Markets and Business
Elasticity: Stretchy Prices, Spending, and Supply
What It Is and How It Works
When we think of the word "elastic," we may consider stretchy material or an adjustable waistband. But why would economists use the same term? In economics, elasticity is used to explain how one thing reacts to another. More precisely, it calculates how responsive a variable is when something else changes.
Just as a person might choose to go out or not, depending on the weather, or how many hours to study, depending on how important an exam is, economic choices also react to changes. Individuals may purchase less of a good if its price goes up, or more if their income does. It is this responsiveness that elasticity measures.
Elasticity is quantified with a straightforward concept: the degree to which one variable alters as a result of a percentage change in another. For instance, how much apple demand declines when apple prices increase (which in this case is the price elasticity of demand for apples).
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Types of Elasticity
The most common is price elasticity of demand, which measures how much people reduce (or increase) their demand for something when prices rise (or fall). A sharp price rise may not change how much people buy if a good is essential, like insulin. But if it’s something less essential, like cherry tomatoes, people might switch to regular tomatoes as soon as prices increase.
We calculate this by dividing the percentage change in quantity demanded by the percentage change in price. If the number is high, we say demand is “elastic” (very sensitive to price). If the number is low, demand is “inelastic” (not very sensitive).
Other useful types of elasticity include:
Income elasticity of demand: how much people buy more (or less) of a good as their income changes. It helps us see whether a good is considered basic, luxury, or inferior.
Cross elasticity of demand: how demand for one good responds when the price of another good changes. For example, if the price of tea rises and people buy more coffee, we know they are substitutes.
Price elasticity of supply: how much producers change the amount they supply when prices rise or fall.
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Why It Matters for Policy
Elasticity is more than a classroom concept: it helps governments design better policies. If the demand for cigarettes is inelastic, for example, raising taxes may increase revenue without reducing smoking much. On the other hand, if a small increase in electricity prices causes demand to collapse, then price changes must be handled cautiously.
Elasticity also plays a role in broader planning. A policymaker might want to know how much the economy must grow to create new jobs (employment elasticity) or how much imports will increase with rising incomes (import elasticity). These links help anticipate problems, like trade imbalances or inflation, before they spiral.