Elasticity of Demand and Supply

 Price Elasticity of Demand (Ep)

 Calculating Percentage Change
 Significance of Price Elasticity of Demand (Ep)
 Determinants of Price Elasticity of Demand (Ep)
 For Next Time
 Price Elasticity of Demand
 A measure of the extent to which the quantity
demanded of a good changes when the price of the
good changes, ceteris paribus.
 We know if we raise a price, the Qd will decline, but
we don’t know how much.
 Elasticity answers the “how much” question.
 In Business, we want to know the relationship
between Qd and Price
 Ep = % Change in Quantity Demanded
% Change in Price
 Price of Latte

 Suppose a retail gourmet coffee outlet is selling its

premium “Latte” for $3/cup. The store generally is
selling 15 cups of “Latte” per hour, and the store
manager is thinking seriously of raising the price to
$5/cup. He knows he will lose some sales but thinks
that most of his customers are willing to pay more.
Help him quantify his decision by determining how
many fewer cups he can sell and still generate more
revenue per hour.
 Calculating Percentage Change

 Percentage Change measures how much a value has

changed from one time period to another
 For Example, if a firm’s sales for the current month
amounted to $100 million and the previous month,
the same firm’s sales were $90 million. What was
the percentage change?
 There are two methods of calculating the percentage
change
• Simple Method
• Midpoint Method
 Calculating Percentage Change

 Simple Method

Percentage Change = Current Value-Previous Value

Previous Value
 or, = $100m - $90 m = $10m = 11.1%
$90m $90m
 Very Common Usage, especially in the business world
 Calculating Percentage Change

 Midpoint Method
Percentage Change = Current Value – Previous Value
(Current Value + Previous Value)/ 2

 Or, = $100m -$90m = $10m = 10.5%

($100m + $90m)/2 $95m

 The midpoint method is the better method because it

gives similar results whether we are measuring
forward or backward
 Price Elasticity of Demand

 From Formula Ep = % Change in Qd

% Change in Price

 If Price Elasticity of Demand > 1, demand is elastic

 If Price Elasticity of Demand = 1, demand is unit
elastic
 If Price Elasticity of Demand < 1, demand is
inelastic
 Demand Elasticity
 Elastic Demand – When % Change in Quantity
Demanded > % Change in Price
 Unit Elastic Demand – When % Change in Quantity
Demanded = % Change in Price
 Inelastic Demand – When % Change in Quantity
Demanded < % Change in Price
 Perfectly Elastic Demand – When Quantity Demanded
Changes by a very large percentage in response to
an almost zero Change in Price
 Perfectly Inelastic Demand – When the Quantity
Demanded remains constant as Price changes
 Perfectly Elastic Demand Curve

14

12

10

8 D

5 10 15 20 25 30
Quantity

The elasticity of a perfectly elastic demand curve is infinity

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-10
 Perfectly Inelastic Demand Curve

30

25

20

15

10

5 10 15 20 25
Quantity

The elasticity of a perfectly inelastic demand curve is 0

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-11
 Relativity Elasticity of Demand Curves

D1

D2

Quantity

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-12
 Elasticity of Straight Line Demand Curve
11
Very elastic
10
e = 6.33

8
Slightly elastic
7
Unit elastic
6 e = 1.0
Slightly inelastic
5

3 e = .29
Very
inelastic
2

1
D
0
0 1 2 3 4 5 6 7 8 9 10 11
Quantity

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-14
Significance of Price Elasticity of Demand

 Profit maximization requires that business set a price

that will maximize the firm’s profit
 Elasticity tells the firm how much control it has over
using price to raise profit
 If Ep > 1, then the % Change in Qd > % Change is
Price and demand is said to be elastic
• An increase in price will reduce total revenue
• A decrease in price will increase total revenue
 Significance of Price Elasticity of Demand

 If Ep < 1, then the % change in Qd < % change in

price, and demand is said to be inelastic
• An increase in price will increase total revenue
• A decrease in price will decrease total revenue

 If Ep = 1, then the % change in Qd = % change in

Price, and demand is said to be unit elastic
• An increase in price will have no impact on total revenue
• A decrease in price will have no impact on total revenue
Price Elasticity of Demand Influences
 Substitute Product Availability (key determinant)
-- Luxury or Necessity (Ep for luxury items is >)
-- How narrowly it is defined (coffee is inelastic but latte
may have more substitutes and therefore is more elastic)
-- Time elapsed since price change (>time, >elasticity;
more time to find substitutes or manage consumption)
 Income Effects
-- The greater the proportion of income spent
on the good, greater a price change impacts
Quantity Demanded
 Advertising
 Purpose – Product Differentiation (Branding)
 To make the demand for a product greater
 To make the demand for a product more inelastic

D D

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-18
 Elasticity Thoughts

 Demand Curve Slope and Elasticity (Steeper the slope, lower the
elasticity)
 A Units-Free Measure (% Change – Absolute Value)
 Elasticity Along a Linear Demand Curve
-- Slope is constant but elasticity varies

 Elasticity and Total Revenue

-- Price and Total Revenue change in opposite directions, demand is elastic
-- Price Change leaves Total Revenue unchanged, demand is unit elastic
-- Price and Total Revenue change in same direction, demand is inelastic
 Price Elasticity of Supply

 A measure of the extent to which the quantity

supplied of a good changes when the price of
the good changes, and all other influences on
seller’s plans remain the same (cateris
paribus)
 Price Elasticity of Supply
 Perfectly Elastic Supply – When the quantity supplied
changes by a very large percentage in response to an
almost zero increase in price
 Elastic Supply – When the % change in the quantity
supplied > the % change in the price
 Unit Elastic Supply – When the % change in the
quantity supplied = the % change in price
 Inelastic Supply – When the % change in the
quantity demanded is < the % change in price
 Perfectly Inelastic Supply – When the quantity
supplied remains the same as the price changes
 Influences on Price Elasticity of
Supply
 Production Possibilities – page 124
-- Opportunity Costs
constant or gently rising opportunity costs
= elastic price elasticity
-- Fixed Production = inelastic price elasticity
-- Time Elapse – longer time, > price
elasticity
 Influences of Price Elasticity of
Supply
 Storage Possibilities

The better the storability, the more elastic is

the price elasticity of supply
 Computing Price Elasticity of Supply

 Percentage change in quantity supplied

Percentage change in price

• If Price Elasticity of Supply > 1, Supply is elastic

• If Price Elasticity of Supply = 1, Supply is unit elastic
• If price elasticity of supply< 1, Supply is inelastic
 Cross Elasticity of Demand
 A measure of the extent to which the demand
for a good changes when the price of a
substitute or complement changes, ceteris
paribus

% Change in Quantity Demanded

% Change in Price of one of its
substitutes or complements
 Income Elasticity of Demand
 A measure of the extent to which the
demand for a good changes when
income changes, ceteris paribus

 % Change in Quantity Demanded

% Change in Income
 Income Elasticity of Demand
 If income elasticity of demand > 1 the
demand for the good is income elastic
 If income elasticity of demand is between
0 and 1, the demand is income inelastic
 * If income elasticity of demand < 0 the
demand is negative income elastic
 For Next Time
 Define the term “Price Elasticity of Supply.” What
does this concept tell us?

 What are the main determinants of supply elasticity?

How do they impact supply?

 If government taxes a product (excise tax), how can

we determine how much of the tax will be passed on
to the buyer and how much will have to be paid by
the seller?