How Elasticity Works
When the value of elasticity is greater than 1.0, it suggests that the demand for the good or
service is affected by the price. A value that is less than 1.0 suggests that the demand is insensitive
to price, or inelastic. Inelastic means that when the price goes up, consumers’ buying habits stay
about the same, and when the price goes down, consumers’ buying habits also remain unchanged. If
elasticity = 0, then it is said to be 'perfectly' inelastic, meaning its demand will remain unchanged at
any price. There are probably no real-world examples of perfectly inelastic goods. If there were, that
means producers and suppliers would be able to charge whatever they felt like and consumers
would still need to buy them. The only thing close to a perfectly inelastic good would be air and
water, which no one controls.
Elasticity is an economic concept used to measure the change in the aggregate quantity demanded
of a good or service in relation to price movements of that good or service. A product is considered
to be elastic if the quantity demand of the product changes drastically when its price increases or
decreases. Conversely, a product is considered to be inelastic if the quantity demand of the product
changes very little when its price fluctuates.
For example, insulin is a product that is highly inelastic. For people with diabetes who need insulin,
the demand is so great that price increases have very little effect on the quantity demanded. Price
decreases also do not affect the quantity demanded; most of those who need insulin aren't holding
out for a lower price and are already making purchases.
On the other side of the equation are highly elastic products. Bouncy balls, for example, are highly
elastic in that they aren't a necessary good, and consumers will only decide to make a purchase if
the price is low. Therefore, if the price of bouncy balls increases, the quantity demanded will greatly
decrease, and if the price decreases, the quantity demanded will increase.
Types of Elasticity
Demand Elasticity
Demand elasticity is an economic measure of the sensitivity of demand relative to a change in
another variable. The quantity demanded of a good or service depends on multiple 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 the quantity demanded and the price of a good or service, the elasticity is known
as price elasticity of demand. The two other main types of demand elasticity are income elasticity of
demand and cross elasticity of demand.
Income Elasticity
Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to
a change in real income of consumers who buy this good, keeping all other things constant. The
formula for calculating income elasticity of demand is the percent change in quantity demanded
divided by the percent change in income. With income elasticity of demand, you can tell if a
particular good represents a necessity or a luxury.
Cross Elasticity
The cross elasticity of demand is an economic concept that measures the responsiveness in the
quantity demanded of one good when the price for another good changes. Also called cross-price
elasticity of demand, this measurement is calculated by taking the percentage change in the quantity
demanded of one good and dividing it by the percentage change in the price of the other good.
Price Elasticity
Price elasticity of supply measures the responsiveness to the supply of a good or service after a
change in its market price. According to basic economic theory, the supply of a good will increase
when its price rises. Conversely, the supply of a good will decrease when its price decreases.
Factors Affecting Demand Elasticity
There are three main factors that influence a good’s price elasticity of demand.
Availability of Substitutes
In general, the more good substitutes there are, the more elastic the demand will be. For example, if
the price of a cup of coffee went up by $0.25, consumers might replace their morning caffeine fix
with a cup of strong tea. This means that coffee is an elastic good because a small increase in price
will cause a large decrease in demand as consumers start buying more tea instead of coffee.
However, if the price of caffeine itself were to go up, we would probably see little change in the
consumption of coffee or tea because there may be few good substitutes for caffeine. Most people,
in this case, might not willingly give up their morning cup of caffeine no matter what the price. We
would say, therefore, that caffeine is an inelastic product. While a specific product within an industry
can be elastic due to the availability of substitutes, an entire industry itself tends to be inelastic.
Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.
Necessity
As we saw above, if something is needed for survival or comfort, people will continue to pay higher
prices for it. For example, people need to get to work or drive for a number of reasons. Therefore,
even if the price of gas doubles or even triples, people will still need to fill up their tanks.
Time
The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very
few available substitutes will most likely continue buying their daily cigarettes. This means
that tobacco is inelastic because the change in price will not have a significant influence on the
quantity demanded. However, if that smoker finds that they cannot afford to spend the extra $2 per
day and begins to kick the habit over a period of time, the price of cigarettes for that consumer
becomes elastic in the long run.
The Importance of Price Elasticity in Business
Understanding whether or not the goods or services of a business are elastic is integral to the
success of the company. Companies with high elasticity ultimately compete with other businesses on
price and are required to have a high volume of sales transactions to remain solvent. Firms that are
inelastic, on the other hand, have goods and services that are must-haves and enjoy the luxury of
setting higher prices.
Beyond prices, the elasticity of a good or service directly affects the customer retention rates of a
company. Businesses often strive to sell goods or services that have inelastic demand; doing so
means that customers will remain loyal and continue to purchase the good or service even in the
face of a price increase.
Examples of Elasticity
There are a number of real-world examples of elasticity we interact with on a daily basis. One
interesting modern-day example of the price elasticity of demand many people take part in even if
they don't realize it is the case of Uber's surge pricing. As you might know, Uber uses a "surge
pricing" algorithm during times when there is an above-average amount of users requesting rides in
the same geographic area. The company applies a price multiplier which allows Uber to equilibrate
supply and demand in real-time.
The COVID-19 pandemic has also shone a spotlight on the price elasticity of demand through its
impact on a number of industries. For example, a number of outbreaks of the coronavirus in meat
processing facilities across the US, in addition to the slowdown in international trade, led to a
domestic meat shortage, causing import prices to rise 16% in May 2020, the largest increase on
record since 1993.1
Another extraordinary example of COVID-19's impact on elasticity arose in the oil industry.
Although oil is generally very inelastic, meaning demand has a little impact on the price per barrel,
because of a historic drop in global demand for oil during March and April, along with increased
supply and a shortage of storage space, on April 20, 2020, crude petroleum actually traded at a
negative price in the intraday futures market.
In response to this dramatic drop in demand, OPEC+ members elected to cut production by 9.7
million barrels per day through the end of June, the largest production cut ever.2