Elasticity (economics)
Definition and Overview
Elasticity in economics is a measure of the responsiveness of one economic variable to a change in another. It gives economists an idea of how changes in quantity demanded or supplied respond to changes in price, income, or other economic factors. The concept of elasticity has its roots in the work of 19th-century economists, most notably Alfred Marshall, who first introduced the concept in his book "Principles of Economics".
Types of Elasticity
There are several types of elasticity in economics, each measuring the responsiveness of different economic variables to changes in others. These include price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity of demand.
Price Elasticity of Demand
Price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in its price, holding all other factors constant. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
Price Elasticity of Supply
Price elasticity of supply measures the responsiveness of the quantity supplied of a good to a change in its price, holding all other factors constant. It is calculated as the percentage change in quantity supplied divided by the percentage change in price.
Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in income, holding all other factors constant. It is calculated as the percentage change in quantity demanded divided by the percentage change in income.
Cross Elasticity of Demand
Cross elasticity of demand measures the responsiveness of the quantity demanded of one good to a change in the price of another good, holding all other factors constant. It is calculated as the percentage change in quantity demanded of the first good divided by the percentage change in price of the second good.
Determinants of Elasticity
Several factors determine the elasticity of a good or service. These include the availability of substitutes, the proportion of income spent on the good, the time period considered, and the degree of necessity or luxury of the good.
Availability of Substitutes
The more substitutes a good has, the more elastic its demand or supply is likely to be. This is because consumers can easily switch to other goods if the price of one good changes, and producers can easily switch to producing other goods if the cost of inputs changes.
Proportion of Income Spent on the Good
The larger the proportion of income spent on a good, the more elastic its demand is likely to be. This is because consumers are more sensitive to changes in the price of goods that take up a large portion of their income.
Time Period
The longer the time period considered, the more elastic demand or supply is likely to be. This is because consumers and producers have more time to adjust their behavior in response to price changes.
Degree of Necessity or Luxury
The more necessary a good is, the less elastic its demand is likely to be. Conversely, the more of a luxury a good is, the more elastic its demand is likely to be.
Applications of Elasticity
Elasticity has several applications in economics, including in the areas of taxation, international trade, and market structure.
Taxation
Understanding elasticity is crucial for policymakers when designing tax policies. For example, if demand for a good is inelastic, a tax increase will result in a relatively small decrease in quantity demanded, meaning that the government can raise revenue without significantly affecting consumption.
International Trade
Elasticity is also important in understanding international trade. For example, if a country's exports are inelastic, a depreciation of the country's currency will increase the value of exports more than it increases the quantity of exports, leading to an increase in export revenue.
Market Structure
In the context of market structure, firms in monopolistic competition and oligopoly use the concept of elasticity to set prices and output levels. For example, a firm with inelastic demand can increase its price without losing many customers, allowing it to increase its total revenue.
