Elasticity measures how strongly one economic variable responds to another, allowing analysts to translate percentage changes into meaningful predictions. Price elasticity of demand compares the percentage change in quantity demanded to the percentage change in price. When the ratio exceeds one, demand is elastic, meaning consumers are highly responsive; below one, demand is inelastic; and equal to one indicates unit elasticity, where spending remains constant as price changes.
Beyond own-price responsiveness, two related elasticities capture how demand depends on other factors. Income elasticity of demand measures how quantity demanded responds to changes in consumer income. A positive income elasticity indicates a normal good, while a negative value signals an inferior good, one whose consumption falls as incomes rise. Cross-price elasticity measures how the quantity demanded of one good responds to changes in the price of another. A positive cross-price elasticity identifies substitutes, goods that replace each other, while a negative value identifies complements, goods consumed together.
These elasticities are vital tools for businesses and policymakers. A firm deciding whether to raise its price needs to know whether demand is elastic or inelastic to predict revenue effects. Governments weighing taxes on goods such as cigarettes, gasoline, or luxury items rely on elasticity estimates to anticipate both the revenue impact and the deadweight loss that taxation creates. Understanding which goods are substitutes or complements also shapes decisions about product lines and competitive strategy.