PRICE ELASTICITY OF

DEMAND AND SUPPLY

PE 451- PETROLEUM
ECONOMICS
DR. K. SARKODIE
LECTURE OBJECTIVES
• TO DEMONSTRATE UNDERSTANDING OF THE CONCEPT
OF ELASTICITY
• KNOW AND EXPLAIN THE TYPES OF ELESTICITY OF
DEMAND AND SUPPLY
• TO COMPUTE AND INTERPRETE PRICE ELASTICITY FOR
CRUDE OIL PRODUCTS
INTRODUCTION
• Price elasticity of demand measures the responsiveness of buyers to a price change.

• If the price of gasoline increases by 10%, how will this affect the amount of gasoline
purchased? Will the amount purchased decrease by more than 10%?

• Will the amount purchased decrease by less than 10%? Will the amount purchased
decrease by exactly 10%? Or will the amount purchased not change at all? Once we
know the price elasticity of demand, we can answer these questions, because price
elasticity of demand measures the relationship between the percentage change in
the amount purchased and the percentage change in the price.
 DETERMINATION OF PRICE ELASTICTY OF DEMAND
We calculate price elasticity of demand by looking at the ratio of

e = The percentage change in quantity demanded divided by the percentage change in the price of the product

Or abbreviated:
e = % change in Q / % change in P

Where:
1. The % change in Q = the change in quantity demanded / the average of the two quantities demanded.
And:
2. The % change in P = the change in price / the average of the two prices.

The above formula for calculating percentages is called the “arc” formula.

There are other ways to calculate percentages, but the arc formula is the most accurate and most commonly
used in economics.

EXAMPLE 1
Problem: Let’s say that a
department store sells pillows,
and that in a typical week, buyers
purchase 6 pillows when the price
is $21. After the department store
decreases its price to $19, it
observes that buyers now
purchase 10 pillows per week.
Given these changes, what is the
price elasticity of demand for the
department store’s pillows?
Solution: Remember that
elasticity = (the change in quantity demanded / the average of the
two quantities demanded) / (the change in the price / the average
of the two prices).
The change in the quantity demanded is 10 pillows minus 6 pillows,
or 4. The average of these quantities is 8 (the sum of the two
quantities (6 plus 10) divided by 2).
The change in the prices is $21 minus $19, or $2. The average of the
two prices is $20 (the sum of the two prices ($19 + $21) divided by
2).
Therefore:
e = ((10 – 6) /8) / (($21 – $19) / $20)
= (4 / 8) / ($2 / $20)
= (0.5) / (0.1) = 5.
Therefore, the price elasticity of demand for the above product is 5.
 EXAMPLE 2
Problem: Let’s compute the price
Interpretation: So the elasticity in this
elasticity of demand for concert tickets.
example is 0.33 (rounded), or 33%. This
Suppose that for a concert, the price of a
means that when concert tickets
ticket is $15 and 25,000 people are in
increase in price by 12.5% (0.125), we
attendance. For another, nearly identical
can expect 4.08% (0.0408) fewer
concert, the organizers charge $17 and
people to attend. So when the price
24,000 fans attend. What is the price
increases by 100%, then we can expect
elasticity of demand for concert tickets?
33% fewer people to purchase tickets
(assuming the price elasticity remains
Solution: Using the formula for price
constant over that range).
elasticity of demand, we get
e = (1,000 / 24,500) / ($2 / $16) = (0.0408)
/ (0.125) = 0.3264
TYPES OF PRICE ELASTICY OF DEMAND
Determinants of price elasticity of demand
• Availabilty of close substitutes
• The importance of the product’s cost in one’s budget.
• The period of time under consideration.
Price elasticity of demand is greater if you study the effect of a price
increase over a period of two years rather than one week. Over a
longer period of time, people have more time to adjust to the price
change. If the price of gasoline increases considerably, buyers may not
decrease their consumption much after one week. However, after two
years, they have the ability to move closer to work or school, arrange
carpools, use public transportation, or buy a more fuel-efficient car.
Price elasticity and Taxes
• Let’s assume that a state government increases the tax on
gasoline by 50 cents. This means that the cost of supplying
the gasoline increases by 50 cents.
• In the graph below, the supply curve shifts leftward.
• Note that the vertical difference between supply curve S1
and supply curve S2 is 50 cents (the increase in the cost of
supplying the gasoline).
• The equilibrium price, however, did not increase by 50 cents,
because the demand curve is sloped at an angle. The burden
of any tax is typically shared between consumers and
suppliers.
 Price Elasticity and Total revenue
• When a product is elastic, and its price rises, what happens to the firm’s total
revenue?
• A firm’s total revenue is equal to the number of products it sells times the price
of the product. Therefore:
• Total Revenue = Price times Quantity
• or
• TR = P x Q
• For example, if a store sells 30 pairs of shoes at $10 each, then its revenue
equals 30 times $10, or $300. If the store sells 20 pairs of shoes after the price
increases to $25, then its total revenue equals 20 times $25, or $500. So the
store’s total revenue increases.
• In the above example, P (the price) increased, so, therefore, Q (the quantity demanded)
decreased, and total revenue increased. Does a price increase always lead to total revenue
increase? The answer is “no”. It depends on the product’s elasticity. Let’s look at the following
example.

• A supermarket sells 50 oranges at $1 each. Its revenue equals 50 times $1 or $50. If the store sells
20 oranges after the price increases to $2, then its revenue equals 20 times $2, or $40. In this case,
the store’s revenue decreases.

• If a product is elastic, the percentage change in the quantity demanded change is greater than the
percentage change in the price. Therefore, for an elastic product, if the price increases, the
percentage change in the quantity demanded decreases by a greater amount, and the firm’s
revenue will decrease, and vice versa.

• If a product is inelastic, the percentage change in the quantity demanded change is smaller than
the percentage change in the price. Therefore, for an inelastic product, if the price increases, the
percentage change in the quantity demanded decreases by a smaller amount, and the firm’s
revenue will increase, and vice versa.
 SUMMARY

• When a product is elastic and its price falls, total revenue increases.
• When a product is elastic and its price rises, total revenue decreases.
• When a product is inelastic and its price rises, total revenue increases.
• When a product is inelastic and its price falls, total revenue decreases.
• When a product is unit elastic and its price changes, total revenue remains
constant.
• A product is elastic when its elasticity is greater than 1.
When a product is elastic and its price changes, the percentage change in quantity demanded is greater than
the percentage change in the price. For example, if buyers purchase 20% fewer products as a result of a 10%
price increase, then the product is elastic.

• A product is inelastic when its elasticity is less than 1.

The numerator (percentage change in quantity demanded) of the elasticity formula is less than the
denominator (percentage change in price). For example, if buyers purchase 6% fewer products as a result of a
15% price increase, then the product is inelastic.

• A product is unit elastic when its elasticity is equal to 1.

If a product’s price rises by 8% and its quantity demanded decreases by 8%, then the product is unit elastic.