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The Price Elasticities
of Demand and
Supply
Chapter 18
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives

After this chapter, you should be able to:
1.
2.
3.
4.
5.
6.
7.
Interpret and calculate the elasticity of demand.
List and discuss the determinants of elasticity.
Examine the relationship between elasticity and total revenue.
Define and examine income elasticity of demand and cross
elasticity of demand.
Discuss the elasticity of supply.
Name and discuss the three phases of the elasticity of supply
over time.
Analyze and measure tax incidence.
18-2
Price Elasticity of Demand
The elasticity of demand for a good or service
measures the change in quantity demanded in
response to a change in price.

•
In other words, the sensitivity (measured in percentage
change) of Qd because of a change (percentage) in P.
When P goes up, we know that Qd declines…

but by how much?
Elasticity provides us a way of measuring this response.
•
•

We will study the price elasticity of demand in three
ways:
1.
2.
3.
Conceptually (in English)
Mathematically (a number)
Graphically
18-3
A Question for Thought and Discussion
(Elasticity Conceptually)

Think of two different products and write them down:
1.
One in which you are highly price sensitive. For example, you
are always checking prices to see when it goes on sale. You will
not buy it at any price.
2.
Another in which you are not price sensitive. You need this
product on a regular basis. You may be loyal to a particular
brand. If the price increases, you are likely to buy it anyway.
18-4
Measuring Elasticity
Calculate the coefficient of price elasticity (Ep)
Percentage change in quantity demanded
Ep =
Percentage change in price
Q2 - Q1 P2 + P1
X
Ep =
Q2 + Q1 P2 - P1
P1 is the initial price; P2 is the new price
Q1 is the initial quantity sold; Q2 is the new quantity sold
18-5
Measuring Elasticity (continued)
A firm has been selling 100 chairs a week. It runs a
sale, charging $8 instead of the usual $10. Sales go up
to 140 chairs.
Ep =
Q2
- Q1
Q2 + Q1
X
P2 + P1
P2 - P1
140 -100
8 + 10
X
Ep =
8 - 10
140 + 100
40
18
Ep = 240 X -2
= - 1.4999994
Ep = 1.5
*Note: the answer is always negative, so the
negative sign is ignored.
18-6
Measuring Elasticity (continued)
Price is raised from $40 to $41, and quantity sold
declines from 15 to 12.
Ep =
Q2
- Q1
Q2 + Q1
X
P2 + P1
P2 - P1
12 - 15
41 + 40
X
Ep =
41 - 40
12 + 15
-3
Ep = 27 X 81
1 = -8.9999991
Ep = 9.0
Note: the answer is always negative, so the
negative sign is ignored.
18-7
The Meaning of Elasticity Mathematically

An Ep > 1 is elastic.
•
This means that demand is relatively sensitive to price
changes.
•
The larger the number, the greater will be the sensitivity to
price changes.
•
This number represents the percent change in quantity
demanded resulting from each 1% change in a goods price.
•
An Ep of 10 means that for every 1% change in price there
will be a 10% change in QD.
18-8
The Meaning of Elasticity Mathematically
(continued)

An Ep < 1 is inelastic.
•
This means that demand is relatively less sensitive to price
changes.
•
The smaller the number, the greater the insensitivity to price
changes.
•
An Ep of .1 means that for every 1% change in price there
will be a .1% change in quantity demanded.
18-9
The Meaning of Elasticity Mathematically
(continued)

An Ep = 1 is unit elastic.
•
This means that demand is neither elastic nor inelastic.
•
An Ep of 1 means that for every 1% change in price there will be a 1%
change in quantity demanded.
18-10
Perfectly Elastic Demand Curve
The elasticity of a perfectly elastic demand curve is infinity.
18-11
Perfectly Inelastic Demand Curve
The elasticity of a perfectly inelastic demand curve is 0.
18-12
Relative Elasticity of Demand Curves
18-13
Relatively Inelastic Demand Curve
18-14
Relatively Elastic Demand Curve
5
4
3
2
1
D
1
2
3
4
5
6
7
8
9
10
11
12
Quantity in pounds
18-15
Elasticity of Straight-Line Demand Curve
18-16
Elasticity of Demand of Selected
Goods and Services






Household electricity
Bread
Telephone service
Medical care
Legal services
Clothing
0.13
0.15
0.26
0.31
0.37
0.49





Gasoline
Milk
Beer
Motor Vehicles
Restaurant meals
0.60
0.63
0.90
1.14
2.27
18-17
Determinants of the Degree of
Elasticity of Demand

The most important influence: the availability of
substitutes

If the product a luxury rather than a necessity

The product’s cost relative to the buyer’s income

The passage of time

The number of uses
18-18
Advertising

Purpose
•
•
To make the demand
for a product greater.
To make the demand
for a product more
inelastic.
18-19
Elasticity and Total Revenue (TR)
The effect of a price increase when demand is elastic.
Prices were raised from $10 to $12 and Qd fell from 20 to 12.
Calculate Ep
Solution: P1=10; P2=12; Q1=20; Q2=12
.
.
12-20 12+10 8 22
=
12+20 12-10 32 2
=
.25 x 11 = 2.75
Price
Qd
TR
$10
20
$200
$12
12
$144
When demand is elastic, a price increase will lead to a fall in total
revenue!
18-20
Elasticity and Total Revenue
The effect of a price decreases when demand is elastic.
Prices were reduced from $12 to $10 and Qd rose from 12 to 20
Calculate Ep
Solution: P1=10; P2=12; Q1=20; Q2=12
.
.
12-20 12+10 8 22
=
12+20 12-10 32 2
=
.25 x 11 = 2.75
Price
Qd
TR
$12
12
$144
$10
20
$200
When demand is elastic, a price decrease will lead to a rise in total
revenue!
18-21
Elasticity and Total Revenue
The effect of a price increase when demand is inelastic.
Prices were raised from $2 to $3 and Qd fell from 9 to 8.
Calculate Ep
Solution: P1=2; P2=3; Q1=9; Q2=8
8-9
8+9
Price
. 33+2-2
-
-1
.125
=17
= -.0588235
Qd
TR
$2
9
$18
$3
8
$24
x 5 = 0.29
When demand is inelastic, a price increase will lead to a rise in total
revenue!
18-22
Elasticity and Total Revenue
The effect of a price decrease when demand is inelastic.
Prices were reduced from $3 to $2 and Qd rose from 8 to 9
Calculate Ep
Solution: P1=2; P2=3; Q1=9; Q2=8
8-9
8+9
. 33+2-2
1
.125
=17
=
.0588235 x 5 = 0.29
Price
QD
TR
$3
8
$24
$2
9
$18
When demand is inelastic, a price decrease will lead to a fall in total
revenue!
18-23
Summary of Elasticity and TR


If demand is elastic:
•
When P goes up, TR goes down.
•
When P goes down, TR goes up.
If demand is inelastic:
•
When P goes up, TR goes up.
•
When P goes down, TR goes down.
18-24
Income Elasticity of Demand
Ei =
Percentage change in quantity demanded
Percentage change in income

When Ei > 1, normal good

When Ei < 1, inferior good
18-25
Cross Elasticity of Demand
EAB =
Percentage change in QA demanded
Percentage change in price of B

When EAB > 1, goods are substitutes

When EAB < 1, good are complementary
18-26
Price Elasticity of Supply

Elasticity of supply is the responsiveness of quantity
to changes in price.

Elastic when E > 1


Inelastic when E < 1


An elasticity of 10 means a 1% change in price brings about a
10% change in quantity supplied.
An elasticity of 0.2 means a 1% change in price gives rise to
just a .2% change in quantity supplied.
Unit elastic when E = 1
18-27
Perfectly Elastic Supply
Curve
Perfectly Inelastic Supply Curve
18-28
Relative Elasticities of Supply
18-29
Elasticity Over Time

Supply grows more elastic over time, especially when
enough time has passed for new firm’s to enter the
industry and for existing firms to increase their output.

Economists have identified three distinct time periods:
1.
2.
3.
The market period
The short run
The long run
18-30
The Market Period

Market period: The time immediately after a change in
market price during which the sellers can’t respond by
changing the quantity supplied.
•
During this period the supply curve may be perfectly inelastic or
with some positive slope because firms have limited ability to
increase output.
18-31
The Market Period
18-32
The Short Run

Short run: A business firm has a fixed productive
capacity.
•
A firm has some ability to increase output.
 A firm could go from two eight-hour shifts to three eighthour shifts.
 Store hours could probably be extended.
 And so, an increase in demand will result in considerably
more output.
18-33
The Long Run

Long run: There is sufficient time for a firm to alter its
productive capacity.
•
•
•
•
•
The firm can leave the industry.
New firms can enter the industry.
When a rise in demand is considered to be long lasting,
some existing firms will add to their plant and equipment, and
new firms, attracted by higher prices, will enter the industry.
Alternatively, if demand falls, some or all firms will cut back
on their plant and equipment, while others may leave the
industry.
The longer the time horizon, the more elastic is supply.
18-34
The Short Run and the Long Run
18-35
Tax Incidence
(tells us who really pays the tax)
S2
A tax increase
S1
lowers supply
$10
8
How much is the
tax??
(hint . . . measure
it vertically)
6
Price
4
D
Answer: $3
2
0
0
2
4
6
8
10
12
Output
18-36
Tax Incidence
(tells us who really pays the tax)
S2
A tax increase lowers
S1
$10
the supply.
8
Who pays the tax?
6
S1/D P=$6; QD=6
Price
S2/D P=$7; QD=4
4
D
2
0
0
2
4
6
Output
8
10
12
The Customer pays
an additional $1
The Supplier
absorbed the rest
($2)
18-37
$10
Tax Incidence
(tells us who really pays the tax)
The demand curve is perfectly inelastic
S2
The burden falls
S1
entirely on the buyer
8
Who pays the tax?
6
S1/D P=$6; QD=6
Price
S2/D P=$9; QD= 6
4
The buyer pays and
additional $3
2
Seller absorbs ($0)
0
0
D
2
4
6
Output
8
10
12
18-38
Tax Incidence
(tells us who really pays the tax)
The supply curve is more elastic than the demand curve.
$10
S2
The burden falls mainly
on the buyer.
8
S1
Who pays the tax?
6
S1/D P=$6; QD=6
Price
S2/D P=$8.30 QD=2
4
D
The buyer pays and
additional $2.30.
2
Seller absorbs $.70.
0
0
2
4
6
Output
8
10
12
18-39
For Further Discussion: Try These
18-40
Summary of Tax Incidence

When supply is perfectly inelastic, the seller bears the
entire tax burden.

When supply is perfectly elastic, the buyer bears entire
tax burden.

As the elasticity of demand rises, the tax burden is shifted
from the buyer to the seller.

As the elasticity of supply rises, the tax burden is shifted
from the seller to the buyer.
18-41
Current Issue: Oil and Gasoline

In the short run, demand for oil is inelastic.
•
•

Over time, the supply of oil becomes more elastic.
•
•

When gas prices rise most drivers do not drive less.
Long run: people tend to buy more fuel efficient cars and
demand becomes more elastic.
Long run: oil production is increased significantly due to
increased oil exploration and increased flows from producing
oil fields.
The supply of oil becomes more elastic in the long run.
The heating oil market is similar.
•
•
•
Short run: people do not sell their homes or switch from oil to
natural gas when oil prices rise.
Long run: fewer oil furnaces will be installed and perhaps
solar panels will be installed.
The demand for heating oil will become more elastic.
18-42
Questions for Thought and Discussion:
How Elastic is Your Demand for Food?

No matter how low your income, you still have to eat.

If your income went down significantly, you would buy
less expensive food.

Higher priced foods become luxuries.

Lower priced foods become necessities.

The bottom line is
•
•
A good or service is a necessity if its share of your budget falls
as your income rises.
It is a luxury if its share of your budget rises as income rises.
18-43