Demand and

Supply: Elasticities
and applications
Introduction ​
The Law of Demand says that consumers respond to a reduction in price by buying more of
the product.

But how much more do they buy?​

That amount varies considerably from one product to another and between different price ranges of
the same product.

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Elasticities​
The response or sensitivity of
consumers to a in the price is
measured by the price elasticity of
demand.​
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 Demand for some
products is such that
consumers have a strong
reaction to price
changes.

1.
Small in price lead to
large in the quantity
they buy.
Example: restaurant meals

Elastic Demand​ The demand for these products

is said to be elastic or relatively
elastic.​

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Inelastic Demand

In other products, consumers hardly react to price changes.

▣ Large price changes only result in very small changes in
the quantity they buy.
Example: Salt
Demand for these products is inelastic or relatively inelastic.

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 Coefficient of
Elasticity
Economists measure the degree of price elasticity or price
inelasticity of demand by the coefficient ℰd , which is defined
as the coefficient ℰd :
"ℰd"=(∆% 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑋)/(∆
% 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡 𝑋)

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 Therefore >

‘’ "ℰd"=∆𝑄/(𝑄1+𝑄2)/2)/
∆𝑃/(𝑃1+𝑃2)/2

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Use of percentages

Why are percentages and not absolute quantities used to measure

elasticities?
There are 2 reasons:
1. Choice of units
2. Comparison of products

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Choice of units

If we use absolutes, our perception of consumer response is affected by

the choice of units.
For example: If the price of product X changes from $3 to $2 and
consumers increase their purchases from 60 to 100 it may appear that
consumers are very sensitive to the change in price and that demand is
elastic because a change in 1 unit in Price causes a change in 40 units of
quantity demanded.
But if the monetary unit is pennies a change in 100 units of price causes a
change of 40 units in quantity which gives the impression of inelasticity. 9
Product Comparisons

With the use of percentages we can make a proper comparison of

the response of consumers to changes in the prices of different
products.
It makes no sense to compare the effects on quantity demanded of:
1. A $1 increase in the price of a $10,000 automobile with.
2. A $1 increase in the price of a soft drink worth $1.

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Omission of the minus sign

The downward sloping demand curve indicates that price and quantity
demanded are inversely related. Therefore, the coefficient of price elasticity of
demand ℰd is always a negative number.
▣ The sign is omitted to avoid ambiguity problems. It would be confusing
to say that:
ℰd = -4 > ℰd =-2.
▣ We avoid this confusion when we take absolute values.
ℰd = 4 > ℰd =2

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Interpretation of ℰd

We can interpret the coefficient of price elasticity of demand as

follows:
1. Price-elastic demand.
2. Price-inelastic demand.
3. Unit-elastic demand.
4. Extreme Cases:
Perfectly elastic demand.
Perfectly inelastic demand.

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 Elastic Demand
Demand is elastic when a percentage change in price results in
a larger percentage change in quantity demanded.
ℰd > 1

"ℰd"=(∆%𝑄)/(∆%𝑃)=(4%)/(2%)>1

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 Inelastic Demand
Demand is inelastic when a percentage change in price results
in a smaller percentage change in quantity demanded.

ℰd < 1

"ℰd"=(∆%𝑄)/(∆%𝑃)=(1%)/(3%)<1

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 Unit Elasticity
The situation that separates elastic demand from inelastic
demand occurs when the percentage change in price and the
percentage change in quantity demanded are equal.
ℰd = 1

"ℰd"=(∆%𝑄)/(∆%𝑃)=(2%)/(2%)=1

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Extreme Cases
Perfectly inelastic demand:
In the extreme situation in which a change in price does not produce any change in
quantity demanded
● Examples: The demand for insulin by diabetics or for heroin by addicts.
Perfectly elastic demand:
In the extreme situation where a small reduction in price leads buyers to increase
their purchases from zero to as much as they can get or an increase in price leads
the quantity demanded to decrease from a finite quantity to zero.

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Graphic Analysis​
The elasticity varies with the price range of the same demand
graph.

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Total Income Test

An alternative way of knowing whether demand is elastic, inelastic or

unitary, is by what is called "The Total Revenue Test."

Total revenue (TR) is the total amount received by the seller of a product;
it is calculated as follows:
TI = P X Q

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TI Grap

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 Elastic Demand:
P IT

‘’ Inelastic Demand:
P IT

Unit Demand:
OR P No IT
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Determinants of ℰd

We cannot say exactly what determines the ℰd in each specific

situation. Nevertheless, the following generalizations are often
useful:
1. Substitutability.
2. Income ratio.
3. Luxury goods and necessary goods.
4. Time.

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Substitutability

In general, the greater the number of available substitutes, the

greater the elasticity of demand.
▣ Example: Honda, Toyota, Nissan, VW, Mazda.

Extreme case: Insulin has no substitutes, therefore its demand

is inelastic.

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Proportion of Income

Other things being equal, the higher the price in relation to a person's
income and budget, the higher the elasticity of demand for that product.
Example: an increase in the P (10%) of chewing gum or pencils is very
few cents so the quantity demanded drops very little. Therefore, the
elasticity of low-priced goods is small.
But a P(10%) cars Qd a lot because it represents a significant
percentage in the budget of many families. Therefore, the elasticity of
high-priced goods tends to be high, i.e., their demand is elastic. 23
Luxury goods and necessary goods

The demand for necessary goods tends to be inelastic and that for
luxury goods elastic.
Example: bread and electric power are considered necessary goods; it is
difficult to live without them. An increase in price does not reduce too
much the amount of bread consumed.
On the other hand, Caribbean cruises and jewelry are luxury goods that,
by definition, can be discontinued. If the price increases, an individual
can refrain from buying them without suffering great deprivation.
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Time

Generally speaking, demand for a product is more elastic the longer

the period of analysis.

Many consumers are people of habit. When the price of a product

increases, it takes some time to search for and try other products and
decide whether they are acceptable.

Consumers do not reduce their purchases as soon as the price of beef

increases 10%, but over time they may consume chicken or fish.
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Application of ℰd

Abundant harvests: the demand for agricultural products is very inelastic.

An increase in production due to a good harvest lowers the price and
therefore the farmers' IT. Therefore, an abundant harvest is undesirable
because of its inelasticity.

Consumption taxes: the government has to pay attention to the elasticity of

demand when selecting the b and s it taxes on consumption. A higher Tx on a
product with an elastic demand decreases tax revenue, therefore, legislators
choose products whose demand is inelastic: liquor, gasoline, cigarettes. 26
Application of ℰd

Drugs and street crime:

The demand for cocaine and heroin is believed to be highly
inelastic.
What is done is to limit their supply.
P and IT of narcos
P % of expenditure is higher crimes
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Price elasticity of supply

The concept of elasticity also applies to supply

▣ Elastic supply: when producers are very responsive to prices.
▣ Inelastic supply: when they are less responsive to prices.
ℰo = % Quantity Offered of product X
% Product Price X
ℰo >1 ℰo = 1 ℰo < 1
Elastic unitary inelastic
ℰo is always positive (P and Q vary directly). 28
Determinants of the elasticity of supply

The main determinant of ℰo is the time that producers have to

respond to the change in the price of the product.
The longer the response time, we can expect the ℰo to be higher.
3 periods are distinguished:
1. Immediate or market.
2. Short term.
3. Long term.

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Determinants of the elasticity of supply

1. The market period: is the period immediately after the in P of

market during which the producers cannot respond with a in the
amount.
a) Example: tomato grower.
▣ Supply P inelastic.
▣ You can only offer the harvest.
▣ Perishable product P anyway sell it.
a) Example: producer of tomato puree.
▣ Quantity Offered your inventories of goods stored (they
may not have a market shelf life)

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Determinants of the elasticity of supply

2. The short term:

a) The amount of capital (plant) is fixed but they can be used
more intensively.
b) It is represented with a more elastic offer (example: vegetable
producer who plants tomatoes).
3. Long term:
c) All desired adjustments are made, including plant capacity, and
supply becomes more elastic.

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Cross Elasticity of Demand
How does the purchase of a product X change when the price of product
Y changes?
ℰxy = % Quantity Demanded Product X
% Price of Product Y

Substitute Goods ℰxy > 0

P of beef chicken meat consumption

The larger the positive coefficient of ℰxy , the greater the substitutability
between the products 32
Cross Elasticity of Demand
Complementary goods ℰxy < 0
P of beef coal consumption.
The larger the negative coefficient of ℰxy the greater the complementarity
between the 2 goods.

Independent goods ℰxy = 0

p nuts No beef consumption.

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Income Elasticity of Demand
Measures the degree to which consumers respond to a of their income by
buying more or less of a given good.
ℰi= % Quantity Demanded
% Income

▣ Normal or Superior Goods ℰi> 0

Agricultural products = .2
Cars = 3
▣ Inferior Goods ℰi< 0
Used clothes, Bologna. 34
Government Controlled Price

The general public and the government believe that supply and
demand sometimes result in prices that are too high for buyers or
too low for sellers. At such times, the government can intervene by
setting the maximum or minimum ceiling that a price can reach.
1. Ceiling Prices and Scarcity:
a) It is the maximum legal price that a seller can charge for a
good or service.
b) A price equal to or less than the ceiling is legal.
c) A higher price is illegal.
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Government Controlled Price

The justification is that consumers obtain an "essential"

good or service that they could not buy at the equilibrium
price:
▣ They control the inflation.
▣ Ceiling prices generate insufficiency, this scarcity is
greater the more elastic the supply and demand are.
▣ Problem how to distribute them make lines,
favoritism.

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Government Controlled Price
The government must make a type of rationing through coupons and divide them
equally among families in an equitable manner.
Black Markets: ration coupons do not prevent this problem from arising.
▣ Many people are willing to pay a P.
▣ It is convenient for sellers to sell to a P.
2. Floor Prices and Surpluses:
▣ They are the minimum prices set by the government.
▣ An equal or higher price is legal.
▣ A lower price is illegal.

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Government Controlled Price
The justification is that they are usually used when society thinks
that the free functioning of the market does not provide sufficient
income to certain groups of providers or producers of resources.
Example: The minimum wage and guaranteed prices for
agricultural producers (Corn)

3. The government buys the surplus

▣ The surplus varies, when the D and the S are more elastic,
then more surplus will generate.

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