What Is Elasticity?
Elasticity measures the relationship between a good and its price based on consumer demand, consumer income, and its available supply. Learn the basics about it here.
Reviewed by Amy DruryFact checked by Pete RathburnReviewed by Amy DruryFact checked by Pete Rathburn
Elasticity vs. Inelasticity of Demand: An Overview
Elasticity and inelasticity of demand refer to the degree to which demand responds to a change in an economic factor. Price is the most common economic factor used when determining elasticity. Other factors include income level and substitute availability.
Goods and services are elastic when demand changes for them in the economy. They become inelastic when demand remains relatively constant even when the economy shows signs of change.
Key Takeaways
- The elasticity of demand refers to the change in demand when there is a change in another economic factor, such as price or income.
- Demand is considered inelastic if the demand for a good or service remains unchanged even when the price changes.
- Elastic goods include luxury items and certain food and beverages, as price changes can have an impact on demand to a great extent.
- Inelastic goods may include items such as tobacco and prescription drugs, as demand often remains constant despite price changes.
Elasticity of Demand
The elasticity of demand measures how demand responds to a change in price or income. An elastic good is defined as one where a change in price leads to a significant shift in demand. Where more substitutes are available for an item, the more elastic the demand for the good will be.
Elasticity of demand is calculated by dividing the percentage change in quantity demanded by the percentage change in price. If the quotient is equal to or greater than one, the demand is considered to be elastic. If it is less than one, demand is considered to be inelastic.
The formula in the image below shows how you can calculate the elasticity of demand:
Investopedia
Arc Price Elasticity of Demand formula
Example of Elasticity of Demand
Common examples of products with high elasticity are luxury items and consumer discretionary items, such as brand-name cereal or candy bars. Food products are easily substituted and brand names are easily replaced by lower-priced items.
A change in the price of a luxury car can cause a change in the quantity demanded. The extent of the price change will determine whether or not the demand for the good changes and if so, by how much.
Other factors such as income level and available substitutes also influence the demand elasticity of goods and services. During a period of job loss, people may save their money rather than upgrade their smartphones or buy designer purses, leading to a significant change in the consumption of luxury goods.
Available substitutes for a good or service make an item more sensitive to price changes. If the price of Android phones increases by 10%, this could shift demand from Androids to iPhones, for instance.
Important
Demand is elastic if the formula above results in a value higher than 1. Demand is inelastic if the value is less than 1.
Inelasticity of Demand
Inelastic demand is evident when demand for a good or service is relatively static even when its price changes. Inelastic products are usually necessities without acceptable substitutes. As such, these products are things that people need in their day-to-day lives regardless of economic conditions.
There are no perfectly inelastic goods. If there were, producers would be able to charge whatever they want for these products. But certain goods have some degree of inelasticity to them. The most common goods with inelastic demand are utilities, prescription drugs, and tobacco products.
Businesses that offer such products maintain greater flexibility with prices because demand remains constant even if prices increase or decrease. In general, necessities and medical treatments tend to be inelastic, while luxury goods tend to be most elastic. Insulin is an inelastic good. Because insulin is essential to those with diabetes, demand will not change even if the price increases.
Special Considerations
There are two other main types of elasticity of demand. They are referred to as the cross elasticity and advertising elasticity of demand.
Cross Elasticity of Demand
The cross elasticity of demand is a concept that measures the responsiveness in quantity demanded of one good when the price of another one changes.
Cross elasticity of demand can refer to substitute goods or complementary goods. When the price of one good increases, the demand for a substitute good may increase as consumers seek a substitute for the more expensive item.
Advertising Elasticity of Demand
The advertising elasticity of demand (AED) measures a market’s sensitivity to increases or decreases in advertising saturation. The elasticity of an advertising campaign is measured by its ability to generate new sales.
Positive advertising elasticity means that an uptick in advertising leads to an increase in demand for the goods or services advertised.
What Are the 4 Types of Elasticity?
The four main types of elasticity of demand are price elasticity of demand, cross elasticity of demand, income elasticity of demand, and advertising elasticity of demand. They are based on price changes of the product, price changes of a related good, income changes, and changes in promotional expenses, respectively.
How Is Elasticity Measured?
Elasticity is measured by the ratio of two percentages: the percentage change in quantity demanded and the percentage change in price. To calculate it, divide the change in quantity demanded by the change in price.
What Does a Price Elasticity of 1.5 Mean?
If the price elasticity is equal to 1.5, it means that the quantity of a product’s demand increased by 15% in response to a 10% reduction in price (15% ÷ 10% = 1.5).
The Bottom Line
Elasticity of demand occurs when demand responds to changes in price or other economic factors. Inelasticity of demand means that demand remains relatively constant even with changes in economic factors. Products and services for which consumers have many options commonly have elastic demand, while products and services for which consumers have few alternatives are most often inelastic.
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