Elasticity - Measuring Market Sensitivity

In the previous chapters, we learned that a price increase leads to a decrease in demand and an increase in supply. However, we didn't discuss by how much. Elasticity is the tool economists use to measure the responsiveness of one variable to changes in another.

1. Price Elasticity of Demand (PED)

PED measures how much the quantity demanded of a good responds to a change in the price of that good.

• Formula: PED = % Change in Quantity Demanded \ % Change in Price
• Types of Elasticity:
  • Inelastic (PED < 1): Quantity changes proportionally less than price (e.g., life-saving medicine or gasoline).
  • Elastic (PED > 1): Quantity changes proportionally more than price (e.g., luxury goods or items with many substitutes).
  • Unit Elastic (PED = 1): Quantity changes by the exact same percentage as price.

2. Determinants of Demand Elasticity

Why are some goods more sensitive to price than others?

• Availability of Substitutes: The more substitutes available, the higher the elasticity.
• Necessities vs. Luxuries: Necessities tend to be inelastic; luxuries tend to be elastic.
• Definition of the Market: Narrowly defined markets (e.g., vanilla ice cream) are more elastic than broadly defined ones (e.g., food).
• Time Horizon: Goods tend to be more elastic over longer time periods as consumers find alternatives.

3. Price Elasticity of Supply (PES)

PES measures how much the quantity supplied of a good responds to a change in the price of that good.

• Formula: PES = % Change in Quantity Supplied \ %Change in Price
• Key Determinant: Flexibility of Sellers:
  • Inelastic Supply: Producers cannot easily change production (e.g., beachfront property or complex manufacturing).
  • Elastic Supply: Producers can quickly adjust output (e.g., manufactured goods like books or clothes).
• Time Horizon: Supply is usually more elastic in the long run than in the short run.

4. Other Types of Elasticity

• Income Elasticity of Demand: Measures how quantity demanded changes as consumer income changes.
  • Normal Goods: Positive elasticity (demand rises as income rises).
  • Inferior Goods: Negative elasticity (demand falls as income rises).
• Cross-Price Elasticity of Demand: Measures how the quantity demanded of one good responds to a change in the price of another good.
  • Substitutes: Positive elasticity.
  • Complements: Negative elasticity.

Summary: Why Elasticity Matters

For a business, understanding elasticity is the difference between a successful price hike and a total loss of revenue. If demand is inelastic, raising prices will increase total revenue. If demand is elastic, raising prices will cause revenue to fall because the drop in quantity sold will outweigh the higher price per unit.