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ELASTICITY OF DEMAND AND SUPPLY
Price Elasticity of Demand:
A tool used to measure how responsive consumers are to price changes.
Calculating Price Elasticity of Demand
Price elasticity of demand = %  in quantity demanded / %  in price.
%  in quantity demanded = change/original quantity
%  in price = change/original price
Categories of Price Elasticity of Demand
 Inelastic: Quantity demanded is unresponsive to a change in price; elasticity value is between 0 and –1.
 Unit elastic: Percent change in quantity equals the percent change in price; elasticity = –1.
 Elastic: Percent change in quantity exceeds the percent change in price; elasticity < –1.
Elasticity and Total Revenue:
A price decline causes total revenue to:
 Increase if demand is elastic.
 Remain the same if demand is unit elastic.
 Decrease if demand is inelastic.
A price increase causes total revenue to:
 Increase if demand is inelastic.
 Remain the same if demand is unit elastic.
 Decrease if demand is elastic.
Determinants of Price Elasticity of Demand
Availability of Substitutes
Proportion of the Consumer’s Budget Spent on the Good
A Matter of Time: Allowed to adjust to a change in price
Necessity
Elasticity Estimates:
ED is greater in the long run than in the short run because consumers have more time to adjust to
changes in price
Price Elasticity and the Linear Demand Curve: Price declines along a downward sloping linear demand curve
cause total revenue to:
 Increase until the halfway point of the linear demand curve.
 Reach a maximum at the halfway point.
 Decrease below the halfway point of the demand curve.
Constant-Elasticity Demand: Occurs along demand curves that are:
Perfectly Elastic: Horizontal line; ED = –.
Perfectly Inelastic: Vertical line; ED = 0.
Unit Elastic: Curves for which total revenue remains the same for every price-quantity combination.
Price Elasticity of Supply:
Measures the responsiveness of producers to a price change. Reflects a positive relationship between price and
quantity supplied.
Categories of Supply Elasticity
Perfectly Elastic Supply: Horizontal line; Es = .
Perfectly Inelastic Supply: Vertical line; Es = 0.
Unit Elastic Supply: The supply curve is a straight line through the origin; Es = 1.
Determinants of Supply Elasticity: Es is greater the longer the time period of adjustment.
Other Elasticity Measures
1
2
Elasticity of Demand and Supply
Income Elasticity of Demand: At a given price, measures how quantity demanded changes in response to a
change in income (%  in quantity demanded / %  in income).
 Inferior goods: Income elasticity of demand is negative.
 Normal goods: Income elasticity of demand is positive.
– Necessities: Income inelastic; income elasticity of demand is less than 1.
– Luxuries: Income elastic; income elasticity of demand is greater than l.
Cross-Price Elasticity of Demand: Responsiveness of the quantity demanded of one good to a change in price
of another good. Cross-price elasticity of demand is:
 Positive for substitutes: An increase in the price of one good causes an increase in quantity demanded of
another good.
 Negative for complements: An increase in the price of one good causes a decrease in the quantity
demanded of another good.
 Zero for unrelated goods.
SUMMARY
Elasticity is important because it provides a measure of how sensitive the quantity of a good supplied or
demanded is to changes in variables influencing the demand or supply of the good. It also can be used to
examine the effects of government regulation and tax policy as well as in the development of marketing
strategies and revenue maximization goals.
The price elasticity of demand is defined as the percentage change in quantity demanded divided by the
percentage change in price. If this ratio (in absolute value) is greater than 1, demand is said to be elastic at that
price. If the ratio is between 0 and 1, demand is said to be inelastic at that price. Demand is unitary elastic at the
price considered if the elasticity measure is exactly equal to 1.
The demand elasticity measure indicates what will happen to sellers’ total revenue if the price of the good
changes. If demand is price inelastic, then an increase in the price of the good will yield an increase in total
revenue. The opposite is true for a price increase when demand is elastic. Note that the price elasticity of
demand decreases (in absolute value) as one moves down along a linear demand curve.
Since elasticity typically changes along the demand curve, an approximation to the price elasticity is accomplished by choosing two points and using the midpoint formula. The midpoint formula computes percentage price
and quantity using average price and average quantity as the bases. When the demand curve is vertical or horizontal, the price elasticity is zero or infinite, respectively.
Several factors affect the elasticity of demand. Demand is more elastic (1) the greater the availability of substitutes, (2) the larger the proportion of the consumer’s budget spent on the product, (3) the longer the time allowed
to adjust to change in price, and (4) the more the good tends to be a luxury rather than a necessity.
Supply elasticity follows the same basic format as demand elasticity. One important determinant of supply elasticity is time. In the short run, supply is less elastic because of the fixity of resources and technology.
In addition to price elasticity, other important demand elasticities include the income elasticity and the cross-price
elasticity. An income elasticity greater than 1 means that, as income increases, the budget share spent on the
good also increases. Cross-price elasticity provides a measure of substitutability or complementarity among a
pair of goods. If the cross-price elasticity is positive, such goods are substitutes. Complements will show a negative cross-price elasticity.
Questions for Review
1.
(Categories of Price Elasticity of Demand) For each of the following values of price elasticity of demand, indicate whether demand is elastic, inelastic, perfectly elastic, perfectly inelastic, or unit elastic. In addition, determine what would happen to total revenue if a firm raised its price in each elasticity range identified.
a. ED = – 2.5
2
b.
ED = –1.0
c.
ED = –
d. ED = –0.8
(Elasticity and Total Revenue) Explain the relationship between the price elasticity of demand and total revenue.
3
Elasticity of Demand and Supply
3. (Determinants of Price Elasticity) Why is the price elasticity of demand for Coca-Cola greater than price
elasticity of demand for soft drinks generally?
4. (Determinants of Price Elasticity) What factors help determine the price elasticity of demand? What factors
help determine the price elasticity of supply?
5.
6.
(Cross-Price Elasticity) Using supply and demand curves, predict the impact on the price and quantity
demanded of Good 1 of an increase in the price of Good 2 if the two goods are substitutes. What if the two
goods are complements?
(Other Elasticity Measures) Complete each of the following sentences:
a. The income elasticity of demanded measures, for a given price, the __________ _____________ in
quantity demand divided by the __________________________ income from which it resulted.
b. If a decrease in the price of one good causes a decrease in demand for another good, the two goods
are ______________.
c. If the value of the cross-price elasticity of demand between two goods is approximately zero, they are
considered _________________.
7.(Calculating Price Elasticity of Demand) Suppose that 50 units of a good are demanded at a price of $1 per
unit. A reduction in price to $0.20 results in an increase in quantity demanded to 70 units. Show that these
data yield a price elasticity of –0.25. By what percentage would a 10 percent rise in the price reduce the
quantity demanded assuming price elasticity remains constant along the demand curve?
8.
(Price Elasticity and Total Revenue) Fill in values for each point listed in the following table. What
relationship have you depicted?
P
8
7
6
5
4
3
2
Q
2
3
4
5
6
7
8
Price
Elasticity
________
________
________
________
________
________
________
Total Revenue
___________
___________
___________
___________
___________
___________
___________
9. (Income Elasticity of Demand) Calculate the income elasticity of demand for each of the following goods:
Quantity Demanded
When Income = $10,000
Good 1
Good 2
Good 3
10
4
3
Quantity Demanded
When Income = $20,000
25
5
2
10. (Price Elasticity of Supply) Calculate the price elasticity of supply for each of the following combinations of
price and quantity supplied. Determine whether supply is elastic, inelastic, perfectly elastic, perfectly inelastic, or unit elastic in each case.
a.
b.
c.
d.
Price falls from $2.25 to $1.75; quantity supplied falls from 600 units to 400 units.
Price falls from $2.25 to $1.75; quantity supplied falls from 600 units to 500 units.
Price falls from $2.25 to $1.75; quantity supplied remains at 600 units.
Price increases from $1.75 to $2.25; quantity supplied increases from 466.67 units to 600 units..