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Elasticity - Explanation and examples

Sensitivity to change in economics and life in general

 

What is Elasticity?

Elasticity measures the sensitivity of change of one variable in response to another, causal variable. We call variables that respond drastically to change as ‘elastic’, and ones that don’t respond a lot as ‘inelastic’.

How do we calculate elasticity? Let’s steal a page from your high school Econ 101 textbook. You can calculate the elasticity of a variable by taking the absolute value of the percentage change in quantity over the percentage change in price.

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Examples of Elasticity

Imagine you’re the owner of a high-tech pizza delivery startup. Your competitive advantage? All your pizzas reach customers at the peak of freshness because they’re quickly delivered by AI-powered drones!

You originally charged $10 per drone-delivered pizza, and business stays steady at 100 pizzas ordered a week, but after a few months you realize your operating costs are higher than you anticipated. In response, you raise the price to $11 per pizza, but - suddenly! - orders plummet to 50 pizzas per week. Plugging in the numerical changes into the formula above, you get the following result:

% change in quantity = (50 pizza orders - 100 pizza orders)/10% = -50%

% change in price = ($11-$10)/$10 = 10%

-50%/10% = |-5| = 5

We consider products with elasticity scores greater than 1 as highly elastic; otherwise, they’re seen as inelastic. It looks like pizza delivery powered by AI-driven drones is a highly elastic service and (sadly for you) raising prices won’t cover your costs.

Interestingly enough, the concept of elasticity is not confined to understanding economic theory. In fact, you can use it to understand the causal relationship between variables in any field of study! Economist, Tyler Cowen, refers to a 2011 experimental political science paper that measures elasticity in gauging degrees of trust in US-Middle East relations. The paper concludes that:

In our experiments, trust was promoted by decreasing the cost of betrayal in the United States but not in Jordan. Punishment functioned differently. Giving the first mover the option to take revenge at a price should she be betrayed enhanced trust in Saudi Arabia but not in the United States.

At the risk of overgeneralizing, in the US trust is a highly elastic variable, in response to changes in betrayal (the causal variable), but this isn’t so in Jordan. In Saudi Arabia, trust is instead observed only as elastic in response to the opportunity for sweet, sweet revenge.

Also check out

  1. https://www.investopedia.com/terms/e/elasticity.asp

  2. Teacher Expectations Matter Marginal Revolution, Tyler Cowen

  3. The elasticity of trust in the Middle East Marginal Revolution, Tyler Cowen

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