Elasticity

1. Elasticity measures the sensitivity between two economic variables.

2. Measuring elasticities is important because it allows individuals, firms, and societies to estimate the impacts that economic decisions will have.

 

Demand Elasticity

Price Elasticity of Demand

1. The price elasticity of demand (PED) measures how much a change in the price of a good affects the quantity demanded.

2. PED = (% change in quantity demanded) / (% change in price).

   1. If the PED is greater than 1, the demand is elastic.

   2. If the PED is less than 1, the demand is inelastic.

   3. If the PED equals 1, the demand is unit elastic.

   4. Elasticity determines the shape of the demand curve.

   5. The PED is actually negative because the demand curve slopes downward, but economists report it as an absolute value.

3. A high (low) PED means that the quantity demanded of a good changes by a lot (a little) when the price changes.

   1. If there are substitutes for a product, the PED is higher. For goods that are completely interchangeable with others, such as two different brands of white rice, the demand curve is horizontal and the PED is perfectly elastic.

   2. If the product is a necessity or has few substitutes, such as water, the PED is lower. For absolute necessities with no substitutes, such as insulin for a diabetic, the demand curve is vertical and the PED is perfectly inelastic.

   3. Long-run elasticity is higher than short-run elasticity because individuals are able to make more adjustments in the long run.

4. Because there are two different opposite effects on revenue when the price changes (quantity also changes), the PED also determines how changes in price will affect revenue.

1. If demand is elastic, the quantity demanded will rise (fall) by a greater percent than the price falls (rises). Revenue will increase (decrease).

2. If demand is inelastic, the quantity demanded will rise (fall) by a lesser percent than the price falls (rises). Revenue will decrease (increase).

3. If demand is unit elastic, the quantity demanded will rise (fall) by the same percent that the price falls (rises). Revenue will stay the same.

Income Elasticity of Demand

1. The income elasticity of demand (IED) measures how much a change in income affects the quantity demanded.

2. IED = (% change in quantity demanded) / (% change in income).

3. IED is reported as a negative number for inferior goods because a change in income causes an opposite change in demand.