Elasticity of demand is an economic measure of the sensitivity of demand to a change in another variable. The quantity demanded of a good or service depends on several factors, such as price, income and preference. Whenever there is a change in these variables, it causes a change in the quantity demanded of the good or service.
For example, when there is a relationship between the change in quantity demanded and the price of a good or service, the elasticity is called the price elasticity of demand.
There are two more main types of elasticity of demand, namely income elasticity of demand and cross elasticity of demand.
Key points to remember
- Elasticity of demand is a measure of the responsiveness to a change in demand given a change in a variety of other factors, including the price of the product.
- Perhaps the best known is price elasticity of demand, measuring how demand changes for an item if its price changes, with demand for some goods being more price sensitive than others.
- Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in the real income of consumers who buy that good.
- Cross elasticity of demand is an economic concept that measures the responsiveness of the quantity demanded of one good when the price of another good changes.
Elasticity of demand by price
The price elasticity of demand is an indicator of the impact of a price change, upward or downward, on the sales of a product.
If the price elasticity of demand is greater than 1, it is considered elastic. That is, the demand for the product is sensitive to an increase in the price. An increase in the price of a fancy cut of steak, for example, can make many customers choose a burger instead. A bargain price for the novelty cut will lead many customers to switch to the novelty cut.
A price elasticity of demand less than 1 is said to be inelastic. The demand for the product does not change significantly after a price increase. For example, a consumer needs or does not need a can of motor oil. A price change will have little or no effect on demand. But few people will stock up on motor oil if its price drops.
Elasticity of demand by income
Consumer income plays a very important role in the demand for a good or service. When there is a change in consumers’ incomes, it causes a change in the quantity demanded of a good or service if all other factors remain the same. The sensitivity of a change in the quantity demanded of a good or service to a change in the incomes of consumers is known as the income elasticity of demand. The formula used to calculate the income elasticity of demand is the percentage change in the quantity demanded of a good or service divided by its percentage change in consumer income.
If the income elasticity of demand is greater than 1, the good or service is considered a luxury and an income elasticity. A good or service with an income elasticity of demand between zero and 1 is considered a normal good and inelastic to income. If a good or service has an income elasticity of demand less than zero, it is considered an inferior good and has a negative income elasticity.
For example, suppose a good has an income elasticity of demand of -1.5. The good is considered inferior and the quantity demanded for that good decreases as consumers’ incomes increase.
Elasticity of demand by substitutes
Another example of elasticity of demand is cross elasticity of demand. It measures the sensitivity of the quantity demanded of a good or service to a change in the price of a similar good or service. Cross elasticity of demand is calculated by dividing the percentage change in the quantity demanded of a good divided by the percentage change in the price of a substitute good.
If the cross elasticity of demand for goods is greater than zero, the goods are said to be substitutes. With goods that have a cross elasticity of demand equal to zero, the two goods are independent of each other. If the cross elasticity of demand is less than zero, the two goods are said to be complementary.
For example, toothpaste is an example of a substitute product. If the price of one brand of toothpaste increases, so does the demand for another brand. An example of complementary products are hot dog buns and hot dogs. If the price of hot dogs goes up while everything else stays the same, the quantity demanded for hot dog buns goes down.