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 price insensitive
side of the market that bears more of the burden of a tax.
