Elasticity: Definition and How It Works

Elasticity is an economic concept that measures how responsive one variable is to changes in another. In business and finance, it most commonly describes how quantity demanded or supplied responds to a change in price.

Key idea

Price elasticity of demand = (percentage change in quantity demanded) / (percentage change in price)

Interpreting the value:
* Elastic (> 1): quantity responds more than proportionally to price changes.
* Inelastic (< 1): quantity responds less than proportionally.
* Unitary (= 1): proportional response.

How elasticity works

• Elastic goods: Small price changes produce large changes in quantity demanded. Examples: discretionary items like spa treatments, many types of clothing and electronics.
• Inelastic goods: Quantity demanded changes little despite price shifts. Examples: essential goods such as insulin, gasoline, or basic food items.
• Supply-side: Price elasticity of supply measures how much the quantity supplied responds to price changes—higher prices tend to increase supply, lower prices reduce it.

Main types of elasticity

• Price elasticity of demand: Sensitivity of demand to changes in the good’s own price.
• Income elasticity of demand: Sensitivity of demand to changes in consumers’ real income (percent change in quantity demanded ÷ percent change in income).
• Cross-price elasticity of demand: Responsiveness of demand for one good when the price of another changes (percent change in quantity demanded of good A ÷ percent change in price of good B). Substitutes produce positive cross-elasticity; complements produce negative cross-elasticity.
• Price elasticity of supply: Responsiveness of supply to changes in the market price of a good or service.

Factors that affect demand elasticity

• Availability of substitutes: More substitutes → more elastic demand. Unique goods with few substitutes (e.g., diamonds) tend to be inelastic.
• Necessity vs. luxury: Necessities (food, basic healthcare) are generally more inelastic; luxuries are more elastic.
• Time horizon: Demand often becomes more elastic over time as consumers find alternatives or change habits.

Why elasticity matters for businesses

• Pricing strategy: Firms selling elastic goods compete on price and need higher sales volume; firms with inelastic goods can raise prices with smaller drops in quantity demanded.
• Revenue and profit planning: Knowing elasticity helps predict revenue effects of price changes.
• Customer retention: Inelastic demand supports pricing power and steadier customer behavior during price shifts.

Real-world examples

• Surge pricing (ride-hailing): Dynamic price increases when demand spikes illustrate how firms alter price to manage demand and supply.
• Pandemic impacts: COVID-19 disrupted supply chains and demand patterns—meat shortages raised import prices; an unprecedented collapse in oil demand briefly pushed futures prices deeply negative, prompting historic production cuts.

Bottom line

Elasticity quantifies responsiveness between economic variables—most often between price and quantity. Understanding different types of elasticity and the factors that influence them helps businesses, policymakers, and consumers anticipate how changes in price, income, or related goods affect market behavior.