Definition of 'Demand Elasticity'

In economics, the demand elasticity refers to how sensitive the demand for
a good is to changes in other economic variables. Demand elasticity is
important because it helps firms model the potential change in demand due
to changes in price of the good, the effect of changes in prices of other
goods and many other important market factors. A firm grasp of demand
elasticity helps to guide firms toward more optimal competitive behavior.
Elasticities greater than one are called "elastic," elasticities less than one are
"inelastic," and elasticities equal to one are "unit elastic."

Investopedia explains 'Demand Elasticity'

Demand elasticity is a measure of how much the quantity demanded will
change if another factor changes. One example is the price elasticity of
demand; this measures how the quantity demanded changes with price. This
is important for setting prices so as to maximize profit.

When price elasticity of demand is elastic, the firm should lower prices, since
it will result in a big uptick in demand, increasing your total revenue. When
price elasticity of demand is inelastic, you should increase prices because
there will be only a small decrease in demand, and again, total revenue will
increase. When price elasticity of demand is unit elastic, changing the price
will not change total revenue, since price and quantity will generally change
in lock step with each other.
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Price elasticity of demand (PED)

Price elasticity of demand (PED) shows the relationship between price and quantity demanded
and provides a precise calculation of the effect of a change in price on quantity demanded. The
following equation enables PED to be calculated.

We can use this equation to calculate the effect of price changes on quantity demanded, and
on the revenue received by firms before and after any price change.
For example, if the price of a daily newspaper increases from 1.00 to 1.20p, and the daily
sales falls from 500,000 to 250,000, the PED will be:
- 50% + 20%
= (-) 2.5
The negative sign indicates that P and Q are inversely related, which we would expect for most
price/demand relationships. This is significant because the newspaper supplier can calculate or
estimate how revenue will be affected by the change in price. In this case, revenue at 1.00 is
500,000 (1 x 500,000) but falls to 300,000 after the price rise (1.20 x 250,000).
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The range of responses
The degree of response of quantity demanded to a change in price can vary considerably. The
key benchmark for measuring elasticity is whether the co-efficient is greater or less than
proportionate. If quantity demanded changes proportionately, then the value of PED is 1, which
is called unit elasticity.
PED can also be:
Less than one, which means PED is inelastic.
Greater than one, which is elastic .
Zero (0), which is perfectly inelastic.
Infinite (), which is perfectly elastic.
PED along a linear demand curve
PED on a linear demand curve will fall continuously as the curve slopes downwards, moving
from left to right. PED = 1 at the midpoint of a linear demand curve.

PED and revenue
There is a precise mathematical connection between PED and a firms revenue.
There are three types of revenue:
1. Total revenue (TR), which is found by multiplying price by quantity sold (P x Q).
2. Average revenue (AR), which is found by dividing total revenue by quantity sold
(TR/Q). Consider theses figures and calculate Total, Marginal and Average Revenue.
3. Marginal revenue (MR), which is defined as the revenue from selling one extra
unit. This is calculated by finding the change in TR from selling one more unit.
PRICE
()
QUANTITY
DEMANDED
TOTAL
REVENUE
MARGINAL
REVENUE
AVERAGE
REVENUE
10 1
9 2
8 3
7 4
6 5
5 6
4 7
3 8
2 9
1 10

Answer
Study the patterns of numbers and see if you can analyse the relationships between the three
measures of revenue then answer the following:
1. How are price and average revenue connected?
2. What happens to total revenue as output increases?
3. What is the connection between total revenue and marginal revenue?
4. How are marginal revenue and average revenue connected?
Observations and comments:
When TR is at a maximum, MR = zero, and PED = 1.

1. Price and AR are identical, because AR = TR/Q, which is P x Q/Q, and cancel out
the Qs to get P.
2. A curve plotting AR (=P) against Q is also a firms demand curve.
3. TR increases, reaches a peak and decreases.
4. When TR is at a maximum, MR is zero.
5. MR falls at twice the rate of AR.
Why does a firm want to know PED?
There are several reasons why firms gather information about the PED of its products. A firm
will know much more about its internal operations and product costs than it will about its
external environment. Therefore, gathering data on how consumers respond to changes in
price can help reduce risk and uncertainly. More specifically, knowledge of PED can help the
firm forecast its sales and set its price.
Sales forecasting
The firm can forecast the impact of a change in price on its sales volume, and sales revenue
(total revenue, TR). For example, if PED for a product is (-) 2, a 10% reduction in price (say, from
10 to 9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will
rise from 10,000 to 10,800.
Pricing policy
Knowing PED helps the firm decide whether to raise or lower price, or whether to price
discriminate. Price discrimination is a policy of charging consumers different prices for the same
product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic,
revenue is gained by raising price.
Non-pricing policy
When PED is highly elastic, the firm can use advertising and other promotional techniques to
reduce elasticity.
Determinants of PED
There are several reasons why consumers may respond elastically or inelastically to a price
change, including:
The number and closeness of substitutes
A unique and desirable product is likely to exhibit an inelastic demand with respect to price.
The degree of necessity of the good
A necessity like bread will be demanded inelastically with respect to price.
Whether the good is habit forming
Consumers are also relatively insensitive to changes in the price of habitually demanded
products.
The proportion of consumer income which is spent on the good
The PED for a daily newspaper is likely to be much lower than that for a new car!
Whether consumers are loyal to the brand
Brand loyalty reduces sensitivity to price changes and reduces PED.
Life cycle of product
PED will vary according to where the product is in its life cycle. When new products are
launched, there are often very few competitors and PED is relatively inelastic. As other firms
launch similar products, the wider choice increases PED. Finally, as a product begins to decline
in its lifecycle, consumers can become very responsive to price, hence discounting is extremely
common.
The effects of advertising
Firms may use persuasive advertising by to win new customers and retain the loyalty of existing
ones.
Advertisers use a range of media, including television, press, and electronic media. Advertising
will shift demand to the right, and make demand less elastic.

There are three extreme cases of PED.
1. Perfectly elastic, where only one price can be charged.
2. Perfectly inelastic, where only one quantity will be purchased.
3. Unit elasticity, where all the possible price and quantity combinations are of the
same value. The resultant curve is called a rectangular hyperbola.


Elasticity (economics)
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 inelasticvariable (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
substitutionbetween 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 regressionequation
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.
A major study of the price elasticity of supply and the price elasticity of demandfor US
products was undertaken by Hendrik S. Houthakker and Lester D. Taylor.
[1]

Specific elasticities[edit]
Elasticities of supply[edit]
Price elasticity of supply
Main article: 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.
[2]
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
Main article: Returns to scale
Elasticity of scale or output elasticities measure the percentage change in output
induced by a percent change in inputs.
[3]
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 ofdecreasing
returns to scale is analogous.
[4]

Elasticities of demand[edit]
Price elasticity of demand
Main article: 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).
Applications[edit]
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 MarshallLerner
condition and SingerPrebisch 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


Elasticity of Demand and Supply

In spite of the cost of living, it's still popular.
...author Laurence Peter

We know that when the price drops the quantity demanded will rise and the quantity
supplied will fall. In many cases, the directions of these changes are all that matter. However, in
other cases, the magnitude of the change matters as well. Will a change in price have a large
impact or only a small impact on consumer and producer behavior?
Economists use the concept of elasticity to measure the changes. The price elasticity of
demand is measured as the percentage change in quantity demanded divided by the percentage
change in price, and the price elasticity of supply is measured as the percentage change in
quantity supplied divided by the percentage change in price. For example, if a 10 percent
increase in price causes consumers to cut their willingness to buy by 12 percent and producers to
increase their quantity supplied by 6 percent, then the elasticity of demand = 12/10 = 1.2 [Purists
will note that the elasticity is actually negative 1.2, but we will worry only about the absolute
value] and the elasticity of supply = 6/10 = 0.6. If the elasticity numbers exceed one, we say that
demand and/or supply is elastic. If the numbers are less than one, we say that demand or supply
is inelastic. If elasticity equals one, we say that demand or supply is unit elastic. In this example,
demand is elastic and supply is inelastic.
The essential idea is that elasticity measures how sensitive we are to changes in price. If
prices matter very little, changes in price only will have small impacts on our willingness to buy
or sell. Because the percentage change in quantities demanded and supplied will be small, the
elasticity calculation will also be small and we will get inelastic results. On the other hand, if we
are very sensitive to prices, even small changes in prices will cause large changes in our
willingness to buy or sell. The large changes in quantity will give us large elasticities. Think of
stretching. We think of something that is elastic as something that stretches easily. It's the same
with elasticity here. For example, if our willingness to buy a product stretches a lot when the
price changes, its demand is very elastic. If our willingness to buy does not change or strectch
much when price changes, its demand is inelastic.
Determinants of elasticity
While both demand and supply elasticities matter, most analysis focuses on the demand
side. What determines elasticity? The primary factor is the availability of close substitutes. For
example, suppose a Sunoco station raises the price of its gasoline by 10 percent. Most
consumers treat rival brands as almost perfect substitutes and will quickly switch to other
suppliers. Sunoco is likely to lose far more than 10 percent of its volume. There will be a big
stretch in our willingness to buy; an elastic response. But, suppose that the Sunoco station is the
only one in town; suppose that no other brands are available. In this case, consumers are stuck.
Without an alternative, they will continue to patronize the Sunoco station despite the higher
price. Consumers might cut back on unnecessary driving to save money, but the drop in quantity
demanded is likely to be quite small -- an inelastic response.
How much of our income we spend on an item can be a second factor that impacts
elasticity. For example, I never comparison shop for shoe laces. The price does not concern me.
I spend so little on laces that even a doubling of their price would have no noticeable impact on
my annual budget. Shopping for a better deal would cost me more than it realistically could be
worth. However, while saving five cents on a pair of laces is insignificant to me, it's not to Nike
or New Balance or Adidas. For a firm that is selling millions of pairs of shoes per year, five
cents per lace really matters. It may not pay an individual to shop around for a better deal on
laces, but it certainly will pay Nike to do so. All else equal, the more we spend on item, the
more elastic our demand will be.
Time is a third factor that affects elasticity. Given more time we can make more
substitutions. Suppose the price of gasoline rises. In the short run consumers will continue to
feed their voracious SUV's. But, when they next shop for a new car, many will shift to more
fuel-efficient options. The more time we have to shift our purchasing patterns, the more elastic
our demands will be.
In terms of the graphs, larger demand elasticities translate into flatter or more horizontal
demand curves. Smaller elasticities translate into more vertical curves. Work through an
example. Imagine that a small 10 percent increase in the price of Sunoco gasoline causes a large
50 percent drop in the quantity demanded. On a graph, the price increase (measured vertically)
would be small, but the quantity decrease (measured horizontally) would be huge. The curve
would be very flat. On the other hand, suppose that the Sunoco station was the only one within
500 miles and that even a large 50 percent increase in price caused only a small 10 percent drop
in the willingness of consumers to buy. This time the vertical or price change would be huge and
the horizontal or quantity change small. In this instnace the demand curve would be very steep.
Elasticity and total revenue
Extend the Sunoco example above. If the Sunoco station does raise price, what will
happen to its total revenue? Total revenue (TR) is simply price multiplied by quantity [TR =
PQ]. In our example, price rises by 10 percent. What happens to TR will depend upon whether
demand turns out to be elastic or inelastic. If demand is elastic and more than 10 percent of the
stations customers jump ship, the Sunoco station will find TR dropping. Its 10 percent increase
in price will be more than offset by the larger drop in quantity. However, if demand is inelastic
and the station can maintain most of its customers at the higher price, its TR will rise. The effect
of the higher price will more than offset the small drop in volume.
Do you see the relationship? If demand is elastic, the percent change in quantity will
exceed the percent change in price and TR will move in the same direction as quantity. But if
demand is inelastic, the percent change in quantity will be smaller than the percent change in
price and TR will move in the same direction as price.
Understanding elasticity is far more than an intellectual exercise; it makes or breaks
commercial ventures. For example, the blockbuster musicals Avenue Q and Rent both closed on
Broadway when they no longer could attract enough patrons to fill the theatres and cover their
costs. Subsequently both shows moved to smaller Off Broadway venues and, instead of charging
the $120 typically paid for seats at Broadway hits, slashed prices to $80. The lower prices
attracted droves of new and repeat customers and both shows thrived in their new environments.