The elasticity of demand () measures the responsiveness of demand to a change in price. It is defined as the percentage change in quantity divided the percentage change in price, such that:
where is the quantity post price change; is the quantity prior to price change; is the initial price and is the new price. Usually, the relationship between price and quantity demanded is negative, so the elasticity of demand is also negative - unless the good is a Giffen good. Often the negative sign is dropped when analysing demand elasticities.
We categorize demand elasticities into the three following categories: (1) unitary elasticity (2) inelastic demand and (3) elastic demand.
Unitary elasticity of demand is when the elasticity of demand is equal to 1. This means that quantity and prices change in equal proportions. For example, if there is a 5% increase in price, there will be a 5% decrease in quantity.
Inelastic demand means that the price elasticity is a value smaller than 1. This means that the percentage change in quantity is less than the percentage change in price. For example, if there is a 5% increase in the price and there was only a 1% decrease in quantity, we could conclude that the elasticity of demand is inelastic.
This tells us that consumers do not change consumption patterns of these goods when there are price changes. These goods are typically seen as necessary goods or goods for which there are few substitutes. Examples of inelastic goods are things like: Cigarettes, healthcare, gas and electricity.
An interesting example is food. The elasticity of all foods are inelastic. However, individual foods may not be inelastic. For example, if the price of apples goes up but the price of oranges remains the same, then you might see consumers substituting from apples to oranges which may cause the elasticity of demand for apples to not be inelastic.
An extreme case of inelastic demand is perfect inelasticity which means that consumers do not change their consumption in response to a price increase. In this case, elasticity of demand equals 0.
Elastic demand means that the price elasticity of demand is a value larger than 1. This means that the percentage change in quantity is larger than the percentage change in price. For example, if there is a 5% increase in price and the quantity changes by 10% the elasticity of demand is elastic.
This tells us that consumers do change their consumption behavior in response to price changes. Examples of goods with elastic demand are goods that are either seen as luxury goods or goods that have lots of substitutes. For example, people may decide to delay an overseas holiday if the price increases. Moreover, they may choose to take their holiday to a different destination (for example go to France instead of Spain) if the price of holiday to Spain becomes more expensive.
Another extreme example of elastic demand is perfectly elastic demand. This means that even the slightest price change would cause consumers to withdraw from the market completely. The elasticity, in this case, is infinite.