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Elasticity

Definition

Elasticity in finance refers to the degree of change in demand or supply of a product or service in response to a change in its price. It is a measure of a variable’s sensitivity to a change in another variable. In financial markets, it often relates to changes in securities prices and their demand levels.

Phonetic

The phonetic pronunciation of “Elasticity” is: ih-las-ti-suh-tee.

Key Takeaways

  • It measures responsiveness: Elasticity is a crucial measure in economics that illustrates the responsiveness of the quantity demanded or supplied to changes in price or income.
  • Different types of Elasticity: There are different types of elasticity – price, income, and cross-elasticity – each measuring different aspects of supply and demand. Price elasticity measures the change in demand or supply due to price changes, income elasticity measures the change due to shifts in consumer’s income, while cross-elasticity measures the sensitivity of the quantity demanded for a product due to a change in the price of another product.</li> <li><b>Implications for businesses and governments:</b> Elasticity carries significant implications for both businesses and policymakers. Understanding price elasticity helps companies set prices to maximise profits, while governments can use these insights to set tax policy. Income elasticity can help predict how changes in the economy will impact businesses, while cross-elasticity can help in understanding the competitive landscape.</li></ol>

Importance

Elasticity is a crucial concept in business and finance as it measures the responsiveness of demand or supply to changes in price or income. It’s a tool for businesses to forecast changes in consumer behavior in response to a price change for goods or services, impacting revenue and sales strategy. Furthermore, in finance, elasticity is used to understand security’s or market’s price sensitivity, which aids in investment decisions. Overall, understanding elasticity helps businesses and investors to optimize pricing and income strategies, maintaining profitability, and market competitiveness.

Explanation

Elasticity in finance or economics is a key concept that quantifies the sensitivity of demand or supply to changes in other economic variables, mainly price. It is an indispensable tool that assists businesses and economists in making significant decisions and devising strategies. This is because understanding how variations in prices or income level influence the demand or supply of a product greatly assists businesses in predicting consumer behavior and making informed choices, such as determination of pricing strategy, product launch, or market entry.

For instance, if a product has high price elasticity, a minor change in its price can lead to significant shifts in its demand, and businesses can utilize this information to maximize their revenue. Similarly, income elasticity of demand helps businesses understand how changes in consumers’ income affect the demand for their product, enabling them to strategize product-placement in various economic scenarios. Overall, elasticity serves as a guidebook, leading businesses through the uncertain world of dynamic consumer behavior, price fluctuations, and shifting income levels.

Examples

1. Fuel Price Elasticity: The price elasticity of gasoline is a common example of elasticity in business. If gasoline prices increase significantly, consumers can not easily change their consumption habits in the short term (they can’t suddenly start using public transport, or buy new fuel-economy cars immediately). Therefore, the demand for gasoline tends to be inelastic – an increase in price doesn’t significantly decrease demand.

2. Elasticity in Entertainment: In the entertainment industry, movie tickets are generally price elastic. If the price of movie tickets increases significantly, consumers can easily substitute it with other forms of entertainment like streaming platforms, books, or video games. Thus, high ticket prices can lead to a substantial decrease in demand, depicting the elasticity.

3. Restaurant Meal Elasticity: The price elasticity of demand for restaurant meals can also be significant. If prices at a particular restaurant rise significantly, customers can choose to visit another more affordable restaurant, eat at home, or use meal delivery services, indicating an elastic response to a price change.

Frequently Asked Questions(FAQ)

What is Elasticity in finance and business?

Elasticity refers to the degree to which demand or supply is influenced by a change in price. It measures how much quantity demanded or supplied of a good or service changes in response to a change in price.

What are the types of Elasticity?

There are two main types of elasticity: Price Elasticity of Demand (PED) and Price Elasticity of Supply (PES).

What is Price Elasticity of Demand (PED)?

Price Elasticity of Demand refers to the sensitivity of the quantity demand of a product or service to a change in its price. If the demand for a product is elastic, then a small change in price can lead to a significant change in quantity demanded and vice versa.

What is Price Elasticity of Supply (PES)?

Price Elasticity of Supply refers to how the quantity supplied of a good can change with a change in its price. If supply is elastic, suppliers can increase or decrease production significantly in response to price changes.

How is Elasticity calculated?

Elasticity is commonly calculated by finding the percentage change in quantity demanded (or supplied) divided by the percentage change in price.

What does it mean if demand or supply is elastic?

If demand or supply is elastic, it means that quantity demanded or supplied responds significantly to price changes. More specifically, if the percentage change in quantity demanded or supplied is greater than the percentage change in price, the good or service is said to be elastic.

What does it mean if demand or supply is inelastic?

If demand or supply is inelastic, it means that quantity demanded or supplied changes very little in response to price changes. Specifically, if the percentage change in quantity demanded or supplied is less than the percentage change in price, the good or service is said to be inelastic.

Are all goods and services elastic?

No, not all goods and services are elastic. Luxury goods, for example, tend to be elastic because consumers can easily cut back on them when prices rise. In contrast, necessities like food and medicine tend to be inelastic because consumers continue to buy them despite price increases.

How does Elasticity affect revenue and production?

Understanding elasticity can help firms predict changes in revenue in response to pricing adjustments. If demand is elastic, for example, reducing prices may increase total revenue as the increase in quantity demanded may outweigh the drop in price. Conversely, if demand is inelastic, raising prices may also increase total revenue, as the reduction in quantity demanded may be less than the increase in price.

Related Finance Terms

  • Price Elasticity of Demand
  • Income Elasticity of Demand
  • Cross-Price Elasticity
  • Price Elasticity of Supply
  • Elasticity Coefficient

Sources for More Information

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