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What Is 'Elasticity'

Elasticity refers to the sensitivity of demand or supply to changes in other variables like price or income. Demand is elastic if it changes substantially with price changes, and inelastic if demand doesn't change much. Price elasticity of demand measures the percentage change in quantity demanded relative to a percentage change in price. Demand is elastic for discretionary goods like bouncy balls but inelastic for necessities like insulin. Income elasticity of demand measures how quantity demanded changes with income changes, showing if a good is a necessity or luxury. Necessities have low positive income elasticity while luxuries have elasticity over 1.

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58 views

What Is 'Elasticity'

Elasticity refers to the sensitivity of demand or supply to changes in other variables like price or income. Demand is elastic if it changes substantially with price changes, and inelastic if demand doesn't change much. Price elasticity of demand measures the percentage change in quantity demanded relative to a percentage change in price. Demand is elastic for discretionary goods like bouncy balls but inelastic for necessities like insulin. Income elasticity of demand measures how quantity demanded changes with income changes, showing if a good is a necessity or luxury. Necessities have low positive income elasticity while luxuries have elasticity over 1.

Uploaded by

Helena Montgomery
Copyright
© © All Rights Reserved
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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Elasticity

What is 'Elasticity'
Elasticity is a measure of a variable's sensitivity to a change in another variable. In business and
economics, elasticity refers the degree to which individuals, consumers or producers change
their demand or the amount supplied in response to price or income changes. It is
predominantly used to assess the change in consumer demand as a result of a change in a good
or service's price.

BREAKING DOWN 'Elasticity'


When the value of elasticity is greater than 1, it suggests that the demand for the good or
service is affected by the price. A value that is less than 1 suggests that the demand is
insensitive to price.

Elasticity is an economic concept used to measure the change in the aggregate quantity


demanded for a good or service in relation to price movements of that good or service. A
product is considered to be elastic if the quantity demand of the product changes drastically
when its price increases or decreases. Conversely, a product is considered to be inelastic if the
quantity demand of the product changes very little when its price fluctuates.

For example, insulin is a product that is highly inelastic. For diabetics who need insulin, the
demand is so great that price increases have very little effect on the quantity demanded. Price
decreases also do not affect the quantity demanded; most of those who need insulin aren't
holding out for a lower price and are already making purchases.

On the other side of the equation are highly elastic products. Bouncy balls, for example, are
highly elastic in that they aren't a necessary good, and consumers will only decide to make a
purchase if the price is low. Therefore, if the price of bouncy balls increases, the quantity
demanded will greatly decrease, and if the price decreases, the quantity demanded will
increase.

Elasticity can be calculated using the following formula:

The Importance of Price Elasticity in Business


Understanding whether or not a business's product or service is 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 products 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.

What is 'Price Elasticity of Demand'


Price elasticity of demand is an economic measure of the change in the quantity demanded or
purchased of a product in relation to its price change. Expressed mathematically, it is:

Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Price elasticity is used by economists to understand how supply or demand changes given
changes in price to understand the workings of the real economy. For instance, some goods are
very inelastic, that is, their prices do not change very much given changes in supply or demand,
for example people need to buy gasoline to get to work or travel around the world, and so if oil
prices rise, people will likely still buy just the same amount of gas. On the other hand, certain
goods are very elastic, their price moves cause substantial changes in its demand or its supply.
Here, we will look just at how the demand side of the equation is impacted by fluctuations in
price by considering the price elasticity of demand - which you can contrast with price elasticity
of supply.

BREAKING DOWN 'Price Elasticity of Demand'


If the quantity demanded of a product exhibits a large change in response to changes in its
price, it is termed "elastic," that is, quantity stretched far from its prior point. If the quantity
purchased has a small change in response to its price, it is termed "inelastic"; or quantity didn't
stretch much from its prior point. 

The more easily a shopper can substitute one product with a rising price for another, the more
the price will fall – be "elastic." In other words, in a world where people equally like coffee and
tea, if the price of coffee goes up, people will have no problem switching to tea, and so the
demand for coffee will fall. This is because coffee and tea are considered goods substitutes to
each other.

The more discretionary a purchase is, the more its quantity will fall in response to price
rises, that is, the higher the elasticity. So, if you are considering buying a new washing
machine but the current one still works (it's just old and outdated), and if the prices of new
washing machines goes up, you're likely to forgo that immediate purchase and wait either until
prices go down or until the current machine breaks down.

On the other hand, the less discretionary a good is, the less its quantity demanded will fall.
Inelastic examples include luxury items where shoppers "pay for the privilege" of buying a
brand name, addictive products, and required add-on products. Addictive products may include
tobacco and alcohol. Sin taxes these types of products are possible to introduce because the
lost tax revenue from fewer units sold is exceeded by the higher taxes on units still sold.
Examples of add-on products are ink-jet printer cartridges or college textbooks. These items are
usually more necessary (as opposed to discretionary) and lack good substitutes (only HP ink will
work in HP printers).

Time also matters. Demand response to price fluctuations is different for a one-day sale than
for a price change over a season or year. Clarity in time sensitivity is vital to understanding the
price elasticity of demand and for comparing it across different products.

Examples of Price Elasticity of Demand


Generally, as rules of thumb, if the quantity of a good demanded or purchased changes more
than the price change, the product is termed elastic. (The price changes by +5%, but the
demand falls by -10%). If the change in quantity purchased is the same as the price change (say,
10%/10% = 1), the product is said to have unit (or unitary) price elasticity. Finally, if the quantity
purchased changes less than the price (say, -5% demanded for a +10% change in price), then
the product is termed inelastic.

To calculate the elasticity of demand, let's take a very simple example: Suppose that the price
of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In response, grocery shoppers
increase their apple purchases by 20%. The elasticity of apples would thus be: 0.20/0.06 = 3.33 -
indicating that apples are quite elastic in terms of their demand.

What is the 'Income Elasticity of Demand'


Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain
good to a change in real income of consumers who buy this good, keeping all other things
constant. The formula for calculating income elasticity of demand is the percent change in
quantity demanded divided by the percent change in income. With income elasticity of
demand, you can tell if a particular good represents a necessity or a luxury.

BREAKING DOWN 'Income Elasticity of Demand'


Income elasticity of demand measures the responsiveness of demand for a particular good to
changes in consumer income. The higher the income elasticity of demand in absolute terms for
a particular good, the bigger consumers' response in their purchasing habits — if their real
income changes. Businesses typically evaluate income elasticity of demand for their products to
help predict the impact of a business cycle on product sales.

Calculation of Income Elasticity of Demand


Consider a local car dealership that gathers data on changes in demand and consumer income
for its cars for a particular year. When the average real income of its customers falls from
$50,000 to $40,000, the demand for its cars plummets from 10,000 to 5,000 units sold, all other
things unchanged. The income elasticity of demand is calculated by taking a negative 50%
change in demand, a drop of 5,000 divided by the initial demand of 10,000 cars, and dividing it
by a 20% change in real income — the $10,000 change in income divided by the initial value of
$50,000. This produces an elasticity of 2.5, which indicates local customers are particularly
sensitive to changes in their income when it comes to buying cars.

Interpretation of Income Elasticity of Demand


Depending on the values of the income elasticity of demand, goods can be broadly categorized
as inferior goods and normal goods. Normal goods have a positive income elasticity of demand;
as incomes rise, more goods are demanded at each price level. Normal goods whose income
elasticity of demand is between zero and one are typically referred to as necessity goods, which
are products and services that consumers will buy regardless of changes in their income levels.
Examples of necessity goods and services include tobacco products, haircuts, water and
electricity. As income rises, the proportion of total consumer expenditures on necessity goods
typically declines. Inferior goods have a negative income elasticity of demand; as consumers'
income rises, they buy fewer inferior goods. A typical example of such type of product is
margarine, which is much cheaper than butter.

Luxury goods represent normal goods associated with income elasticities of demand greater
than one. Consumers will buy proportionately more of a particular good compared to a
percentage change in their income. Consumer discretionary products such as premium cars,
boats and jewelry represent luxury products that tend to be very sensitive to changes in
consumer income. When a business cycle turns downward, demand for consumer
discretionary goods tends to drop as workers become unemployed.

Basically, a negative income elasticity of demand is linked with inferior goods, meaning rising
incomes will lead to a drop in demand and may mean changes to luxury goods. But a positive
income elasticity of demand is linked with normal goods. In this case, a rise in income will lead
to a rise in demand. 

Types of Income Elasticity of Demand


There are five types of income elasticity of demand:
1. High: A rise in income comes with bigger increases in the quantity demanded.
2. Unitary: The rise in income is proportionate to the increase in the quantity demanded. 
3. Low: A jump in income is less than proportionate than the increase in the quantity
demanded. 
4. Zero: The quantity bought/demanded is the same even if income changes
5. Negative: An increase in income comes with a decrease in the quantity demanded. 

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