BNET Basics

Analyzing Elasticity

by BNET Editorial

Elasticity in the financial sense is a term used to describe the degree to which a change in one variable leads to a change in another variable�how a price increase or decrease affects sales.

If, for example, a small change in the price of a commodity produces a relatively big change in demand for it, then demand is said to be elastic. But if the price change has little or no effect on demand, then demand is said to be inelastic.

Elasticity in practical terms indicates the extent to which consumers respond to changes in price. It is obviously important to consider such a response when contemplating changes in price or supply, just as it is to consider the relationship between those two variables. If it is assumed that reducing prices will produce more sales, and in the process possibly strain supply, then increasing prices will logically produce fewer sales and ease the strain on supply. Both courses of action should meanwhile stabilize sales revenue.

What to Do

The general formula for elasticity is:

Elasticity = % change in � / % change in y

In theory, � and y can be any variables. However, the most common application measures price and demand. For example, if the price of a product is increased from $20 to $25, or 25%, and demand in turn falls from 6,000 to 3,000, elasticity would be calculated as:

-50 / 25 = � 2

A value higher than 1 means demand is very sensitive to price, while a value lower than one means demand is only slightly sensitive to price.

What You Need to Know

There are five examples of elasticity:

1. E = 1, or unit elasticity. The proportional change in one variable is equal to the proportional change in another variable. For example, if the price rises by 5%, and demand falls by 5%.

2. E is greater than 1 (E > 1), or just elastic. The proportional change in � is greater than the proportional change in y. For example, if the price rises by 5% and demand falls by 3%.

3. E = infinity, or perfectly elastic. This is a special case of elasticity; any change in y will produce no change in x. Medical costs, for example, can be increased, but this is hardly likely to curb demand.

4. E is less than 1, or just inelastic. The proportional change in � is less than the proportional change in y, for example if prices are increased by 3%, and demand falls by 30%.

5. E = 0, or perfectly inelastic. This is another special case of elasticity: any change in y will have an infinite effect on x.

There are more complex formulae for determining a range of variables, or arc elasticity.

Elasticity can be used to affirm two rules of thumb: demand becomes elastic if consumers have an alternative or adequate substitute for the product or service, and demand is more elastic if consumers have an incentive to save money.