What Is Elasticity?
Elasticity is a measure of a variable's sensitivity to a change in another variable. In business and economics, elasticity refers 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.
What Is Elasticity?
How Elasticity Works
When the value of elasticity is greater than 1, it suggests that the demand for the good or service is affected by the price. A value that is less than 1 suggests that the demand is insensitive to price.
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.
Elasticity can be calculated using the following formula:
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand:
- 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 willing to 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.
- 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 any number of reasons. Therefore, even if the price of gas doubles or even triples, people will still need to fill up their tanks.
- Time: The third influential factor is time. If the price of cigarettes goes up $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.