The subject of economics has several concepts that need our attention. These concepts explain different phenomena. Elasticity is one such concept in economics. It talks about the sensitivity of one variable due to a change in other variables. In business and economics, elasticity refers to the degree of change, to which individuals, customers, producers, and suppliers alter demand and supply when variables like income is changed.
There are different types of elasticity. Each of these explains the effect of changes on a specific variable. When we discuss the subject of economics, two of the most talked-about terms are- demand and supply. So, elasticity also covers these two terms. Elasticity of demand and elasticity of supply are the two main types of elasticity. However, they are further classified into sub-categories.
In this blog, we will be mainly discussing elasticity and its different types. We will also look at the way elasticity works. Later in the blog, we will discuss the factors affecting the elasticity of demand.
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What is Elasticity?
As Investopedia explains,
“Elasticity is a measure of a variable's sensitivity to a change in another variable, most commonly this sensitivity is the change in price relative to changes in other factors. In business and economics, elasticity refers to the degree to which individuals, consumers, or producers change their demand or the amount supplied in response to price or income changes. It is predominantly used to assess the change in consumer demand as a result of a change in a good or service's price.”
Elasticity is also defined in economics as the measurement of percentage change of one economics value in response to change in the other. Elasticity is a central concept in economics and has many applications. Basic demand and supply models explain that different variables like price, demand, income are generally related. So, what elasticity does is that it can provide crucial information about the strength and weakness of such relationships.
Based on the value of elasticity variables are categorized as elastic or inelastic. An elastic variable (with an absolute elasticity value greater than 1) is one that responds more than proportionally to changes in other variables. In contrast, an inelastic variable (with an absolute elasticity value less than 1) is one which changes less than proportionally in response to changes in other variables. To better understand the working we should move to the next section of the blog.
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How Elasticity works?
When the value of elasticity is greater than 1.0, it means that the demand for that good or service is affected by the price. On the other hand, when the value of elasticity is less than 1.0, the demand for goods/services remains unaffected by the change in price. We also call it inelastic. Inelastic means that the buying habit of consumers remains more or less the same, irrespective of the change in prices.
There is one more situation that is just theoretical i.e. ‘perfectly inelastic’. This happens when the value of elasticity is zero. This would mean that the demand for the perfectly inelastic good will remain the same even if the prices are changed drastically. The explanation itself might have cleared that there are no real-world examples of perfectly inelastic goods. Even if there was a good, it might have been the costliest as the producers and suppliers would be free to charge anything considering the demand.
Elasticity is a financial idea used to gauge the adjustment in the total amount demanded for a good or service according to value developments of that good or service. An item is viewed as elastic if the amount of interest in the item changes radically when its cost increments or diminishes. On the other hand, an item is viewed as inelastic if the amount of interest of the item changes almost no when its cost vacillates.
Taking the examples of both kinds of goods. An example of a highly inelastic good is insulin. The consumers of insulin are diabetic patients who won’t deny buying if there is an increase in the prices. On the other hand are highly elastic products. There can be various examples of goods that fall in this category. For example, the demand for refrigerators go high during festive seasons as the prices are slashed and people wait for it.
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4 Types of Elasticity
As mentioned above in the blog, there are mainly two types of elasticity- Elasticity of Demand and Elasticity of Supply. Elasticity of demand is an economic measure of the sensitivity of demand relative to a change in another variable. The demand for a good or service depends on multiple factors such as price, income, and preference. Whenever there is a change in any of these variables it causes a change in the quantity demanded of the good or service.
Four types of elasticity
1. Price Elasticity of Demand (PED)
Price Elasticity of Demand or PED measures the responsiveness of quantity demanded to a change in price. There are two ways to measure PED- arc elasticity that measures over a price range, and point elasticity that measures at one point.
2. Cross Elasticity of Demand (XED)
Cross Elasticity of Demand (XED) is an economic concept that measures the responsiveness in the quantity demanded of one good when the price of other goods changes. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good.
3. Income Elasticity of Demand (YED)
Income Elasticity of Demand measures the responsiveness in the quantity demanded for a good or service when the real income of the consumers is changed, keeping all the other variables constant. The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income. This concept helps us to find whether a good is a necessity or luxury.
4. Price Elasticity of Supply (PES)
Price Elasticity of supply (PES) measures the responsiveness to the supply of a good or service after a change in its market price. Some basic economic theories explain that when there is a fall in the price of a good its supply is also decreased and when the prices are on a rise the supply is increased.
So, these were the four different types of elasticity that measure responsiveness of two main economic variables, demand and supply, when other market variables are changed.
Factors affecting Demand Elasticity
Three main factors affect a good’s price elasticity of demand.
1. Availability of substitutes
In general, we can say that the more good substitutes are there, the more elastic demand will be. This can be understood by an example. Suppose a coffee seller company increases the price for its cup of coffee by $1. The consumers are likely to switch to another company or they may even replace their cup of coffee with a cup of strong tea. This means that the cup of coffee is an elastic good as a small increase in the price is resulting in a large decrease in the demand.
Another example could be of caffeine. Let us say that the price of caffeine goes up. But this time the consumers will not switch to another beverage or drink as there are very few good substitutes for caffeine. So, most people may not willingly give up their cup of caffeine. This means that caffeine is an inelastic product.
These two examples also tell us that there may be an elastic product within an industry while the industry is inelastic.
This is not a mystery at all. We all need a few things for survival and we can not give up on them. These products that we require for survival are termed as necessity products. For example, rice grains. A large part of the Indian population is a daily consumer of rice grains. So, even if the prices go higher the consumption won’t decrease drastically and the demand will almost remain the same. This makes the good inelastic.
The third influential factor is time. We consume some goods as we are addicted to them. Two of the most popular examples are alcohol and tobacco. We will understand the role of time with an example. Suppose the government increases the taxes on tobacco which leads to an increase in the prices. So, a person addicted to smoking won’t stop buying cigarettes. This makes the product inelastic. However, if the prices go on increasing and the person now can not afford to spend extra on those cigarettes, he or she may get rid of the habit. This makes the price elasticity of cigarettes for that consumer elastic in the long run.
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The importance of Price Elasticity in Business
Elasticity is a concept of economics that affects businesses. So, they need to understand whether their goods or services are elastic or inelastic. This helps them form business strategies and also in the marketing of those goods or services.
Companies selling high elasticity goods compete with other businesses on price and they are required to have a high volume of sales transactions to remain solvent.
On the other hand, firms that sell inelastic goods that are must-have enjoy the luxury of setting higher prices without worrying about the decrease in demand and sales.
Besides affecting prices, the elasticity of goods also affects the customer retention rates of a company. Every business strives to sell goods or services that have inelastic demands; doing so will ultimately increase the customer retention rate. The customer will remain loyal to the business and will continue to buy the goods/services even in the case of a price surge.
In this blog, we tried to explain to you another concept of economics i.e. elasticity. By now, it may be clear what it means. In simpler terms, elasticity is a measurement of change in a market variable in response to change in other market variables. We also explained how elasticity works. Based on the values of elasticity we categorize goods or services as elastic or inelastic. Elastic are those that are highly affected by changes in the variables while inelastic goods are those that have negligible effects of changes in the market variables. The four different types of elasticity explain the effect of variables on demand and supply.
Elasticity is a great concept to understand the dynamics of the market. It plays a significant role in the success of businesses.