3 Elasticity: Measurement and Determinants

What elasticity measures

Elasticity measures how strongly one economic variable responds, in percentage terms, to a change in another. Price elasticity of demand measures the response of quantity demanded to price; price elasticity of supply measures the response of quantity supplied. Both measures hold other relevant factors constant.

Demand elasticity is normally negative because price and quantity demanded move in opposite directions. It is commonly reported as the absolute value, $|E_d|$, to make responsiveness easier to compare. Supply elasticity is usually positive because price and quantity supplied move in the same direction.

Calculating elasticity

Measuring change between two observations

The midpoint method is used when calculating elasticity between two observed points. It uses the average of the starting and ending values as the base for each percentage change, so the result is the same whichever point is treated as the starting point.

After calculating both percentage changes, divide the percentage change in quantity by the percentage change in price.

For example, suppose price rises from $\$10$ to $\$12$, while quantity demanded falls from $100$ to $80$ units. The percentage change in quantity is $(80-100)/90\times100\approx-22.2\%$, and the percentage change in price is $(12-10)/11\times100\approx18.2\%$. Thus, $E_d\approx-22.2/18.2=-1.22$, so $|E_d|\approx1.22$: demand is elastic over this interval.

Measuring elasticity at one point

Point elasticity is used when a demand or supply function is known and elasticity is needed at a specific point:

Here, $dQ/dP$ is the slope of the quantity function with respect to price, and $P$ and $Q$ are the price and quantity at the point. The sign is typically negative for demand and positive for supply. Because elasticity accounts for price and quantity levels as well as slope, it can vary along a straight-line curve even when the slope is constant.

Interpreting elasticity

For demand, compare the absolute value of elasticity with $1$; for supply, compare elasticity itself with $1$.

• Elastic: Elasticity is greater than $1$. Quantity changes by a larger percentage than price.

• Unit elastic: Elasticity equals $1$. Quantity and price change by the same percentage.

• Inelastic: Elasticity is less than $1$. Quantity changes by a smaller percentage than price.

An elasticity of $0.5$, for example, means a $1\%$ price change is associated with about a $0.5\%$ quantity change. For demand, the changes are in opposite directions; for supply, they are in the same direction. Elasticity is a ratio of percentage changes and therefore has no units. A perfectly inelastic curve has elasticity zero, while a perfectly elastic curve has infinite elasticity.

Elasticity and total revenue

Total revenue is price multiplied by quantity sold:

Demand elasticity predicts how total revenue responds to a price change:

• When demand is inelastic, price and total revenue move in the same direction. A price increase raises total revenue.

• When demand is elastic, price and total revenue move in opposite directions. A price increase lowers total revenue.

• When demand is unit elastic, total revenue is unchanged for a small price change. For a finite change, the midpoint measure is an interval summary, so compare actual revenue at the two endpoints when needed.

For example, if a seller raises price and demand is elastic, the percentage decline in sales is larger than the percentage increase in price, so revenue falls.

What determines responsiveness

Determinants of elasticity include factors that affect buyers’ ability or incentive to change how much they purchase, and producers’ ability to change output.

Demand responsiveness

• Availability of close substitutes: More and closer alternatives make it easier for buyers to switch when price rises, increasing the absolute value of demand elasticity. Demand for one brand is generally more elastic than demand for the broader product category.

• Importance in the household budget: A price change for a large budget item tends to affect purchasing decisions more than the same proportional change for a minor expense.

• Time to adjust: Demand is usually more elastic when consumers have more time to find alternatives or change habits. A sudden fuel-price increase may have a modest immediate effect but a larger effect after buyers can change vehicles or travel patterns.

Supply responsiveness

• Time available to adjust: Supply is generally more elastic over a longer period. Producers may initially have little ability to change output, but later may expand capacity, alter production, or new firms may enter.

• Spare capacity and access to inputs: Firms with unused capacity and readily available labor or materials can respond more readily to higher prices. When capacity is fully used or important inputs are difficult to obtain, short-run supply tends to be less elastic.

• Production constraints: Goods requiring long growing periods, specialized facilities, or hard-to-move resources are often difficult to produce in greater quantities quickly. Easily stored goods or goods made with flexible processes may allow a quicker response.

Elasticity and market equilibrium

Elasticity helps predict how a market responds when demand or supply shifts. For example, after demand increases, relatively inelastic supply means quantity cannot expand much, so equilibrium price tends to rise more. With more elastic supply, quantity can expand more and the price rise tends to be smaller.

Elasticity describes responsiveness along a curve. A change in the good’s own price causes movement along that curve, while a change in another determinant shifts the curve.