What do these terms even mean? In English, please!
Merriam-Webster defines the word elastic as follows:
capable of ready change or easy expansion or contraction : not rigid or constricted
In plain English, something elastic is thus something that is capable of changing a lot. On the contrary, something inelastic is something that does not change.
Before we jump into labeling things as elastic or inelastic, let’s recall why economists use elasticities in the first place. That will give us a sense of purpose and shed light on the terminology.
In economics, an elasticity is a measure of the magnitude of the change in one variable, our variable of interest, may it be quantity demanded or quantity supplied, to a change in another variable, may it be the price of the good, income, or the price of another good.
What Do You Mean by “A Lot” or “A Little”?
Let’s use the Price Elasticity of Demand (PED) to guide our thought. A similar logic applies to the other elasticities.
Remember, the PED measures how much quantity demanded responds to a change in the price of a good:
Price Elasticity of Demand: absolute value of
% Change in Quantity Demanded
% Change in Price
Suppose we’re talking about a 10% change in price.
If quantity demanded changes by, say 40%, oh man, we’re talking about a 4-fold response (because 40% is 4 times greater than 10%), that’s “a lot”:
40% / 10% = 4
It will be quite a different matter if quantity demanded changes by, say, 1%. Here, we’re talking about a minuscule one-tenth of a response (1% is one tenth of 10%), that’s “a little”:
1% / 10% = 0.1
But what is “a lot” or “a little” for me may be different than for you.
Put A Number On It!
The cool thing about an elasticity is that it puts a number to our saying a variable changed by a lot or by a little, which are subjective (economists don’t like this fuzziness).
In the first scenario, quantity demanded is very sensitive to a change in price. We see this because the magnitude of the change in quantity demanded is greater than the original percentage change in price. When this happens, PED is greater than one. Another name for this is elastic.
% Change in Quantity Demanded > % Change in Price
PED > 1
In the second scenario, quantity demanded is not sensitive to a change in price. We see this because the magnitude of the change in quantity demanded is smaller than the original percentage change in price. When this happens, PED is less than one. Another name for this is inelastic.
% Change in Quantity Demanded < % Change in Price
PED < 1
For completeness… if the quantity demanded changes by 10%, that means that it changed by exactly the same percentage as price. When this happens, when the percentage change in quantity demanded matches the percentage change in price, then PED is 1. Another name for this is unit-elastic.
% Change in Quantity Demanded = % Change in Price
PED = 1
Sign is Blah (shrugs) on Price Elasticity of Demand
When calculating the Price Elasticity of Demand, the sign does not matter, and we make our lives simpler by taking the absolute value of the ratio of the percentage change in quantity demanded to the percentage change in price. This is in stark contrast to when we calculate the Income Elasticity of Demand and the Cross-Price Elasticity (of Demand), where the sign matters greatly.
To see why the sign of the Price Elasticity of Demand is not important, consider the following.
First, the Law of Demand tells us quantity demanded and price always react negatively, higher price less quantity demanded, lower price higher quantity demanded, so the ratio is inevitably negative as well (until we calculate its absolute value, that is).
Second, when we use the mid-point method, the percentage variations (in price and in quantity demanded) are independent of whether the variable increased or decreased, so the elasticity is the same regardless, i.e. it does not matter whether the change in quantity demanded was caused by an increase in price or a decrease in price, the end result is the same.