Demand Elasticity

What is 'Demand Elasticity'

Demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables, such as the prices and consumer income. Demand elasticity is calculated by taking the percent change in quantity of a good demanded and dividing it by a percent change in another economic variable. A higher demand elasticity for a particular economic variable means that consumers are more responsive to changes in this variable, such as price or income.

BREAKING DOWN 'Demand Elasticity'

Demand elasticity measures a change in demand for a good when another economic factor changes. Demand elasticity helps firms model the potential change in demand due to changes in price of the good, the effect of changes in prices of other goods and many other important market factors. A grasp of demand elasticity guides firms toward more optimal competitive behavior and allows them to make more precise forecasts of their production needs. If the demand for a particular good is more elastic in response to changes in other factors, companies must be more cautions with raising prices for their goods.

Types of Demand Elasticities

One common type of demand elasticity is the price elasticity of demand, which is calculated by dividing the percent change in quantity demanded of a good by the percent change in its price. Firms collect data on price changes and how consumers respond to such changes and later calibrate their prices accordingly to maximize their profits. Another type of demand elasticity is cross-elasticity of demand, which is calculated by taking the percent change in quantity demanded for a good and dividing it by percent change of the price for another good. This type of elasticity indicates how demand for a good reacts to price changes of other goods.

Interpretation and Example of Demand Elasticity

Demand elasticity is typically measured in absolute terms, meaning its sign is ignored. If demand elasticity is greater than 1, it is called elastic, meaning it reacts proportionately higher to changes in other economic factors. Inelastic demand means that the demand elasticity is less than 1, and the demand reacts proportionately lower to changes in another variable. When a change in demand is proportionately the same as that for another variable, the demand elasticity is called unit elastic.

Suppose that a company calculated that the demand for soda product increases from 100 to 110 bottles as a result of the price decrease from \$2 to \$1.50 per bottle. The price elasticity of demand is calculated by taking a 10% increase in demand (10 bottles change divided by initial demand of 100 bottles) and dividing it by a 25% price decrease, producing a value of 0.4. This indicates that lowering soda prices will result in a relatively small uptick in demand, because the price elasticity of demand for soda is inelastic. Also, an increase in total revenue will be smaller in this case compared to more elastic demand for soda.