What is Elasticity of Demand? Types, Formula & Examples

Elasticity of demand shows how much demand for a product changes when its price, income, or other factors change. It helps businesses understand customer behaviour. 

Have you noticed that when tomato prices rise, everyone says, “bas ab toh kadhi chawal hi sahi”.  However, a ₹5 hike in iPhone prices barely makes a difference. Why? This is because the demands for both commodities are different. While people might avoid tomatoes for a few days, they'll still buy an iPhone, no matter the price.

Technically, it is called the Elasticity of Demand. It tells us how sensitive buyers are to changes in price, income, or even the price of related items. 

Why should you care? There are many reasons, but for starters, businesses set prices based on the elasticity of demand. So, let’s explore the Elasticity of Demand from a broader perspective, including its types and formulas.

What is Elasticity of Demand?

Elasticity of demand is an economic concept, so it becomes more important to explain it in simple terms. It measures how much the demand for a good or service changes when the price or income changes. 

In other words, it answers questions like: “If prices go up 5%, will people buy a lot less, a little less, or almost the same?” It helps businesses, policymakers, and economists predict consumer behaviour, optimise pricing strategies, and design taxes or subsidies.

How Elasticity Impacts You, Businesses, and Governments?

Elasticity of Demand allows you to understand the BTS (behind the scenes) of ever-growing businesses, government-induced taxes and subsidies, and everyday decision-making. Let’s decode where it helps:

1. Pricing Strategy Optimisation

Businesses use elasticity to decide how much they can push prices without losing customers.

• If demand is inelastic (like petrol or milk), firms can increase price and still retain buyers.
   
• If it’s elastic (like chips or branded water), even a ₹2 hike can reduce sales.

2. Tax Policy Design

Governments use elasticity to figure out where taxes will earn more.

• Governments tax inelastic goods like fuel or cigarettes because people keep buying them despite higher prices.
   
• Elastic goods are usually not taxed much, as buyers quickly stop buying when prices rise.

3. Revenue Forecasting

Elasticity helps businesses and governments predict changes in revenue when price, tax, or income levels fluctuate.

• Companies use price elasticity to estimate how much sales and revenue will change after a price adjustment.
   

• Governments assess whether a tax hike will bring in more revenue or reduce collections due to a fall in demand.

4. Marketing & Advertising Planning

Elasticity helps firms decide how effective advertising will be and where to spend their budgets.

• Advertising Elasticity of Demand (AED) tells how much sales change when a company spends more on ads. If AED is high, spending more on ads leads to more sales per rupee spent. 

• Brands use elasticity to promote products when and where people respond best.

Types of Elasticity
 

A. Price Elasticity of Demand (PED)

Price elasticity of demand tells us how much the quantity demanded of a product changes when its price changes. It helps businesses understand whether raising or lowering prices will increase or decrease total sales.

Formula: 

PED = (% Change in Quantity Demanded) / (% Change in Price). 

Different types of PED are:

• Perfectly elastic (∞): Buyers stop buying if the price even slightly increases.
   
• Relatively elastic (> 1): Demand changes more than the price change.
   
• Unitary (1): Change in demand equals price change.
   
• Relatively inelastic (< 1): Demand changes less than the price change.
   
• Perfectly inelastic (0): Quantity stays the same no matter the price.

For example, A shoe brand increases the price of its ₹2,000 sneakers by 20%. As a result, monthly sales drop from 1,000 pairs to 750 pairs. The brand wants to know how sensitive buyers are to this price hike. So, they did the following calculations:

• Original Price = ₹2,000
   
  • New Price = ₹2,400
  • %ΔP = (2400 – 2000)/2000 × 100 = 20%
     
• Original Qty = 1,000
   
  • New Qty = 750  
  • %ΔQd = (750 – 1000) / 1000 × 100 = –25%
• PED = −25% / +20%

• PED = −1.25 

With a PED of -1.25, demand is relatively elastic. This means customers are quite sensitive to price changes. If you increase prices, sales will drop even faster. Businesses in such cases should avoid frequent price hikes unless necessary. Discounts may work better to boost sales.

B. Income Elasticity of Demand (YED)

Income elasticity of demand shows how the quantity demanded of a product changes when people's income changes. It helps us know if a product is a necessity, a luxury, or an inferior good.

Formula: 

YED = %ΔQd​​ / %ΔIncome

• %ΔQd​​ = Percentage change in Quantity Demand
• %ΔIncome = Percentage change in Income

Based on the values of YED, we have 2 types of goods:

1. Normal Goods: When YED is positive or more than 0 (>0). These are further categorised into: 
    
   1. Necessities (0–1): Demand rises, but less than the income rise.
   2. Luxuries (> 1): Demand rises more than income rises.
       
2. Inferior goods: When YED value is less than zero or negative (<0). Here, demand drops as income increases.

For example, after a 10% rise in household income, a family increases its monthly spending on restaurant food from ₹4,000 to ₹5,000. They want to understand if dining out is a necessity or a luxury for them. So, they did the necessary calculations as shown below:

• Initial Spending = ₹4,000
   
• New Spending = ₹5,000 
  • %ΔQd = (5000 – 4000) / 4000 × 100 = +25%
     
• Income increase = 10%
   
• YED = +25% / +10%
• YED = 2.5

A YED of +2.5 means the product is a luxury good. Demand is rising faster than income, showing people spend more on it as they get richer. Businesses can target higher-income consumers and premium positioning. It’s income-sensitive and seasonal.

C. Cross‑Price Elasticity of Demand (XED)

Cross-price elasticity shows how the demand for one product changes when the price of a different product changes. It helps us understand whether the two goods are substitutes or complements.

Formula:

  XED = %ΔQd​ (Good A) / %ΔP (Good B)​ 

• %ΔQd​ (Good A) = Percentage change in Quantity Demanded of Good A
• %ΔP (Good B) = Percentage change in Price of Good B

The values of XED can be categorised as follows:

• Positive XED (> 0): When A and B are substitutes, that is, A can be replaced by B (e.g., tea & coffee). This replacement happens due to the increased price of B, which causes high demand for A.
   
• Negative XED (< 0): Here, A and B are complements, that is, one can be enjoyed without replacing the other (e.g., burgers & fries). So, when the price of B rises, demand for A falls.
   
• Zero XED (~0): Here, goods are unrelated. When the price of B goes up, the demand for A remains unaffected.

For example, the price of instant coffee rises from ₹200 to ₹240 (20% increase). Due to this, the monthly demand for tea increases from 2,000 to 2,400 packets. The tea company wants to know if coffee and tea are close substitutes. So they calculated XED as shown below:

• %ΔP (coffee) = (240 – 200) / 200 × 100 = +20%
   
• %ΔQd (tea) = (2,400 – 2,000) / 2,000 × 100 = +20%
   
  • XED = +20% / +20% ​

  • XED = +1

A positive XED of +1 shows that tea and coffee are strong substitutes. When coffee becomes expensive, people switch to tea at the same rate. The higher the XED, the more sensitive consumers are to the other product’s price.

D. Advertising Elasticity of Demand (AED)

Advertising elasticity tells us how demand for a product changes when advertising expenses go up or down. It shows how effective your ads are in increasing sales.

Formula:

AED = % ΔQd / % ΔA

• % ΔQd = Percentage change in Quantity Demanded
• % ΔA = Percentage change in Advertising Expenditure

The values of AED can be interpreted as follows:
 

• AED > 1: If the value is more positive, that is more than 1, ads are highly effective. Demand rises more than the ad spend.
   
• 0 < AED < 1: If the AED value is positive but less than 1, this means that ads are helping, but less efficiently.
   
• AED < 0: If the AED is negative, that means ads may be counterproductive. There might be something wrong with the ads that is decreasing the demand.

For example, a cold drink company increases its advertising budget from ₹10 lakh to ₹13 lakh (30% increase). As a result, monthly sales rise from 50,000 to 60,000 bottles. The marketing team wants to measure ad effectiveness on demand, which is why they calculated the AED.

• %ΔAd Spend = (13 – 10) / 10 × 100 = +30%
   
• %ΔQd = (60,000 – 50,000) / 50,000 × 100 = +20%
   
  • AED = +20% / +30%
  • AED = 0.67E

Since AED is less than 1, the ad campaign is moderately effective. Demand is rising, but not as fast as ad spending. The company may need better messaging or offers to boost results further.

Conclusion

The first time I heard elasticity, it was in my physics textbook. Well, that term and the one we discussed in this blog are miles or planets apart. Elasticity is a powerful tool for pricing, marketing, and policy-making. Knowing whether your product is elastic or inelastic can help you make smarter decisions in business or budgeting. ‘Samjhe, kya?’

Frequently Asked Questions

What is the price elasticity of demand?
It shows how much demand changes when the price of a product goes up or down.

What does it mean if demand is elastic?
It means people quickly change how much they buy when the price changes, like luxury goods.

What is inelastic demand?
Even if the price rises, demand stays almost the same, like for petrol or medicine.

What are other types of elasticity?
There’s income elasticity (based on income changes) and cross elasticity (based on related product prices).

How is elasticity calculated?
It’s the percentage change in quantity demanded divided by the percentage change in price.
 

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