Resource Demand Elasticity

The elasticity of resource demand depends on whether there are close substitutes for the resource, how much the cost of the resource accounts for the cost of the product, and on the demand elasticity of the products that require the resource. Resource demand elasticity is equal to the percentage change in resource quantity divided by percentage change in resource price.

Resource Demand Elasticity =Percentage Change in Resource Quantity
Change Percentage in Resource Price

Just as for the elasticity of demand for consumer products, the elasticity of demand for resources depends on the ratio.

Elasticity of Demand
If demand elasticity< 1then demand isinelastic
= 1unit elastic
> 1elastic

First, consider resource substitutability. Generally, the more substitutable a particular resource is, the more elastic the demand for that resource will be. For instance, if the price of cotton rises, then there are other materials that can be substituted, such as polyester or rayon. Substituting cheaper resources lessens the impact of price changes of a given resource on the final product.

Whether a resource is substitutable will also depend on the amount of time that the firm has to find substitutes. For instance, a firm with fixed assets will first increase variable inputs when experiencing increased demand, but when it does have to replace fixed assets, then it can buy cheaper or more productive resources to replace or reduce the need for more expensive resources. Thus, if the cost of labor rises, the firm may, in time, replace some labor with real capital to reduce production costs. Indeed, the cost of labor has steadily risen while the cost of technology has steadily declined. Hence, it is inevitable that firms will replace labor with technology, but at the same time, the productivity of labor will be increased, which will allow laborers to earn higher wages.

If a resource is not substitutable, then the demand for a resource by a firm will depend on the elasticity of demand for the product that it produces and the ratio of the resource cost to the total cost of the product. If demand for products produced by the resource is elastic, then it is more likely that demand for that resource will also be elastic. Likewise, if product demand is inelastic.

If the resource accounts for a major percentage of the total product price, then the product elasticity will be more important. This results from the fact that the demand for a product depends on its price and how much demand changes with price depends on the price elasticity of product demand. If the cost of the resource is only a small portion of the total product price, then it will have little effect on product demand. Likewise, if it accounts for a major portion of the cost, then changes in resource prices will cause correspondingly large changes in the product price, with corresponding changes in demand for the product, depending on the elasticity of demand for the product. Hence, the demand for a resource that accounts for a major portion of the product cost will be more elastic than for minor-cost resources.

For instance, in 2010, the price of oil accounted for 68% of the price of gasoline while refining costs accounted for only 7%.1 Since the demand for gasoline is inelastic, the demand for oil is, likewise, inelastic. However, since refining accounts for only 7% of the gasoline price, large changes in refining costs will only have a small effect on the price, and therefore, on the demand for gasoline. Because refining is necessary to produce gasoline from oil, the demand for the real capital and labor to refine oil will only depend on the demand for gasoline. Since the price of oil accounts for the major portion of the price of gasoline, changes in oil prices will have a much larger effect on the price of gasoline than changes in refining costs. Therefore, the elasticity of demand for oil is greater than the demand for refining services.

Another major factor affecting elasticity of resource demand is the change in marginal product as a consequence of changes in the amount of resource used. Marginal product (MP) is the additional product that can be produced when one unit of a resource is added. For instance, if a machine can cut the cost of producing widgets by 50%, then there will be a greater demand for it than for a machine that cuts costs by only 10%, and production efficiency will be more important for a product that has greater elasticity of demand than for a product whose demand is inelastic. So, for a highly automated factory, where real capital is the major input in producing the product, the cost of labor will have much less impact on product pricing, and since labor is necessary to operate the machinery, the demand for labor will be inelastic. On the other hand, for labor intensive activities such as farming, the cost of labor is very significant, and thus, demand elasticity for agricultural products will be more important in determining the demand elasticity for labor, which is why the United States has tolerated illegal immigration, since it provided cheap labor for farmers.