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  • Writer's picturePeak Frameworks Team

What is Elasticity? Explaining Types of Elasticity in Finance and Economics

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What is Elasticity?

Elasticity, in simple terms, refers to a measure of the responsiveness of demand or supply to changes in price or income.

It is a valuable tool, providing insight into how changes in external factors, like price or income, can influence economic behaviors and outcomes. The primary types of elasticity we'll delve into include price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross-price elasticity.

Elasticity
Source: Corporate Finance Institute


Price Elasticity of Demand

Price elasticity of demand is the initial type we'll explore. It measures the sensitivity of the quantity demanded to a change in price. The formula for this calculation is the percentage change in quantity demanded divided by the percentage change in price.

A practical example can be observed in the aftermath of the 2008 financial crisis. The demand for luxury goods, such as high-end jewelry and designer clothing, dipped dramatically as people tightened their belts during the economic downturn.

This instance demonstrates the high price elasticity of demand, as consumers could readily substitute luxury items with more affordable alternatives during tough economic times.

Price Elasticity of Supply

Price Elasticity of Supply Formula
Source: EduCBA

On the other side, we have the price elasticity of supply. This measures how the quantity supplied responds to changes in price. It's fascinating to note real-world instances of this principle at work.

A potent illustration is the oil industry. When oil prices skyrocketed in the early 2010s due to geopolitical tensions and supply disruptions, oil companies reacted by increasing their supply. The higher price triggered a surge in oil exploration and extraction, which is evidence of a higher price elasticity of supply. The goal was to take advantage of high prices, which would lead to increased revenues and profits.

Income Elasticity of Demand

Income elasticity of demand analyzes how the demand for a product or service changes in response to changes in consumer income. When incomes rise, the demand for certain goods can increase or decrease depending on whether they're normal or inferior goods.

For instance, during periods of economic prosperity, income elasticity for luxury cars tends to be high. This means that as people's incomes rise, they are more likely to splurge on luxury items like high-end automobiles. Conversely, the demand for inferior goods like generic-brand groceries might decrease as higher incomes allow people to afford name-brand alternatives.

Cross-Price Elasticity

Cross Price Elasticity
Source: EduCBA

Cross-price elasticity measures how the quantity demanded of one good responds to a change in the price of another good. It's an essential consideration when evaluating potential substitutes or complements in the market.

An example can be drawn from the entertainment industry. As prices for cable TV rose steadily over the past decade, consumers began looking for more affordable alternatives. The demand for more cost-effective streaming services like Netflix, Hulu, and Amazon Prime increased, illustrating positive cross-price elasticity. This trend has been a significant factor in the "cord-cutting" movement, where people abandon traditional cable TV in favor of streaming services.

Elasticity and Government Policies

Government bodies also utilize the principle of elasticity when formulating tax, subsidy, and trade policies. Policymakers consider the price elasticity of demand for goods when determining taxes.

For example, commodities with inelastic demand, such as gasoline and cigarettes, often carry higher taxes. This is because consumption is less likely to decrease significantly despite the price increase, resulting in increased tax revenue.

Similarly, subsidies are often provided for goods with elastic demand to stabilize prices and increase consumption. Furthermore, international trade policies often consider the price elasticity of demand when imposing tariffs or negotiating trade agreements.

The Limitations of Elasticity

While elasticity is undoubtedly a powerful tool, it's essential to be aware of its limitations. One significant assumption when using elasticity is that all other factors remain constant when price or income changes, which is rarely the case in real-world scenarios.

Moreover, accurately measuring elasticity can be challenging, as a wide array of factors can influence demand and supply. These considerations should always be kept in mind when making strategic decisions based on elasticity.

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