Elasticity is a central concept in economics and is applied in many situations. In this lesson, we’ll discuss elasticity in economics, including its definition, the different types of elasticity, and their effect.
Elasticity refers to the responsiveness of one economic variable, such as the quantity demanded to a change in another variable such as price.
For instance, you design billboard ads for local businesses. You charge $200 per billboard ad and currently sell 12 billboard ads in a month. Your costs are rising, so you can consider raising the price to $250. The law of demand says that you won’t sell as many billboards if you raise your price. How many fewer billboards? How much will your revenue fall, or might it increase? These questions can be answered by using the concept of elasticity, which measures how much one variable responds to changes in another variable. In other words, elasticity measures how much buyers and sellers respond to changes in market conditions.
The elasticity of y with respect to x is calculated as the ratio of the percentage change in the quantity of y to the percentage change in the quantity of x. In algebraic form, elasticity (E) is defined as
\(E = \frac{\%\Delta y }{\%\Delta x}\)
If E is greater than 1, y is elastic with respect to x. That means demand for goods or services changes when the price or income changes. Some examples of elastic goods include clothing or electronics.
If E is less than 1, y is inelastic with respect to x. That means demand for a goods or services is relatively static even when the price changes. Some inelastic goods are items like food and prescription drugs.
If E is equal to 1, y is “unit elastic” with respect to x. That means demand for goods or services is exactly proportionate to the change in price. For example, a 20% change in price causes 20% change in demand.
Take a look at the below diagram showing elasticity of demand. The changes in price (p) of Susie’s homemade cookies and the corresponding change in the quantity demanded. The slanting line is called the demand curve. At a price of $1.50, the quantity demanded is three units. When the price is lowered to $1.00, the quantity demand increased to five units. Ms. Susie can then make the assumption that every increase in price will result in fewer purchases of her cookies.
There are four types of elasticity, each one measuring the relationship between two significant economic variables. These are:
It measures the responsiveness of quantity demanded to a change in price.
Let us take the simple example of gasoline. A surge of 60% in gasoline price resulted in a decline in the purchase of gasoline by 15%. Using the above-mentioned formula, the calculation of price elasticity of demand can be done as:
Price elasticity of demand = percentage change in quantity/percentage change in price
Price elasticity of demand = − \(\frac{15}{60}\)= − \(\frac{1}{4}\) or − 0.25
It measures the responsiveness of quantity supplied to a change in price.
Let us take the simple example of pizza. A surge of 40% in pizza price resulted in an increase in the supply of pizza by 25%. Using the above-mentioned formula, the price elasticity of supply can be calculated as:
Price elasticity of supply = % change in quantity supplied ∕ % change in price
Price elasticity of supply = 25% ∕ 40%
Price elasticity of supply = 0.625
It measures the responsiveness of the quantity demanded of one good (X), to a change in the price of another good (Y).
Assume product A (butter) has a 10% positive change in quantity demanded when product B (margarine) has a positive 5% change or increase in price. If we enter those numbers into our formula, we see that
10% ∕ 5% is equal to 2. So, what this tells us? The following rules of thumb are applied to determine the relationship between the two goods.
If cross-price elasticity > 0, then the two goods are substitutes.
If cross-price elasticity = 0, then the two goods are independent.
If cross-price elasticity < 0, then the two goods are complements.
In the above example with elasticity = 2, we can say that butter and margarine are substitute goods for each other. When the price of margarine went up, more people switched to butter. You can increase the sales of one good, by increasing the price of the other.
It measures the responsiveness of quantity demanded to a change in consumer incomes.
Let us assume the economy is doing well and everyone’s income rises by 30%. Because people have extra money and can afford nicer shoes, the quantity of cheap shoes demanded decreases by 10%.
The income elasticity of cheap shoes is:
Income elasticity = −10% ∕ 30% =−0.33
Advantages:
Disadvantages
There aren’t any disadvantages except that it may not be helpful in decision making if the user does not know how to interpret and apply the results. It is also important to consider other factors that may affect the quantity demanded, aside from changes in price. These factors include changes in income, family circumstances or external economic environment.
