What elasticity measures
Elasticity is the percentage change in one variable divided by the percentage change in another. It is unit-free, so it lets us compare goods measured in different units.
Price elasticity of demand
Price elasticity of demand (PED) = % change in quantity demanded ÷ % change in price. We usually ignore the negative sign and use the absolute value.
- PED greater than 1: elastic, buyers respond strongly.
- PED less than 1: inelastic, buyers respond weakly.
- PED equal to 1: unit elastic.
The midpoint method avoids the problem that a rise from 10 to 12 differs from a fall from 12 to 10. It divides each change by the average of the start and end values.
Worked example
A cinema raises its ticket price from 10 to 12 dollars and weekly tickets fall from 100 to 80.
- % change in quantity = (80 − 100) ÷ ((80 + 100) ÷ 2) = −20 ÷ 90 = −22.2%
- % change in price = (12 − 10) ÷ ((12 + 10) ÷ 2) = 2 ÷ 11 = 18.2%
- PED = 22.2 ÷ 18.2 ≈ 1.22, so demand is elastic.
What drives elasticity
Demand is more elastic when there are close substitutes, when the good is a luxury or a large share of income, and when buyers have more time to adjust. Demand for insulin or petrol in the short run is inelastic.
Elasticity and total revenue
Total revenue is price times quantity. If demand is elastic, a price rise lowers revenue, because quantity falls proportionally more. If demand is inelastic, a price rise raises revenue. In the cinema example, revenue goes from 10 × 100 = 1,000 to 12 × 80 = 960, a fall, matching PED above 1.
Other elasticities
- Income elasticity = % change in quantity ÷ % change in income. Positive for normal goods, above 1 for luxuries, negative for inferior goods.
- Cross-price elasticity = % change in quantity of A ÷ % change in price of B. Positive for substitutes, negative for complements.
- Price elasticity of supply = % change in quantity supplied ÷ % change in price. Supply is more elastic when producers can easily raise output, as with spare capacity or in the long run.
Remember: elasticity changes along a straight-line demand curve even though the slope is constant.