Elasticity

Elasticity

Elasticity measures the responsiveness of one economic variable to a change in another. It is one of the most practically useful concepts in economics — enabling businesses to predict how changes in price will affect revenue, how consumers will respond to income changes, and how producers will adjust supply. All elasticity measures are expressed as ratios of percentage changes, making them independent of the units in which variables are measured.

Price Elasticity of Demand (PED)

Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price. It is calculated as:

PED = (% change in quantity demanded) / (% change in price)

Because of the law of demand (price and quantity demanded move in opposite directions), PED is always negative. We typically work with the absolute value |PED| for classification purposes:

• Elastic demand — |PED| greater than 1; quantity demanded is highly responsive to price changes; a 1% price increase causes more than a 1% fall in quantity demanded
• Unit elastic demand — |PED| equals 1; quantity demanded changes by exactly the same percentage as price
• Inelastic demand — |PED| less than 1 but greater than 0; quantity demanded is not very responsive to price changes; a 1% price increase causes less than a 1% fall in quantity demanded
• Perfectly inelastic demand — |PED| equals 0; quantity demanded does not change at all with price (vertical demand curve); extremely rare in practice
• Perfectly elastic demand — |PED| is infinite; consumers will buy any quantity at the given price but nothing above it (horizontal demand curve)

The Midpoint Formula

The standard PED formula gives different values depending on whether price rises or falls between two points, because the base changes. The midpoint formula solves this by using the average of the starting and ending values as the base, giving the same elasticity value regardless of direction of change:

PED = [(Q2 - Q1) / ((Q1 + Q2)/2)] / [(P2 - P1) / ((P1 + P2)/2)]

This makes elasticity calculations consistent and comparable across different starting points.

Determinants of Price Elasticity of Demand

The elasticity of demand for a particular good depends on several factors:

• Availability of substitutes — the more substitutes available, the more elastic demand is (consumers can easily switch when price rises)
• Necessity vs luxury — necessities (food, water, medicine) tend to have inelastic demand; luxuries tend to have more elastic demand
• Definition of the market — broadly defined markets (e.g. food) are more inelastic than narrowly defined markets (e.g. organic biscuits); the more substitutes exist within the broader category, the more elastic the narrower market is
• Time horizon — demand is generally more elastic in the long run than in the short run because consumers have more time to find alternatives, change habits, and adjust their behaviour
• Share of income — goods that represent a large share of consumer income tend to have more elastic demand; small expenditure items tend to be more inelastic

Price Elasticity of Demand and Total Revenue

The relationship between elasticity and total revenue (price times quantity sold) is one of the most important business applications of elasticity:

• Elastic demand (|PED| greater than 1) — if price rises, total revenue falls (because quantity falls by a larger percentage than price rises); if price falls, total revenue rises. To increase revenue, lower the price.
• Inelastic demand (|PED| less than 1) — if price rises, total revenue rises (because quantity falls by a smaller percentage than price rises); if price falls, total revenue falls. To increase revenue, raise the price.
• Unit elastic demand (|PED| = 1) — total revenue remains constant when price changes.

This relationship is fundamental for pricing strategy: a firm with inelastic demand has pricing power and can raise prices without large revenue losses, while a firm with elastic demand must be cautious about price increases.

Cross-Price Elasticity of Demand

Cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another good:

Cross-PED = (% change in QD of Good A) / (% change in price of Good B)

• Positive cross-price elasticity — Goods A and B are substitutes; when the price of B rises, demand for A rises (e.g. coffee and tea)
• Negative cross-price elasticity — Goods A and B are complements; when the price of B rises, demand for A falls (e.g. printers and ink cartridges)
• Zero cross-price elasticity — the goods are unrelated

Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of quantity demanded to a change in consumer income:

Income elasticity = (% change in QD) / (% change in income)

• Positive income elasticity greater than 1 — luxury good; demand rises proportionately more than income (e.g. overseas travel, expensive electronics)
• Positive income elasticity between 0 and 1 — normal necessity; demand rises but less than proportionately with income (e.g. groceries)
• Negative income elasticity — inferior good; demand falls as income rises (e.g. budget brands when consumers can afford premium alternatives)

Price Elasticity of Supply

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price. It is always positive (law of supply). Supply is more elastic when producers can easily increase output in response to price rises — which depends on how quickly inputs can be obtained, spare capacity in the industry, and the time available. Like demand elasticity, supply is generally more elastic in the long run than in the short run, as producers have more time to adjust capacity and technology.