Note · Fundamental concepts
What is elasticity in economics? How demand reacts to price
Price elasticity of demand is the percentage change in quantity bought divided by the percentage change in price. How to work it out, what makes it high or low, and why it decides who pays a tax.
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Contents · 6 sections
Elasticity in economics measures how strongly one thing responds to a change in another. The most used kind, price elasticity of demand, is the percentage change in the quantity people buy divided by the percentage change in price. If a 10% price rise cuts sales by 20%, the elasticity is −2: demand is elastic. If it cuts sales by 2%, the elasticity is −0.2: demand is inelastic, and buyers keep paying.
In short
- Price elasticity of demand = % change in quantity ÷ % change in price. Beyond 1 in size, demand is elastic; below 1, inelastic.
- Demand is more elastic when there are close substitutes, when the item is a big share of spending, and when buyers have time to adjust.
- Elasticity decides whether a price rise raises or lowers a seller's revenue, and who really bears a tax or a tariff.
How do you calculate price elasticity of demand?
The formula is:
Elasticity = % change in quantity demanded ÷ % change in price
Because quantity usually falls when price rises, the answer is normally negative, and economists often drop the minus sign and talk about its size. OpenStax's Principles of Economics recommends the midpoint method, which measures each change against the average of the start and end values, so the answer is the same whether the price goes up or down:
% change = (new − old) ÷ ((new + old) ÷ 2) × 100
Take a café that raises its latte from $4.00 to $5.00, and daily sales fall from 200 to 150. Step by step:
- Change in quantity: 150 − 200 = −50. Average quantity: (150 + 200) ÷ 2 = 175. Percentage change: −50 ÷ 175 = −28.6%.
- Change in price: $5.00 − $4.00 = $1.00. Average price: $4.50. Percentage change: 1 ÷ 4.50 = 22.2%.
- Elasticity: −28.6% ÷ 22.2% = −1.29.
The size, 1.29, is above 1, so demand for this café's lattes is elastic. Its revenue tells the same story: 200 × $4.00 = $800 a day before, 150 × $5.00 = $750 after. When demand is elastic, raising the price loses more in sales than it gains per sale.
| Elasticity, in size | Name | What a price rise does to the seller's revenue |
|---|---|---|
| Above 1 | Elastic | Revenue falls |
| Exactly 1 | Unit elastic | Revenue stays the same |
| Below 1 | Inelastic | Revenue rises |
| 0 | Perfectly inelastic | Buyers take the same amount at any price |
Why is gasoline inelastic and restaurant food less so?
Real estimates show how different goods can be. For US gasoline, Jonathan Hughes, Christopher Knittel and Daniel Sperling estimated short-run price elasticities of −0.034 to −0.077 for 2001 to 2006, down from −0.21 to −0.34 in 1975 to 1980. At −0.05, a 20% jump in the price of gasoline would cut the amount bought in the following months by only about 1%. People still have to get to work in the car they already own.
For food away from home, including restaurant meals and fast food, a review of 160 studies by Tatiana Andreyeva, Michael Long and Kelly Brownell found an average elasticity of 0.81 in size, the most price-sensitive of the 16 food categories it pooled. A 10% rise in restaurant prices across the board would cut meals bought by about 8%, more than ten times the response of gasoline to the same rise.
Both numbers are below 1, so both categories are inelastic overall. But a single restaurant faces far more elastic demand than restaurants as a whole, because its diners can go next door. The same is true of the café above: lattes in general may be inelastic, while one café's lattes are elastic. Elasticity depends on how broadly the good is defined.
What makes demand elastic or inelastic?
Four things do most of the work, and the gasoline and restaurant numbers show each of them:
- Substitutes. The closer and more available the alternatives, the more elastic the demand. There is little to replace fuel in the car you own; there are many ways to eat other than in a restaurant.
- Necessity or luxury. Goods people feel they need, such as insulin, electricity or the commute, are inelastic. Treats and extras are more elastic.
- Share of the budget. A price rise on something that takes a big slice of income, such as rent or a car, is felt more than one on salt or matches.
- Time. Demand is more elastic in the long run than the short. Given years rather than months, drivers buy more efficient cars, move closer to work or switch to transit, which is why short-run gasoline estimates are so low.
One more distinction matters: elasticity is not the same as the slope of the demand curve. Along a straight-line demand curve, the slope is the same everywhere, but elasticity changes, high at high prices and low at low ones, because the same change in units is a different percentage change at each point.
Why does elasticity decide who pays a tax?
When a government taxes a good, the law says who hands over the money, but elasticity decides who bears the cost. OpenStax calls this tax incidence: the burden falls more on whichever side, buyers or sellers, is less able to walk away. A handy rule of thumb, for a small tax and straight-line curves, is:
Share paid by buyers ≈ elasticity of supply ÷ (elasticity of supply + size of the elasticity of demand)
Suppose a 20-cent tax per gallon of gasoline, and assume an elasticity of supply of 0.5. With demand at 0.05, buyers bear about 0.5 ÷ 0.55, or 91%, of the tax: roughly 18 cents of the 20 shows up at the pump. Put the same tax on restaurant meals, with demand at 0.81, and buyers bear about 0.5 ÷ 1.31, or 38%, and restaurants absorb the other 62% as a lower price kept after the tax. The supply figure here is an assumption for the example, not an estimate.
The same logic answers who pays a tariff, a tax on imports: the side with fewer alternatives pays more of it. And it explains the power of a producers' group such as OPEC: because short-run demand for oil is so inelastic, cutting supply a little raises the price a lot, and total revenue rises.
What other elasticities are there?
The same ratio works for any response. Price elasticity of supply measures how much more sellers offer when the price rises. Income elasticity measures how much more people buy when their incomes rise: positive for most goods, negative for "inferior goods" people buy less of as they get richer. Cross-price elasticity measures how demand for one good responds to the price of another: positive for substitutes such as tea and coffee, negative for complements such as printers and ink.
Elasticity is the quantity that turns supply and demand from a picture into numbers. Because resources are scarce and every purchase competes with others, elasticity measures how readily people shift their spending when a price moves, and it is the first thing a seller, a tax authority or a regulator wants to know.
Check yourself
- Using the latte example, explain why a price rise lowered the café's revenue.
- Why can demand for restaurant meals as a whole be inelastic while demand at one restaurant is elastic?
- Why do gasoline buyers bear most of a gasoline tax in the short run?
Sources
- 5.1 Price Elasticity of Demand and Price Elasticity of Supply — OpenStax, Principles of Economics 3e, 2022
- 5.3 Elasticity and Pricing — OpenStax, Principles of Economics 3e, 2022
- Evidence of a Shift in the Short-Run Price Elasticity of Gasoline Demand — Hughes, Knittel and Sperling, NBER, 2006
- The Impact of Food Prices on Consumption: A Systematic Review of Research on the Price Elasticity of Demand for Food — Andreyeva, Long and Brownell, American Journal of Public Health, 2010