Elasticity

Copyright 1985, 1988, 1991, 1996, 1998, 2006 Samuel L. Baker Elasticity is a measure of responsiveness. It tells how much one thing changes when you change something else that affects it. For example, the elasticity of demand tells us how much the quantity demanded changes when the price changes. The elasticity of demand measures the responsiveness of quantity demanded to changes in the price charged. Elasticity = Responsiveness The following discussion mostly uses the elasticity of demand for its examples. The elasticity concept can be used for other things, too, like supply or income.

Elastic and Inelastic

Elasticity is a noun. The adjective form, "elastic," means something is highly responsive to changes in something else. For example, elastic demand means that the quantity demanded changes a lot when the price changes. Inelastic demand means that the quantity demanded does not change much when the price changes. In class, we'll get more precise about where to draw the line between elastic and inelastic. For now, though, let's start with the qualitative idea: Elastic = Responsive Inelastic = Unresponsive By the way, if this usage of "elasticity" as "responsiveness" seems peculiar, it's because it is peculiar. Economists are about the only people who use "elasticity" this way. But, if you want to understand economists, you need to understand "elasticity." I suppose you could find an analogy between the elasticity of demand and the elasticity of rubber, but that would be stretching it. "Elastic" and "inelastic" can be used to describe supply or demand. Let's use them with demand. In each of the following examples, choose whether you would expect demand to be elastic or inelastic. In none of these examples will the demand be as elastic as the demand for gasoline at a particular gas station on a street with many gas stations. Drivers will flock to a gas station with a price a few pennies below its neighbors' prices, and will abandon a gas stations with a price a few pennies higher. Choose "Elastic demand" if you think that buyers will buy somewhat less if the price goes up, or somewhat more if the price goes down. Choose "Inelastic demand" if you think that the buyers will buy about the same amount if the price goes up or down. An unconscious bleeding man is brought to a hospital emergency room.

Elasticity (economics)
In economics, elasticity is the ratio of the percent change in one variable to the percent change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between 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 regression equation 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. Generally, an elastic variable is one which responds a lot to small changes in other parameters. Similarly, an inelastic variable describes one which does not change much in response to changes in other parameters. A major study of the price elasticity of supply and the price elasticity of demand for US products was undertaken by Hendrik S. Houthakker and Lester D. Taylor.[1]

Mathematical definition
The definition of elasticity is based on the mathematical notion of point elasticity. In general, the "x-elasticity of y", also called the "elasticity of y with respect to x", is:

The approximation becomes exact in the limit as the changes become infinitesimal in size. Sometimes the elasticity is defined without the absolute value operator. A context where this use of a signed elasticity is necessary for clarity is the cross-price elasticity of demand the responsiveness of the demand for one product to changes in the price of another product; since the products may be either substitutes or complements, this elasticity could be positive or negative.

Specific elasticities
Elasticities of demand
Price elasticity of demand Main article: Price elasticity of demand 2

Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change in price. As such, it measures the extent of movement along the demand curve. This elasticity is almost always negative and is usually expressed in terms of absolute value (i.e. as positive numbers) since the negative can be assumed. In these terms, then, if the elasticity is greater than 1 demand is said to be elastic; between zero and one demand is inelastic and if it equals one, demand is unit-elastic. Income elasticity of demand Main article: Income elasticity of demand Income elasticity of demand measures the percentage change in demand caused by a percent change in income. A change in income causes the demand curve to shift reflecting the change in demand. IED is a measurement of how far the curve shifts horizontally along the X-axis. Income elasticity can be used to classify goods as normal or inferior. With a normal good demand varies in the same direction as income. With an inferior good demand and income move in opposite directions.[2] Cross price elasticity of demand Main article: Cross price elasticity of demand Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a percent change in the price of another good. Goods can be complements, substitutes or unrelated. A change in the price of a related good causes the demand curve to shift reflecting a change in demand for the original good. Cross price elasticity is a measurement of how far, and in which direction, the curve shifts horizontally along the x-axis. A positive cross-price elasticity means that the goods are substitute goods. Cross elasticity of demand between firms Main article: Conjectural variation Cross elasticity of demand for firms, sometimes referred to as conjectural variation, is a measure of the interdependence between firms. It captures the extent to which one firm reacts to changes in strategic variables (price, quantity, location, advertising, etc.) made by other firms. Elasticity of intertemporal substitution Main article: Elasticity of intertemporal substitution Combined Effects It is possible to consider the combined effects of two or more determinant of demand. The steps are as follows: PED = (Q/P) x P/Q. Convert this to the predictive equation: Q/Q = PED(P/P) if you wish to find the combined effect of changes in two or more determinants of demand you simply add the separate effects: Q/Q = PED(P/P) + YED(Y/Y)[12] Remember you are still only considering the effect in demand of a change in two of the variables. All other variables must be held constant. Note also that graphically this problem would involve a shift of the curve and a movement along the shifted curve.

Elasticities of supply
Price elasticity of supply Main article: Price elasticity of supply The price elasticity of supply measures how the amount of a good firms wish to supply changes in response to a change in price.[3] In a manner analogous to the price elasticity of demand, it captures the extent of movement along the 3

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.[4] 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 of decreasing returns to scale is analogous.[5]

Applications
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 Marshall Lerner 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