A measure used to describe a variable’s reaction to a change in another variable.

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Last Updated:December 10, 2023

What is Elasticity?

Elasticity is a measure used to describe a variable's reaction to a change in another variable. In economics, this sensitivity is generally the change in demand or supply of a product relative to the change in the price of the good or a consumer's income.

The measure allows economists to determine how different variables affect each other. 

It can be especially useful for business owners. It is one of the most important concepts in business for maximizing a company's bottom line. 

It is even a concept that the government uses to set tax levels. Most things in the economy can be traced back to the workings of elasticity. 

It is divided into three categories of goods: elastic goods, unit elastic goods, and inelastic goods. 

When the price elasticity of demand (PED) is greater than 1.0, the demand (which can be used for supply too) of that good is highly responsive to the change of its determinant. 

This means that a change in the price of a variable will result in a highly responsive change in the demand. Goods that fall under this category are said to be elastic goods. 

If the value is equal to 1.0, then the demand of the variable changes proportionately to the change in its determinant. This is called a unit elastic good.

Inelastic goods have a value of less than 1.0. Therefore, these goods have low responsiveness to price changes, meaning that a high change in price will result in a low change in quantity demanded or supplied

A product is said to be perfectly inelastic if the value is equal to 0. 

Perfectly inelastic goods do not exist in the real world. Otherwise, these goods would see no change in quantity demanded or supplied after any price change.

Price Elasticity of Demand

The most commonly used method for calculating the Price Elasticity of Demand (PED) is the midpoint method. It corrects the inconsistencies of the other methods.

The midpoint method is the standard way to calculate PED in economics. The midpoint refers to the number halfway between the start and end values. This method averages the two values, so the initial (Q1) doesn't matter. 

Below is the Midpoint formula:

*PED = (Q2 - Q1) / [(Q2 +Q1) / 2] / (P2 - P1) / [(P2 +P1) / 2]

*Can be used for PES too

The result of using this formula is your price elasticity! But hold on now, as seen in the descriptions above, there are no negative numbers. This is because economists easily categorize your results' absolute value to categorize them. 

The lowest PED you can have when measuring is 0. 

Otherwise, all elasticities of demand would result in a negative number due to the downward-sloping nature of the demand curve.

Why is the elasticity of demand always negative?

Since price and quantity demanded always move in opposite ways, making the demand slope downward sloping, the PED always results in a negative number. On the other hand, economists always talk about PED as a positive number, so we take the absolute value of the result. 

Different Types of Elasticity

It can be classified as:

1. Price Elasticity of Demand (PED)

The PED refers to a change in quantity demanded of a good in response to a change in the price of that good. The formula above is used to calculate the PED of a good.  

Examples of elastic goods include: 

  • Sports Cars
  • Designer Clothing
  • Watches

Examples of inelastic goods include:

  • Prescription drugs
  • Gasoline 
  • Rice
  • Medical Surgery

2. Income Elasticity (YED)

It refers to how much the quantity demanded of good changes in response to a change in consumers' income. Goods are split up into normal and inferior goods.

Normal goods refer to products demanded more when consumers' incomes rise. Normal goods have a YED of greater than 0. An example of a normal good would be cars. 

Inferior goods are products that customers demand less when their incomes rise.

Public transportation is an inferior good because as a person's income level rises, they are more likely to invest in a car for personal transportation. 

3. Cross Elasticity 

It measures the responsiveness in quality demand to the price change of another good. This is calculated by dividing the percentage change in quantity demanded of one good by the percentage change in the price of another good. 

This formula can be used to determine if goods are substitutes or complements. 

Substitutes are products or services similar to another good in the customer's eyes. 

If goods are substitutes, a price increase of one product will cause the quantity demanded of the other good to rise, according to the law of demand. However, substitute goods have an inverse relationship. Once the price rises of one good, consumers will look for a cheaper option to replace it.

Complementary goods are different than substitutes. Complementary goods are products or services that are generally used together. An example would be a hotdog and hotdog buns. Usually, when consumers purchase hotdogs, they also buy hotdog buns because they go together.

These goods have a positive correlation, so a price increase in one product will lead to a demand increase in the other. 

4. Price Elasticity of Supply (PES)

It demonstrates the relationship between a good or service's price and the quantity supplied

Products usually follow the law of supply, meaning that as the price of a product increases, so does the supply. The PES measures how much a firm is willing to supply based on the price increase. 

The greater the PES, the more easily firms can change the quantity they produce. 

PES is greater in the long run than in the short run. This is because, in the long run, firms can build new infrastructure, or new firms can enter the market. 

Factors That Affect the Price Elasticity of Demand

Various factors affecting demand elasticity are:

1. Substitutes

Products with close substitutes generally have a higher sensitivity to price change than those without close substitutes. 

Substitutes allow buyers to get a similar product to the one they are willing to buy. If there is a price increase in one product, buyers will switch to the other product if there are close substitutes.

Products without close substitutes tend to be more inelastic. This is because buyers have fewer choices, so they are forced to pay the price increase if they want a product with the capabilities they're looking for. 

An example is a food:

If McDonald's increases the price of their hamburger by 50%, then a majority of customers would go to competing fast-food brands to avoid having to pay the price increase.

This is because they are substitutes for each other so that customers would get similar products. This is an example of an elastic product. 

On the other hand, if the price of eggs went up by 50%, buyers would be forced to pay the price increase. Eggs do not have close substitutes because there is nothing similar to it. This is an example of an inelastic product.  

2. Necessary vs. Luxury Goods

Goods can usually be categorized as either necessities or luxuries.

Necessary goods are products or services that are essential to your life. You can't live without them. 

Luxury goods are products or services you may want but do not need. These goods tend to be more elastic than necessary goods. 

For example, insulin is a necessary good. People with diabetes need it to survive. Therefore, as the price increases, most people will continue to buy insulin because it is a basic need. 

A Lamborghini would be considered a luxury good. If the price of the Lamborghini increases, many people will buy other alternatives or save money for something else. 

Since the demand decreases dramatically as the price increases, Lamborghinis represent how luxury goods are usually inelastic.

3. Time

People tend to be less sensitive to price in a short time frame. People may have fewer available options or a pressing need for the product.

Over a longer time frame, people tend to be more sensitive to price. More substitutes exist, and people may no longer need the product.

An example is an umbrella. 

If it is about to rain in two minutes, then people will have a pressing need to buy an umbrella. However, business owners may be able to jack up the price and sell most of the umbrellas due to customers' limited options.

A week after the rainfall, people have less need for an umbrella. There is no longer a pressing matter to get one, and people won't buy one if the price is too high. 

4. Income

A product that takes up a lower % of a person's income will be more inelastic. Even if the price rises, consumers can still justify purchasing because the prices aren't too high. 

If the product takes up a higher % of a person's income, they will be more sensitive to price changes.

With a higher percentage, consumers cannot justify purchasing the item with a price increase. They may not even be able to afford the increase.

Potato chips would be an example of the former. If the chips go from $1 to $1.50, they are still pretty cheap relative to most consumers' incomes. 

Cars would be an example of the latter. Most cars are already in the five-figure range; raising the price more would result in some people not having the ability to purchase them. Moreover, even if people can afford the increase, buying the car may take away from purchasing other things they desire.

use of elasticity in business

It is a very important concept that business owners use when looking to set prices and influences many business decisions.

All business owners face the tough challenge of setting the price for their goods or services. For most people, maximizing their bottom line is the main goal of finding the right price. 

When raising prices, two scenarios can happen (except in the extreme cases where good is perfectly elastic or perfectly inelastic):

You raise the price too high, and the increase in the price level does not make up for the loss of demand. This scenario is called a quantity effect and results in total revenue loss.

On the other hand, if you raise the price, the price increase may dominate the loss of demand. This is because the total revenue would increase in this case. This example is called a price effect. 

Business owners must determine if their product or service has inelastic or elastic demand.

If the demand for a good is elastic, a price increase reduces total revenue. In this case, the quantity effect is stronger than the price effect.

If the demand for a good is inelastic, a higher price increases total revenue. In this case, the price effect is stronger than the quantity effect. 

Elasticity Examples

Let's take a few examples to understand the concept better.

Example 1

Say Holiday Inn is increasing the price of a single bedroom from $100 to $150 in the city of Boston. 

There are multiple hotels in the same area, and the average price of their rooms for a single bedroom is $115. There are also tons of options on Airbnb, with an average price of a single bedroom at $125. 

The lodging industry is extremely competitive in Boston. 

Due to the many different options and the fact that local customers don't feel like Holiday Inn is a clear better option, their demand increases drastically for alternative options.

What kind of PED would we say Holiday Inn has, and is the price increase going to benefit Airbnb in the long run?

Answer: Since there are many substitutes for Holiday Inn and the demand went significantly down after a price increase, the demand is inelastic. This means that the quantity effect dominates the price effect, resulting in a decrease in total revenue.

Example 2

Apple just released the new version of the Apple Airpods!

They increased the price from $150 to $175.

The last version sold a total of 10.4 million units. They have projected that this new version is going to sell about 9.7 million units. 

Using the midpoint formula, is the demand for the new Apple Airpods elastic or inelastic? 


(175 - 150) / 162.5 = .1538

(9.7-10.4) / 10.05 = -.0697

| -.0697/.1538 | = 0.4527

This means that in this example, Apple AirPods have an inelastic demand. 

Edited by Colt DiGiovanni | LinkedIn

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