Elasticity (economics)

Elasticity (economics), responsiveness of dependent variables in economic calculations to changes in independent variables; these variables being measurable quantities, some of which (dependent) change if others (independent) do. The term was invented by Alfred Marshall, and is used to measure relationships of price and demand, or of various factors in production.

There are several ways in which elasticity is measured. Price elasticity of demand measures how much a (marginal) change in the price of a good affects demand for that good, all other factors remaining constant. It is calculated by dividing the proportionate change in demand by the proportionate change in the price. For example, if a good's price is raised to 106 from a baseline of 100 (a change of +6), and the quantity bought falls from 100 to 90 (a change of -10), the resulting percentage changes are 10/100 x 100= -10 % and 6/100 x 100= +6 %. Dividing the proportionate change in quantity (10 %) by the proportionate change in price (6 %) gives 1.66. Because the answer is more than 1 it means that the good is price-elastic and demand will fall by proportionately more than the increase in price; therefore, even though the price has increased, total expenditure on the good by consumers will fall. If the answer is less than 1, the good is price-inelastic and demand will not fall proportionately more than the increase in price; therefore, total expenditure on the good by consumers will rise.

Cross-price elasticity of demand measures how much demand for one good is affected by a change in price of another good. The cross-elasticity is calculated by dividing the proportional change in the quantity of X by the proportional change in the price of Y. If the goods are substitutes (different brands of cola, for example) an increase in the price of brand X will result in an increase in sales of brand Y, and so cross-elasticity is positive. If the goods are complementary (computers and software, for example) an increase in the price of one will depress demand for the other, so the cross-elasticity will be negative. If the goods are unrelated (toupees and toothbrushes, for example), however much the price of one is increased demand for the other will not be affected by that increase, so the cross-elasticity will be zero.

Income elasticity of demand measures how much a change in the income of consumers affects demand for a good if the price and other factors remain constant. It is calculated by dividing the proportionate change in demand by the proportionate change in income. A product with an income elasticity of more than 1 will experience a growth in demand that is higher than the growth in consumers' incomes. Luxury goods tend to have a relatively high income elasticity. Low-quality goods tend to have negative income elasticities, as people stop buying them when they can afford to.

Elasticity of substitution measures how easy it is to substitute one factor of production for another in a given process; to use more machines and fewer workers, for example. If wages rise proportionately more than the cost of machinery, the elasticity of substitution will be positive. In other instances substitution will not be possible: the factory may already be fully mechanized, for example, in which case the elasticity is zero. The rate of technical substitution is the increase in the input of one factor of production necessary to keep output constant when the input of the other factor of production is reduced by a marginal amount.