Elasticity of demand & supply

Supply and demand tell us the direction prices and quantities move when conditions change, but not by how much. Elasticity fills that gap. It is a family of measures of responsiveness — how strongly buyers or sellers react to a change in price or income. Getting elasticity right is what separates a vague hunch (“higher prices mean fewer sales”) from a usable prediction (“a 10% price rise will cut sales by 4%, so revenue will rise”). It underpins how firms set prices and how governments design taxes.

Price elasticity of demand

The most important measure is the price elasticity of demand (PED): the percentage change in quantity demanded divided by the percentage change in price. Because price and quantity move in opposite directions, the raw number is negative, so economists usually talk about its size, or absolute value.

• If the size of PED is greater than 1, demand is elastic: quantity responds more than proportionately to price.
• If it is between 0 and 1, demand is inelastic: quantity responds less than proportionately.
• If it is exactly 1, demand is unit elastic.

Two theoretical extremes bracket these cases. Perfectly inelastic demand (PED = 0) is a vertical line: quantity does not change at all when price does. Perfectly elastic demand (PED approaching infinity) is horizontal: buyers will take any amount at one price but nothing above it.

What determines PED?

Demand is more elastic when:

• Close substitutes are available, so buyers can switch easily.
• The good takes a large share of income, so price changes are keenly felt.
• It is a luxury rather than a necessity.
• The market is narrowly defined (one brand of butter is more elastic than butter in general).
• More time has passed, letting buyers change habits.

Necessities with few substitutes — certain medicines, salt, or fuel in the short run — tend to be inelastic.

Why pricing decisions hinge on elasticity

The practical payoff of PED is its link to total revenue (price times quantity). When a firm raises price, two forces pull against each other: each unit earns more, but fewer units sell. Which wins depends on elasticity.

If demand is inelastic, raising price increases revenue. If demand is elastic, raising price reduces revenue. At unit elasticity, revenue is unchanged.

This is why a train operator with many empty seats and elastic leisure demand might offer cheap advance fares, while charging inelastic business commuters far more. The same logic guides everything from streaming subscriptions to airline pricing.

Income and cross elasticities

Income elasticity of demand (YED) measures the percentage change in quantity demanded divided by the percentage change in income. Its sign and size classify goods:

• Normal goods have positive YED — demand rises with income.
• Inferior goods have negative YED — demand falls as income rises, because people trade up. Bus travel and supermarket value ranges are common examples.
• Among normal goods, luxuries have YED greater than 1 (demand rises faster than income) and necessities have YED between 0 and 1.

YED matters for businesses planning for the economic cycle: firms selling luxuries boom in good times but are exposed in downturns, whereas sellers of necessities are steadier.

Cross elasticity of demand (XED) measures how the demand for one good responds to a change in the price of another. A positive XED signals substitutes (a rise in the price of coffee raises tea demand); a negative XED signals complements (a rise in the price of cars lowers petrol demand); a value near zero means the goods are unrelated. Competition authorities use XED-style reasoning to decide which products compete in the same market.

Price elasticity of supply

On the other side of the market, price elasticity of supply (PES) is the percentage change in quantity supplied divided by the percentage change in price. Supply is elastic when firms can readily change output and inelastic when they cannot.

Supply is more elastic when firms hold spare capacity, when goods can be stored, when factors of production are mobile, and over longer time periods. In the short run, a farmer cannot grow more wheat once a crop is planted, so supply is highly inelastic; over several seasons, planting decisions can adjust, and supply becomes more elastic.

Elasticity and the burden of a tax

Elasticity also decides who really pays a tax on a good. The general rule is that the more inelastic side of the market bears more of the tax. If demand is inelastic relative to supply, buyers keep purchasing despite higher prices, so consumers shoulder most of the burden; if supply is inelastic, producers absorb more.

This explains a familiar pattern in UK policy. Duties on tobacco and alcohol fall on goods with relatively inelastic demand, so they raise substantial, predictable revenue and the cost lands largely on consumers. Understanding elasticity is therefore not an academic nicety — it is central to forecasting revenue, designing taxes fairly, and setting prices that actually achieve a firm’s goals.