Elasticity of Demand - Explained
What is Elasticity of Demand?
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Table of ContentsWhat is Elasticity of Demand?How does Demand Elasticity Work?Types of Demand ElasticityInterpretation and an Example of Demand ElasticityAcademic Research for Elasticity of Demand
What is Elasticity of Demand?
Elasticity of demand is an economic term which denotes the rate of change of demand for goods and services due to change in prices and other economic variables (price, income, tax and consumer taste etc.). Elasticity of demand is measured by dividing percentage change in quantity demanded by percentage changed in economic variables. If elasticity of demand is higher for goods and services, then it will mean consumers are more sensitive of economic variables and likely to respond more to changes in economic variables.
How does Demand Elasticity Work?
Elasticity of demand measures how fluctuation in economic factors can cause change quantity for goods and services. Firms like to know how the changes in economic factors such as income, price of other goods, taxes, and taste can bring variation in quantity demanded. Elasticity of demand enables firm to make rational choices and to forecast future sales. For example, high elasticity of demand means a firm should be very cautious in changing price of goods and services. Consumers will be affected to a greater extent and may choose competitor or substitute goods.
Types of Demand Elasticity
Demand elasticity has many types. One of the most important types of demand elasticity is price elasticity. Price elasticity shows how consumers react to change in price of certain goods and services. Consumers often react to any change in economic variables. However, in some cases consumers respond to changes significantly. If demand for goods and services is inelastic then any change in price will have no or little effect on quantity demanded. Firms can do market research on how consumers respond to price changes and then set prices accordingly. Another type is cross elasticity, which measures how demand for a certain goods and services change is relation to changes in price of other goods and services.
Interpretation and an Example of Demand Elasticity
Demand elasticity is measured in absolute values. If the demand elasticity is greater than 1 then it means consumers are more responsive to changes and slight changes in price (or other economic variables) can change demand. If elasticity is less than 1, it means demand is inelastic and change in economic variables does not bring significant change in quantity demanded. If elasticity of demand is equal to 1, then demand is unit elastic and quantity demand change in proportion to change in economic variables. Let's assume that company XYZ decreases the price of a soda bottle from $3 to $2, the demand increases from 100 to 120. Demand elasticity can be measured as percentage changes in quantity demanded (120-100/100= 20%) divided by percent of change in price ($3 - $2 / $2 = 20%). Thus the elasticity of demand measurement is .4. The demand is inelastic here, so the change in price has slight effects on demand.