Elasticity explained

If you are a frequent reader of economic or financial columns, you might have already come across numerous times with the term “elasticity”.  Today let’s dive into this word and try to understand it.

1. Why do I need to know bout elasticity?

There are two reasons why elasticity is a must-know term in economics:

1) It is an essential concept in understanding micro-economic phenomenons 

2) It is important for decision making in both public and private sector

2. What is Elasticity?

To fully understand what this term means, let’s first define a few basic terms.

a. Demand

Demand can be defined as the willingness and ability to purchase a certain product at a certain price level. To illustrate the concept in a graph:

The downward sloping of demand curve is due to the fact that when price of a product decreases, more people will be willing and able to purchase it. Demand curve can be shifted by factors such as change in income level. 

b. Supply

Similar to demand, supply can be defined as the willingness and ability to produce a certain product. 

The upward sloping of supply curve is because when price of a product increases, more producers are willing to product the same product. Supply curve, similarly, can be shifted by external factors such as imposed government tax.

With the understanding of demand and supply curves, we can give a formal definition of elasticity:

Elasticity measures the responsiveness of quantity demanded/supplied to a change in an external factor.

Since demand and supply are often affected by many factors, there are many types of elasticity: price elasticity, income elasticity, etc. Take price elasticity as an example, which is defined by

Price Elasticity (PE) = (% change in quantity) / (% change in price)

On graphs, PE can be illustrated roughly by the slope of the demand or supply curve:

Products with higher price elasticity, such as smart phone, has gentler demand curves. This means they are less “dependent” on the products such that they will reduce consumption of it by a large amount even for a small increase in price. On the other hand, products with lower price elasticity, such as cigarette, has gentler demand curves. They are usually the more “addictive” or necessary products which people will continue to consume despite increase in price.

3. So, how does elasticity concept affect decision making?

To illustrate this, we take price elasticity as an example, which is often applicable in government’s decision of whether to impose a tax on a certain product.

One important factor in tax policy consideration is the tax incidence, which measure the amount of burden on either consumers or producers due to the imposed tax. To illustrate with a graph:

Often, government may want to discourage the production of a certain product deemed harmful to society by imposing heavy tax on it. A government tax will shift the supply curve upwards. As a result, there are burdens on both consumers and producers. However, if the demand curve is steeper than the supply curve, i.e. supply has a larger price elasticity, the resulting incidence on consumers will be much larger than incidence on producers. This means that producers will only bear a small portion of the burden of the tax. Thus, imposing tax will be an ineffective policy to discourage the production of this product, and the government may need to choose another policy tool to achieve the goal.