Unless otherwise specified, the elasticity of demand refers
to the own-price elasticity. It measures the sensitivity
of quantity demanded to changes in the own price of a good, holding constant
the prices of other goods and income. Demand elasticities are negative since
demand curves slope down. In general, the demand elasticity changes as we
move along a given demand curve. Along a straight-line demand curve, elasticity
falls as price falls.
Demand is elastic if the price elasticity is more negative
than –1 (for example –2). Price cuts then increase total spending
on the good. Demand is inelastic if the demand elasticity
lies between –1 and 0. Price cuts then reduce total spending on the
good. Demand is unit-elastic if the demand elasticity is
–1. Price changes then have no effect on total spending on the good.
The demand elasticity depends on how long customers have to adjust to a
price change. In the short run, substitution possibilities may be limited.
Demand elasticities will typically rise (become more negative) with the length
of time allowed for adjustment. The time required for complete adjustment
varies from good to good.
The cross-price elasticity of demand measures the sensitivity
of quantity demanded of one good to changes in the price of a related good.
Positive cross-elasticities tend to imply that goods are substitutes,
negative cross-price elasticities that goods are complements.
The income elasticity of demand measures the sensitivity
of quantity demanded to changes in income, holding constant the prices of
all goods.
Inferior goods have negative income elasticities of demand.
Higher incomes reduce the quantity demanded and the budget share of such goods.
Luxury goods have income elasticities larger than 1. Higher
incomes raise the quantity demanded and the budget share of such goods.
Goods that are not inferior are called normal goods and
have positive income elasticities of demand. Goods that are not luxuries are
called necessities and have income elasticities less than
1. All inferior goods are necessities but normal goods are necessities only
if they are not luxuries.
Doubling all nominal variables should have no effect on demand since it
alters neither the real value (purchasing power) of incomes nor the relative
prices of goods. In examining data from economies experiencing inflation,
it is often best to look at real prices and real incomes, adjusting prices
and incomes for the effect of inflation.
The supply elasticity measures the percentage response
of quantity supplied to a 1 per cent increase in the price of the commodity.
Since supply curves slope up, the supply elasticity is positive.
Tax incidence measures who eventually pays the tax. Since
taxes induce changes in equilibrium prices and quantities, this can be very
different from the people from whom the government appears to collect the
money.
For specific taxes, slopes of supply and demand curves
are relevant. For ad valorem taxes, elasticities of supply and demand
are relevant. In either case, it is the relatively more priceinsensitive side
of the market that bears more of the burden of a tax.
