Chapter 4

Supply and Demand: Elasticity and

Applications
By Amjad Laghari
 Contents
Application and Elasticity of Supply and Demand

4.1 Elasticity of Demand and Supply

Price Elasticity of Demand
Calculating Elasticities
Elasticity and Revenue
Price Elasticity of Supply
Other Important Elasticities

4.2 Issues and Applications

Price Rationing
Elasticity and Tax Revenues
Minimum Floors and Maximum Ceilings
PRICE ELASTICITY OF DEMAND

The responsiveness (or sensitivity) of consumers to a price change is

measured by a product’s price elasticity of demand.

OR

The price elasticity of demand (sometimes simply called price elasticity)

measures how much the quantity demanded of a good changes when its
price changes.
OR

The precise definition of price elasticity is the percentage change in quantity

demanded divided by the percentage change in price.
 When the price elasticity of a good is high, we say that the good has
“elastic” demand, which means that its quantity demanded responds
greatly to price changes.

 When the price elasticity of a good is low, it is “inelastic” and its quantity
demanded responds little to price changes.

 Price elasticities tend to be higher when the goods are luxuries, when
substitutes are available, and when consumers have more time to adjust
their behavior.

 By contrast, elasticities are lower for necessities, for goods with few
substitutes, and for the short run.
During calculating elasticities we have to be careful for three key steps

1. All elasticities are written as positive numbers, even though prices and
quantities demanded move in opposite directions for downward-sloping
demand curves.

2. Elasticity uses percentage changes in price and demand rather than

absolute changes. a change in the units of measurement does not affect
the elasticity. So whether we measure price in pennies or dollars, the price
elasticity stays the same.

3. For very small percentage changes, such as from 100 to 99, it does not
much matter whether we use 99 or 100 as the denominator. But for larger
changes, the difference is significant. To avoid ambiguity, we will take the
average price to be the base price for calculating price changes.
The Price-Elasticity Coefficient and Formula

To obtain Percentage change in Quantity is ΔQ/Q

Q = (Q1+ Q2)/2
P = (P1+P2)/2

To obtain Percentage change in Price is ΔP/P

Elasticities in diagrams

Elastic Demand is elastic if a specific percentage change in price results in a

larger percentage change in quantity demanded. Then Ed will be greater than
1.

Inelastic Demand If a specific percentage change in price produces a smaller

percentage change in quantity demanded, demand is inelastic. Then Ed will
be less than 1.

Unit Elasticity The case separating elastic and inelastic demands occurs
where a percentage change in price and the resulting percentage change in
quantity demanded are the same.
Extreme Cases

Where a price change results in no change whatsoever in the quantity

demanded, economists say that demand is perfectly inelastic. The price-
elasticity coefficient is zero because there is no response to a change in price.

Where a small price reduction causes buyers to increase their purchases from
zero to all they can obtain, the elasticity coefficient is infinite ( ) and economists
say demand is perfectly elastic.
Price Elasticity in Diagrams
A Shortcut for Calculating Elasticities
The elasticity of a straight line at a point is given by the ratio of the length of
the line segment below the point to the length of the line segment above the
point.
The Algebra of Elasticities
 Class Activity

Draw a graph and Calculate Elasticity Coefficient for Elastic, Inelastic and Unit Elastic Demand

Q P
0 90
100 60
200 30
300 0
ELASTICITY AND REVENUE

Many businesses want to know whether raising prices will raise or lower
revenues?

Total revenue is by definition equal to price times quantity (or P x Q ). If

consumers buy 5 units at $3 each, total revenue is $15. If you know the
price elasticity of demand, you know what will happen to total revenue
when price changes:
How airlines Use demand elasticities?
They do price discrimination

Divide Customers according to Elasticities

 Business Class Passengers  Low Price elasticity

 Economy Class Passengers  High Price elasticity

Airlines offer discount fares for travelers who plan ahead and who tend to stay
longer.
One way of separating the two groups is to offer discounted fares to people who
stay over a Saturday night—a rule that discourages business travelers who want to
get home for the weekend. Also, discounts are often unavailable at the last minute
because many business trips are unplanned expeditions to handle an unforeseen
crisis.
PRICE ELASTICITY OF SUPPLY
Supply as the responsiveness of the quantity supplied of a good to its market
price.
OR

The price elasticity of supply is the percentage change in quantity supplied

divided by the percentage change in price.
 The degree of price elasticity of supply depends on how easily—and
therefore quickly—producers can shift resources between alternative uses.

 If the quantity supplied by producers is relatively responsive to price

changes, supply is elastic.

 If it is relatively insensitive to price changes, supply is inelastic.

 The easier and more rapidly producers can shift resources between
alternative uses, the greater the price elasticity of supply.

 In analyzing the impact of time on elasticity, economists distinguish among

the immediate market period, the short run, and the long run.
Price Elasticity of Supply: The Market Period

The market period is the period that occurs when the time immediately after
a change in market price is too short for producers to respond with a change
in quantity supplied.

 Supply is perfectly inelastic

Price Elasticity of Supply: The Short Run
The short run is a period of time too short to change plant capacity but long
enough to use the fixed-sized plant more or less intensively.

The equilibrium price is lower in the short run than in the market period.
 Supply is elastic
Price Elasticity of Supply: The Long Run

The long run is a time period long enough for firms to adjust their plant sizes
and for new firms to enter (or existing firms to leave) the industry.
 Supply is more elastic
 There is no total-revenue test for elasticity of supply.

 Supply shows a positive or direct relationship between price and amount

supplied; the supply curve is upsloping.

 Regardless of the degree of elasticity or inelasticity, price and total revenue

always move together.
Cross Elasticity of Demand

The cross elasticity of demand measures how sensitive consumer purchases

of one product (say, X) are to a change in the price of some other product
(say, Y)
Substitute Goods: If cross elasticity of demand is positive, meaning that sales of X
move in the same direction as a change in the price of Y, then X and Y are substitute
goods.

The larger the positive cross-elasticity coefficient, the greater is the substitutability
between the two products.

Complementary Goods: When cross elasticity is negative, we know that X and Y “go
together”; an increase in the price of one decreases the demand for the other.

The larger the negative cross elasticity coefficient, the greater is the
complementarity between the two goods.

Independent Goods: A zero or near-zero cross elasticity suggests that the two
products being considered are unrelated or independent goods.
For example, the cross elasticity between Coke and Pepsi is high, making them
strong substitutes for each other. Consequently, the government would likely
block a merger between them because the merger would lessen competition.

In contrast, the cross elasticity between cola and gasoline is low or zero. A
merger between Coke and Shell would have a minimal effect on competition.
So government would let that merger happen.
Income Elasticity of Demand

Income elasticity of demand measures the degree to which consumers

respond to a change in their incomes by buying more or less of a particular
good.
Normal Goods For most goods, the income-elasticity coefficient Ei is positive,
meaning that more of them are demanded as incomes rise.

Inferior Goods A negative income-elasticity coefficient designates an inferior

good. Consumers decrease their purchases of inferior goods as incomes rise.
APPLICATIONS TO MAJOR ECONOMIC ISSUES
Agriculture Sector
Agricultural Distress Results from Expanding Supply and Price-Inelastic Demand

Higher revenue being the result of inelastic demand.

Crop-Restriction Programs Raise Both Price and Farm Income

Price-inelastic demand, farm incomes decline with increases in supply.

Restrictions on production are a typical example of government interference
in individual markets.

They often raise the income of one group at the expense of consumers.
These policies are generally inefficient: the gain to farmers is less than the
harm to consumers.
IMPACT OF A TAX ON PRICE AND QUANTITY
We are often interested in determining who actually bears the burden of the
tax?
By incidence we mean the ultimate economic effect of a tax on the real incomes of
producers and consumers.
Subsidies:

 If taxes are used to discourage consumption of a commodity, subsidies are

used to encourage production.

General Rules on Tax Shifting:

 If demand is inelastic relative to supply, as in the case of gasoline, most of

the cost is shifted to consumers.

 By contrast, if supply is inelastic relative to demand, as is the case for land,

then most of the tax is shifted to the suppliers.
Thanks