Negative Elasticity: What Does It Mean? Generally speaking, demand will decrease when price increases, and demand will increase when price decreases. That means that the price elasticity of demand is almost always negative (since demand and price have an inverse relationship).

elastic demand

A positive cross elasticity of demand means that the demand for good A will increase as the price of good B goes up. This means that goods A and B are good substitutes, so that if B gets more expensive, people are happy to switch to A. An example would be the price of milk.

The price elasticity of supply measures the responsiveness of quantity supplied to changes in price. It is the percentage change in quantity supplied divided by the percentage change in price. It is usually positive. When applied to labor supply, the price elasticity of supply is usually positive but can be negative.

PES > 1: Supply is elastic. PES < 1: Supply is inelastic. PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices change.

Elasticity of supply figures range from zero to infinity. However, it is possible for the results to be a negative number. Negative elasticities of supply figures result in an inelastic relationship between quantity supplied and price. This means a change in price has no effect on the change in supply.

If there is spare capacity then a business can increase output without a rise in unit costs and thus supply will be price elastic if there is an outward shift of demand. Supply is elastic if the coefficient of PES is greater than +1. E.g. a construction company might have spare capacity towards the end of a recession.

Spare capacity occurs when a business is not making full use of its available capacity – there are spare factors of production including land, labour and capital. When an economy has plenty of spare capacity, short run aggregate supply (SRAS) is elastic, and the output gap is negative.

First, inflation tends to be less responsive to spare capacity when demand is weak. This could be because firms are less able to increase demand for their product by lowering prices when consumers are less willing to spend. Second, uncertainty about the economy may make prices less responsive to spare capacity.

Non-linear SRAS curve • When the economy has plenty of spare capacity – SRAS will be elastic – Rise in AD can be met easily by increased output – Little threat of rising prices (inflation) • Elasticity of SRAS curve falls as output increases – Spare capacity falls – Possibility of diminishing returns in production – …

If there is spare capacity in the economy, an increase in investment could cause a knock on effect throughout the economy. The initial increase in investment causes a rise in output and so people gain more income, which is then spent causing a further rise in AD.

Increase demand for existing products by promotional activity, price cutting or re-positioning in the market. It could also be possible to launch new products. To lower the capacity by either reducing the factors of production employed or to move to smaller premises.

Disadvantage: a cut to capacity (such as selling off store sites) cannot easily be reversed if customers start to return. As total fixed costs are unchanged when production changes, a fall in utilisation means that fixed costs per unit rise. This puts a squeeze on profit margins.

Capacity is over-utilised when the firm attempts to produce more than its capital is capable of. This could mean average costs increase due to falling levels of efficiency. This could be due to breakdowns and overcrowding in the production process.