Extensions of

Demand and
Supply Analysis
Elasticities of Supply and Demand

 Not only are we concerned with what direction price and

quantity will move when the market changes, but we are
concerned about how much they change
 Elasticity gives a way to measure by how much a variable
will change with the change in another variable
 Specifically, it gives the percentage change in one variable
resulting from a one percent change in another
Price Elasticity of Demand
 Measures the sensitivity of quantity demanded to
price changes
 It measures the percentage change in the quantity
demanded of a good that results from a one percent
change in price

%Q D
E D
P
%P
Price Elasticity of Demand
 The percentage change in a variable is the absolute
change in the variable divided by the original level of
the variable
 Therefore, elasticity can also be written as:

Q Q P Q
E 
D
P 
P P Q P
Price Elasticity of Demand
 Usually a negative number
 As price increases, quantity decreases
 As price decreases, quantity increases
 When |EP| > 1, the good is price elastic
 |%Q| > |%P|
 When |EP| < 1, the good is price inelastic
 |%Q| < |% P|
Price Elasticity of Demand
 PED represents a movement along the demand
curve
 The primary determinant of price elasticity of
demand is the availability of substitutes
 Many substitutes, demand is price elastic
 Can easily move to another good with price increases
 Few substitutes, demand is price inelastic
 Proportion of Income
 The higher the price of good relative to consumer’s
incomes, the greater the price elasticity of demand
 Luxuries versus Necessities
 Time
 Generally, product demand is more elastic the longer
the time period under consideration
Price Elasticity of Demand
 Looking at a linear demand curve, as we move
along the curve Q/P is constant, but P and Q
will change
 Elasticity will change along the demand curve in a
particular way
Price Elasticity of Demand
 Given a linear demand curve
 Elasticity depends on slope and on the values of P and
Q
 The top portion of demand curve is elastic
 Price is high and quantity small
 The bottom portion of demand curve is inelastic
 Price is low and quantity high
Price Elasticity of Demand
Price EP = -
Demand Curve
4
Q = 8 – 2P
Elastic

2 Ep = -1

Inelastic

Ep = 0
4 8 Q
Price Elasticity of Demand
 The steeper the demand curve, the more inelastic
the demand for the good becomes
 The flatter the demand curve, the more elastic the
the demand for the good becomes
 Two extreme cases of demand curves
 Completely inelastic demand – vertical
 Infinitely elastic demand – horizontal
Infinitely Elastic Demand
Consumers will buy as much as they can at
a single price, p*.
Price
For even a small increase in p, demand
falls to zero.

For a small decrease in p, demand goes to

infinity.

P* D

EP = 

Quantity
Completely Inelastic Demand

Price
D

EP = 0

Demand remains the same no

matter what the price.

Q* Quantity
 The Total Revenue Test
 Elasticity of Demand is important for firms with regards to
changes in total revenue and thus profits (TR – TC)

 TR is the total amount the seller receives from the sale of a

product in a particular time period
 TR = P * Q

 To infer whether demand is elastic or inelastic, apply the total

revenue test (TRT)
 If TR changes in same direction as price, demand is inelastic
 Eg: P increases, Q fall by less than the increase in P, so TR increases
 If TR changes in opp. direction as price, demand is elastic
 Eq: P increases, Q decreases by more than P, so TR falls.
TR and Price change in opposite
direction when Demand is Elastic

 If demand is elastic:

 A decrease in price will increase total revenue

 While less is received per unit due to a fall in price.
 This is offset by an increase in total quantity demanded due to a
price fall.

 An increase in price causes TR to decline

 While more is received per unit.
 This is offset by a decline in quantity demanded due to the
higher price.
 The Total Revenue Test
 Lower price and elastic demand
 grey (gain) exceeds gold (loss)
When p falls from 2
to 1: P
•While less is
received per unit $3
•This loss is shown
by the gold area a
•This is offset by an 2
increase in qty.
demanded b
•This gain shown by 1 D1
the grey area.

0 10 20 30 40 Q
TR and Price change in same direction
when Demand is Inelastic
 If demand is inelastic:

 A decrease in price will reduce total revenue

 Less is received per unit due to a price decline
 Due to inelastic demand qty. demanded will not increase enough
to offset the decline in revenue per unit  TR will decrease

 An increase in price causes TR to increase

 More is received per unit
 Due to inelastic demand, qty. demanded will not fall enough so
as to offset the increase in revenue per unit  TR will increase
 The Total Revenue Test
 Lower price and inelastic demand
 Gold (loss) exceeds grey (gain)
P
c
$4

Loss
3

2
d

1
Gain D2
0 10 20 Q
TR stays constant with Price changes
when Demand is Unit elastic

 If demand is unit elastic, a decrease/increase in price will

leave total revenue constant

 When price falls,

 Less is received per unit
 But, increase in sales (due to lower price) will be enough
to just offset the reduction in revenue per unit
 Overall TR will be unchanged.
 The Total Revenue Test
 Lower price and unit-elastic demand
 Grey (gain) equals gold (loss)

P
e
$3

Loss
2

f
1 D3

Gain
0 10 20 30 Q
Elasticity on a Linear Demand Curve
Price Elasticity of Demand for Movie G 18.1
Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1)
Total Quantity of (3) (4) (5)
Tickets Demanded (2) Elasticity Total Revenue Total-Revenue
Per Week, Thousands Price Per Ticket Coefficient (Ed) (1) X (2) Test

1 8 $8,000
2 7
] 5.00
14,000
] Elastic

3 6
] 2.60
18,000
] Elastic

4 5
] 1.57
20,000
] Elastic
] 1.00 ] Unit Elastic
5 4 20,000
] 0.64 ] Inelastic
6 3 18,000
7 2
] 0.38
14,000
] Inelastic

8 1
] 0.20
8,000
] Inelastic

Graphically…
Price Elasticity and the Total-Revenue
Curve
Elastic
$8 a Ed > 1
7
6
b Unit Elastic
c
Ed = 1

Price
5
d
4
e Inelastic
3 Ed < 1
f
2 g
1 h D
0 1 2 3 4 5 6 7 8
Quantity Demanded Elastic
Ed > 1
(Thousands of Dollars)

$20
18
Total Revenue

16
14 Unit Elastic
12 Ed = 1
10
8
6 TR Inelastic
4 Ed < 1
2
0 1 2 3 4 5 6 7 8
Quantity Demanded
Price Elasticity and Demand: A Summary

IF PRICE IF PRICE
DEMAND INCREASES, DECREASES,
TOTAL REVENUE TOTAL REVENUE
Inelastic Increases Decreases
Unit elastic is unchanged is unchanged
Elastic Decreases Increases
 Point vs. Arc Elasticities
 Point elasticity of demand
 Price elasticity of demand at a particular point on the
demand curve

 Arc Elasticity
 Calculates elasticity using the average P and Q between
two points on the demand curve. Useful because
ensures that elasticity between two points is the same
regardless of whether considering a price increase or a
price decrease.
 An illustration of elasticity
between two points

Price

A(initial point)
P
ΔP B
Demand curve
ΔQ Q
Q
Arc Elasticity of Demand or “midpoint
method”

where
Other Demand Elasticities
 Income Elasticity of Demand
 Measures how much quantity demanded changes with
a change in income
 Positive for normal goods
 Necessities: IE is close to zero
 Luxuries: greater than 1
 Negative for inferior goods

Q/Q I Q
EI  
I/I Q I
Other Demand Elasticities
 Cross-Price Elasticity of Demand
 Measures the percentage change in the quantity
demanded of one good that results from a one percent
change in the price of another good
 Negative for complements
 Positive for substitutes

Qb Qb Pm Qb
EQb Pm  
Pm Pm Qb Pm
Other Demand Elasticities
 Complements: Cars and Tires
 Cross-price elasticity of demand is negative
 Price of cars increases, quantity demanded of tires
decreases
 Substitutes: Butter and Margarine
 Cross-price elasticity of demand is positive
 Price of butter increases, quantity of margarine demanded
increases
Price Elasticity of Supply
 Measures the sensitivity of quantity supplied
given a change in price
 Represents a movement along the supply curve
 Measures the percentage change in quantity supplied
resulting from a 1 percent change in price

%QS
E S
P
%P
Short-Run Versus Long-Run
Elasticity

 Price elasticity varies with the amount of time

consumers have to respond to a price
 Short-run demand and supply curves often look
very different from their long-run counterparts
Short-Run Versus Long-Run
Elasticity
 Demand
 In general, demand is much more price elastic in the
long run
 Consumers take time to adjust consumption habits
 Demand might be linked to another good that changes
slowly
 More substitutes are usually available in the long run
Gasoline: Short-Run and Long-Run Demand Curves

Price DSR • People cannot easily

adjust consumption in the
short run.
• In the long run, people

tend to drive smaller and

more fuel efficient cars.

DLR

Quantity of Gas
Short-Run Versus Long-Run
Elasticity
 Demand and Durability
 For some durable goods, demand is more elastic in the
short run
 If goods are durable, then when price increases, consumers
choose to hold on to the good instead of replacing it
 But in long run, older durable goods will have to be
replaced (if you already hold a durable good, then the
elasticity will be more in the long run. If you do not hold it,
then an increase in price will mean that you defer your
purchasing/consumption decision making short run demand
more elastic)
Cars: Short-Run and Long-Run
Demand Curves
Price DLR
• Initially, people may put
off immediate car purchase
• In long run, older cars

must be replaced

DSR

Quantity of Cars
Short-Run Versus Long-Run
Elasticity
 Most goods and services:
 Long-run price elasticity of supply is greater than
short-run price elasticity of supply

 Other Goods (durables, recyclables):

 Long-run price elasticity of supply is less than short-
run price elasticity of supply
Short-Run Versus Long-Run Elasticity

SSR
Price

SLR

Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.

Quantity Primary Copper

Short-Run Versus Long-Run
Elasticity
Price SLR SSR

Example from Pindyck:

Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long run, this
stock of scrap copper
begins to fall.

Quantity Secondary Copper

Predicting the Effects of Changing
Market Conditions
 Supply and demand analysis can be used to predict
the effects of changing market conditions
 Linear demand and supply must be fit to market data
 Given equilibrium price and quantity along with elasticities
of supply and demand, we can calculate the curves that fit
the information
 We can then calculate changes in the market
Predicting the Effects of Changing
Market Conditions
 We know
 Equilibrium Price, P*
 Equilibrium Quantity, Q*
 Price elasticity of supply, ES
 Price elasticity of demand, ED
Predicting the Effects of Changing
Market Conditions
 Let’s begin with the equations for supply, demand,
elasticity:
 Demand: Q = a – bP
 Supply: Q = c + dP
 Elasticity: (P/Q)(Q/P)
 We must calculate numbers for a, b, c, and d.
Predicting the Effects of Changing
Market Conditions
 The slope of the demand curve above equals -1/b
so Q/P equals -b
 The slope of the supply curve above equals 1/d so
Q/P equals d

Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
Practice Question
 How would the following changes in price affect total
revenue? That is, would total revenue increase,
decrease or remain unchanged?
 Price falls and demand is inelastic
 Price rises and demand is elastic
 Price rises and supply is elastic
 Price rises and supply is inelastic
 Price rises and demand is inelastic
 Price falls and demand is elastic
 Price falls and demand is of unit elasticity