In economics, elasticity is the measurement of how responsive an economic variable is to a change in another. For example:
- "If I lower the price of my product, how much more will I sell?"
- "If I raise the price of one good, how will that affect sales of this other good?"
- "If we learn that a resource is becoming scarce, will people scramble to acquire it?"
An elastic variable (or elasticity value greater than 1) is one which responds more than proportionally to changes in other variables. In contrast, an inelastic variable (or elasticity value less than 1) is one which changes less than proportionally in response to changes in other variables.
Elasticity can be quantified as the ratio of the percentage change in one variable to the percentage change in another variable, when the latter variable has a causal influence on the former. A more precise definition is given in terms of differential calculus. It is a tool for measuring the responsiveness of one variable to changes in another, causative variable. Elasticity has the advantage of being a unitless ratio, independent of the type of quantities being varied. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between factors of production and elasticity of intertemporal substitution.
Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation, marginal concepts as they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus.
In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis.
Elasticities of supply
- Price elasticity of supply
- The price elasticity of supply measures how the amount of a good that a supplier wishes to supply changes in response to a change in price. In a manner analogous to the price elasticity of demand, it captures the extent of movement along the supply curve. If the price elasticity of supply is zero the supply of a good supplied is "inelastic" and the quantity supplied is fixed.
- Elasticities of scale
- Elasticity of scale or output elasticities measure the percentage change in output induced by a percent change in inputs. A production function or process is said to exhibit constant returns to scale if a percentage change in inputs results in an equal percentage in outputs (an elasticity equal to 1). It exhibits increasing returns to scale if a percentage change in inputs results in greater percentage change in output (an elasticity greater than 1). The definition of decreasing returns to scale is analogous.
Elasticities of demand
- Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income).
The concept of elasticity has an extraordinarily wide range of applications in economics. In particular, an understanding of elasticity is fundamental in understanding the response of supply and demand in a market.
Some common uses of elasticity include:
- Effect of changing price on firm revenue. See Markup rule.
- Analysis of incidence of the tax burden and other government policies. See Tax incidence.
- Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firms investment decisions. See Income elasticity of demand.
- Effect of international trade and terms of trade effects. See Marshall–Lerner condition and Singer–Prebisch thesis.
- Analysis of consumption and saving behavior. See Permanent income hypothesis.
- Analysis of advertising on consumer demand for particular goods. See Advertising elasticity of demand
In some cases the discrete (non-infinitesimal) arc elasticity is used instead. In other cases, such as modified duration in bond trading, a percentage change in output is divided by a unit (not percentage) change in input, yielding a semi-elasticity instead.
- Hendrik S. Houthakker, Lester D. Taylor (1970).
- Perloff, J. (2008). p.36.
- Varian (1992). pp.16–17.
- Samuelson, W. & Marks, S. (2003). p.233.
- Economics Basics: Elasticity from Investopedia.com. Accessed February 29, 2008.
- Revenue and Elasticity and Elasticity, Total Revenue, and the Linear Demand Curve by Fiona Maclachlan, Wolfram Demonstrations Project.