What is Elasticity?

Elasticity is a general measure of the responsiveness of an economic variable in response to a change in another economic variable. Economists utilize elasticity to gauge how variables affect each other. The three major forms of elasticity are price elasticity of demand, cross-price elasticity of demand, and income elasticity of demand.

Summary

  • Elasticity is a general measure of the responsiveness of an economic variable in response to a change in another economic variable.
  • The three major forms of elasticity are price elasticity of demand, cross-price elasticity of demand, and income elasticity of demand.
  • The four factors that affect price elasticity of demand are (1) availability of substitutes, (2) if the good is a luxury or a necessity, (3) the proportion of income spent on the good, and (4) how much time has elapsed since the time the price changed.
  • If income elasticity is positive, the good is normal. If income elasticity is negative, the good is inferior.

Price Elasticity of Demand

Demand elasticity demonstrates how a price change affects the quantity demanded. It is computed as the percentage change in quantity demanded over the percentage change in price. It will commonly result in a negative elasticity because of the law of demand.

The law of demand states that a price increase reduces the quantity demanded, which is why demand curves are downwards sloping unless the good is a Giffen good. It is common to drop the negative of the quotient.

The larger the price elasticity of demand, the more responsive quantity demanded is given a price change. When the price elasticity of demand is greater than one, the good is considered to demonstrate elastic demand. When the quantity demanded drops to zero with a price rise, it is said that demand is perfectly elastic. If the price of an elastic good increase, there is a corresponding quantity effect, where fewer units are sold, reducing revenue.

The lower the price elasticity of demand, the less responsive the quantity demanded is given a price change. When the price elasticity of demand is less than one, the good is considered to show inelastic demand. When the quantity demanded does not respond to a change in price, it is said that demand is perfectly inelastic. If an inelastic good has its price increased, it will lead to increased revenues because each unit will be sold at a higher price.

If a change in price comes with the same proportional change in the quantity demanded, it is said that the good is unit elastic. Indicating that X% change in price results in an X% change in the quantity demanded. Therefore, if the price elasticity of demand equals one, the good is unit elastic. If a good shows a unit elastic demand, the quantity effect and price effect exactly offset each other.

Calculation of Price Elasticity of Demand through the Midpoint Method

The midpoint method is a commonly used technique to calculate the percent change of price. The primary difference is that it calculates the percentage change of quantity demanded and the price change relative to their average.

Examples of Goods with a Price Inelastic Demand

1. Beef

2. Gasoline

3. Salt

4. Textbooks

5. Prescription drugs

Examples of Goods with a Price Elastic Demand

1. Housing

2. Furniture

3. Cars

Factors That Affect the Price Elasticity of Demand

  1. Availability of close substitutes

If consumers can substitute the good for other readily available goods that consumers regard as similar, then the price elasticity of demand would be considered to be elastic. If consumers are unable to substitute a good, the good would experience inelastic demand.

  1. If the good is a necessity or a luxury

The price elasticity of demand is lower if the good is something the consumer needs, such as Insulin. The price elasticity of demand tends to be higher if it is a luxury good.

  1. The proportion of income spent on the good

The price elasticity of demand tends to be low when spending on a good is a small proportion of their available income. Therefore, a change in the price of a good exerts a very little impact on the consumer’s propensity to consume the good. Whereas, when a good represents a large chunk of the consumer’s income, the consumer is said to possess a more elastic demand.

  1. Time elapsed since a change in price

In the long term, consumers are more elastic over longer periods, as over the long term after a price increase of a good, they will find acceptable and less costly substitutes

The Importance of Price Elasticity in Business

Understanding whether or not the goods or services of a business are elastic is integral to the success of the company. Companies with high elasticity ultimately compete with other businesses on price and are required to have a high volume of sales transactions to remain solvent. Firms that are inelastic, on the other hand, have goods and services that are must-haves and enjoy the luxury of setting higher prices.

Beyond prices, the elasticity of a good or service directly affects the customer retention rates of a company. Businesses often strive to sell goods or services that have inelastic demand; doing so means that customers will remain loyal and continue to purchase the good or service even in the face of a price increase.

Examples of Elasticity

There are a number of real-world examples of elasticity we interact with on a daily basis. One interesting modern-day example of the price elasticity of demand many people take part in even if they don’t realize it is the case of Uber’s surge pricing. As you might know, Uber uses a “surge pricing” algorithm during times when there is an above-average amount of users requesting rides in the same geographic area. The company applies a price multiplier which allows Uber to equilibrate supply and demand in real-time.

The COVID-19 pandemic has also shone a spotlight on the price elasticity of demand through its impact on a number of industries. For example, a number of outbreaks of the coronavirus in meat processing facilities across the US, in addition to the slowdown in international trade, led to a domestic meat shortage, causing import prices to rise 16% in May 2020, the largest increase on record since 1993.1

Another extraordinary example of COVID-19’s impact on elasticity arose in the oil industry. Although oil is generally very inelastic, meaning demand has a little impact on the price per barrel, because of a historic drop in global demand for oil during March and April, along with increased supply and a shortage of storage space, on April 20, 2020, crude petroleum actually traded at a negative price in the intraday futures market.

In response to this dramatic drop in demand, OPEC+ members elected to cut production by 9.7 million barrels per day through the end of June, the largest production cut ever

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