Price Elasticity
Price elasticity is a measure of the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is defined as the percentage change in quantity divided by the percentage change in price, and it is usually expressed as a positive number, with the direction of the relationship indicated by the context. Price elasticity is a central concept in microeconomics, informing pricing decisions, the analysis of tax incidence, and the evaluation of market power.
Definition and calculation
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. Because quantity and price move in opposite directions along a demand curve, the elasticity is negative, but it is often reported as an absolute value. The elasticity of supply is defined similarly, with the percentage change in quantity supplied divided by the percentage change in price, and it is positive.
Elasticity is calculated using percentage changes, which makes it unit-free and comparable across goods and across measures. For small changes, the arc elasticity is approximated by the point elasticity, and for large changes, the midpoint or arc formula is used to avoid the dependence of the result on the direction of the change. The distinction matters for accuracy, and the appropriate formula depends on the size of the change being considered.
Determinants
The elasticity of demand depends on several factors. The availability of close substitutes is the most important: a good with many substitutes has elastic demand, because consumers can switch when the price rises. The share of the good in the consumer's budget also matters, since a larger share makes consumers more sensitive to price. Necessities tend to have inelastic demand, while luxuries tend to have elastic demand.
The time horizon is critical. In the short run, consumers may be locked into existing patterns of consumption and may have limited ability to adjust, so demand is relatively inelastic. In the long run, they can change their behaviour, adopt substitutes, and adjust their durable goods, so demand is more elastic. The elasticity of supply also depends on the time horizon, since capacity can be expanded over time and inputs can be reallocated.
Relationship to revenue
The elasticity determines how total revenue responds to a price change. If demand is elastic, a price increase reduces revenue, because the fall in quantity outweighs the higher price. If demand is inelastic, a price increase raises revenue, because the fall in quantity is proportionally smaller. Revenue is maximised at the point where elasticity equals one, which is where marginal revenue is zero.
This relationship informs pricing decisions. A firm with market power will set price where marginal revenue equals marginal cost, which occurs in the elastic region of demand. A firm with inelastic demand has more scope to raise prices without losing revenue, though the scope depends on the extent of competition and on the presence of alternatives. The elasticity of demand is therefore a key input to pricing strategy and to the assessment of market power.
Applications
Elasticity is used to analyse the incidence of taxes, since the share of the burden borne by consumers and producers depends on the relative elasticities of demand and supply. It is used to assess the effects of price controls, since the size of shortages or surpluses depends on the elasticities. It is used in competition policy, to define markets and to assess the closeness of substitutes, and in the analysis of trade, to evaluate the effects of tariffs on imports and on domestic prices.
Elasticity is also central to welfare analysis, since the deadweight loss from a tax or a price distortion depends on the elasticities of demand and supply. The more elastic the demand and supply, the larger the distortion for a given tax, and the larger the efficiency cost. The concept therefore links the behaviour of consumers and firms to the welfare consequences of policy, and it is an essential tool in applied economics.
Elasticity and the slope of the curve
Elasticity is not the same as the slope of the demand or supply curve. The slope measures the change in quantity per unit change in price, while elasticity measures the percentage change in quantity per percentage change in price. The two are related, and the elasticity changes along a linear demand curve even when the slope is constant, because the ratio of price to quantity changes. A linear demand curve is elastic at high prices and inelastic at low prices.
The distinction matters for measurement and for interpretation. A steep curve, with a small change in quantity for a given change in price, is described as inelastic, while a flat curve is described as elastic, but the elasticity also depends on the point at which it is measured. Analysts therefore report elasticities at particular points or ranges, and they use functional forms that allow the elasticity to vary, such as constant elasticity specifications.
Cross and income elasticities
The concept of elasticity extends to other variables. The cross-price elasticity of demand measures the response of the quantity demanded of one good to a change in the price of another, and it is positive for substitutes and negative for complements. The income elasticity measures the response to a change in income, and it distinguishes normal goods, with positive elasticities, from inferior goods, with negative ones.
These elasticities are used to define markets, to assess the closeness of substitutes, and to forecast the effects of changes in prices and incomes. The cross-price elasticity is central to competition policy, since it indicates the extent to which consumers would switch between products, and the income elasticity is central to the analysis of demand growth and of structural change. Together, the elasticities describe the response of demand to the full range of influences.
Elasticity and market outcomes
The elasticities of demand and supply determine the outcomes of many policies and market events. The incidence of a tax, the size of a shortage or surplus from a price control, and the effect of a supply shock on prices all depend on the elasticities. In general, the less elastic side of the market bears more of the burden of a tax or a shock, because it has fewer options for adjustment.
The elasticities also determine the effect of a change in costs on prices. Where demand is inelastic, a cost increase is passed on to consumers with little change in quantity, so prices rise substantially. Where demand is elastic, the increase in price reduces quantity, and firms may absorb part of the cost. The degree of pass-through, and hence the effect of cost shocks on inflation, depends on the elasticities, and it is a central consideration in the analysis of inflation dynamics.
Empirical estimation
Estimating elasticities requires data on prices and quantities and a strategy for identifying the relationship. Because price and quantity are determined jointly, estimation requires variation in one of the curves that is independent of the other. Analysts use instrumental variables, natural experiments, and controlled trials to identify the elasticities, and the credibility of the estimates depends on the validity of the identification strategy.
The estimated elasticities vary widely across goods, markets, and periods. Necessities tend to have inelastic demand, and goods with close substitutes have elastic demand, and the elasticities are larger in the long run than in the short run, as consumers adjust their behaviour. The estimates are used in policy analysis, in forecasting, and in the design of pricing and tax policy, and their measurement is a continuing area of empirical research.