In Economics, elasticity is the ratio of the percent change in one variable to the percentage change in another variable.
The most frequently used elasticities in economics include:
- Price Elasticity of Demand
- Price Elasticity of Supply
- Income Elasticity of Demand
- Cross Price Elasticity
Price Elasticity of Demand(PED)
Price Elasticity of demand is the responsiveness of the quantity demanded of a particular product to a change in its price.
In simple words, PED measures how far the quantity demanded of a product changes when the price of it goes up or down.
Price elasticity is calculated by the formula
PED = % change in demand of good X / % change in price of good X
If PED is greater than 1, then the good is price elastic. Suppliers and shop owners can increase revenue by reducing the price as long as the good is price elastic.
If PED is less than 1, then the good is price inelastic. Suppliers and shop owners can increase revenue by incrasing the price as long as the good is price inelastic.
Factors that determine the value of price elasticity of demand
1. Number of close substitutes within the market – If more substitutes are available, an increase in price of one item will make people switch to the other substitute goods. Therefore the quantity demanded will easily change therefore is termed as ‘elastic’. If substitutes are not available, people have no choice but to buy the item even if the price increases.
2. Luxuries and necessities – Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for motor cycles is more elastic than the demand for wheat flour.
3. Percentage of income spent on a good – It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.
4. Habit forming goods – Goods such as cigarettes and drugs tend to be inelastic in demand. Once a person is addicted to drugs, he will buy it even if the price increases so much, unless he gets rehabilitated.
5. Short run or long run – Demand tends to be more elastic in the long run rather than in the short run. This is because suppliers are usually able to introduce substitutes in the long run.
Price Elasticity of Supply(PED)
Price elasticity of supply is the responsiveness of the quantity supplied of a good to a change in its price.
Suppliers would want to increase the supply of a particular good if the price goes up. The more they are able to do so, the higher is the elasticity. Price elasticity of supply is affected by:
1. Whether suppliers have access capacity to accommodate a sudden need to increase production.
2. Some factors of production can be substituted for one another. Production can be done using labour intensive methods and capital intensive methods as well. The firms may not be able to invest in capital in the short run, but they can increase production by hiring more labour.
3. If the firms have a good stock ready for supply, they can put them in the market if the price increases, so that supply is elastic.
4. In the long run supply tends to be elastic since the firms can invest in capital and grow in size in the long run.
Next Topic: Inflation