3 Factors and Applications of Elasticity

Measuring price responsiveness

Elasticity measures how strongly buyers or sellers respond to a change in price. It helps explain why a price change can greatly affect purchases in one market but have little effect in another, and why firms’ ability to adjust production varies across goods and time periods.

The two main measures compare percentage changes in quantity with percentage changes in price:

• Price elasticity of demand measures buyers’ responsiveness:

  $$E_d = \frac{\%\text{ change in quantity demanded}}{\%\text{ change in price}}$$

• Price elasticity of supply measures sellers’ responsiveness:

  $$E_s = \frac{\%\text{ change in quantity supplied}}{\%\text{ change in price}}$$

Price and quantity demanded generally move in opposite directions, so the calculated demand elasticity is negative. Economists usually report its absolute value. For either measure, elasticity greater than one means quantity changes by a greater percentage than price; elasticity less than one means it changes by a smaller percentage; and elasticity equal to one means the percentage changes are equal. These categories compare percentage responses, not absolute changes in units.

For example, if price rises by $10\%$ and buyers reduce purchases by $4\%$, demand is inelastic over that range, with an elasticity of $0.4$. If sellers respond to the same price rise by increasing output by $15\%$, supply is elastic, with an elasticity of $1.5$.

What affects demand elasticity

Demand tends to be more elastic when buyers can respond readily to a price change. These factors are tendencies rather than absolute rules: elasticity depends on the particular buyers, how the market is defined, and the time period.

• Close substitutes: When similar alternatives are readily available, buyers can switch if one product becomes more expensive. Demand for a narrowly defined product, such as one brand of bottled water, is often more elastic than demand for a broad category such as drinking water.

• Necessity or luxury: Buyers can more easily postpone or forgo a luxury than a necessity, so demand for luxuries tends to be more elastic.

• Share of the budget: A price change on a purchase that takes a large share of a buyer’s budget is more noticeable than the same percentage change on an inexpensive item.

• Time to adjust: Buyers may have few alternatives immediately after energy prices rise. Over time, they may change vehicles, insulation, or commuting habits.

When substitutes are scarce, a good is essential, or buyers have little time to adjust, demand is more likely to be inelastic.

What affects supply elasticity

Supply tends to be more elastic when sellers can increase or reduce output without major delay or cost. Spare capacity, available inventories, inputs that are readily obtainable, and production methods that are easy to adjust all help firms respond.

Supply is more likely to be inelastic when production takes a long time, capacity is already fully used, inputs are difficult to obtain, or output depends on conditions sellers cannot control, such as a growing season.

Time is especially important for sellers. A bakery may be able to bake more bread the next day by adding a shift, while a farm cannot immediately produce more mature crops. Supply is therefore often less elastic in the short run and more elastic over a longer period, although the size of the difference varies by market.

Using demand elasticity to predict revenue

A seller’s total revenue is price multiplied by the quantity sold:

Demand elasticity at the current price predicts how a price change affects revenue:

• With elastic demand, a price rise reduces total revenue, while a price fall increases it.

• With inelastic demand, a price rise increases total revenue, while a price fall reduces it.

• With unit-elastic demand, total revenue is approximately unchanged for a small price change.

For example, a shop raises a product’s price by $10\%$, and the quantity sold falls by $3\%$. Because the percentage fall in sales is smaller than the price increase, demand is inelastic over this range and the shop’s total revenue rises. If quantity instead fell by $15\%$, demand would be elastic and total revenue would fall.

This revenue test concerns demand. Supply elasticity describes how sellers adjust quantity supplied when price changes; it does not describe how much buyers purchase.

Applying elasticity to market changes

A drought can reduce the amount of produce farmers bring to market, shifting supply left. In the short run, supply may be inelastic because crops cannot be grown immediately. If demand for the crop is also relatively inelastic, the market price can rise substantially while quantity falls by a smaller percentage. Farmers’ total revenue may rise if the price increase outweighs the reduced sales volume, but the result depends on the actual demand response.

A production method that lowers the cost of making a product shifts supply right, tending to lower the market price and raise the quantity sold. If demand is inelastic, the price decline can be proportionally larger than the increase in sales, reducing sellers’ total revenue even as buyers pay less. If demand is elastic, the expanded quantity may offset the lower price more strongly.

Elasticity and the burden of a tax

The side of a market that is less responsive to price changes generally bears more of a per-unit tax’s economic burden. If buyers have few substitutes and demand is inelastic relative to supply, more of the burden tends to fall on buyers. If sellers have few production alternatives and supply is less elastic than demand, more of the burden tends to fall on sellers.

The legal party that sends the tax payment to the government does not by itself determine who bears its economic cost.

• unit elastic