What is Demand Elasticity/Elasticity of Demand
In economics, the demand elasticity (elasticity of demand) refers to how sensitive the demand for a good is to changes in other economic variables, such as prices and consumer income. Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent change in another economic variable. A higher demand elasticity for an economic variable means that consumers are more responsive to changes in this variable.
BREAKING DOWN Demand Elasticity/Elasticity of Demand
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 the price of a 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 precise forecasts of their production needs. If the demand for a good is more elastic in response to changes in other economic factors, companies must use caution when raising prices.
Types of Demand Elasticities
One common type of demand elasticity is the price elasticity of demand, which shows the responsiveness of the quantity demanded for a good relative to a change in its price. Firms collect data on price changes and how consumers respond to such changes. They then later calibrate their prices accordingly to maximize 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 the 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 (e.g., "-") is ignored. If demand elasticity is greater than 1, it is elastic: Demand is sensitive to economic changes (e.g., price). Demand elasticity that is less than 1 is inelastic: Demand does not change relative to economic changes such as price. Demand is unit elastic when the absolute value of demand elasticity is equal to 1, which means that demand will move proportionately with economic changes.
Suppose that a company calculated that the demand for a soda product increases from 100 to 110 bottles because of the price decrease from $2 to $1.50 per bottle. The price elasticity of demand is calculated as the percentage change in quantity demanded (110-100/100= 10%) divided by a percentage change in price ($2-$1.50/$2); therefore, the price elasticity of demand for this example is .4. Since the result is less than 1, it is inelastic; the change in price has little effect on the quantity demanded.