The Concept of Elasticity in Economics

Estimation

Other Measures

Application

Other Elasticity Measures

The concept of elasticity can be applied in case of any two variables where economists want to find the impact of one variable on the other. In this section I point out some useful elasticity concepts that students of economics often come across.

Cross Price Elasticity
This measures the responsiveness of quantity demanded of one good (X) when price of another good (Y) changes. For example, if price of butter goes up by 10%, many people are going to switch from butter to margarine. The quantity demanded of margarine is going to rise, but the question is by how much is it going to rise? Cross price elasticity number is the answer to that. The general expression for this elasticity will be:

Example: If cross price elasticity is +2, then a 10% rise in price of butter is going to increase quantity demanded of margarine by 20%. This means that consumers are substituting margarine for butter.

A positive sign for cross-price elasticity tells us that the goods are substitutes. A negative sign of cross-price elasticity tells us that goods are complements.

Income Elasticity
This measures the responsiveness of quantity demanded of a good when income of the consumer changes. The expression for elasticity in this case will be:

For example, when income of the consumer increases, he might buy more electrical appliances and demand for electricity might go up. The utility companies may be interested in knowing by how much does electricity consumption increase if income of the population rises by 10%.

Example: If income elasticity is 1, then a rise in income by 10% will lead to a rise in electricity consumption by 10%.

Advertising Elasticity
This measures the change in quantity demanded of a product when there is a change in advertisement dollars. For example, McDonald spends $1 million dollar in its new ad campaign, what impact does this have on people's demand for Mcdonald's food? This is indeed a very significant for McDonald and the answer is given by the advertisement elasticity of demand. We can calculate this advertising elasticity as follows:

Revenue Elasticity of Tax-rate
Economists may be interested in finding the impact of tax-rate on tax revenue. Government may try to increase tax rate on income with the hope of raising tax revenue. Raising tax rate may increase the revenue if income earned does not change significantly. However, raising taxes may reduce workers incentive to work and hence reduce income and taxes.

Similarly, higher tax-rate on consumption may lead to higher tax revenue provided, the consumers do not significantly reduce the consumption of the item. However, if consumers reduce the consumption, the tax-revenue may fall as a result of tax hike. It is important to know the revenue elasticity of tax-rate before implementing a policy of tax-hike.

Output Elasticity of Input
This is a concept that students encounter while studying production theory. Returns to Scale is a phenomenon associated with long run production. In the long run all inputs in production process are considered variable. The question then is if all inputs are varied in a certain proportion, to what extent does output increase? The answer can be given by the elasticity coefficient of output.

One way to measure returns to scale is to use a coefficient of output elasticity (E)

Output Elasticity of Inputs
E>1
E=1 E<1
Increasing Returns to Scale
Constant Returns to Scale
Decreasing Returns to Scale
If you increase all inputs, say, twice, and output increases by MORE THAN two times you have Increasing Returns to Scale.

If you increase all inputs twice, and output increases by EXACTLY TWO TIMES you have Constant Returns to Scale.

If you increase all inputs twice, and output increases by LESS THAN two times you have Decreasing Returns to Scale.

 

 

Copyright © Dr. Satarupa Das
Contact email: satarupa.das@montgomerycollege.edu
Last revised: April 28, 2005