Engineering Economics

SIU - Engineering

Elasticity of Demand and Supply

and Law of Diminishing Returns
 Elasticity of (Supply) Demand

• It is the degree to which supply or demand

for a good or service varies with its price.

• Elasticity of supply reflects how much the

amount produced increases when the price
increases.

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• Elasticity of demand reflects how much the
amount bought reduces when the price
increases.
• The demand is elastic for luxuries as the
quantity demanded decreases rapidly when
price increases.
• Inelastic demand is for necessities as the
quantity demanded changes at a rate less than
that of the price.

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 Elasticity of Demand

• Unitary demand is when the quantity demanded

changes at the same rate as that of the price.
ǀ ∆Q ǀ/ Qh or (1 – Q/Qh)
ED = ǀ ∆P ǀ/ Ph (1 – P/Qh)

as ∆Q = Qh – Q ∆P = Ph – P

Where Qh and Ph are for the higher values in

order to have positive ∆Q and ∆P
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 Elasticity of Supply
ES or ED > 1. the supply or demand is elastic

ES or ED < 1. the supply or demand is

inelastic

ES or ED = 1. the supply or demand is

unitary

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 Example on the elasticity of supply:

A refinery used to produce 200,000 barrels/day

of gasoline at a price of $25.0 per barrel. When
the price went up to $32.5, production was raised
to 300,000 barrels/day. Determine the elasticity
of supply of the refinery.
ES = (300,000–200,000)*32.5/(300,000*7.5) =
1.444
Therefore the supply is elastic

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Example on Elasticity of Demand
When the unit price of a certain good rose from $32.0 to
$40.0, the demand dropped from 15,000 to 12,000 units
per day. Determine the elasticity of demand for the
good and the change in the quantity demanded, if any.
ED = ∆Q/ Qh or (1 – Q/Qh)
∆P/ Ph (1 – P/Qh)

ED = (15,000 – 12,000)/15,000) / (($40 – $32)/$40) = 1

Q = $32*15,000 = $40*12,000 = 48,000
the demand is unitary so no change in the quantity
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 The Law of Diminishing Returns
• It refers to the point when additional input
(money or energy invested) will result in less
corresponding incremental output (profit or
benefit gained)
• In other words, after a certain point of
production each input will not increase outputs at
the same rate.
• That means the output will not increase at the
same rate when increasing one input and keeping
the others constant,.
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Examples of the Law of Diminishing Returns

• Consider a wheat farmer with 40 feddans of land.

• Assume s/he has already decided on how much
seed, water, and labor he will be using this season.
• S/he has to decide on how much fertilizer to use.
• As s/he increases the amount of fertilizer, the
output of wheat will increase.
• It may also reach a point where the output actually
begins to decrease since too much fertilizer can
become poisonous.

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Examples of the Law of Diminishing Returns

If you are eating your

favorite fruit. When you
are given one, you will
finish it quickly. When
another is brought to you,
you will eat it and still
want more.

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As more and more fruits are given to you, you
start eating slower than before and also with less
enthusiasm, since you are satisfied and your
stomach is full.

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Examples of the Law of Diminishing Returns

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Example on Elasticity and Diminishing
Returns

• For selling price/unit = $15, the demand Q = 30,000

• If the elasticity of demand ED =3
• Determine Q for unit prices of $16, $17, $18, $19,
and $20
• If production cost for one unit = $13.5, find:
• The point of diminishing returns and the
corresponding unit price (optimum price)
• The worse selling price

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 Example on Elasticity and Diminishing
Returns

• ED= ∆Q*Ph/(Qh*∆P)
• ∆Q = ED*Qh* ∆P/Ph
• Q = Qh - ∆Q and P = Ph - ∆P
• Profit/unit = selling price/unit – production cost/unit
• Total profit = profit/unit * demanded quantity Q
• Ph and Qh are the higher values

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 ED = 3
∆Q = ED*Q1*∆P/Ph
Unit production cost = $ 13.5
Profit/unit ∆Q P Q Total Profit
1.5 15 30,000 45000
2.5 5625 16 24,375 60938
3.5 10588 17 19,412 67941
4.5 15000 18 15,000 67500
5.5 18947 19 11,053 60789
6.5 22500 20 7,500 48750
7.5 25714 21 4,286 32143
8.5 28636 22 1,364 11591
9 30000 22.5 0 0

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 Chart Title
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
15 16 17 18 19 20 21 22 23
Q Total Profit

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Assignment on Elasticity of Demand and
Law of Diminishing Returns

• For selling price/unit = $15, the demand Q = 30,000

• If the elasticity of demand ED = 3
• Determine Q for unit prices of $16, $17, $18, $19,
and $20
• If production cost for one unit = $13.0, find:
• The point of diminishing returns and the
corresponding unit price (optimum price)
• The worse selling price

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 ED = 3.00 ∆Q = ED*Q1*∆P/Ph

Unit production cost = 13

Profit/unit P Q Total Profit
2 15 30,000 60000
3 16 24,375 73125
4 17 19,412 77647
5 18 15,000 75000
6 19 11,053 66316
7 20 7,500 52500
8 21 4,286 34286
9 22 1,364 12273
9.5 22.5 0 0
10 23 -1,304 -13043
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 Chart Title
100,000
80,000
60,000
40,000
20,000
0
15 16 17 18 19 20 21 22 23
-20,000
Q Total Profit
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Assignment on Elasticity of Demand and
the Law of Diminishing Returns

If the selling price = $20, the demanded quantity Q =

20,000. If the elasticity of demand ED = 4
• Determine the quantity demanded for prices of
$21,22,23,24,25, and 26
• Sketch the demand curve
If the unit production cost = $19
• Sketch the diminishing return curve and find the
point of diminishing returns
• Find the worse selling price
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