Elasticity in economics expands the principles of supply and demand by examining how these two forces respond to changes in prices or incomes. When demand or supply shifts sharply in response to a change in price, then elasticity exists. However, supply and demand are inelastic when they show little or no response to a price change.
Price Elasticity of Demand
Arguably the most commonly discussed type of elasticity, price elasticity of demand involves how a change in price alters the level of demand for a particular good or service. If a higher price results in lower demand for the good, then demand is elastic. If a price increase causes little or no change in the level of demand, then demand is inelastic. In general, demand is more inelastic for goods that are considered essentials, or for which few or no substitutes exist (see References 1). Demand may be highly elastic, in contrast, for goods that are considered luxuries or non-essential.
Income Elasticity of Demand
As incomes change, so do consumers’ buying habits. A big pay raise gives a person more money to spend on goods he or she could not afford otherwise. In contrast, a drop in income may force a family to cut its budget, limiting itself to the essentials. This introduces income elasticity of demand, or the change in demand that results from income changes. Harvard economist Greg Mankiw points out in his “Principles of Economics” textbook that a higher income raises demand for most goods, referred to as normal goods. However, a higher income can lower demand for some goods, which Mankiw refers to as inferior goods. He cites bus rides as an example of an inferior good.
Cross-Price Elasticity of Demand
Cross-price elasticity of demand looks at how the price of one good affects the level of demand for another good. This usually involves goods that are substitutes for each other, or goods that are complementary. Consider chicken and beef as examples of substitute goods. A rise in beef prices may fuel higher demand for chicken, as consumers shift their preferences. Mankiw, in “Principles of Economics,” identifies computers and software as examples of complementary goods. If a rise in computer prices reduces the demand for software, Mankiw writes, then demand for software shows cross-price elasticity.
Price Elasticity of Supply
Elasticity applies not only to demand, but also to supply. Suppliers of a good or service want to sell more of it when the price rises. Price elasticity of supply measures how much the quantity supplied changes in response to a change in price. Mankiw points out that elasticity of supply depends greatly on the ability of a supplier to change the amount of the good it produces.