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Elasticity is a fundamental economics concept that refers to the measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. Elastic goods see their demand respond rapidly to changes in factors like price or supply, whereas inelastic goods remain static.
(Investopedia, 2024)
Price Elasticity of Demand: Price elasticity of demand refers to the extent to which price changes affect a product's demand. Economists have found that the prices of certain goods are highly inelastic. This means that a decrease in price does not significantly boost demand, and an increase in price does not considerably reduce demand. Gasoline is a prime example; despite price changes, every buyer with a vehicle requiring fuel will continue to purchase the same amount they need.
When the quantity demanded for a product changes significantly in response to price changes, the product is considered elastic. In other words, the demand stretches far from its original point. For instance, if the price of a luxury good increases, most consumers will opt not to purchase it as it is not a necessity. Conversely, if the quantity purchased changes slightly after a price adjustment, the product is inelastic, indicating that demand remains close to its original level despite the price change.
Own price elasticity of demand
Elasticity = | (% change in quantity demanded) / (% change in price) |
Price elasticities are negative as demand is downward sloping, and hence the absolute value sign is employed in the formula. A positive price elasticity of demand would imply that as a good becomes more expensive its demand goes up. Two types of goods exhibit this behavior: Veblen goods and Giffen goods.
Elastic demand (Elasticity > 1): Quantity demanded is highly responsive to price changes. A small change in price leads to a proportionally larger change in quantity demanded.
Inelastic demand (Elasticity < 1): Quantity demanded is relatively unresponsive to price changes. A change in price results in a less-than-proportional change in quantity demanded.
Unitary elasticity (Elasticity = 1): Quantity demanded changes exactly in proportion to price changes.
Practical Applications
Pricing decisions: Firms can utilize price elasticity to determine optimal pricing strategies. Elastic demand suggests that reducing prices will lead to a significant increase in the quantity demanded.
Tax: Governments consider price elasticity when deciding on tax rates. The more elastic side of the market, whether it's buyers or sellers, will bear a smaller share of the burden as they can adjust their behavior more easily by reducing quantity or finding alternatives/substitute goods. The opposite applies to inelastic goods.
Cross price elasticity
The cross-price elasticity of demand measures the responsiveness of the quantity demanded of one good to changes in the price of another related good. A positive cross-price elasticity indicates that the two goods are substitutes, as an increase in the price of good x leads to an increase in the quantity demanded of good y. A negative cross-price elasticity indicates that the two goods are complements, as an increase in the price of good x leads to a decrease in the quantity demanded of good y.
Elasticity = (% change in quantity of good x) / (% change in quantity of good y)
Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of quantity demanded to changes in consumers' income. It quantifies the percentage change in quantity demanded resulting from a 1% change in income.
Elasticity = (% change in quantity demanded) / (% change in income)
Normal goods (Elasticity > 0): Quantity demanded increases proportionally more than income. These goods are considered necessities or luxury goods, depending on the magnitude of the elasticity.
Inferior goods (Elasticity < 0): Quantity demanded decreases as income increases. These goods are generally of lower quality and are replaced with better (and usually healthier) alternatives as consumers' income rises.
Practical Applications:
Market segmentation: Understanding income elasticity helps firms identify target markets for their products. Luxury goods with high elasticity cater to higher-income consumers, while necessities with low elasticity target a broader consumer base.
Conclusion
Elasticity is a crucial concept in economics that provides insights into the responsiveness of demand or supply to changes in price and income. Price elasticity of demand helps firms determine pricing strategies and tax policies, while income elasticity of demand aids in market segmentation and economic forecasting. Understanding elasticity empowers economists, businesses, and policymakers to make informed decisions and navigate the complexities of the market.
Reference List
Clifford, J. (2014). Elasticity of Demand- Micro Topic 2.3. YouTube. Available at: https://www.youtube.com/watch?v=HHcblIxiAAk [Accessed 30 Aug. 2024].
Investopedia. (2024). What Is Elasticity in Finance; How Does it Work (with Example)? [online] Available at: https://www.investopedia.com/terms/e/elasticity.asp#:~:text=Elasticity%20is%20an%20economic%20concept,its%20price%20increases%20or%20decreases. [Accessed 30 Aug. 2024].
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