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Elasticity, Complements & Substitutes

What is Elasticity?

Elasticity is a concept in economics describing how responsive consumers and producers are to changes in price or income. Understanding elasticity is crucial for analyzing market behavior and predicting consumer responses. There are several types of elasticity, each focusing on different aspects of economic relationships.

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Price Elasticity

Price elasticity of demand (PED) measures how much the quantity demanded of a good responds to changes in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price:

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PED =  %change in quantity demanded / %change in price

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Levels of Elasticity

There are multiple levels of elasticity:

  • Perfectly elastic – A small price change causes the quantity demanded to change infinitely. In a perfectly competitive market, products with perfect substitutes might behave this way. The elasticity coefficient would be infinity. 

  • Elastic: The elasticity coefficient is greater than 1, meaning the percentage change in quantity demanded is greater than the percentage change in price. Consumers are highly sensitive to price changes.

  • Unit elastic: The percentage change in quantity demanded is exactly equal to the percentage change in price, with a coefficient of 1.

  • Inelastic: The percentage change in quantity demanded is less than the percentage change in price, so the calculated elasticity coefficient is less than 1. This is common for goods that people need regardless of price. 

  • Perfectly inelastic: Demand remains constant despite any price change, meaning a coefficient of 0, as seen with life-saving drugs without substitutes.

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Income Elasticity

Income elasticity of demand (YED) measures how much the quantity demanded of a good responds to changes in consumer income. 

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The formula is: YED = %change in quantity demanded / %change in income

 

Goods can be classified based on their YED:

  • Normal goods – These have positive income elasticity, meaning that as income increases, demand for the good increases.

  • Inferior goods – These have negative income elasticity, meaning that as income increases, demand decreases (e.g., instant noodles).

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Cross Price Elasticity

Cross price elasticity of demand (XED) measures how the quantity demanded of one good responds to the price change of another good. 

 

The formula is: XED=%change in quantity demanded of good A / %change in price of good B

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If XED is positive, the goods are substitutes, goods that can replace each other, like tea and coffee. A price increase in one will lead to increased demand for the other. If XED is negative, the goods are complements, goods that are used together. A price increase in one will lead to a decrease in demand for the other.

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The Midpoint Formula

Elasticity calculations follow a general formula: the percentage change in one variable divided by the percentage change in another variable. To compute these percentage changes, economists often use the midpoint formula for more accuracy, especially when working with large changes:

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Elasticity = ((New quantity−Old quantity)/Average quantity) / (New Price - Old Price)/Average Price

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TL;DR

  • Elasticity measures responsiveness. It shows how much consumers or producers change their behavior when prices, income, or related goods’ prices change.

  • Price elasticity of demand (PED) measures how demand changes in response to price changes. Goods can be perfectly elastic, elastic, unit elastic, inelastic, or perfectly inelastic based on their sensitivity to price.

  • Income elasticity of demand (YED) shows how demand changes when consumer income changes. Normal goods have positive elasticity, while inferior goods have negative elasticity.

  • Cross-price elasticity of demand (XED) measures how the demand for one good changes when the price of another good changes. It identifies whether goods are substitutes or complements.

  • Substitutes are goods that can replace each other, while complements are goods used together.

  • Elasticity is calculated by dividing the percentage change in quantity by the percentage change in price, income, or the price of a related good.

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