Elasticity of Demand and Supply

ELASTICITY
AND ITS
APPLICATION
PRICE, INCOME AND CROSS ELASTICITY
Elasticity
• Elasticity is a measure of the
responsiveness of quantity demanded or
quantity supplied to one of its
determinants.
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Price Elasticity of
Demand
• Is a measure of how much the quantity demanded of a
good responds to a change in the price of that good,
computed as the percentage change in quantity
demanded divided by the percentage change in price
• Demand for a good is said to be elastic if the quantity
demanded responds substantially to changes in the
price.
• Demand is said to be inelastic if the quantity
demanded responds only slightly to changes in the
price.
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PRICE ELASTICITY OF DEMAND
• The law of demand means consumers will respond to a price decline by
buying more of a product.
• But the degree of consumer of responsiveness to a price change may
vary considerably from product to product.
• The responsiveness or sensitivity, of consumers to a change in price of a
product is measured by the concept of price elasticity of demand.
• It measures how much the quantity demanded responds to a change in
price
• Demand for some goods is very responsive to price changes and for
some other products consumers are relatively unresponsive to price
changes.

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What Determines Price
Elasticity?
• What determines whether the demand for a
good is elastic or inelastic?
• Because the demand for any good depends on
consumer preferences, the price elasticity of
demand depends on the many economic,
social, and psychological forces that shape
individual desires

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Determinants of Elasticity
• No of substitutes: The more the number of substitutes of the good, higher is likely to be
the Ep of that good. This is so because the consumer can easily shift from one substitute to
another in case of price change.
• Proportion of income spent on a good by the consumer: Higher the proportion of
income of consumer spends on a good, higher is the Ep of that good. If a larger proportion
of income is spent on a specific good and the price of the good rises, it affects the total
budget and makes the consumer more likely to shift to other options.
• Number of uses of the good: More the number of uses of a good more likely is to be the
Ep of that good. In the event of a change in price, a consumer can easily cut down or
increase the uses.
• Income of consumer: Richer the consumer, more likely the demand for a good by him is
less elastic. A rich consumer is less likely to reduce consumption of a good when its price
rises.
• How high is the price of the good: Higher the price of the good, higher is the elasticity. It
is so because a change in price of a high priced good affects the total budget significantly.
• Necessity of the good: The elasticity of demand also depends on how important or
necessary the good is for the consumer. It is a matter of habit. If the consumer is used to a
certain product, he is less likely to shift to other goods in case of rise in price of the good.

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Price Sensitivity
• The first step in estimating demand is to understand what affects price
sensitivity.
• Nagle says there is less price sensitivity when:
1. The product is more distinctive,
2. Buyers are less aware of substitutes,
3. Buyers cannot easily compare the quality of substitutes,
4. The expenditure is a lower part of buyer’s total income,
5. The expenditure is small compared to the total cost of the end product
6. Part of the cost is borne by another party,
7. The product is used in conjunction with assets previously bought,
8. The product is assumed to have more quality, prestige, or exclusiveness,
and
9. Buyers cannot store the product

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• Demand is likely to be less elastic when:
1. There are few or no substitutes or competitors;
2. buyers do not readily notice the higher price;
3. buyers are slow to change their buying habits and search for lower
prices; and
4. buyers think the higher prices are justified by quality differences,
normal inflation, and so on.
• If demand is elastic, sellers will consider lowering the price to
produce more total revenue.
• This makes sense as long as the costs of producing and selling more
units do not
• increase disproportionately.
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DETERMINANTS OF PRICE ELASTICITY
i. Substitutability
ii. Definition of a market
iii.Proportion of income
iv. Luxuries vs. necessities
v. Time (Whether it is short run or
long run)

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Availability of Close
Substitutes
Goods with close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that good to
others.
For example, butter and margarine are easily substitutable.
A small increase in the price of butter, assuming the price of
margarine is held fixed, causes the quantity of butter sold to
fall by a large amount.
By contrast, because eggs are a food without a close substitute,
the demand for eggs is probably less elastic than the demand
for butter.

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Definition of the Market
• The elasticity of demand in any market depends on how we draw the
boundaries of the market.
• Narrowly defined markets tend to have more elastic demand than broadly
defined markets, because it is easier to find close substitutes for narrowly
defined goods.
• For example, food, a broad category, has a fairly inelastic demand because
there are no good substitutes for food. Ice cream, a more narrow category,
has a more elastic demand because it is easy to substitute other desserts for
ice cream.
• Vanilla ice cream, a very narrow category, has a very elastic demand because
other flavors of ice cream are almost perfect substitutes for vanilla.

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Proportion of Income
• If a good takes a larger proportion of a household’s
income, demand for that product tends to be very sensitive
to price changes than goods which take a very small
proportion of the household’s income.

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Necessities versus
Luxuries
Necessities tend to have inelastic demands, whereas
luxuries have elastic demands.
When the price of a visit to the doctor rises, people will not
dramatically alter the number of times they go to the doctor,
although they might go somewhat less often.
By contrast, when the price of holiday trips rises, the
quantity of holiday trips demanded falls substantially.
The reason is that most people view doctor visits as a
necessity and holiday trips as a luxury

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Time Horizon
• Goods tend to have more elastic demand over longer time
horizons.
• When the price of gasoline rises, the quantity of gasoline
demanded falls only slightly in the first few months.
• Over time, however, people buy more fuel-efficient cars,
switch to public transportation, and move closer to where they
work.
• Within several years, the quantity of gasoline demanded falls
substantially.

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 Economists compute the price elasticity of demand as the percentage
change in the quantity demanded divided by the percentage change in the
price
 Economists measure the degree of elasticity or inelasticity by the
coefficient Ed using the following formulae:
Ed = % Change in Quantity Demanded

% Change in Price
Ed = ∆ in Q divided by ∆ in P
Q1 P1
 Because of the down sloping demand curve, the price elasticity coefficient
of demand will always yield a negative number.
 Economists usually ignore the minus sign and simply present the absolute
value of the elasticity coefficient to avoid any ambiguity.

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Mid Point Formula
Ed = ∆ in Q divided by ∆ in Price
(Q1+Q2)/2 (P1+P2)/2
Price elasticity of demand= (Q2 -Q1)/[(Q2 +Q1)/2]

• (P2 -P1)/[(P2 +P1)/2]
• The price elasticity of demand determines
whether the demand curve is steep or flat.
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Elastic Demand
• Demand is elastic if a given %
∆ in price results in a larger
%∆ in quantity demanded.
• Ed > 1

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Inelastic Demand
• If a given %∆ in price is accompanied by
a relatively smaller change in quantity
demanded, demand is inelastic.
• Ed < 1

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Unity Elasticity
• Where a %∆ in price is accompanied
by an equal % ∆ in quantity
demanded this is called unit
elasticity
• Ed = 1

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• The term perfectly inelastic refers to the extreme

case where a price change results in no change in the
quantity demanded.
• Ed = 0

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Perfectly Elastic Demand
• Another extreme case where a small price
reduction would cause buyers to increase
their purchases from zero to all they can
buy.
• Demand is said to be perfectly elastic
• Ed = 

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Price elasticity of demand: numerical value,
terminology and description

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COMPUTING THE ELASTICITY
OF A LINEAR DEMAND CURVE

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LINEAR DEMAND CURVE
The slope of a linear demand curve is

constant, but its elasticity is not.
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Unit Elastic Demand

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TOTAL REVENUE AND THE
• In any market, total revenue is P x Q, the price
of the good times the quantity of the good sold
• How does total revenue change as one moves
along the demand curve?
• The answer depends on the price elasticity of
demand.

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TOTAL REVENUE
The total amount paid by buyers, and received as revenue by

sellers, equals the area of the box under the demand curve,
P Q. Here, at a price of $4, the quantity demanded is 100,
and total revenue is $400.
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Total Revenue Test
INELASTIC DEMAND
If demand is inelastic, a price decrease will
cause total revenue to decrease
If demand is inelastic, an increase in price will
increase total revenue.
If demand is inelastic, a price change will
cause total revenue to change in the same
direction.

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INELASTIC DEMAND
• With an inelastic demand curve, an increase in the price leads to a

decrease in quantity demanded that is proportionately smaller.
• Therefore, total revenue (the product of price and quantity) increases.
• Here, an increase in the price from $1 to $3 causes the quantity demanded
to fall from 100 to 80, and total revenue rises from $100 to $240.

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Total Revenue Test
ELASTIC DEMAND
• If demand is elastic, a decrease in price will result in an
increase in total revenue
• Even though a lesser price is being received per unit, enough
additional units are now being sold to more than make up for
the lower price.
• If demand is elastic, a price increase will cause total revenue
to decrease
• If demand is elastic, a price change will cause total revenue to
change in the opposite direction.

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• When a demand curve is inelastic (a price elasticity less
than 1), a price increase raises total revenue, and a price
decrease reduces total revenue.
• When a demand curve is elastic (a price elasticity greater
than 1), a price increase reduces total revenue, and a price
decrease raises total revenue.
• In the special case of unit elastic demand (a price
elasticity exactly equal to 1), a change in the price does
not affect total revenue.

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ELASTIC DEMAND
• With an elastic demand curve, an increase in the price leads to a

decrease in quantity demanded that is proportionately larger.
• Therefore, total revenue (the product of price and quantity) decreases.
• Here, an increase in the price from $4 to $5 causes the quantity
demanded to fall from 50 to 20, so total revenue falls from $200 to
$100.

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Total Revenue: Unit
Elasticity
 In the case of unit elasticity, an
increase or decrease in price will
leave total revenue unchanged.

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Total Revenue - Summary
1. When a demand curve is inelastic (a price elasticity less than
1), a price increase raises total revenue, and a price decrease
reduces total revenue.
2. When a demand curve is elastic (a price elasticity greater than
1), a price increase reduces total revenue, and a price
decrease raises total revenue.
3. In the special case of unit elastic demand (a price elasticity
exactly equal to 1), a change in the price does not affect total
revenue.

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• Some Practical Applications
a. Wage bargaining
b. Bumper harvests of crops
c. Automation
d. Airline deregulation
e. Excise taxes
f. Drugs and street crime
g. Minimum wage

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INCOME ELASTICITY OF DEMAND
• Income elasticity measures the % change in quantity of a
product demanded which results from some % change in
consumer incomes.
• For normal or superior goods the elasticity coefficient is
positive. These are products for which more is purchased
when income increases.
• A negative income elasticity implies an inferior good e.g.
used clothes, retreaded tyres, cabbage, bus tickets consumers
decrease their purchases of such products as income increases
• The practical significance of income elasticity is that they help
us predict which industries are likely to be prosperous as
overall incomes in the economy increase.

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• Even among normal goods, income elasticities vary
substantially in size.
• Necessities, such as food and clothing, tend to have
small income elasticities because consumers,
regardless of how low their incomes, choose to buy
some of these goods.
• Luxuries, such as caviar and furs, tend to have large
income elasticities because consumers feel that they
can do without these goods altogether if their income
is too low

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Types of Income Elasticities

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• (a) Here the product is normal with the percentage
increase in the quantity demanded outweighing the
percentage rise in income, so that a 10% rise in income results
in a 15% increase in quantity demanded, giving a YED of
+1.5. This would suggest that the product could be a
consumer durable such as a CD player where the demand
increases rapidly as income increases.
• (b) Here the 10% rise in income leads to exactly the same
10% increase in quantity demanded, giving a YED of +1.

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• (c) Here the percentage increase in the quantity demanded
is smaller than the percentage rise in income, so that a 10%
rise in income results in a 5% increase in quantity demanded,
giving a YED of +0.5. Basic foodstuffs is a type of product
which could result in this response since we would not expect
a substantial increase in the quantity of basic food purchased
as income rises.

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• (d) Here the 10% rise in income has no effect on the
quantity demanded, giving a zero income elasticity of
demand.
• (e) Here the 10% rise in income leads to a 5% decrease in
the quantity demanded, giving a YED of −0.5. Clearly this is
an inferior product or inferior good, with consumers switching
away from this product to a better quality alternative which
they can now afford.

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CROSS ELASTICITY OF DEMAND
Cross elasticity of demand measures how sensitive consumer
purchases of one product (X) are to a change in the price of some
other product (Y}
If cross elasticity is +ve X and Y are substitutes
When cross elasticity is –ve, then X and Y go together and are
complimentary goods
A zero or near-zero coefficient suggests X and Y are unrelated or
independent goods.
 Exy= % ∆ in Quantity Demanded of X
% ∆ in the price of Y
Whether the cross-price elasticity is a positive or negative
number depends on whether the two goods are substitutes or
complements
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INCOME ELASTICITY OF DEMAND
Ei = %∆ in Q demanded
% ∆ in income
Applications
o Price ceilings and floors
o Price Controls
o Rent Controls
o Credit card interest ceilings
o Music concerts

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PRICE ELASTICITY OF
SUPPLY
• Price elasticity of supply (PES) refers to the responsiveness
of supply of a product to a change in its own price.
• PES refers to movement along the supply curve, i.e.
expansion/contraction of supply
• Supply of a good is said to be elastic if the quantity supplied
responds substantially to changes in the price.
• Supply is said to be inelastic if the quantity supplied responds
only slightly to changes in the price
• Es = %∆ in Quantity Supplied
%∆ in price of the product

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of Supply

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1. Flexibility of Sellers
• The price elasticity of supply depends on the flexibility of
sellers to change the amount of the good they produce.
• For example, beachfront land has an inelastic supply because
it is almost impossible to produce more of it.
• By contrast, manufactured goods, such as books, cars, and
televisions, have elastic supplies because the firms that
produce them can run their factories longer in response to a
higher price.

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2. The existence of spare
capacity.
• Even if the price of the product rises a firm may not be able to
expand supply if it does not have spare capacity.
• It may, in fact, be operating at full capacity so that, in the short
run at least, supply may be perfectly inelastic.
• On the other hand, if the firm does have spare capacity with a
plentiful supply of labour, capital equipment and raw materials
it could respond to the price change by expanding output, in
which case supply will be more elastic.

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3. The availability of
stocks
• The firm may have accumulated a large quantity of unsold
stocks or inventories, which can be quickly supplied to the
market.
• If this is the case then supply will tend to be more elastic.

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4. Mobility of the factors
of production.
• If the firm can easily reallocate its resources (namely its land,
labour, capital equipment and raw materials) from one type of
production to another, then the supply for that product will
tend to be more elastic.
• However, the labour force employed by a firm may be highly
skilled in the production of a particular product and the capital
equipment highly specialized.
• If this is the case then it may be difficult to shift resources
from one use to another. In this situation the factors of
production are said to be immobile and supply will tend to be
relatively inelastic.

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5. Time Period: Short run
vs. Long run
In most markets, a key determinant of the price elasticity of supply is the time
period being considered.
In analyzing the impact of time on elasticity of supply, economists distinguish
between immediate market period, the short run and the long run
Supply is usually more elastic in the long run than in the short run.
Over short periods of time, firms cannot easily change the size of their
factories to make more or less of a good.
Thus, in the short run, the quantity supplied is not very responsive to the
price. By contrast, over longer periods, firms can build new factories or close
old ones.
In addition, new firms can enter a market, and old firms can shut down.
Thus, in the long run, the quantity supplied can respond substantially to the
price.

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• The main determinant of price elasticity
of supply is the amount of time which a
producer has to respond to a given
change in product price.
• A producer’s response to an increase in
price of product X depends on its ability
to shift resources from the production of
other products to the production of X.

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The Immediate Market Period
o The immediate market period is so short a time that producers

cannot respond to a change in demand and price.
o In the immediate market period, the supply curve is perfectly
inelastic

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The Short Run
• In the short run, the plant capacity

of individual producers and the
industry is assumed to be fixed
but firms do have time to use their
plants more or less intensively.
• Supply is therefore more elastic

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The Long run
• The long run is a time period sufficiently long enough that
firms can make all desired resource adjustments: individual
firms can expand their plant capacities and new firms can
enter (or existing firms can leave) the industry.
• These adjustments mean an even more elastic supply curve.
• However in an increasing cost industry, supply will not be
perfectly elastic as industry’s expansion will cause prices of
resources to rise.
• In a constant-cost industry, the supply curve would be
perfectly elastic.

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Elasticity of Demand and Supply (Long run and Short run)-
OPEC case
• Supply and demand can behave differently in the short run and
in the long run.
• In the short run, both the supply and demand for products like
oil are relatively inelastic.
• Supply is inelastic because the quantity of known oil reserves
and the capacity for oil extraction cannot be changed quickly.
• Demand is inelastic because buying habits do not respond
immediately to changes in price.
• Many drivers with old gas-guzzling cars, for instance, will just
pay the higher prices.

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• Thus, as panel (a) below shows, the short-run supply and demand curves
are steep.
• When the supply of oil shifts from S1 to S2, the price increase from P1 to
P2 is large.
• The situation is very different in the long run.
• Over long periods of time, producers of oil outside of OPEC respond to
high prices by increasing oil exploration and by building new extraction
capacity.
• Consumers respond with greater conservation, for instance by replacing
old inefficient cars with newer efficient ones.
• Thus, as panel (b) shows, the long-run supply and demand curves are
more elastic.
• In the long run, the shift in the supply curve from S1 to S2 causes a much
smaller increase in the price.

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THE VARIETY OF
SUPPLY CURVES
Because the price elasticity of supply measures the
responsiveness of quantity supplied to the price, it is reflected
in the appearance of the supply curve
In the extreme case of a zero elasticity, supply is perfectly
inelastic and the supply curve is vertical. In this case, the
quantity supplied is the same regardless of the price.
As the elasticity rises, the supply curve gets flatter, which
shows that the quantity supplied responds more to changes in
the price.
At the opposite extreme, supply is perfectly elastic.

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Unit Elasticity

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Elasticity of Supply Varies
In some markets, the elasticity of supply is not constant but varies over the
supply curve
The diagram below shows a typical case for an industry in which firms have
factories with a limited capacity for production.
For low levels of quantity supplied, the elasticity of supply is high, indicating
that firms respond substantially to changes in the price.
In this region, firms have capacity for production that is not being used, such as
plants and equipment sitting idle for all or part of the day.
Small increases in price make it profitable for firms to begin using this idle
capacity.
As the quantity supplied rises, firms begin to reach capacity. Once capacity is
fully used, increasing production further requires the construction of new plants.
To induce firms to incur this extra expense, the price must rise substantially, so
supply becomes less elastic.

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Changing Elasticity of
Supply

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Application of Elasticity- Drug
Interdiction and Drug education
A persistent problem facing our society is the use of illegal drugs,
such as heroin, cocaine, and crack. Drug use has several adverse
effects.
One is that drug dependency can ruin the lives of drug users and
their families.
Another is that drug addicts often turn to robbery and other violent
crimes to obtain the money needed to support their habit.
To discourage the use of illegal drugs, governments devotes
billions of dollars each year to reduce the flow of drugs into the
country.
Let’s use the tools of supply and demand to examine this policy of
drug interdiction.
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Suppose the government increases the number of agents devoted to
the war on drugs.
What happens in the market for illegal drugs?
Although the purpose of drug interdiction is to reduce drug use, its
direct impact is on the sellers of drugs rather than the buyers.
When the government stops some drugs from entering the country and
arrests more smugglers, it raises the cost of selling drugs and,
therefore, reduces the quantity of drugs supplied at any given price.
The demand for drugs—the amount buyers want at any given price—
is not changed.
As panel (a) of the diagram below shows, interdiction shifts the supply
curve to the left from S1 to S2 and leaves the demand curve the same.
The equilibrium price of drugs rises from P1 to P2, and the equilibrium
quantity falls from Q1 to Q2.
The fall in the equilibrium quantity shows that drug interdiction does
reduce drug use.

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Application of Elasticity

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But what about the amount of drug-related crime?
Because few drug addicts are likely to break their
destructive habits in response to a higher price, it is likely
that the demand for drugs is inelastic
If demand is inelastic, then an increase in price raises total
revenue in the drug market.
That is, because drug interdiction raises the price of drugs
proportionately more than it reduces drug use, it raises the
total amount of money that drug users pay for drugs.
Addicts who already had to steal to support their habits
would have an even greater need for quick cash.
Thus, drug interdiction could increase drug-related crime.

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• Because of this adverse effect of drug interdiction, some
analysts argue for alternative approaches to the drug problem.
• Rather than trying to reduce the supply of drugs, policymakers
might try to reduce the demand by pursuing a policy of drug
education.
• Successful drug education has the effects shown in panel (b) .
• The demand curve shifts to the left from D1 to D2
• Because both price and quantity fall, the amount paid by drug
users falls.
• In this case, drug interdiction would increase drug-related crime
in the short run while decreasing it in the long run.

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Can good news for farming
be bad news for farmers?
• Use the demand and supply framework to explain what
happens to wheat farmers’ revenue and the market for wheat
when university agronomists discover a new wheat hybrid that
is more productive than existing varieties? Assume that the
demand for wheat is inelastic (10 marks)
• How might a drought that destroys half of all farm crops be
good for farmers? If such a drought is good for farmers, why
don’t farmers destroy their own crops in the absence of a
drought? (10 marks)

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Elasticity of Demand and Supply

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ELASTICITY

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

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Ed = % Change in Quantity Demanded

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Price elasticity of demand= (Q2 -Q1)/[(Q2 +Q1)/2]

MEC101 Economic Principles 1 Africa

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• The term perfectly inelastic refers to the extreme

MEC101 Economic Principles 1 Africa

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MEC101 Economic Principles 1 Africa

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The slope of a linear demand curve is

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

The total amount paid by buyers, and received as revenue by

MEC101 Economic Principles 1 Africa

• With an inelastic demand curve, an increase in the price leads to a

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

MEC101 Economic Principles 1 Africa

• With an elastic demand curve, an increase in the price leads to a

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o The immediate market period is so short a time that producers

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• In the short run, the plant capacity

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