Demand elasticity is an economic measure of the sensitivity of demand relative to a change in another variable. The quantity demanded of a good or service depends on multiple factors, such as price, income and preference. Whenever there is a change in these variables, it causes a change in the quantity demanded of the good or service.

For example, when there is a relationship between the change in the quantity demanded and the price of a good or service, the elasticity is known as price elasticity of demand.

There are still two other main types of demand elasticity, which are income elasticity of demand and cross elasticity of demand.

Key Takeaways

  • Elasticity of demand is a measure of the responsiveness of a change in demand given a change in a variety of other factors including the product's price.
  • Price elasticity of demand is perhaps the most well-recognized, measuring how demand changes for an item if its price changes, with some goods' demand more sensitive to price than others.
  • Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in real income of consumers who buy this good.
  • Cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price for another good changes

Elasticity of Demand by Price

Price elasticity of demand is an indicator of the impact of a price change, up or down, on a product's sales.

If the price elasticity of demand is greater than 1, it is deemed elastic. That is, demand for the product is sensitive to an increase in price. A price increase for a fancy cut of steak, for example, may make many customers choose hamburger instead. A bargain price for the fancy cut will lead many customers to upgrade to the fancy cut.

Price elasticity of demand that is less than 1 is called inelastic. Demand for the product does not change significantly after a price increase. For example, a consumer either needs a can of motor oil or doesn't need it. A price change will have little or no effect on demand. But not many will stock up on motor oil if its price decreases.

Elasticity of Demand by Income

Consumers' incomes play a very important role in the demand for a good or service. When there is a change in consumers' incomes, it causes a change in the quantity demanded of a good or service if all other factors remain the same. The sensitivity of a change in the quantity demanded of a good or service relative to a change in consumers' incomes is known as income elasticity of demand. The formula used to calculate the income elasticity of demand is the percent change in the quantity demanded of a good or service divided by its percent change in consumers' incomes.

If the income elasticity of demand is greater than 1, the good or service is considered a luxury and income elastic. A good or service that has an income elasticity of demand between zero and 1 is considered a normal good and income inelastic. If a good or service has an income elasticity of demand below zero, it is considered an inferior good and has negative income elasticity.

For example, suppose a good has an income elasticity of demand of -1.5. The good is considered inferior and the quantity demanded for this good falls as consumers' incomes rise.

Elasticity of Demand by Substitutes

Another example of demand elasticity is cross elasticity of demand. This measures how sensitive the quantity demanded of a good or service is relative to a change in the price of a similar good or service. The cross elasticity of demand is calculated by dividing the percent change of the quantity demanded of one good divided by the percent change in the price of a substitute good.

If the cross elasticity of demand of goods is greater than zero, the goods are said to be substitutes. With goods that have a cross elasticity of demand equal to zero, the two goods are independent of each other. If the cross elasticity of demand is less than zero, the two goods are said to be complementary.

For example, toothpaste is an example of a substitute good. If the price of one brand of toothpaste increases, the demand for another brand increases as well. An example of complementary goods are hot dog buns and hot dogs. If the price of hot dogs increases with everything else remaining unchanged, the quantity demanded for hot dog buns decreases.