Inelasticity Makes Commodities Unique - dummies

Inelasticity Makes Commodities Unique

By Amine Bouchentouf

As an asset class, commodities have unique characteristics that separate them from other asset classes and make them attractive, whether as independent investments or as part of a broader investment strategy. One of these is the inelasticity of commodities.

In economics, elasticity seeks to determine the effects of price on supply and demand. The calculation can get pretty technical, but, essentially, elasticity quantifies how much supply and demand will change for every incremental change in price.

Goods that are elastic tend to have a high correlation between price and demand, which is usually inversely proportional: When prices of a good increase, demand tends to decrease. This relationship makes sense because you’re not going to pay for a good that you don’t need if it becomes too expensive. Capturing and determining that spread is what elasticity is all about.

Inelastic goods, however, are goods that are so essential to consumers that changes in price tend to have a limited effect on supply and demand. Most commodities fall in the inelastic goods category because they’re essential to human existence.

For instance, if the price of ice cream increased by 25 percent, chances are, you’d stop buying ice cream. Why? Because it’s not a necessity, but more of a luxury.

However, if the price of unleaded gasoline at the pump increased by 25 percent (as it did during 2003–2006), you definitely wouldn’t be happy about the price increase, but you’d still fill up your tank. The reason? Gas is a necessity — you need to fill up your car to go to work or school, run errands, and so on.

The demand for gasoline isn’t absolutely inelastic, however — you won’t keep paying for it regardless of the price. A point will come at which you’d decide that it’s simply not worth it to keep paying the amount you’re paying at the pump, so you’d begin looking for alternatives.

But the truth remains that you’re willing to pay more for gasoline than for other products you don’t need (such as ice cream); that’s the key to understanding price inelasticity.

Most commodities are fairly inelastic because they’re the raw materials that allow you to live the life you strive for; they help you maintain a decent (and, in some cases, extravagant) standard of living.

Without these precious raw materials, you wouldn’t be able to heat your home in the winter — actually, without cement, copper, and other basic materials, you wouldn’t even have a house to begin with! And then there’s the most essential commodity of all: food. Without food, you wouldn’t exist.

Because of the absolute necessity of commodities, you can be sure that as long as there are humans around, there’s going to be a demand for these raw materials.