Question: On one of the financial shows they were talking about inelastic product demand -- that it's important to know about when buying stocks. Could you explain why?

Elisa Durham

Answer:

Dear Elisa,

The concept of elastic vs. inelastic is indeed something to keep in mind when buying stocks or readjusting your portfolio, but it's not as broad in scope nor quite as important as a company's balance sheet, its debt to equity ratio, marketing savvy, R&D budget and, of course, the intelligence of its management.

Let's take a look at both terms.

When a product or service has competition -- in other words, many other companies make or do the same thing or something very similar, the demand for its output is elastic because even a small increase in price is likely to push customers away -- to cause them to switch to a competing brand.

On the other hand, when a product or service has little or no competition and is basically a monopoly within its field, then it falls under the category of inelastic. A rise in price will have little impact on demand because buyers have few or no alternatives. These companies have a much easier time passing on price increases and so, provided they are well run, could conceivably be a sounder investment.

The first on the block

Related to the elastic vs. the inelastic nature of a company also is the fact of who got there first. We have already witnessed the fact that the first fast food chain for years was "the" winner. So was the first motel chain, the first to market bubble gum and the first to market soap packaged in a bottle with a pump (as opposed to a bar of soap). The list goes on and on.

However, smart imitators can quickly gain market edge if they spot key flaws in the initial company's product or service and if they find and understand any marketing weaknesses on the part of the first-on-the-block company. By appearing on the scene at the right time with a new improved version of a product or service, the second-on-the-block company can turn out to be an excellent investment.

Bottom line

So as you study various stocks for your portfolio, keep in mind that being first is often an enviable position -- at least temporarily. However, a company coming in after the initial play and capitalizing on the mistakes made by the firm who got there first is yet another approach to smart stock picking.