over Time
Both supply and demand elasticities are higher in the long run than over a short time period. Economics professors often teach that there are two elasticities, one for that period when capital equipment is fixed (short run) and one for the period when capital is variable (long run). In practice, some new equipment can be installed quickly, while other equipment takes longer. That’s not just a supply issue. In order to reduce demand for the commodity, new equipment may be needed. When a person owns a gas guzzler, buying a new car is one way to lower the quantity of fuel demanded. So elasticity is a gradual function of the time that prices have been high (or low).Elasticity is also higher when producers and consumers expect the price change to be long-lasting. That often occurs when the price change has lasted for a while, though other factors also affect expectations.
High Specialization Lowers Elasticity
A product that can be made with low-skilled labor and common tools (physical or software) will have high supply elasticity. But if highly specialized skills and specialized tooling is needed, then supply elasticity will be low in the short run. The specialized skills are very important if occupational licensing is required. In the early 2010s, the demand for computer programmers was strong, with the traditional career path requiring a four-year college degree. Then programming boot camps emerged, providing intensive training in a short period of time. Companies were willing to hire programmers without degrees if they had the requisite skills. Supply increased rapidly.Healthcare, on the other hand, has had limited supply elasticity because the licensing requirements are fairly rigid. Few workarounds, such as those boot camps, are available.The same is true of physical tooling. The more specialized the equipment needed to produce a product, the lower the elasticity will be. Software, fortunately, is easily reproduced and distributed.
Storage Capacity Increases Supply Elasticity
Products that can be stored easily tend to have high elasticity. On the other hand, perishable goods, such as fresh fish and fruit, cannot be stockpiled to take advantage of random price hikes. This may also work, to a lesser degree, on the demand side. Consumers with storage capacity may buy staples at a good price, thus reducing their purchases when prices are temporarily high.
Good Alternatives Increase Demand Elasticity
If a house floor is damaged, there are many good choices, including solid wood, veneers, plastics that look like wood, tile, carpet, etc. Thus, the demand elasticity is high for any particular product. But if a component of my home furnace fails, I need a particular part compatible with a particular model furnace. Demand elasticity is very low; I will pay a high price for the component rather than replace the entire system.
Business Strategy For Large Price Changes
When the price of an important cost item changes substantially, business managers must decide how to proceed. For price increases, that means considering ways to use a substitute or to get by with less of the product. Any choice with long-lasting consequences should be made with elasticity in mind. Running through the sub-headings above will make the analysis—and final decision—much betterNew Census Report Explained Job Growth, But Labor Market Likely To TightenFewer Interest Rate Cuts Likely In 2025 Due To Continued InflationHealthcare Employment Surge: Beyond Government Spending
