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ELASTICITIES OF SUPPLY AND DEMAND

Price elasticity of demand

The law of demand tells us that consumers will respond to a price decline by buying more of a
product. But the degree of the consumers’ responsiveness to a price change may be different
for particular products. Often we want to know how much demand will rise or fall. To answer
question like this, we use the concept of price elasticity of demand. The formula of elasticity
is as follows:
∆ Q D ∆p
Ep= :
QD p
∆ QD
in - percentage change quantity demanded
QD
∆p
- percentage change in price
p
We calculate percentage changes by dividing the change in price by original price and the
change in demand by original demand.

We know from the down sloping demand curve that price and quantity demanded are
inversely related. This means that the price elasticity coefficient of demand is always
negative. For example, if price declines, demand rises. This means that the numerator in our
formula will be positive and the denominator negative, resulting in negative elasticity
coefficient. There is a convention to ignore the minus sign and to present absolute value
of the elasticity coefficient. This is done to avoid an ambiguity that may arise. For example,
it can be confusing to say that elasticity coefficient –4 is greater than –2. That is why we
ignore minus sign and show the absolute value.

Interpretations of the elasticity

Demand is elastic if a given percentage change in price results in a larger percentage


change in demand. Example: if a 2 percent decline in price results in a 4 percent increase in
quantity demanded, demand is elastic. In all such cases where demand is elastic, the
elasticity coefficient will be greater than 1. In this case it will be 2. If a given percentage
change in price is accompanied by a relatively smaller change in the quantity demanded,

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demand is inelastic. To illustrate: a 3 percent increase in price causes only 1 percent decrease
in quantity demanded – the coefficient is 1/3 in this case. The elasticity coefficient will
always be less than 1 when demand is inelastic. The borderline case that separates elastic
and inelastic demands occurs when a percentage change in price and the percentage
change in demand are equal. For example, a 10 percent drop in price causes a 10 percent
rise in demand. This special case is named unit elasticity, because the elasticity coefficient
is exactly 1. If a demand is perfectly inelastic it is an extreme situation when a change in
price results in no change in demand - this would be the case of insulin for a diabetic. In
such a case an elasticity coefficient equals zero. This is a case of a good that satisfies basic
consumer’s needs and do not have substitutes. If a demand is perfectly elastic consumers
will buy as much as they can at a given price. For even the smallest increase in price above
this level, quantity demanded drops to zero, and for any decrease in price, quantity demanded
increases without limits. This is the case of perfectly competitive market that will be
discussed during the next lectures.

Figure 1. Perfectly inelastic and perfectly elastic demand

Cross-price elasticity of demand

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The demand for some goods is affected by the prices of other goods. For example, because
butter and margarine can easily be substituted for each other, the demand for each depends on
the price of the other. A cross-price elasticity of demand refers to the percentage change in
the quantity demanded for a given good resulting from a 1 percent change in the price of
another good.
∆ Q A ∆p B
E cp = :
QA pB
∆ QA
- percentage changes in quantity demanded of good A
QA

∆p B
- percentage changes in price of good B
pB

If goods are substitutes, the cross-price elasticity will be positive. Such goods compete in
the market, hence a rise in the price of margarine makes butter cheaper relatively to
margarine, and leads to an increase in the demand for butter. If goods are complements, they
are used together, and the increase in the price of one good tends to reduce the consumption of
the other. For example, if the price of petrol goes up, the demand for it falls, but the demand
for motor oil also falls. Thus, the cross-price elasticity for complements is negative. If E p = 0,
the goods are independent (not related), so a change in price of one good does not cause a
change in demand for the other.

The total revenue test

Perhaps the easiest way to establish whether demand is elastic or inelastic is to observe what
happens to total revenue of producers/sellers when product price changes. Total revenue is
price times quantity. If demand is elastic, a decrease in price will result in an increase in
total revenue. This is so because although a lower price is being received per unit of product,
enough additional units are now being sold to outweigh the lower price. If demand is elastic,
a price increase will cause total revenue to decrease. Why? Because the gain in total
revenue caused by the higher unit price is less than the loss in total revenue due to fall in
sales. To generalize: if demand is elastic, a change in price will cause total revenue to
change in opposite direction.
If demand is inelastic, a price decrease will cause total revenue to decrease. The slight
increase in sales that occurs due to lower price will be insufficient to offset the decline in

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revenue per unit, and the net result is that total revenue declines. If demand is inelastic, a
price increase will increase total revenue. Generalization: if demand is inelastic, a
change in price will cause total revenue to change in the same direction.
In the special case of unit elasticity, an increase or decrease in price will leave total
revenue unchanged. The loss in revenue due to a lower unit price will exactly offset the gain
in revenue brought about by the accompanying increase in sales. Conversely, the gain in
revenue due to a higher unit price will be exactly offset by the loss in revenue associated with
the accompanying decline in the amount demanded.

Table 1. Impact of price elasticity of demand on total revenue – summary

Absolute value Terminology Description Impact on total revenue


of elasticity price price
coefficient increases decreases
Greater than 1 Elastic demand Quantity demanded Total revenue Total revenue
changes by a larger decreases increases
percentage that price
does
Equal to 1 Unitary elastic Quantity demanded Total revenue is Total revenue is
demand changes by the same unchanged unchanged
percentage that price
does
Less than 1 Inelastic demand Quantity demanded Total revenue Total revenue
changes by a smaller increases decreases
percentage that price
does

Table 2. Total revenue test (hypothetical data)

Total Price per Total revenue of Total Elasticity coefficient


quantity unit of a producers (total revenue test Ep (magnitude)
demanded good expenditure of
per week consumers)
2000 5 10000 Elastic 2000 1
÷ =5
4000 4 16000 demand 2000 5
Elastic 3000 1
÷ =3
7000 3 21000 demand 4000 4

Elastic 2000 1 6
÷ =
demand 7000 3 7
11000 2 22000

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Inelastic 5000 1 10
÷ =
demand 11000 2 11
16000 1 16000

Determinants of price elasticity of demand

1. Substitutability – generally speaking, the larger the number of substitutes of a given


product available, the greater the elasticity of demand for such a product. For example,
in a perfectly competitive market where there is the great number of producers selling very
similar products (perfect substitutes to one another), a demand will be perfectly elastic. This
means that if one seller raises a price, a demand for his/her product will drop to zero, as the
buyers will turn to other sellers offering the same product. At the other extreme, there are
some products that have no substitutes. In such a case, a change in price will not cause a
change in demand (the diabetic’s demand for insulin). It is worth noting that the elasticity of
demand for a product depends on how narrowly the product is defined. The demand for Shell
motor oil would be more elastic that the overall demand for motor oil. A number of other
brands are readily substitutable for Shell motor oil, but there is no good substitute for motor
oil as such.

2. Proportion of income – other things being equal, the larger the expenditures for a given
good in the consumer’s budget, the greater the elasticity of demand for that good is. For
example, a 10 percent increase in the price of pencils will amount to only a few cents and
therefore will have little response in terms of amount demanded. A 10 percent increase in the
price of cars or housing means a price increase of, say, 5000 and 10000 zloty respectively.
These increases are significant fractions of the annual incomes of many families, and demand
is expected to diminish significantly.

3. Luxuries versus necessities – the demand for necessities tends to be inelastic. Bread
and electricity are generally regarded as necessities; we can’t get along without them. A price
increase will not reduce significantly the amount of bread consumed and lighting used in a
household. On the other hand, French cognac and emeralds are luxuries that can be forgone
without inconvenience. If the price of them rises, the consumers do not need purchase them,
so a demand will fall significantly.

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4. Time – the demand for a product tends to be more elastic in the long run than in the
short run. One aspect of this results from a fact that many consumers have strong habits.
When a price of a product rises, it takes time to seek and to experiment with other products to
see if they are acceptable for us. Another explanation has to do with product durability. For
example, studies show that a short run demand for petrol is more inelastic than is a long run
demand. Why so? Because in the long run large, petrol-consuming cars wear out and, in a
context of rising petrol prices, are replaced by smaller, more efficient cars.

Point and arc elasticity of demand

The point elasticity of demand is defined as the price elasticity at a particular point on the
demand curve. It is calculated by substituting for ∆p/∆QD in the elasticity formula the absolute
value (magnitude) of the slope of the demand curve at that point (∆p/∆QD is the slope for
small ∆p because price is measured on the vertical axis and quantity demanded on the

∆ Q D ∆p ∆ QD p
horizontal axis. As a result, equation E p = : can be written as E p = ⋅ . If we
QD p ∆p Q D
substitute ∆p/∆QD with the absolute value of the slope of the demand curve, we will obtain

1 p
Ep= ⋅ .
slope Q D

Sometimes we want to calculate a price elasticity over some portion of demand curve rather
than at a single point. Suppose, for example, that we consider an increase in the price of a
product from 8 zl to 10 zl and expect a demand to fall from 6 units to 4. How should we
calculate the price elasticity of demand? Is the price increase 25% (a 2 zl increase divided by
the original price 8 zl) or is it 20% (a 2 zl increase divided by the new price of 10 zl? Is the
percentage decrease in quantity by 33,3% (2/6) or by 50% (2/4)? We can resolve this problem
by using the arc elasticity of demand: the elasticity calculated over the range of prices.
Instead of using the initial or final price, we use an average of them; the same refers to
quantity demanded. Therefore the arc elasticity of demand is given by:
p1 + p 2
∆ QD 2
Ep= ⋅ .
∆p QD1 + QD 2
2

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In our example, the average price is 9 zl, and the average quantity is 5 units. Thus the arc
elasticity is
8 + 10
−2
Ep= ⋅ 2 = −1,8 .
2 6+4
2
The arc elasticity will always lie somewhere between the point elasticises calculated for the
original and final prices.

Price elasticity of supply

If producers are responsive to price changes, supply is elastic. If they are relatively insensitive
to price changes, supply is inelastic. The formula of supply elasticity is as follows:
∆ Q S ∆p
ES = :
QS p
∆ QS
- percentage change in quantity supplied
QS
∆p
- percentage change in price
p

The supply and price are directly related. This means that the price elasticity of supply
coefficient will be positive (ES>0). If EI>1, percentage changes in quantity supplied are
bigger than percentage changes in price. If EI<1, percentage changes in quantity
supplied are lower than percentage changes in price. In a case of E S=0, the change in
price does not cause the change in demand.

The main determinant of the elasticity of supply is the amount of time, which a producer
has to respond to a given change in a product price. Generally speaking, we can expect a
greater output response – and therefore greater elasticity of supply – the longer the amount of
time a producer has to adjust to a given price change. This is so because a producer’s response
to an increase in price of a given product depends upon his ability to shift resources from the
production of other products to the production of a given product. And the shifting of
resources takes time: the longer time, the greater the resource “shiftability”.

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In analysing the impact of time upon the elasticity of supply, economists distinguish
between the immediate market period, the short run, and the long run.

The immediate market period is so short a time that producers can not respond to a
change in demand and price. Suppose a farmer who brings his entire output of tomatoes to
the market: one truck. The supply curve will be perfectly inelastic – the farmer will sell his
tomatoes despite the price is high or low. Why? Because he can not offer more than one
truckload even if the price is high. Even if he would like to sell more, tomatoes can not be
produced overnight. It will take another full season to respond to - higher than expected -
price. Similarly, because the product is perishable, the farmer can not withhold it from the
market. It the price is lower than he expected, he will still send the entire output. Costs of
production will not be important in making this decision. Even if the price of tomatoes is
lower than production costs, the farmer will sell to avoid a total loss through spoilage. In a
very short time, then, the farmer’s supply of tomatoes is fixed. Figure 2 illustrates the inelastic
supply curve in the market period (Pd1). The farmer is not able to respond to assumed increase
in demand (shift of the demand curve from P p1 to P p2). The price increases from c 1 to c 2, but
there is no increase in output.
Figure 2. Supply in particular market periods

Pd1- quantity supplied in the market period


Pd2- quantity supplied in the short run
Pd3- quantity supplied in the long run

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In the short run, the plant capacity of individual producer is assumed to be fixed. But firms
have time to use their plants more or less effectively. In our case our farmer’s land and farm
machinery are fixed. But he has enough time to cultivate tomatoes more intensively by
applying more fertilizers. The result is a greater output response to increase in demand. This
greater output response is reflected in a more elastic supply curve, as shown by Pd2 in Figure
2. The increase in demand is met by a larger quantity adjustment (from Q1 to Q2) and a
smaller price adjustment (from c1 to c3) than in the market period.
The long run is a time sufficiently long so that firms can make all needed resource
adjustment. Individual firm can expand their plant capacities, buying new machines and
equipment, constructing new buildings etc. New firms can enter the industry. In our example
the farmer is able to buy additional land and more agricultural machines and trucks. These
adjustments mean that supply can increase even more than in the short run. The supply curve
for the long run is Pd3. An increase in demand results in small price effect (from c1 to c4) and a
large output effect (from Q1 to Q3).

Income elasticity of demand

We will also be interested in the response of demand to changes in other variables, for
example income. Demand for most goods increase when income rises. The income elasticity
of demand is the percentage change in demand resulting form the percentage change in
income.

∆ Q D ∆I
EI = :
QD I

∆ QD
- percentage changes quantity demanded
QD
∆I
- percentage changes in income
I

If goods are normal, the demand and income are directly related. This means that the
income elasticity of demand coefficient will be positive (EI>0). Normal goods can be
divided into two groups: luxuries and necessities. For luxuries (EI>1), while for necessities
(1>EI>0). In a case of EI=0, the change in income does not cause the change in demand.

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For inferior goods, the demand and income are inversely related. An increase in income will
result in a decrease in demand. Therefore the income elasticity of demand coefficient will
be negative (EI<0).

Government intervention on a market

There is a lot of opinions that activity of market mechanism results in prices that are unfairly
high for the buyers and unfairly low for the sellers. In such cases the government may
intervene by legally limiting how high or low the price may be.

Price ceilings

A price ceiling is a maximum legal price that a seller may charge for a product or
service. The objective of ceiling prices is that they enable consumers to obtain goods which
they could not afford at the equilibrium price. Rent controls, energy prices controls are
examples of this. To be effective, a ceiling price must be below the market equilibrium
price. What will be effects of a ceiling price? At this price there will be a persistent shortage
of a good. The quantity demanded at the ceiling price pc is QD, and the quantity supplied is
only QS. The ceiling price prevents the market adjustment of the price. The market
disequilibrium causes some problems. The first is how to distribute the available supply QS
among buyers who want the amount QD? Usually the government introduces a formal
system of rationing the product to consumers. An effective rationing system consists in
printing of coupons equal to the amount QS and to distribute equally this amount among
consumers. The assumption is that each person, despite the level of income, receives the same
number of coupons. However, in such a case another problem arises. The demand curve in
figure 3 shows that there are some buyers who are able to pay more than the ceiling price.
And, of course, it is more profitable for producers to sell above the ceiling price. Therefore an
illegal black market is a common situation on the markets with price ceilings. It is a market
where products are bought and sold at prices above the ceiling price.

Figure 3. Market with a ceiling price

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Price supports

Price support it is a minimum price fixed by the government which is above the
equilibrium price. It is implemented when the government is of opinion that the free market
system fails to provide the equal distribution of income. The most common examples are
minimum-wage legislation and the support of agricultural prices. Let’s assume that the market
price for corn is 10 zl for 1 kilogram and as a result of this price farmers earn extremely low
incomes. Government decides to establish a legal minimum price of 4 zl for kilogram. What
will be the effects? At any price above the equilibrium price quantity supplied will exceed
quantity demanded. There will be a persistent surplus of the product. Farmers will be willing
to produce and offer for sale more than private buyers are willing to purchase at the supported
price. If government imposes a supported price of ps, farmers will be willing to produces QS,
but private buyers will only buy the quantity QD. The surplus is measured by the excess of QS
over QD. To cope with the surplus of supply, the government may purchase the surplus and
store it. This way the market is in equilibrium again, although the minimum price is not the
market equilibrium price.

Figure 4. Market with supported price

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