Chapter III: Demand and

Supply : elasticities
Content

 Elasticity of Demand
 Elasticity of Supply
 Predicting Price Changes

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Elasticity of Demand
The Quantity and Price

 Some argue that people don’t vary the

quantity of gasoline they buy as the price
changes.
 Do you think this is correct?

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Elasticity

 People do respond to incentives, changing

their behavior as prices, incomes, and prices
of related goods change.
 Elasticity is a measure of how much
one economic variable responds to
changes in another economic
variable

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Elasticity of Demand
 The price elasticity of demand is the responsiveness of the
quantity demanded to a change in price:
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price

 Since price and quantity change in opposite directions on the

demand curve, the price elasticity of demand is a negative
number.
 However we often refer to “more negative” elasticities as being
“larger” or “higher”.

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Elasticity of Demand

 A “large” value for the price elasticity of

demand means that quantity demanded
changes a lot in response to a price change.
 Formally, we say demand is price elastic if its
price elasticity of demand is larger (in absolute
value) than 1.
 So a 10 percent increase in price would result
in a greater than 10 percent decrease in
quantity demanded.

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Elasticity of Demand

 Demand is price inelastic if its price elasticity

of demand is smaller (in absolute value) than
1.
 That is, close to zero, indicating that quantity
demanded changes little in response to a price
change.
 Demand is unit price elastic if the price
elasticity of demand is exactly equal to 1.

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Elasticity of Demand

 Along D1, cutting the price

from $3.00 to $2.70
increases the number of
gallons sold from 1,000 per
day to 1,200 per day;
demand is elastic between
point A and point B.
 Along D2, cutting the price
from $3.00 to $2.70
increases the number of
gallons sold from 1,000 per
day only to 1,050 per day;
demand is inelastic between
point A and point C.

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Examples

 Provide some of your own examples for:

 Inelastic demand
 Elastic demand
 Unitary elastic demand

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Estimated Real-World Price
Elasticities of Demand

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Elasticity of Demand: example

 What are the demand

elasticities for both D1
and D2?

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Calculating price elasticity of demand

 At your gas station, you cut price from $2.50 per gallon to
$2.30 per gallon. Gasoline sales went up from 2,000 to
2,500 gallons per day, as on demand curve D1.
 To calculate this price elasticity; we first need the average
quantity and price:

2,000 + 2,500
Average quantity = = 2, 250
2

$2.50 + $2.30
Average price = = $2.40
2

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Calculating price elasticity of demand

 Now calculate the percentage change in quantity and price:
2,500  2, 000
Percentage change in quantity demanded =  100=22.2%
2, 250
$2.30  $2.50
Percentage change in price =  100  8.3%
$2.40
 Then price elasticity of demand is the ratio
of these two:
22.2%
Price elasticity of demand = = 2.7
8.3%
 This is greater in absolute value than-1,
 So we say that demand in this range is price elastic.

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Calculating price elasticity of demand

 What if quantity had only increased to 2,100 as in demand curve D2 ?
 Percentage change in price remains the same (-8.3 percent); however

2,100  2, 000
Percentage changed in quantity demanded =  100  4.9%
2, 050
 So price elasticity of demand is now:
4.9%
Price elasticity of demand =  0.6
8.3%
 This is smaller (in absolute value)
than-1, so demand is inelastic.

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Observations about elasticity

 A vertical demand curve means that quantity demanded

does not change as price changes. So elasticity is zero.
 A vertical demand curve is perfectly inelastic.

 Perfectly inelastic demand: The case where the quantity

demanded is completely unresponsive to price and the
price elasticity of demand equals zero.

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Observations about elasticity

 A horizontal demand curve means quantity demanded is infinitely
responsive to price changes.
 Elasticity is infinite.
 A horizontal demand curve is perfectly elastic.

 Perfectly elastic demand: The case where the quantity demanded is

infinitely responsive to price and the price elasticity of demand equals
infinity.

 Another special case occurs when a decrease in price results in the

same percentage increase in quantity demanded; in this case we say
demand is unit elastic.

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Summary of the price elasticity of demand

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Summary of the price elasticity of demand

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Summary of the price elasticity of demand

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So, do people respond to changes in

the price of gasoline?
 Gasoline demand is inelastic: the quantity demanded
does not change much as the price of gasoline changes.
 It is not perfectly inelastic: it is somewhat responsive to
price.
 Which panel shows this?

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The Determinants of the Price

Elasticity of Demand
 Why do some goods have a high price elasticity of
demand, while others have a low price elasticity of
demand?
 There are several characteristics of the good, of the
market, etc. that determine this.

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The Determinants of the Price Elasticity
of Demand
1. The availability of close substitutes
 If a product has more substitutes available, it
will have more elastic demand.
 Example: There are few substitutes for gasoline,
so its price elasticity of demand is low.
 Example: There are many substitutes for Nikes
(Reeboks, Adidas, etc.), so their price elasticity of
demand is high.

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The Determinants of the Price

Elasticity of Demand
2. The passage of time
 Over time, people can adjust their buying
habits more easily. Elasticity is higher in the
long run than the short run.
 Example: If the price of gasoline rises, it takes
a while for people to adjust their gasoline
consumption. How might they do that?
 Buying a more fuel-efficient car
 Moving closer to work

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The Determinants of the Price Elasticity
of Demand
3. Whether the good is a luxury or a
necessity
 People are more flexible with luxuries than
necessities, so price elasticity of demand is
higher for luxuries.
 Example: Many people consider milk and bread
necessities; they will buy them every week
almost regardless of the price.

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The Determinants of the Price Elasticity
of Demand
4. The share of a good in a consumer’s
budget
 If a good is a small portion of your budget,
you will likely not be very sensitive to its
price.
 Example: You might buy table salt once a year
or less; changes in its price will not affect very
much how much you buy.

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Determinants of Price Elasticity
Determinants of Elasticity
Demand is Demand is
Factor relatively relatively
elastic if … inelastic if …
Availability of There are many There are few
substitutes substitutes. substitutes.
Passage of time a long time passes. a short time passes.
Fraction of is large. is small.
consumer budget the product is a the product is a
Necessity luxury. necessity.

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Price elasticity of demand for breakfast

cereal
 What is the price elasticity of demand for breakfast cereal?
 The answer depends on whether you mean:
 A particular brand of a particular breakfast cereal
 A particular category of breakfast cereal
 Breakfast cereal in general
 The further down the list we go, the more broadly the market is defined, and
hence the fewer close
substitutes are available. Price elasticity
 So we would expect the price Cereal of demand
elasticity of demand to become Post Raisin Bran –2.5
smaller as we move down the list.
All family breakfast
–1.8
cereals
All types of breakfast
–0.9
cereal

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Group work: Elasticity of Demand

 Calculate the elasticities of

demand for D1 and D2

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Elasticity of Demand and
Total Revenue
Using Price Elasticity
Price Elasticity and Total Revenue
Total revenue
The money a firm generates from selling its product.
total revenue = price per unit × quantity sold

What happens to Total Revenue if price goes up?

Good News: You get more for each unit sold

Bad News: You sell fewer units

Effect on TR depends on which effect is bigger, i.e. whether

the price elasticity is less than or greater than one.

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The Relationship between Price Elasticity

of Demand and Total Revenue
 If you are a business owner, you need to decide how to price your
product.
 “How many customers will I gain if I cut my price?”
 “What will happen to my total revenue if I cut my price?”

 Total revenue: The total amount of funds received by a seller of a

good or service, calculated by multiplying the price per unit by the
number of units sold.

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Effect of cutting price with different

elasticities
 Suppose demand for your product is relatively price inelastic.
Customers are not very sensitive to the price of your product.
 As you decrease the price, you expect to gain few additional
customers.
 The few additional customers do not compensate for the lost revenue, so
overall revenue goes down.

 Suppose demand for your product is relatively price elastic.

Customers are very sensitive to the price of your product.
 As you decrease the price, you expect to gain many additional customers.
 The many additional customers more than compensate for the lost
revenue, so overall revenue goes up.

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The relationship between price elasticity and
total revenue
 Revenue before price cut
(at A):
1,000 x $3.00
= $3,000
 Revenue after price cut
(at B):
1,050 x $2.70
= $2,835
 The decrease in price
does not generate
enough extra customers
(area E) to offset revenue
loss (area C).

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The relationship between price elasticity and
total revenue
 Revenue before price cut (at
A):
1,000 x $3.00
= $3,000
 Revenue after price cut (at
B):
1,200 x $2.70
= $3,240
 The decrease in price does
generates enough extra
customers (area E) to more
than offset revenue loss
(area C).

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Using Price Elasticity: example 2

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Case 1: Using Price Elasticity: Bus case
Bus Fares and Deficits
In every large city in the United States, the public bus system runs a deficit Here is the
exchange between two city officials:
Buster:“A fare increase is a great idea. We’ll collect more money from bus riders, so
revenue will increase, and the deficit will shrink.”
Bessie: “Wait a minute, Buster. Haven’t you heard about the law of demand? The increase
in the bus fare will decrease the number of passengers taking buses, so we’ll collect less
money, not more, and the deficit will grow.”
Who’s right? It depends on the price elasticity of demand for bus ridership.
The price elasticity of demand for bus ridership in the typical city is 0.33, meaning that a
10 percent increase in fares will decrease ridership by only about 3.3 percent.
Because demand for bus travel is inelastic, the good news associated with a fare hike (10
percent more revenue per rider) will dominate the bad news (3.3 percent fewer riders), and
total fare revenue will increase.
In other words, an increase in fares will reduce the transit deficit, so Buster is right.

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Case 2: Using Price Elasticity: Farmers’ case
Why Are Bumper Crops Bad News for Farmers?
Suppose favorable weather generates a “bumper crop” for
soybeans that is 30 percent larger than last year’s harvest.
The bumper crop brings good news and bad news for
farmers.
The good news is that they will sell more bushels of
soybeans.
The bad news is that the increase in supply will decrease
the equilibrium price of soybeans, so farmers will get less
money per bushel.

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Case 2: Using Price Elasticity: Farmers’ case

 Unfortunately for farmers, the demand for soybeans and

many other agricultural products is inelastic.
 With inelastic demand, consumers need a large price
reduction to buy more of the product. Therefore, to
increase the quantity demanded of soybeans by 30
percent to meet the higher supply, the price must
decrease by more than 30 percent.

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Estimating price elasticity of demand

 We can see that knowing the price elasticity of demand
would be very useful for a firm. But how can a firm know
this information?
 For a well-established product, economists can use
historical data to estimate the demand curve.
 To calculate the price elasticity of demand for a new
product, firms often rely on market experiments.
 With market experiments, firms try different prices and
observe the change in quantity demanded that results.

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Case 3:Using Elasticity to Analyze the

Disappearing Family Farm
 Over the last century farms have become much more
efficient at producing food.
 This might appear to make farming more profitable, and
hence encourage more people into farming.
 But the number of people in farming has fallen
substantially (23 million in 1950, 3 million in 2011 in USA).
 Why have productivity gains in farming led to fewer people
choosing to farm?

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Elasticity and the disappearing family farm

 In 1950, U.S.
farmers produced
1.0 billion bushels of
wheat at a price of
$19.53 per bushel.
 Over the next 65
years, rapid
increases in farm
productivity caused
a large shift to the
right in the supply
curve for wheat.

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Elasticity and the disappearing family farm

 Income elasticity of
demand for wheat is
low, so demand for
wheat increased
little over this
period.
 Demand for wheat
is also inelastic, so
the large shift in the
supply curve and
the small shift in the
demand curve
resulted in a sharp
decline in the price
of wheat.

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Elasticity and the disappearing family farm

 In combination, this
led to a dramatic fall
in the price of the
farmers’ output.
 Making a living on a
small farm has
become harder and
harder, so the
increase in output is
supplied by fewer
and fewer large-
scale farmers.

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Elasticity of Supply
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The Price Elasticity of Supply and Its

Measurement
 Price elasticity of supply is the responsiveness of the quantity
supplied to a change in price, measured by dividing the percentage
change in the quantity supplied of a product by the percentage
change in the product’s price.
 It is very much analogous to price elasticity of demand
Percentage change in quantity demanded
Price elasticity of demand 
Percentage change in price
Percentage change in quantity supplied
Price elasticity of supply =
Percentage change in price

 So the same sort of calculation methods apply.

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Determinants of the price elasticity of

supply
 Price elasticity of supply depends on the ability and
willingness of firms to alter the quantity they produce as price
increases.
 The time period in question is critically important for
determining the price elasticity of supply.
 Suppose the wholesale price of grapes doubled overnight:
 Farmers could do little to increase their quantity immediately;
the initial price elasticity of supply would be close to 0.
 Over time, farmers could plant more fields in grapes; so over
the course of several years, the price elasticity of supply would
rise.

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Why are oil prices so unstable?

 Oil producers
cannot change
output very quickly.
 When demand
increases
suddenly, price
rises, acting as a
rationing
mechanism for the
increased demand.

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Why are oil prices so unstable?

 On the other hand,

during a recession,
demand for oil falls.
 Oil producers cannot
adjust their output
quickly, so the price
falls dramatically.

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Determinants of the price elasticity of
supply

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Extreme cases: perfectly elastic and

perfectly inelastic supply
 If a supply curve is a vertical line, we say it is perfectly inelastic.
 Quantity supplied is completely unresponsive to price.
 Price elasticity of supply equals zero.
 Example: Fixed number of spaces in a parking lot.

 If a supply curve is a horizontal line, we say it is perfectly elastic.

 Supply is infinitely responsive to price.
 Price elasticity of supply equals infinity.
 Example: Long-run production of agricultural products is (approximately)
perfectly elastic: at prices above the cost of production, farmers will supply
as much as is demanded.

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Summary of the price elasticity of supply

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Summary of the price elasticity of supply

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Summary of the price elasticity of supply

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What impact on Elasticity of Supply?

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Why is knowing the price elasticity of

supply useful?
 Knowing the price elasticity of supply can help us to
predict the effect that a change in demand will have:
 When demand increases, we know equilibrium price and quantity
will increase.
 But if supply is inelastic, quantity supplied cannot change
much in response to the demand change; so price will rise
a lot.
 If supply is elastic, price will rise much less.

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Changes in price depend on the price elasticity of
supply
 DemandTypical represents
the typical demand for
parking spaces on a
summer weekend at a
beach resort.
 DemandJuly 4 represents
demand on the 4th of July.
 When supply is inelastic,
the price increase will be
large.

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Changes in price depend on the price elasticity of
supply

 If supply is
elastic instead,
then the
resulting price
change will be
much smaller.

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Example
Why is supply more price-elastic in the long run?

• The coffee industry provides a good example of the difference between the
short-run and long-run price elasticity of supply. The price elasticity of supply
over a one-year period relatively low: If the price of coffee beans increases by
20 percent and stays there for a year, the quantity of coffee supplied will
increase by a relatively small amount. A newly planted coffee bush takes 3-5
years to yield marketable beans.
• In the short run, an increase in coffee production requires more beans
harvested per bush, which is possible with more fertilizer and water.
• In the long run, coffee farmers can plant more bushes so a sustained increase
in price generates a larger increase in quantity supplied.

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Predicting Price change
Using Elasticities To Predict Changes In
Prices
The Price Effects of a Change in Demand
Under what conditions will an increase in demand cause a relatively
small increase in price?

Small increase in demand.

Highly elastic demand.

Highly elastic supply.

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Using Elasticities To Predict Changes In
Prices
The Price Effects of a
Change in Demand
An increase in demand
shifts the demand curve to
the right, increasing the
equilibrium price.
In this case, a 35 percent
increase in demand
increases the equilibrium
price by 10 percent. Using
the price-change formula,
10% = 35% / (2.5 + 1.0).
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Using Elasticities To Predict Changes In
Prices
The Price Effects of a Change in Supply
Under what conditions will a decrease in supply cause a
relatively small increase in price?

Small decrease in supply.

Highly elastic demand.

Highly elastic supply.

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Using Elasticities To Predict Changes In
Prices
The Price Effects of a Change in
Supply
An import restriction on shoes
decreases the supply of shoes,
shifting the market supply curve
to the left and increasing the
equilibrium price from $40 to $44.
In this case, a 30 percent
reduction in supply increases the
equilibrium price by 10 percent.
Using the price-change formula,
10% = –(–30% / (2.3 + 0.70)).

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 Example
A BROKEN PIPELINE AND THE PRICE OF GASOLINE
How does a decrease in supply affect the equilibrium price?
• A pipeline break decreased the supply of gasoline to the city of
Phoenix by 30 percent and increased the equilibrium price by only 40
percent. Given a short-run price elasticity of demand for gasoline of
0.20, a price increase of 150 percent would be required to decrease
the quantity demanded by 30 percent. Why did the price increase by
only 40 percent?

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Example
• To predict a change in the equilibrium price, we must look at both sides
of the market, demand and supply.

• When the Texas pipeline broke, gasoline sellers in Phoenix switched

to the West Coast pipeline. The increase in the Phoenix retail price
allowed Phoenix sellers to outbid sellers in other cities for gasoline
produced by West Coast refineries. This is the law of supply in
action: the increase in the Phoenix price diverted gasoline from other
cities, reducing the impact of the pipeline break. As a result, the
equilibrium price increased by only 40 percent, not the 150 percent
that would have occurred in the absence of the supply boost from
West Coast refineries.

• We can use the price-change formula to illustrate this case. Suppose the
price elasticity of supply is 0.55 and the price elasticity of demand is
0.20. In this case, a 30 percent decrease in supply generates a 40
percent increase in the equilibrium price.

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Case study 1

 What is the value of the price elasticity of

supply between g and h?

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Case study 2

 Suppose you own a bookstore. You believe that you can

sell 40 copies per day of the latest John Grisham novel
when the price is $35. You consider lowering the price to
$25 and believe this will increase the quantity sold to 50
books per day.
 What is the price elasticity of demand ? What are the
implications?

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Case study 3

 Sam operates near a college campus. Sam

has been selling 120 burgers a day at $4.50
each and is considering a price cut. He
estimates that he would be able to sell 200
burgers per day at $3.50 each.
 Calculate the price elasticity of demand using
the midpoint formula.
 Calculate the change in revenue as a result of
the price cut.

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Case study 4
“In 2007, Apple unveiled its first smartphone, the
iPhone. Since then, although the average price of
the iPhone has risen steadily from $449 in 2008 to
more than $900 in 2021, sales of this smartphone
have still seen a sharp increase, from $1.8 billion
last year in 2008 to $191.9 billion in 2021.”

How do you explain that revenues are rising when the

prices are rising as well?

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Case study 5

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Next Course…

 Chapter IV : Firm’s Market Structure

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