What Is Elasticity?

Elasticity is a measure of a variable's sensitivity to a change in another variable, most commonly this sensitivity is the change in price relative to changes in other factors. In business and economics, elasticity refers to the degree to which individuals, consumers or producers change their demand or the amount supplied in response to price or income changes. It is predominantly used to assess the change in consumer demand as a result of a change in a good or service's price.

Key Takeaways

  • Elasticity is an economic measure of how sensitive an economic factor is to another, for example changes in price to supply or demand, or changes in demand to changes in income.
  • If demand for a good or service is relatively static even when the price changes, demand is said to be inelastic, and its coefficient of elasticity is less than 1.0.
  • Examples of elastic goods include clothing or electronics, while inelastic goods are items like food and prescription drugs.
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What Is Elasticity?

How Elasticity Works

When the value of elasticity is greater than 1.0, it suggests that the demand for the good or service is affected by the price. A value that is less than 1.0 suggests that the demand is insensitive to price, or inelastic. Inelastic means that when the price goes up, consumers’ buying habits stay about the same, and when the price goes down, consumers’ buying habits also remain unchanged.If elasticity is zero it is known as perfectly inelastic. If elasticity = 0, then it is said to be 'perfectly' inelastic, meaning its demand will remain unchanged at any price. There are probably no real-world examples of perfectly inelastic goods. If there were, that means producers and suppliers would be able to charge whatever they felt like and consumers would still need to buy them. The only thing close to a perfectly inelastic good would be air and water, which no one controls. 

Elasticity is an economic concept used to measure the change in the aggregate quantity demanded for a good or service in relation to price movements of that good or service. A product is considered to be elastic if the quantity demand of the product changes drastically when its price increases or decreases. Conversely, a product is considered to be inelastic if the quantity demand of the product changes very little when its price fluctuates.

For example, insulin is a product that is highly inelastic. For diabetics who need insulin, the demand is so great that price increases have very little effect on the quantity demanded. Price decreases also do not affect the quantity demanded; most of those who need insulin aren't holding out for a lower price and are already making purchases.

On the other side of the equation are highly elastic products. Bouncy balls, for example, are highly elastic in that they aren't a necessary good, and consumers will only decide to make a purchase if the price is low. Therefore, if the price of bouncy balls increases, the quantity demanded will greatly decrease, and if the price decreases, the quantity demanded will increase.

Types of Elasticity

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. The two other main types of demand elasticity are income elasticity of demand and cross elasticity of demand.

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, keeping all other things constant. The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income. With income elasticity of demand, you can tell if a particular good represents a necessity or a luxury.

The 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. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good.

Price elasticity of supply measures the responsiveness to the supply of a good or service after a change in its market price. According to basic economic theory, the supply of a good will increase when its price rises. Conversely, the supply of a good will decrease when its price decreases

Factors Affecting Demand Elasticity

There are three main factors that influence a good’s price elasticity of demand:

  1. Availability of Substitutes: In general, the more good substitutes there are, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeine fix with a cup of strong tea. This means that coffee is an elastic good because a small increase in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. However, if the price of caffeine itself were to go up, we would probably see little change in the consumption of coffee or tea because there may be few good substitutes for caffeine. Most people, in this case, might not willingly give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product. While a specific product within an industry can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
  2. Necessity: As we saw above, if something is needed for survival or comfort, people will continue to pay higher prices for it. For example, people need to get to work or drive for a umber of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.
  3. Time: The third influential factor is time. If the price of cigarettes goes up to $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

The Importance of Price Elasticity in Business

Understanding whether or not a business's good or service is elastic is integral to the success of the company. Companies with high elasticity ultimately compete with other businesses on price and are required to have a high volume of sales transactions to remain solvent. Firms that are inelastic, on the other hand, have goods and services that are must-haves and enjoy the luxury of setting higher prices.

Beyond prices, the elasticity of a good or service directly affects the customer retention rates of a company. Businesses often strive to sell goods or services that have inelastic demand; doing so means that customers will remain loyal and continue to purchase the good or service even in the face of a price increase.