What is Elasticity of Demand in Economics?
In economics, elasticity refers to the sensitivity of one economic variable in response to a change in another variable. It relates to the degree to which a variable changes as another variable is changed. For example, how higher will the price of a commodity go when the demand of the price increase.
Elasticity of demand can therefore be defined as the degree of change in demand as a result of change in another economic factor such as technology, price, income, availability of substitutes, or prices of other commodities,
Elastic demand occurs when there is a substantial change in quantity demanded in response to a change in another economic factor changes. For example, the demand for meat will reduce if its prices increase as people shift to less expensive substitutes such as vegetables.
On the other hand, inelastic demand occurs when the demand of a product does not change even if other factors change. For example, the demand of alcohol and luxury products does not change significantly as prices change.
Types of Elasticity of Demand
There are basically three major types of elasticity of demand:
- Price Elasticity of Demand
- Cross Elasticity of Demand
- Income Elasticity of Demand
Price Elasticity of Demand
Price elasticity of demand is a measure of responsiveness of the demand of a product to its own price. It shows the change in quantity demanded of a product when its price changes by one unit (Pindyck, 2001). Its formula is given as (Q1-Q2)/(P1-P2). The sign of price elasticity of demand is negative because demand increases as prices decrease.
Cross Elasticity of Demand
Cross elasticity of demand refers to the measure of responsiveness of the demand of a product to the price of a different product (Perloff, 2008). It shows the change in quantity demanded of a product due to a unit change in the price of a related product. Its formula is given as CED = % change in QA/% change in PB. The sign of cross elasticity of demand is positive for substitutes and negative for complements because when the price of a complement increases, the demand for its complement decreases (positive relationship), and the demand of a product increases if the price of its substitute increases (inverse relationship).
Income Elasticity of Demand
Income elasticity of demand is the measure of responsiveness of the quantity demanded of a product to the income of the consumer (Perloff, 2008). Its formula is given as IED = % change in Q/% change in income. This yields a positive relationship because the increase of a consumer’s income will lead to an increase in demand of his favourite product.