Price Elasticity

Price elasticity, as it relates to economics, is a measure of the responsiveness of demand or supply to a change in price. Elasticity is a measure of responsiveness.

The most common elasticity measurement is that of price elasticity of demand. It measures how much consumers respond in their buying decisions to a change in price.

The word responsiveness is important here. It means that there is a stimulus-reaction involved. Some change or stimulus causes people to react by changing their behavior. The elasticity measure captures the extent to which people react.

How is price elasticity calculated?

Price elasticity is the percentage change in quantity divided by the percentage change in price.

      percentage change in quantity
e = ---------------------------------
       percentage change in price

Elasticity of demand...

For example if the price of a good increases by 5% and consumers respond by decreasing their purchases by 10%, then the elasticity equals negative 2.

The result is negative because we are talking about the elasticity of demand here. An increase in price (a positive number) leads to a decrease in purchases (a negative number).

Elasticity of supply...

If we talked about the supply side, for example if the price of a good increases by 5% and manufacturers respond by increasing their output by 10%, then the elasticity would equal positive 2.

Elasticity of demand: elastic vs. inelastic

If demand changes by more than the price has changed, the good is price-elastic. If demand changes by less than the price, it is price-inelastic.

An elasticity coefficient of 2 shows that consumers respond greatly to a change in price. If the price changes a little, they respond a lot. Consumers have elastic demand in this case.

When the elasticity coefficient is greater than one, we say that the demand is elastic.

On the other hand, if a 10% change in price causes only a 5% change in sales, the elasticity coefficient will be only 1/2.

In this case the demand is inelastic. Demand is inelastic whenever the elasticity coefficient is less than one.

When the elasticity coefficient equals to one, we say that the demand is unit elastic.

What determines elasticity?

Substitutes...

Products that have few good substitutes generally have a lower elasticity of demand than products with many substitutes. More broadly defined products have a lower elasticity than narrowly defined products.

If one bakery increases their prices of bread loaf, consumers can freely switch to bread rolls. If the price of gas goes up, consumers have no choice than to keep buying the gas because substitutes are not freely available and easy to switch to.

Time...

Time plays an important role in determining both consumer and producer responsiveness for many items. Generally the greater the time period, the more possible it may be for a good to be replaced with a substitute as people have longer to make adjustments. Using gasoline as an example, when the price of gasoline rose rapidly in the late 1970s as a result of the OPEC cartel, the only adjustment consumers could initially make was to drive less. With time, they could also move closer to work or find jobs closer to home, and switch to more fuel-efficient cars.

The proportion of the consumer's income the good represents...

Inelastic demand is commonly associated with goods that are needed. However, there are many other reasons a good or service may have inelastic demand. For example, demand for salt. Demand for salt is highly inelastic not because it is a necessity but because it is such a small part of the household budget.

How the good or service is defined...

In general, cigarettes are considered good with inelastic demand. That is because smokers will keep smoking no matter what. However, if we talk about a particular brand of cigarettes, the demand becomes much more elastic.

Obligatory goods...

The same way as alcohol, and cigarettes, some drugs are addictive. If people are addicted to something, they will buy it regardless of its price. Therefore, goods where dependency plays a key role will naturally exhibit inelastic properties. Governments often place taxes on these types of goods because they know they always will be a stable source of tax revenue.