Businesses set prices to attract customers while maximizing profits. Consumers make buying decisions based on how much they are willing to pay. But what happens when prices change? Do people buy less? Do businesses produce more?

This is where elasticity comes in. It measures how much supply and demand react to price changes. Companies, policymakers, and investors use elasticity to predict consumer behavior, set pricing strategies, and make informed decisions.

What Is Elasticity?

Elasticity measures how sensitive demand or supply is to price changes. Some products see a big drop in demand when prices rise, while others don’t. Gasoline, for example, is something people still buy even when prices go up. But if a fast-food chain raises burger prices too much, customers may go elsewhere.

By understanding elasticity, businesses can adjust pricing, avoid losses, and boost revenue.

Types of Elasticity

Different types of elasticity impact markets in various ways.

1. Price Elasticity of Demand (PED)

PED shows how much demand changes when prices rise or fall.

Formula:

PED = (% Change in Quantity Demanded) / (% Change in Price)

• Elastic Demand (>1) – Demand drops significantly when prices go up. Example: luxury goods, electronics.
• Inelastic Demand (<1) – Demand barely changes even if prices rise. Example: medicine, gasoline.
• Unitary Elastic Demand (=1) – Demand changes at the same rate as the price.

Factors Affecting PED:

• Substitutes – If there are alternatives, demand tends to be elastic.
• Necessity vs. Luxury – Essentials have inelastic demand; luxuries have elastic demand.
• Price vs. Income – If a product takes up a large share of a budget, people react more to price changes.
• Time Frame – Demand tends to be more elastic in the long run as people find substitutes.

2. Price Elasticity of Supply (PES)

PES measures how supply changes when prices shift.

Formula:

PES = (% Change in Quantity Supplied) / (% Change in Price)

• Elastic Supply (>1) – Businesses can quickly increase production. Example: clothing, gadgets.
• Inelastic Supply (<1) – It’s harder to change supply levels. Example: oil production, real estate.
• Unitary Elastic Supply (=1) – Supply changes at the same rate as price changes.

Factors Affecting PES:

• Production Time – If production takes longer, supply is inelastic.
• Availability of Resources – If raw materials are easy to get, supply is more elastic.
• Storage Ability – If businesses can store products, they can adjust supply faster.

3. Income Elasticity of Demand (YED)

YED measures how demand changes when income rises or falls.

Formula:

YED = (% Change in Quantity Demanded) / (% Change in Income)

• Normal Goods (YED > 0) – Demand increases as income rises. Example: cars, dining out.
• Luxury Goods (YED > 1) – Demand grows faster than income. Example: designer fashion, travel.
• Inferior Goods (YED < 0) – Demand drops when income rises. Example: generic brands, fast food.

4. Cross Elasticity of Demand (XED)

XED shows how the demand for one product changes when the price of another product shifts.

Formula:

XED = (% Change in Quantity Demanded of Product A) / (% Change in Price of Product B)

• Substitutes (XED > 0) – Demand for one product increases when the other gets more expensive. Example: Pepsi vs. Coca-Cola.
• Complements (XED < 0) – Demand for one product falls when the other’s price rises. Example: coffee and sugar.
• Unrelated Goods (XED = 0) – No impact between products. Example: shoes and laptops.

How Businesses Use Elasticity

Elasticity helps companies set the right prices and maximize revenue.

1. Pricing Strategies

• If demand is elastic, lowering prices can attract more buyers and increase sales volume.
• If demand is inelastic, businesses can raise prices without losing many customers.

2. Taxation and Government Policies

Governments tax goods differently based on elasticity. Inelastic goods (like cigarettes) often carry higher taxes because demand doesn’t drop much even when prices go up.

3. Revenue Optimization

Businesses use elasticity to adjust supply based on market conditions. For example, airlines set ticket prices based on demand elasticity during peak and off-peak seasons.

4. Competition and Market Positioning

Understanding cross elasticity helps businesses predict how competitors’ price changes will affect their own sales. If a competing product becomes more expensive, demand may shift toward their brand.

5. Inventory and Supply Chain Management

If a company sells a product with inelastic demand, they can afford to keep more stock without worrying about sudden drops in sales.

Final Thoughts

Elasticity plays a huge role in pricing, supply, and demand. Businesses that understand it can make smarter pricing decisions, plan better for market changes, and gain a competitive edge. Whether adjusting prices, setting taxes, or managing supply chains, elasticity helps predict how consumers and businesses react to market shifts.