Definition
Elasticity is the measurement of how sensitively one economic variable responds to changes in another. The most important form is price elasticity of demand: the percentage change in quantity demanded divided by the percentage change in price that caused it. A good is elastic if demand is highly sensitive (|E| > 1) — a 10% price rise leads to more than a 10% drop in quantity. It is inelastic if demand barely changes (|E| < 1) — a 10% price rise leads to less than a 10% drop in quantity.
Elasticity is expressed as a ratio of percentage changes rather than absolute changes, making it unit-free and comparable across goods with very different price levels and quantities. Whether insulin and luxury yachts are elastic or inelastic can be compared on the same scale.
Why it matters
Elastic versus inelastic — the revenue implications
Determinants of elasticity
The four key factors
Availability of substitutes is the most important determinant. Goods with many close substitutes are elastic — if your brand of yogurt raises its price, you switch. Goods with no substitutes are inelastic — if insulin prices rise, diabetics still need insulin.
Necessity vs. luxury: necessities (food, basic transport, medication) are inelastic — people continue buying even at higher prices. Luxuries are elastic — people reduce or eliminate purchases when prices rise.
Budget share: goods that take a large share of income are more elastic — a 10% rise in housing costs forces adjustment. Goods that take a tiny share (salt, toothpicks) are inelastic — the absolute dollar impact is too small to bother substituting.
Time horizon: demand is always more elastic in the long run. When gasoline prices rise, consumers cannot immediately buy a new car — but over several years, they shift toward fuel-efficient vehicles. Short-run elasticity is almost always lower than long-run elasticity.
Tax incidence and elasticity
The burden of a tax is shared between buyers and sellers, and the split is determined by relative elasticities — not by who legally pays the tax. When demand is inelastic and supply is elastic (as with cigarettes), sellers can pass most of the tax to buyers, who cannot easily substitute. When demand is elastic and supply is inelastic (as with luxury yachts under the 1990 US luxury tax), sellers bear most of the burden — consumers switch to alternatives, and sellers' revenue falls.