Elasticity

Elasticity

BIBLIOGRAPHY

In economics, elasticity measures a response of one variable to changes in the other variable. The concept of elasticity can be applied to any two variables, but the most commonly used are price elasticity of demand and elasticity of substitution between factors of production, consumer goods, or bundles of consumption in different periods of time (elasticity of intertemporal substitution).

Elasticity measures the percentage change in variable Y in response to a 1 percent change in variable X. Formally, the elasticity of Y with respect to X is defined as

or, for continuous changes,

The concept of the price elasticity of demand, which was introduced in 1890 by Alfred Marshall, measures the percentage change in the quantity of a good demanded when the price of this good changes by 1 percent. The demand is elastic if price changes lead to large changes in quantity demanded. The demand is inelastic if the quantity demanded does not respond much to changes in price. If demand is perfectly elastic, even a small increase in price will send the quantity demanded to zero. If demand is perfectly inelastic, the quantity demanded will be constant regardless of the price.

Price elasticity of demand for goods depends on the characteristics of the goods—that is, whether or not they are necessities and whether or not there are close substitutes for these goods. Price elasticity of demand also varies with the time horizon in consideration. For example, demand for gasoline is very inelastic in the short run, because people have to fill up their gas tanks, but in the long run, if prices remain high, people will switch to more gasoline-efficient cars and will demand less gasoline. By the estimates of the Mackinac Center for Public Policy, a 10 percent increase in the price of gasoline will lower the demand for it by 2 percent in the short run (elasticity of -0.2), and by 7 percent in the long run (elasticity of -0.7).

Price elasticity of demand also depends on how narrowly a good is defined. For example, demand for milk in general is quite inelastic, because there are no close substitutes. However, demand for milk of a specific brand is very elastic because there are many close substitutes (i.e., other brands of milk).

The concept of the elasticity of substitution was introduced independently by John Hicks and Joan Robinson in 1932 and 1933, respectively. It is used to measure how easily factors of production can be substituted for one another. For example, how much will the ratio of capital input to labor input in production increase if the ratio of capital cost to labor cost falls by 1 percent? Samuel de Abreu Pessoa, Silvia Matos Pessoa, and Rafael Rob (2005) estimate this elasticity to be 0.7, on average.

The concept of the elasticity of substitution can also be applied to consumption of goods, to measure how relative consumption of two goods is affected by their relative price. Most frequently, the concept of the elasticity of substitution in consumption is used to construct the baskets of consumer goods in economic models and to measure the substitutability of consumption across different time periods—“elasticity of intertemporal substitution.” This measures how the ratio of future to current consumption reacts to the change in relative price of consumption tomorrow and consumption today, commonly measured by the interest rate. Elasticity of intertemporal substitution is estimated to be close to zero, indicating that consumers are not sensitive in their intertemporal consumption decisions to the changes in the interest rate.

SEE ALSO Demand; Hicks, John R.; Marshall, Alfred; Production Function; Robinson, Joan; Substitutability; Time

BIBLIOGRAPHY

Anderson, Patrick L., Richard D. McLellan, Joseph P. Overton, and Gary L. Wolfram. 1997. Price Elasticity of Demand. Mackinac Center for Public Policy. http://www.mackinac.org/article.aspx?ID=1247.

Hicks, John. 1932. The Theory of Wages. London: Macmillan.

Marshall, Alfred. [1890] 1920. Principles of Economics. 8th ed. London: Macmillan.

Pessoa, Samuel de Abreu, Silvia Matos Pessoa, and Rafael Rob. 2005. Elasticity of Substitution between Capital and Labor and Its Applications to Growth and Development. PIER Working Paper Archive 05–012, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.

Robinson, Joan. 1933. The Economics of Imperfect Competition. London: Macmillan.

Yogo, Motohiro. 2004. Estimating the Elasticity of Intertemporal Substitution When Instruments Are Weak. Review of Economics and Statistics 86(3): 797–810.

Galina Hale