Elasticity is a measure of the responsiveness of one variable to changes in some other variable. For example, advertising elasticity is the relationship between a change in a firm's advertising budget and the resulting change in product sales. Economists are often interested in the price elasticity of demand, which measures the response of the quantity of an item purchased to a change in the item's price. Elasticity measures are reported as a proportional or percent change in the variable being studied. The general formula for elasticity, represented by the letter "E" in the equation below, is:
E percent change in x / percent change in y.
Elasticity can be zero, one, greater than one, less than one, or infinite. When elasticity is equal to one, there is unit elasticity. This means the proportional change in one variable is equal to the proportional change in another variable, or in other words, the two variables are directly related and move together. When elasticity is greater than one, the proportional change in x is greater than the proportional change in y and the situation is said to be elastic.
Inelastic situations result when the proportional change in x is less than the proportional change in y. Perfectly inelastic situations result when any change in y will have an infinite effect in x. Finally, perfectly elastic situations result when any change in y will result in no change in x. A special case known as unitary elasticity of demand occurs if total revenue stays the same when prices change.
Economists compute several different elasticity measures, including the price elasticity of demand, the price elasticity of supply, and the income elasticity of demand. Elasticity is typically defined in terms of changes in total revenue since that is of primary importance to managers, CEOs, and marketers. For managers, a key point in the discussions of demand is what happens when they raise prices for their products and services. It is important to know the extent to which a percentage increase in unit price will affect the demand for a product. With elastic demand, total revenue will decrease if the price is raised. With inelastic demand, however, total revenue will increase if the price is raised.
The possibility of raising prices and increasing dollar sales (total revenue) at the same time is very attractive to managers. This occurs only if the demand curve is inelastic. Here total revenue will increase if the price is raised, but total costs probably will not increase and, in fact, could go down. Since profit is equal to total revenue minus total costs, profit will increase as price is increased when demand for a product is inelastic. It is important to note that an entire demand cure is neither elastic or inelastic; it only has the particular condition for a change in total revenue between two points on the curve (and not along the whole curve).
Demand elasticity is affected by the availability of substitutes, the urgency of need, and the importance of the item in the customer's budget. Substitutes are products that offer the buyer a choice. For example, many consumers see corn chips as a good or homogeneous substitute for potato chips, or see sliced ham as a substitute for sliced turkey. The more substitutes available, the greater will be the elasticity of demand. If consumers see products as extremely different or heterogeneous, however, then a particular need cannot easily be satisfied by substitutes. In contrast to a product with many substitutes, a product with few or no substitutes—like gasoline—will have an inelastic demand curve. Similarly, demand for products that are urgently needed or are very important to a person's budget will tend to be inelastic. It is important for managers to understand the price elasticity of their products and services in order to set prices appropriately to maximize firm profits and revenues.
Hodrick, Laurie Simon. "Does Price Elasticity Affect Corporate Financial Decisions?" Journal of Financial Economics. May 1999.
Montgomery, Alan L., and Peter E. Rossi. "Estimating Price Elasticity with Theory-Based Priors." Journal of Marketing Research. November 1999.
Perreault, William E. Jr., and E. Jerome McCarthy. Basic Marketing: A Global-Managerial Approach. McGraw-Hill, 1997.