Meaning of Price Elasticity
Price elasticity of demand measures how much the quantity demanded responds to a change in price. It shows how sensitive consumers are to a change in the price of a good. The larger the response of quantity demanded relative to the price change, the more elastic the demand. Elasticity is usually stated as an absolute value because quantity and price move in opposite directions.
Formula
Price elasticity of demand = percentage change in quantity demanded ÷ percentage change in price
Types of Elasticity
- Elastic — coefficient greater than 1; quantity demanded changes more than price.
- Inelastic — coefficient less than 1; quantity demanded changes only a little.
- Unit elastic — coefficient equal to 1; the percentage change in quantity equals the percentage change in price.
In extreme cases demand can be perfectly elastic (an infinite coefficient) or perfectly inelastic (a coefficient of zero), although both cases are rare in real life.
Example
The price of a drink falls by 10% and the quantity demanded rises by 30%. The elasticity coefficient = 30% ÷ 10% = 3, so demand is elastic.
Determinants of Elasticity
Demand is more elastic when there are many substitutes, when the good is a luxury, or when it takes up a large share of income. Demand for necessities such as rice is usually inelastic because consumers keep buying them even when the price rises. Time also matters, since in the long run demand is usually more elastic because consumers have time to find substitutes. Conversely, goods with no close substitute or that take up only a small share of income tend to be inelastic.
Why It Matters
Price elasticity of supply measures how the quantity supplied responds to a change in price. Elasticity is important for decision-making. For example, the government taxes goods with inelastic demand such as cigarettes because tax revenue is high while the quantity demanded falls only slightly. Elasticity also helps sellers set prices: if demand is elastic, lowering the price raises total revenue, whereas if demand is inelastic, raising the price raises total revenue. Supply, in turn, is more elastic when producers have spare capacity or the good can be stored easily, but it is usually less elastic in the short run. Understanding elasticity therefore helps governments and businesses make wiser decisions about prices, taxes and subsidies.
Remember
Use the absolute value of the coefficient: greater than 1 means elastic, less than 1 means inelastic.