Elasticity of Demand: Definition and Explanation
Elasticity of demand measures how sensitive the quantity demanded of a good or service is to changes in its price or other factors such as income. The most common type is price elasticity of demand , which specifically looks at how much the quantity demanded changes in response to a change in price
Key Points
- Price elasticity of demand is calculated as:
Price Elasticity of Demand=Percentage Change in Quantity DemandedPercentage Change in Price\text{Price Elasticity of Demand}=\frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}Price Elasticity of Demand=Percentage Change in PricePercentage Change in Quantity Demanded
- If the elasticity value is greater than 1 (in absolute value), demand is considered elastic , meaning consumers are highly responsive to price changes.
- If the elasticity value is less than 1 , demand is inelastic , meaning consumers are less responsive to price changes.
- If the elasticity is exactly 1 , demand is said to have unitary elasticity , where the percentage change in quantity demanded equals the percentage change in price
Types of Elasticity
- Elastic demand : Quantity demanded changes significantly with price changes (e.g., luxury goods, goods with many substitutes)
- Inelastic demand : Quantity demanded changes little with price changes (e.g., necessities like gasoline, goods with few substitutes)
- Perfectly elastic : Demand changes infinitely with even a tiny price change.
- Perfectly inelastic : Demand does not change at all with price changes
Why It Matters
Understanding elasticity helps businesses and policymakers predict how changes in prices (or other factors, like income) will affect consumer behavior, total revenue, and market outcomes
Example
If the price of a product increases by 10% and the quantity demanded falls by 20%, the price elasticity of demand is:
−20%10%=−2\frac{-20%}{10%}=-210%−20%=−2
This means demand is elastic, as the absolute value is greater than 1
. In summary, elasticity of demand is a crucial economic concept that quantifies how much demand will change as prices or other factors shift, guiding decisions in pricing, taxation, and policy
