Introduction
In economics, understanding how sensitive buyers and sellers are to changes in prices, income, or other economic variables is crucial for policy-making, business strategy, and market analysis. This sensitivity is captured by the concept of elasticity.
Elasticity measures the responsiveness of quantity demanded or supplied when there is a change in another variable, such as price, income, or the price of related goods. It plays a central role in both microeconomic theory and applied decision-making.
Elasticity of Demand
Elasticity of demand refers to the degree to which quantity demanded of a good responds to changes in various factors such as price, consumer income, or the prices of related goods.
1. Price Elasticity of Demand (PED)
Definition:
Price Elasticity of Demand measures how much the quantity demanded of a good changes in response to a change in its price.
Formula:
Price Elasticity of Demand (PED) =
% Change in Quantity Demanded / % Change in Price
Types of PED:
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Elastic Demand (PED > 1): Demand changes more than proportionately to price.
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Inelastic Demand (PED < 1): Demand changes less than proportionately to price.
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Unitary Elastic Demand (PED = 1): Demand changes exactly in proportion to price.
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Perfectly Elastic Demand (PED = ∞): Consumers will buy only at one price.
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Perfectly Inelastic Demand (PED = 0): Quantity demanded does not change regardless of price.
Graphically:
A flatter demand curve indicates more elastic demand; a steeper curve shows inelastic demand.
Determinants of PED:
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Availability of Substitutes: More substitutes → higher elasticity.
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Nature of the Good: Necessities tend to be inelastic; luxuries are more elastic.
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Proportion of Income Spent: Goods that take a larger share of income are more elastic.
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Time Period: Demand becomes more elastic over time as consumers adjust.
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Addiction or Habitual Consumption: Goods like tobacco or alcohol tend to be inelastic.
Applications of PED:
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Pricing Strategies: Businesses may lower prices for elastic goods to boost revenue.
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Tax Policy: Governments impose taxes on inelastic goods (e.g., petrol) to maximize revenue.
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Public Transport Policy: If demand for public transport is elastic, fare hikes may reduce revenue.
2. Income Elasticity of Demand (YED)
Definition:
Measures how quantity demanded changes in response to a change in consumer income.
Formula:
YED =
% Change in Quantity Demanded / % Change in Income
Types:
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Positive YED (> 0): Normal goods. Demand increases with income.
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Negative YED (< 0): Inferior goods. Demand decreases as income rises.
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YED > 1: Luxury goods.
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0 < YED < 1: Necessities.
Application:
Income elasticity helps businesses forecast demand based on economic cycles and helps governments identify which sectors need subsidies or price controls during recessions.
3. Cross-Price Elasticity of Demand (XED)
Definition:
Measures how the quantity demanded of one good responds to a change in the price of another good.
Formula:
XED =
% Change in Quantity Demanded of Good A / % Change in Price of Good B
Types:
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Positive XED: Substitutes (e.g., tea and coffee).
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Negative XED: Complements (e.g., cars and petrol).
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Zero XED: Unrelated goods.
Application:
Understanding XED helps firms anticipate the impact of competitors’ pricing and helps policymakers understand interdependencies between markets.
Elasticity of Supply
Elasticity of supply refers to how responsive the quantity supplied of a good is to changes in its price.
Price Elasticity of Supply (PES)
Definition:
Price Elasticity of Supply measures the responsiveness of quantity supplied to a change in the price of the good.
Formula:
PES =
% Change in Quantity Supplied / % Change in Price
Types of PES:
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Elastic Supply (PES > 1): Supply responds more than proportionally to price.
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Inelastic Supply (PES < 1): Supply responds less than proportionally.
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Unitary Elastic Supply (PES = 1): Supply changes in exact proportion.
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Perfectly Elastic Supply (PES = ∞): Suppliers can supply unlimited quantity at one price.
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Perfectly Inelastic Supply (PES = 0): Supply remains constant regardless of price.
Determinants of PES:
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Time Period: Short-run supply tends to be inelastic; long-run supply is more elastic.
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Availability of Inputs: Easier access to inputs means more elastic supply.
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Production Flexibility: If production can be scaled quickly, supply is more elastic.
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Spare Capacity: Firms with unused capacity can respond quickly to price changes.
Applications of PES:
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Agriculture: Supply is often inelastic in the short term due to growing seasons.
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Energy Sector: Supply of oil or electricity may be slow to respond, leading to volatility.
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Policy Planning: Elasticity helps anticipate shortages or surpluses when prices fluctuate.
Importance of Elasticity in Economics and Policy
For Businesses:
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Guides pricing decisions.
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Helps in estimating the effect of promotional campaigns.
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Assists in forecasting revenue under different market conditions.
For Government Policy:
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Determines the burden of taxation (more falls on inelastic goods).
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Assists in designing subsidies and price supports.
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Helps evaluate the impact of regulation on industries.
In International Trade:
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Countries may specialize in producing goods with inelastic global demand to ensure stable export revenue.
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Helps understand the terms of trade effects when global commodity prices fluctuate.
Real-Life Examples
Petrol (Inelastic Demand):
Despite rising fuel prices, demand changes very little in the short run, making petrol highly inelastic. Hence, governments often tax petrol to generate revenue.
Luxury Cars (Elastic Demand):
High-income elasticity means that during a recession, demand for luxury cars falls significantly.
Agricultural Produce (Inelastic Supply):
A bumper crop can cause prices to crash because supply increases but cannot be absorbed proportionally due to demand being inelastic.
Streaming Services (Elastic Demand):
If prices for Netflix increase slightly, consumers might cancel subscriptions and shift to competitors, indicating elastic demand.
Conclusion
The concept of elasticity of demand and supply is a cornerstone of economic theory and policy. It provides valuable insights into how markets respond to changes in price, income, and external factors. For IAS aspirants, it forms a key part of the economics syllabus in both the prelims and mains examinations. For MBA students, it is foundational for strategic pricing, market segmentation, and revenue management.
Elasticity is not just a theoretical construct—it has real-world applications in taxation, international trade, business planning, and consumer behavior analysis. A clear understanding of elasticity equips individuals with the tools to interpret market signals and make informed economic and business decisions.