Elasticity is a concept introduced by British economist Alfred Marshall, and is used in order to measure the variation that a variable suffers when another variable is changed. We can distinguish between different types of elasticity depending on the variables we are using.
Probably the most common example is price elasticity of demand, which measures changes in the demand of a good or service when its price is increased or decreased. It’s important to note that only price should be modified; this is, ceteris paribus, as in the contrary our measurement would be affected by changes in other variables. Depending on the type of good we analyse, we will see different relations between price changes and demand variation. For example, in the case of ordinary goods, an increase (decrease) of price will result in a decrease (increase) of demand, and thus will follow a negative relation. However, with Giffen goods the contrary will be true, an increase (decrease) of price will result in an increase (decrease) of demand, which this time implies a positive relation between both variables. Regarding elasticity, apart from the direction or the sign of the relation we also look at the degree of responsiveness. This way, we distinguish between inelastic goods (or relative inelasticity) and elastic goods (or relative elasticity). When, in absolute terms, the value of price elasticity of demand is lower than one, we’ll have inelasticity and, if it is higher than one, we’ll have elasticity.
Another example of elasticity that is frequently found in Economics textbooks is income elasticity of demand. It measures variation in demand due to changes in the consumers’ income. Normal goods are those whose demand increases due to a rise in income levels, having therefore a positive correlation, which implies that the elasticity of this kind of goods is always higher than 0. On the other hand, inferior goods are those whose demand moves in opposite direction to the income variation of consumers.
Similarly to price elasticity of demand, crossed elasticity measures the variation in demand but in this case as a result of changes in other goods’ prices. In the case of normal goods, an increase in the price of substitutive goods will imply a higher demand for the other substitutive goods.
Concerning firms, the Lerner index can capture the relationship between price elasticity of demand and market power. It does this by measuring the firm’s level of market power by relating the selling price to marginal cost. Therefore, the extent to which a firm can take advantage of its monopolistic power will highly depend on the elasticity of its demand curve. If it is more rigid (steeper), it will only have to reduce its production in order to achieve a higher price. However the more flexible (flatter) the demand curve is, the less market power the firm has to increase prices.