Elasticity

How responsive is quantity to price? Price elasticity of demand answers that question with a single ratio: the percentage change in quantity demanded divided by the percentage change in price. When a 10% price increase causes a 20% drop in quantity, elasticity is 2 — demand is elastic. When a 10% price increase causes a 2% drop in quantity, elasticity is 0.2 — demand is inelastic. The number determines who captures value in every market. Unit elasticity (E = 1) is the boundary: a 10% price change produces a 10% quantity change, and total revenue stays constant. Below that, demand is inelastic and price increases raise revenue. Above that, demand is elastic and price increases destroy revenue.

Elastic demand means small price changes produce large quantity changes. Luxury goods, discretionary spending, and products with close substitutes behave this way. Raise the price of a mid-tier restaurant meal 15% and watch reservations collapse. Raise the price of a generic painkiller 15% and customers switch to the store brand. The demand curve is flat. Price sensitivity is high. Competing on price in elastic markets is a race to the bottom — margins compress, and the winner is whoever can survive the longest at the lowest price.

Inelastic demand means large price changes produce small quantity changes. Necessities, addictive products, and goods with no substitutes behave this way. Insulin prices in the United States rose 600% between 2001 and 2017. Diabetics kept buying. Gasoline demand barely budged when prices doubled in 2008. Smokers kept buying when cigarette taxes tripled. The demand curve is steep. Price sensitivity is low. The companies that control inelastic demand can raise prices with impunity — until a substitute emerges or regulation intervenes.

Alfred Marshall formalised the concept in Principles of Economics (1890), building on earlier work by Augustin Cournot. Marshall's insight was that elasticity varies by product, by segment, and by time horizon. The same good can be elastic in the short run and inelastic in the long run — or the reverse. Gasoline is inelastic over a month (you need to drive to work) but elastic over a decade (you can buy an electric car, move closer to transit, or change jobs). The strategic question is always: over what horizon am I making this decision, and what is the elasticity over that horizon?

Amazon's dynamic pricing tests elasticity by product category. The company runs thousands of price experiments daily, measuring how quantity responds to marginal price changes across millions of SKUs. Categories with elastic demand get aggressive discounting to capture volume. Categories with inelastic demand get higher margins. The same customer sees different pricing logic for different products because elasticity differs by category. Netflix's price increases — from $8 to $15.49 for the standard plan between 2014 and 2024 — succeeded because streaming demand is inelastic for most subscribers. Few substitutes exist. The content library creates switching costs. Churn increased modestly; revenue increased dramatically. Tesla's premium segment is less elastic than mass-market EVs. Buyers of $80,000 Model S sedans care less about a $5,000 price adjustment than buyers of $40,000 Model 3 sedans. The strategic use: price where elasticity is favourable. Avoid competing where elasticity is high.