Elasticity

Elasticity is a fundamental concept in economics and finance that measures the responsiveness of one variable to changes in another variable. It is commonly used to evaluate how changes in price influence demand or supply for goods and services.

Definition of Elasticity

Elasticity quantifies how much the quantity demanded or supplied of a good or service will change as a response to a change in various factors, such as price, income, or the price of related goods.

Types of Elasticity

Elasticity can be classified into several types, each measuring different aspects of economic responsiveness:

Price Elasticity of Demand (PED)

Price Elasticity of Demand measures how the quantity demanded of a good changes in response to a change in its price. A higher PED indicates that consumers are sensitive to price changes.

Price Elasticity of Supply (PES)

Price Elasticity of Supply assesses how the quantity supplied of a good changes in response to a change in its price. A higher PES indicates that suppliers can quickly adjust production levels.

Income Elasticity of Demand (YED)

Income Elasticity of Demand measures how the quantity demanded of a good changes as consumers’ incomes change. It helps determine whether a good is a necessity or a luxury.

Cross Elasticity of Demand (XED)

Cross Elasticity of Demand gauges how the quantity demanded of one good changes in response to the change in the price of a different good, indicating whether the goods are substitutes or complements.

Calculation of Price Elasticity of Demand

The formula for calculating the Price Elasticity of Demand is:

PED = (% Change in Quantity Demanded) / (% Change in Price)

Real-World Example of Price Elasticity of Demand

For example, if a coffee shop increases the price of a coffee cup by 10%, and as a result, the quantity demanded decreases by 20%, the calculation of PED would be:

• % Change in Quantity Demanded = (-20%)
• % Change in Price = (10%)

Now, using the formula:

PED = (-20%) / (10%) = -2

This indicates that the demand for coffee is elastic since the absolute value of PED is greater than 1, meaning consumers are quite responsive to price changes. If the PED were less than 1, it would indicate inelastic demand, where quantity demanded is less responsive to price changes.

Elasticity is a crucial concept for businesses and policymakers as it helps them understand market dynamics, set prices, and forecast changes in demand and supply.