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Elasticity – CPA Exam Definitions

Elasticity CPA Exam

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Elasticity

Elasticity, in economics, is a measure of the responsiveness or sensitivity of one economic variable to changes in another economic variable. It is commonly used to analyze the relationship between the quantity demanded or supplied of a good or service and its price. Elasticity helps economists and businesses understand how changes in market conditions, such as price or income, affect consumer behavior and market equilibrium.

There are several types of elasticity, including:

  • Price elasticity of demand: This measures the responsiveness of the quantity demanded of a good or service to a change in its price. If the percentage change in quantity demanded is greater than the percentage change in price, the demand is considered elastic. If the percentage change in quantity demanded is less than the percentage change in price, the demand is considered inelastic. For example, luxury goods like high-end jewelry or designer clothing often have elastic demand, meaning that a price increase may lead to a significant drop in quantity demanded.
  • Price elasticity of supply: This measures the responsiveness of the quantity supplied of a good or service to a change in its price. Similar to demand, if the percentage change in quantity supplied is greater than the percentage change in price, the supply is considered elastic. If the percentage change in quantity supplied is less than the percentage change in price, the supply is considered inelastic. For example, agricultural products like fruits and vegetables often have inelastic supply in the short term because it takes time for farmers to adjust production in response to price changes.
  • Income elasticity of demand: This measures the responsiveness of the quantity demanded of a good or service to a change in consumers’ income. If the percentage change in quantity demanded is greater than the percentage change in income, the good is considered a normal good, and it has a positive income elasticity of demand. If the percentage change in quantity demanded is less than the percentage change in income, or the quantity demanded decreases when income increases, the good is considered an inferior good, and it has a negative income elasticity of demand. For example, public transportation may have a negative income elasticity of demand because as people’s income increases, they may choose to purchase cars and use public transportation less.
  • Cross-price elasticity of demand: This measures the responsiveness of the quantity demanded of one good to a change in the price of another related good. If the cross-price elasticity of demand is positive, the goods are considered substitutes, meaning that an increase in the price of one good leads to an increase in the quantity demanded of the other good. If the cross-price elasticity of demand is negative, the goods are considered complements, meaning that an increase in the price of one good leads to a decrease in the quantity demanded of the other good. For example, if the price of coffee increases, the demand for tea (a substitute) may also increase, while the demand for coffee creamer (a complement) may decrease.

Elasticity is a valuable concept in economics as it helps businesses and policymakers understand how changes in prices, income, and other factors affect consumer behavior, production decisions, and overall market dynamics.

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