What Makes Demand Elastic or Inelastic — and What Follows From It

What Determines Elasticity of Demand

• Availability of close substitutes: The single biggest factor. The more easily buyers can switch to something else, the more elastic demand is.
• Necessity versus luxury: Goods buyers regard as essential tend to have inelastic demand; discretionary purchases tend to be elastic.
• Share of the budget: Items that absorb a large fraction of income (a car, rent) invite more shopping around than trivially cheap ones (salt, shoelaces).
• Time horizon: Demand is almost always more elastic in the long run, because buyers can change habits, equipment, and contracts.
• How narrowly the market is defined: Demand for one brand of cereal is far more elastic than demand for cereal in general, which is more elastic than demand for food.

What Determines Elasticity of Supply

• Spare capacity: Firms sitting on idle plant and inventory can raise output quickly, making supply elastic.
• Time to adjust: Supply is typically very inelastic immediately after a price change and more elastic as firms hire, build, or enter.
• Mobility of inputs: If labor and equipment can be redirected easily from other uses, supply responds more.
• Storability: Goods that can be stockpiled let sellers shift output across time, raising responsiveness.
• Production lags: Crops, mines, and housing face long lead times, which is why their short-run supply is close to fixed.

Effects: Revenue, Taxes, and Incidence

• Total revenue test: If demand is elastic, a price cut raises total revenue; if demand is inelastic, a price cut lowers it. At unit elasticity, total revenue is at its maximum.
• Tax incidence: The side of the market that is less responsive to price bears more of a tax. If demand is more inelastic than supply, buyers pay most of it.
• Deadweight loss: The more elastic either side of the market, the larger the quantity distortion a tax creates, and the bigger the efficiency loss.
• Pricing power: A firm facing inelastic demand can raise price with a relatively small loss of unit sales, which is why elasticity sits at the center of antitrust and regulatory analysis.

Reading the Numbers

Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. Because the two move in opposite directions, the raw number is negative, so economists usually discuss its absolute value. A value greater than one means elastic, less than one means inelastic, and exactly one means unit elastic. Because ordinary percentage changes differ depending on which endpoint you start from, introductory courses generally use the midpoint method, dividing each change by the average of the starting and ending values so the elasticity between two points is the same in either direction.