Elasticity of demand
Also known as: price elasticity of demand, demand elasticity
Elasticity of demand measures how much the quantity demanded of a good changes when its price changes. Demand is elastic when buyers cut back sharply in response to a price increase, and inelastic when they keep buying roughly the same amount.
Elasticity of demand is a sensitivity measure. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a 10% price increase causes a 20% drop in units sold, the elasticity is 2 — demand is elastic. If the same 10% increase causes only a 4% drop, elasticity is 0.4 and demand is inelastic. An elasticity of exactly 1 is called unit elastic.
What makes a good elastic is usually the availability of substitutes and whether the purchase is a want rather than a need. Restaurant meals, brand-name soft drinks, airline seats for leisure travel, and designer clothing are classic elastic goods: buyers can easily switch or simply go without. Goods treated as necessities tend to be inelastic — gasoline, electricity, table salt, insulin, and cigarettes hold their sales volume even when prices rise, because there is no close substitute and the purchase cannot easily be postponed.
Elasticity drives pricing strategy because it determines what happens to total revenue. When demand is elastic, raising the price reduces total revenue, since the volume lost outweighs the higher price per unit; cutting the price increases revenue. When demand is inelastic, the reverse holds — a price increase raises revenue. Time also matters: demand is usually more elastic over the long run, because buyers eventually find alternatives.
Elasticity appears throughout business and economics exams. The CIMA Certificate in Business Accounting tests price elasticity of demand directly, including the revenue implications and the factors that shift a demand curve, and introductory microeconomics courses use the same concepts when analyzing markets and consumer behavior.
Key takeaways
- Elasticity of demand equals the percentage change in quantity demanded divided by the percentage change in price.
- Elasticity greater than 1 is elastic; less than 1 is inelastic; exactly 1 is unit elastic.
- Goods with many substitutes or that are considered wants tend to be elastic; necessities tend to be inelastic.
- Raising the price of an elastic good lowers total revenue, while raising the price of an inelastic good raises it.
- Demand generally becomes more elastic over longer time horizons as substitutes emerge.