Elasticity, Consumers, Producers, and Market Efficiency

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Elasticity

In practical terms, elasticity refers to the responsiveness of the quantity demanded and supplied to changes in price. A more technical definition is that elasticity is the ratio of the percent change in one variable to the percent change in another variable. The ratio is expressed as the change in quantity divided by the change in price demanded or supplied.

Elasticity = % Change in quantity / % Change in price

The elasticity of a good determines the slope or "steepness" of its supply and demand curves.

Elasticity of Demand

The elasticity of demand tells us how consumers modify their consumption behavior in response to a change in price for a given good. If a change in the price of a good results in a drastic change in the quantity demanded, the demand for the good can be described as highly elastic. For example, if the price of a good drops by 1% and the quantity demanded increases by 80%, the good is described as elastic. Conversely, an inelastic good is one for which the quantity demanded remains little changed by a change in price

What does the elasticity of demand tell us about the nature of the good it is describing? Let's first start with a highly elastic good.

When the demand for a good is highly elastic, consumers make drastic changes to the quantity they demand in response to relatively small changes in price. Let's say the cost of a movie ticket increases from $10 to $11, an increase of 10%. Now lets assume that as a result of this change in price ticket sales decrease from 100 per day to 10, a decrease of 90%. The elasticity of demand for movie tickets is 90%/10%, or 9/1, making it highly elastic. The nature of this change in demand illustrates that consumers feel that going to the movies is something they can easily sacrifice in response to an increase in price. Goods with high elasticities of demand are often described as luxury goods; that is, things that consumers feel they can go without. They also may be goods that are readily available in the market place or have plenty of substitutes. For instance, consumers may substitute renting movies and watching them at home in response to rising movie ticket prices. They may even find other forms of entertainment such as saving their money to go to a baseball game or to attend a concert.

Conversely, when the demand for a good is highly inelastic, consumers respond very little to changes in price. Let's use water as an example. Let's assume that the price for a gallon of water increases from $10 to $11, a 10% increase. Now lets assume that as a result of this change in price the quantity of water consumed drops from 100 gallons per day to 99 gallons per day, a 1% decrease. The elasticity of demand for a gallon of water is 1%/10%, or 1/10, making it highly inelastic. The nature of this change in demand illustrates that consumers feel that water is not something they are readily willing to sacrifice in response to an increase in price. Goods with highly inelastic demands are often described as necessities; that is, things that consumers feel they cannot do without. Examples of goods commonly described as inelastic are food and housing. These goods may also have few substitutes in the market place. For instance, there are few substitutes for the various roles water plays in our everyday lives.