Price elasticity is a measure of how much producers or consumers respond to an external disturbance. There are four different measures of price elasticity:
Price Elasticity of Demand
Income Elasticity of Demand
Cross Price Elasticity of Demand
Price Elasticity of Supply
These measures can produce measures that can determine whether the product or service sold is 'elastic' or 'inelastic.'
An elastic product means that there is a relatively large reaction to a change in market conditions. In contrast, an inelastic good has a relatively small response.
Importance of Elasticity
The measure of elasticity is very important for businesses as their knowledge of consumers responses can influence their generation of profits and growth. It is important to note that firms want price elasticity to be low (or inelastic), this means that businesses can charge higher prices with a small decrease in demand or response from consumers.
Elasticity is also important for the Government as their knowledge of inelastic goods can influence the effectiveness of taxes. For instance, inelastic goods, such as cigarettes, can generate lots of revenue for governments as the increase in price as a result of the tax has little effect on the consumption or demand for the goods.
Calculating percentage changes
In each of the Elasticity formulas, you will need to calculate both the percentage change in price and the percentage change in the external factor. To do this, use the formula above and insert these values into the elasticity formula to find your final value.
Another way of looking at solving the elasticity questions is thinking of it as a three-step process:
Find the percentage change in both values required.
Insert these values into the required elasticity formula.
Write a final statement using your answer to determine the nature of the good. For example, is it an elastic or inelastic product?
Each type of elasticity has a different formula. These are looked at in more detail in the following modules.