What Elasticity Is
Price elasticity of demand measures how much the quantity demanded of a good changes when its price changes. It answers a simple question: if I raise the price by 10%, does my customer buy 5% less, or 50% less?
The formula is:
Elasticity = (% change in quantity demanded) / (% change in price)
The result is always negative (higher price → lower quantity), but economists typically refer to the absolute value.
Elastic vs. Inelastic
Elastic demand (elasticity > 1) - quantity changes more than price. A 10% price increase leads to a 20% drop in sales. These are goods with close substitutes or that are luxuries. Examples: a particular brand of cereal, airline tickets for holidays, restaurant meals.
Inelastic demand (elasticity < 1) - quantity changes less than price. A 10% price increase leads to only a 2% drop in sales. These are necessities with few substitutes. Examples: insulin, gas, electricity, basic food staples.
Unit elastic (elasticity = 1) - quantity changes by exactly the same percentage as price. Total revenue stays the same.
What Determines Elasticity
Four main factors:
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Availability of substitutes - more substitutes = more elastic. If your coffee shop raises prices by 20%, customers go to the one next door. If there is no next door, they pay.
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Necessity vs. luxury - necessities are inelastic (you need gas to get to work). Luxuries are elastic (you can skip the holiday).
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Share of budget - goods that take a small share of your budget are more inelastic (salt, matches). Goods that take a large share are more elastic (housing, cars).
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Time horizon - demand is more elastic in the long run than the short run. Gas is inelastic today (you still need to get to work), but over years, people buy more efficient cars, move closer to work, or take public transport.
Why It Matters
Elasticity is one of the most practically useful concepts in economics because it determines the answer to almost every policy question involving prices.
Tax incidence - who actually pays a tax? When demand is inelastic (gas, cigarettes), the consumer bears most of the tax. The seller can pass the cost on without losing many customers. When demand is elastic (luxury goods), the seller bears most of the tax. Raising the price would cause too many customers to walk away.
Price controls - a price ceiling on rent does less harm when housing demand is elastic, and more harm when it is inelastic (because tenants cannot easily move, so the shortage is acute).
Business pricing - if demand is inelastic, you can raise prices and increase revenue. If it is elastic, raising prices reduces revenue.
Minimum wage - the employment effect of a minimum wage depends on the elasticity of demand for low-skilled labor. Estimates vary, but the central finding of most research is that demand is moderately elastic - significant job losses for large increases.
Elasticity vs. the Slope of the Demand Curve
A common confusion: a steep demand curve does not mean inelastic demand, because elasticity depends on the starting point as well as the slope. Near the top of a straight-line demand curve, demand is elastic. Near the bottom, it is inelastic. Elasticity changes along the curve; slope does not.
The Extreme Cases
Perfectly inelastic (elasticity = 0) - quantity does not change at all when price changes. The demand curve is vertical. No real-world good is perfectly inelastic, but some come close (life-saving medicine at a specific dosage).
Perfectly elastic (elasticity = infinity) - any price increase causes quantity demanded to drop to zero. The demand curve is horizontal. This describes a firm in a perfectly competitive market selling an identical product to everyone else.
See also: Supply & Demand, Prices, Giffen Goods, Taxes - Who Actually Pays