To understand elasticity measures, you will need to have a solid understanding of the law of supply and demand. In short, the law of supply and demand says that a price increase will increase supply and decrease consumer demand, but a price decrease will decrease supply and increase demand. Aside from changes in price, there are a number of other factors that an increase or decrease supply, as well drive an increase or decrease in demand.

Elasticity measures how changes in one variable affect a change in another variable. The four types are price elasticity of demand, price elasticity of supply, cross elasticity of supply/demand, and income elasticity of demand.

Price Elasticity of Demand

What is price elasticity of demand? Price elasticity of demand focuses on how percentage changes in price affect the percentage change in demand. The formula for calculating elasticity is:

While understanding how to calculate elasticity, it is more important to understand what it means when a product is elastic or inelastic. To determine whether a product is elastic or inelastic, you must compare the % change in price vs the % change in demand on an absolute basis. As you can see below, there are two types of elasticity to understand:

Elastic (>1): Occurs when the % change in price is less than the % change in demand. For example, if the company implements a 10% price increase, then the % change in demand will decrease by more than 10%. This suggests that consumer behavior is heavily impacted by price.

Inelastic (<1): Occurs when the % change in price is greater than the % change in demand. For example, if the company implements a 10% price increase, then the % change in demand will decrease by less than 10%. This suggest that consumer behavior isn’t heavily impacted by price.

What are some examples of elastic goods? Elastic goods typically have substitutes and are considered a luxury good rather than a necessity. A few examples of elastic goods include watches, cars, and clothes.

What are some examples of inelastic goods? Inelastic goods typically don’t have substitutes and are considered a necessity rather than a luxury. A few examples of inelastic goods include gas, salt, medicine (especially prescription), and corn (or other fruits and vegetables).

Relationship between price changes and total revenue

While it is important to understand whether a good is elastic or inelastic, we need to understand how changes in price can impact a company’s revenues and profitability. Ultimately, a company will need to assess whether the goods they sell are elastic or inelastic as that will influence their pricing strategy.

Elastic: If a product is elastic, price and revenue are inversely related. A price increase will decrease revenue and a price decrease will increase revenue.

Inelastic: If a product is inelastic, price and revenue are directly related. A price increase will increase revenue and a price decrease will decrease revenue.

Unit elastic: If a product has unit elasticity, then there is no impact of revenue from a change in price. Unit elasticity occurs when price and demand are perfectly aligned. This is very rare, which is why we have a unicorn in the visual!

Price elasticity of demand example:

Let’s say that Big Mountain Gas currently sells 100,000 gallons of gas at $10 per gallon. Big Mountain Gas decides to increase the price per gallon by 10%, which brings the price per gallon up to $11. As a result, demand drops by 5%. However, since the gas is inelastic and the % chance in price is greater than the % change in demand, then total revenue for Big Mountain Gas increases by $45,000!

To calculate the elasticity, we would divide 5% by 10%, which equals 0.5. Since 0.5 is less than 1, that confirms that the gas is inelastic.

Price Elasticity of Supply

Price elasticity of supply focuses on how percentage changes in price affect the percentage change in supply. The formula for calculating elasticity is:

Similar to price elasticity of demand, to determine if supply is elastic or inelastic, we compare the % change in quantity supplied to the % change in price.

Elastic (>1): Occurs when the % change in price is less than the % change in supply. For example, if the company implements a 10% price increase, then the % change in supply will decrease by more than 10%. This suggests supply is impacted by changes in price.

Inelastic (<1): Occurs when the % change in price is greater than the % change in demand. For example, if the company implements a 10% price increase, then the % change in supply will decrease by less than 10%. This suggest that quantity supplied isn’t impacted by price changes.

Cross Elasticity of Demand or Supply

Cross elasticity relates to demand or supply. Cross elasticity measures the percentage change in the quantity demanded/supplied for a specific good to the price change of another good. An example of cross elasticity would be comparing quantity demanded/supplied at grocery stores if the price to eat dinner at a restaurant fluctuates. Assessing cross elasticity helps business owners identify substitutes and complementary goods.

The formula illustrates how we can calculate the cross elasticity of demand/supply. As you can see, we divide the % change of quantity demanded/supplied of Product A (i.e. grocery stores) by the % change in price of Product B (restaurants).

Awesome. You’ve calculated cross elasticity, but how do you interpret the coefficient that you calculated using the cross-elasticity formula. The coefficient will either be greater than 0 (positive), less than 0 (negative), or equal to 0.

>0 (Positive) = Substitute good: If the result is greater than 0, then this suggests good is considered to be a substitute.

<0 (Negative) = Complementary good: If the result is less than 0, then this suggests good is considered to be complementary.

=0: If the result is equal to 0, then this suggests that the goods are unrelated, and that no relationship exists.

Income Elasticity of Demand

Income elasticity of demand is used to understand how quantity demanded is impacted by a percentage change in income. For example, if your income increased, do you think you would continue to sit in economy when flying, or would you start sitting in first class? Using the income elasticity of demand, you could figure out how changes in your income level impact the types of items you demand.

Knowing the formula is important, but you must understand how to interpret the result. The coefficient will either be greater than 0 (positive), less than 0 (negative), or equal to 0.

>0 (Positive)= Normal good: If the result is greater than 0, then this suggests the good is a normal good. As your income increases, then your demand for those goods will increase.

<0 (Negative) = Inferior good: If the result is less than 0, then this suggests the good is inferior. As your income increases, the quantity demanded for that good will decrease.

=0: If the result is equal to 0, then this suggests that the goods are unrelated to changes in income.