BUSINESS ECONOMICS-I

LESSON 6:
ELASTICITY OF SUPPLY AND DEMAND

6.1 Price Elasticity will make. When the price of gasoline rose rapidly in the late
Businesses know that they face demand curves, but rarely do 1970s as a result of the OPEC cartel, the only adjustment
they know what these curves look like. Yet sometimes a consumers could initially make was to drive less. With time,
business needs to have a good idea of what part of a demand they could also move closer to work or find jobs closer to
curve looks like if it is to make good decisions. If Rick’s Pizza home, and switch to more fuel-efficient cars.
raises its prices by ten percent, what will happen to its revenues? The concept of elasticity can help explain some situations that at
The answer depends on how consumers will respond. Will they first glance may seem puzzling. If American farmers all have
cut back purchases a little or a lot? This question of how excellent harvests, they may have a very poor year financially.
responsive consumers are to price changes involves the eco- They may be better off if they all have mediocre harvests. If a
nomic concept of elasticity. bus company decides it needs more revenue and tries to get it
Elasticity is a measure of responsiveness. Two words are by raising fares, its revenues may decrease rather than increase.
important here. The word “measure” means that elasticity
results are reported as numbers, or elasticity coefficients. The
word “responsiveness” means that there is a stimulus-reaction
involved. Some change or stimulus causes people to react by
changing their behavior, and elasticity measures the extent to
which people react.1
The most common elasticity measurement is that of price
elasticity of demand. It measures how much consumers
respond in their buying decisions to a change in price. The basic
formula used to determine price elasticity is
e = (percentage change in quantity) / (percentage change in In the case of the farmers, the key to their problem is that the
price). demand curve for their products is quite inelastic. This means
(Read that as elasticity is the percentage change in quantity that if the harvest is unusually good, a large drop in price is
divided by the percentage change in price.) necessary to encourage consumers to use the additional grain. If
If price increases by 10% and consumers respond by decreasing the elasticity coefficient is .5, for example, and the harvest is 10%
purchases by 20%, the equation computes the elasticity coeffi- larger than the previous year, then a 20% drop in prices will
cient as -2. The result is negative because an increase in price (a occur (assuming that the many things that we keep constant in
positive number) leads to a decrease in purchases (a negative drawing the demand curve have remained constant). Because
number). Because the law of demand says it will always be this price reduction more than offsets the effect of the larger
negative, many economists ignore the negative sign, as we will harvest, the average farmer’s income drops.
in the following discussion.
An elasticity coefficient of 2 shows that consumers respond a
great deal to a change in price. If, on the other hand, a 10%
change in price causes only a 5% change in sales, the elasticity
coefficient will be only 1/2. Economists would say in this case
that demand is inelastic. Demand is inelastic whenever the
elasticity coefficient is less than one. When it is greater than one,
economists say that demand is elastic.
Products that have few good substitutes generally have a lower For the bus company, the key is that demand is elastic. For
elasticity of demand than products with many substitutes. As a example, suppose that the elasticity is 1.5. Then, if price is raised
result, more broadly defined products have a lower elasticity by 10%, quantity (ridership) must drop by 15%. But the drop
than narrowly defined products. The price elasticity of demand in ridership more than offsets the increase in price, and so
for meat will be lower than the price elasticity of pork, and the revenue will drop.
price elasticity for soft drinks will be less elastic than the price
Just as we can measure how responsive buyers are to a change in
elasticity for colas, which in turn will be less elastic than the price
price, we can measure how responsive sellers are. This measure-
elasticity for Pepsi.
ment, the price elasticity of supply, has the same formula as
Time plays an important role in determining both consumer price elasticity of demand, only the quantity in the formula will
and producer responsiveness for many items. The longer refer to the quantity that sellers will sell.
people have to make adjustments, the more adjustments they

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As with demand elasticity, supply elasticity depends on the
amount of time available for adjustment. In the very short run,
there may be no adjustments they can make, which would mean
a perfectly vertical supply curve. For example, if on December 1
the price of apples doubles, there will be minimal effect on the
number of apples available to the consumer. Producers cannot
make adjustments until a new growing season begins. In the
short run, producers can use their facilities more or less
intensively. In the apple example, they can vary the amounts of
pesticides, and the amount of labor they use to pick the apples.
Finally, in the long run, not only can producers change their
facilities, but they can also leave the industry or new producers
may enter it. In our apple example, new orchards can be planted
or old ones destroyed.
6.2 Types of Price Elasticity of Demand
Different commodities respond differently to changes in their
price. A price change has relatively much less impact on quantity
demanded of a necessity than it has on the quantity demanded
of a luxury. In fact, it is the nature of a commodity which is
responsible for differing elasticities of demand in case of
different commodities. Conceptually price elasticities of demand
is generally classified into the following categories:
1. Perfectly elastic demand (e = (0). Where no reduction in
price is needed to cause an increase in quantity demanded
[figure (a)];
2. Absolutely inelastic demand (e = 0). Where a change in
price, however large, causes no change in quantity demanded
[Fig. (b)];
3. Unit elasticity of demand (e = 1). Where a given
proportionate change in price causes an equally proportionate
change in quantity demanded (in this case the demand curve
takes the form of a rectangular hyperbola. [Fig. (c)];
4. Relatively elastic demand (e > 1). Where a change in price
causes a more than proportionate change in quantity
demanded [Fig. (d)]
5. Relatively inelastic demand (e < 1). Where a change in
price causes a less than proportionate change in quantity
demanded [Fig. (e)].
Now comes the technical stuff, a discussion on how to
compute price elasticity.
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11.104
BUSINESS ECONOMICS-I
6.3 Computing Price Elasticity
(Warning: This section involves some simple algebra. If you are
math-challenged, take it slowly and it will probably be OK.)
You can calculate elasticity in two different ways:
1. Point Elasticity
2. Arc Elasticity
When we try to use the equation in the first section to calculate
elasticity coefficients, we run into a problem. If we look at an
increase in price from $3.00 to $4.00, we have an increase of
33%. However, if we have a price reduction from $4.00 to
$3.00, we have a reduction of 25%. Thus, there are two ways of
viewing what happens between $3.00 and $4.00.
Suppose that when price of a product is $3.00, people will buy
60, but when price is $4.00, they will buy only 50. What is the
elasticity over this segment of the demand curve, between prices
$3.00 and $4.00? Should one start at the price of $3.00 and
compute a price rise of 33 1/3% and a quantity decline of 16 2/
3%, or
e =(16.67%)/(33.33%) = .5.
Or, should one start at the $4.00 price, and compute a price
decline of 25% and a quantity increase of 20%, or
e = (20%)/(25%) = .8.
The formula mentioned in the previous section does not tell us
which way to proceed, and it matters. To get around the
problem of deciding which starting point to use, economists
compute elasticity based on the midpoint, or in the example
above, at a price of $3.50. The formula that does this is
e = (Change in quantity divided by average quantity) / (Change
in price divided by
average price)
or
e = ((Q1 - Q2) / (Q1 + Q2)/2 )) / ((P1 - P2)/((P1 + P2)/2)).
Putting the numbers from the previous example into this
equation yields:
e = (60-50)/ (60+50)/2 divided by ($4-$3) / ($4+$3)/2
or
e = (10/55)/(1.00 /3.50) = (10/55)x(35/10) = 7/11 = .6363...
This formula is the formula for arc elasticity, or the elasticity
between two points on the demand curve. As the two points
get closer together, arc elasticity approaches point elasticity, the
measure of elasticity preferred by professional economists.
With a bit of algebra, one can show that the equation for
elasticity above can be rewritten as:
e = (1 / (Slope of Demand Curve)) multiplied by ((Average
Price)/(Average Quantity))
Using this last equation, consider what happens when the slope
gets steeper, which means that the slope becomes a bigger
number.1 Elasticity becomes smaller, which means that
consumers are less responsive. As the demand curve approaches
a vertical line, the slope approaches infinity and elasticity
approaches zero. As the demand curve approaches a horizontal
line, the slope approaches zero and elasticity approaches infinity.
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One can also see what happens when the slope is constant, measures total revenue (or total expenditure by buyers, which is
which means that the demand curve is a straight line. As one the same thing from another viewpoint) is a key idea used
moves along the line, elasticity changes because average price and repeatedly in microeconomics.
average quantity change. At the top of the demand curve, price
is high and quantity is low, so elasticity is high. At the bottom
price is low and quantity is high, so elasticity is low.
Wow. You’ve made it through all that technical stuff. Now, you
can relax a bit and look at some other things that can be
measured with the elasticity concept.
6.4 Other Elasticities
In addition to price elasticities of supply and demand, econo-
mists frequently refer to other elasticity measurements. Income
elasticity of demand measures the responsiveness of
people’s purchases to changes in income. It is defined as
From the demand curve, we can obtain total revenue. From
Income Elasticity = (percentage change in amount bought)
total revenue, we can obtain another key concept: marginal
divided by (percentage change in income)
revenue. Marginal revenue is the additional revenue added by
Income elasticity measures whether a good is a normal or an an additional unit of output, or in terms of a formula:
inferior good. A product is a normal good when its income
Marginal Revenue = (Change in total revenue) divided by
elasticity is positive, meaning that higher income causes people
(Change in sales)
to purchase more of the product. For an inferior good, income
elasticity is negative because an increase in income causes people According to the picture, people will not buy more than 100
to buy less of the product. units at a price of $10.00. To sell more, price must drop.
Suppose that to sell the 101st unit, the price must drop to
Cross-price elasticity, often simply called just cross-elasticity,
$9.95. What will the marginal revenue of the 101st unit be? Or,
measures whether goods are substitutes or complements. It
in other words, by how much will total revenue increase when
looks at the response of people in buying one product when
the 101st unit is sold?
the price of another product changes. The formula for cross-
price elasticity is There is a temptation to answer this question by replying,
“$9.95.” A little arithmetic shows that this answer is incorrect.
Cross-Price Elasticity = (percentage change in amount of A
Total revenue when 100 are sold is $1000. When 101 are sold,
bought) divided by (percentage change in price of B).
total revenue is (101) x ($9.95) = $1004.95. The marginal
If goods are complements, cross-price elasticity will be negative. revenue of the 101st unit is only $4.95.
For example, if the price of gasoline rises, the sales of large cars
To see why the marginal revenue is less than price, one must
will decline. The positive change in the denominator (bottom)
understand the importance of the downward-sloping demand
is matched with a negative change in the numerator (top) of the
curve. To sell another unit, sellers must lower price on all units.
equation. The result is therefore negative. If cross-price elasticity
They received an extra $9.95 for the 101st unit, but they lost
is positive, B is a substitute for A. For example, sales of Coke
$.05 on the 100 that they were previously selling. So the net
will fall if the price of Pepsi falls because some Coke drinkers
increase in revenue was the $9.95 minus the $5.00, or $4.95.
will switch from Coke to Pepsi.
There is a another way to see why marginal revenue will be less
Next lets shift gears and see how revenue and the demand curve
than price when a demand curve slopes downward. Price is
are related.
average revenue. If the firm sells 100 for $10.00, the average
6.5 Revenue And Demand revenue for each unit is $10.00. But as sellers sell more, the
The demand curve is a tremendously useful illustration for average revenue (or price) drops, and this can only happen if the
those who can read it. We have seen that the downward slope marginal revenue is below price, pulling the average down.
tells us that there is an indirect relationship between price and
The reasoning of why marginal will be below average if average
quantity. One can also view the demand curve as separating a
is dropping can perhaps be better seen in another example.
region in which sellers can operate from a region forbidden to
Suppose that the average age of 20 people in a room is 25 years,
them. But there is more, especially when one considers what an
and that another person enters the room. If the average age of
area on the graph represents.
the people rises as a result, the extra person must be older than
If people will buy 100 units of a product when its price is 25. If the average age drops, the extra person must be younger
$10.00, as the picture below illustrates, total revenue for sellers than 25. If the added person is exactly 25, then the average age
will be $1000. Simple geometry tells us that the area of the will not change. Whenever an average is rising, its marginal
rectangle formed under the demand curve in the picture is must be above the average, and whenever an average is falling,
found by multiplying the height of the rectangle by its width. its marginal must be below the average.
Because the height is price and the width is quantity, and since
If one knows marginal revenue, one can tell what happens to
price multiplied by quantity is total revenue, the area is total
total revenue if sales change. If selling another unit increases
revenue. The fact that area on supply and demand graphs
total revenue, the marginal revenue must be greater than zero.

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If marginal revenue is less than zero, then selling another unit
takes away from total revenue. If marginal revenue is zero, than
selling another does not change total revenue. This relationship
exists because marginal revenue measures the slope of the total
revenue curve.
The picture above illustrates the relationship between total
revenue and marginal revenue. The total revenue curve will be
zero when nothing is sold and zero again when a great deal is
sold at a zero price. Thus, it has the shape of an inverted U. The
slope of any curve is defined as the rise over the run. The rise
for the total revenue curve is the change in total revenue, and
the run is the change in output. Therefore,
Slope of Total Revenue Curve = (Change in total revenue) /
(Change in amount sold)
But this definition of slope is identical to the definition of
marginal revenue, which demonstrates that marginal revenue is
the slope of the total revenue curve.
Next we tie marginal revenue to elasticity.
6.6 From Elasticity to Marginal Revenue
(This is a moderately technical section that may trouble those
who fear math, but it logically completes the chapter.)
Marginal revenue is the extra revenue from adding another unit
of output. If a firm finds that when it sells six units, its
revenue is 24, and when it sells eight, its revenue is 28, its extra
revenue for adding two more units is four. Its marginal
revenue, or the extra revenue for adding one more unit of
production, will be two.
BUSINESS ECONOMICS-I
price on the six units it was previously selling. The loss is these
six units times $.5 each, or $3. The net change in revenue is $7
less $3, or $4. Equation (6) says that to get marginal revenue,
the change in total revenue ($4) must be divided by the change
in output (2), which in this example gives us $2.
We have shown that marginal revenue can be computed as
(Change in Q)P + (Change in P)Q) divided by (Change in Q).
(This formula holds only approximately when changes are big,
but becomes exact as the changes get very very small. Because
the change in price will be negative, the second term in the
numerator will be subtracted from the first.)
When changes in price and quantity are very, very small, the
formula for price elasticity can be written as
e = ((Change in Q)/Q) divided by ((Change in P)/P)
If your algebra is fairly good, you should be able to use these
two formulas to show that the following equation is true:
Marginal Revenue = Price (1 - 1/|elasticity|)
(Verbally, this says divide one by the absolute value of elasticity.
Subtract this number from one. Then, take this second number
and multiply it by price. The result is marginal revenue.)
This last formula says that if demand is inelastic (less than one),
trying to sell more will reduce total revenue, whereas if demand
is elastic (greater than one), trying to sell more will increase total
revenue. This should make intuitive sense. If people are not
sensitive to price, then one must reduce price a great deal to sell
more, which means that total revenue declines.
Notes

The graph above illustrates an alternative way to compute this

extra revenue. When the firm sells six, it can charge a price of $4,
but when it sells eight, it can charge only $3.50. (Thus, six units
at $4 each gives a total revenue of $24 and eight units at $3.50
each gives a total revenue of $28.) When the firm sells the extra
two units, it adds two units at $3.50 each, or $7 to its revenue.
However, it also loses something because it had to lower the

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BUSINESS ECONOMICS-I

TUTORIAL 2

1. Case study iii. Both moves show the same result on demand.
Explore & Apply: Demanding Better Schools, Supplying Better iv. None of the above.
Schools
2 . Refer to the figure below. Assume that TVs and VCRs are
According to an article from the Wall Street Journal (July 1, 2003) two complement goods and that the diagram below
entitled “President Bush Renews Push for School-Voucher represents the demand for VCRs. Which move would best
Program”, the President “has rarely spoken out for vouchers describe the impact of a decrease in the price of TVs on this
since Congress rejected his proposal two years ago to strip diagram?
federal funds from the worst-performing schools and make
them available to parents for private education vouchers.”
However, in an address on July 1, 2003, he renewed his push by
supporting legislation for a national “school choice” incentive
plan.
According to the article, Bush is supporting a bill to allocate $75
million for a national “school choice” incentive plan, of which
$15 million would go to the District of Columbia, largely
because its students score lower on some standardized tests
than those anywhere else in the nation. Part of the money
allocated to the District would go to lower-income children i. The move from a to b.
enrolled in targeted public schools. The President said he hoped ii. The move from a to c.
the D.C. program would become a national model for how iii. Both moves. Demand first moves from a to b, then from
private school choice can cause improvements in public schools. b to c.
Critics of vouchers, including teachers unions, contend that iv. None of the above. Since this is the demand for VCRs,
research does not show that students in voucher schools do changes in the price of other goods would have no
better than those children who are not receiving vouchers. They impact on it.
argue that vouchers “drain money from public schools and too
3 . Refer to the figures below. Which figure shows the impact of
often end up supporting religious schools.” Pointing to
a decrease in income, assuming that the good in question is a
examples from Cleveland and Milwaukee, union officials assert
normal good?
“vouchers subsidize a choice that parents have already made—
the choice to send their child to a private school.”
Thinking Critically
Apply what you have read and answer the following questions:
1. Why might private-school choice make a difference in quality
education in public schools?
2. What do critics say about vouchers?
2. Multiple choice questions
1 . Refer to the figure below. Which move illustrates the impact
of a decrease in market price on market demand, all else the
same?

i. A.
ii. B.
iii. C.
iv. D.
4 . In a figure of supply and demand, can you describe more
optimistic expectations on the part of business firms in the
market?
i. The move from a to b. i. Yes, by shifting the supply curve to the left.
ii. The move from a to c. ii. Yes, by shifting the supply curve to the right.

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 BUSINESS ECONOMICS-I
iii. Yes, by a move from one point to another along the 8 . Refer to the figures below. Which of these markets depicts a
supply curve. situation of high market supply relative to market demand?
iv. No, optimism is not a determinant of supply or
demand.
5 . Factors that quickly and directly affect the market demand for
a good or service do not include:
i. The price of related goods—substitutes and
complements.
ii. The number of sellers, or business firms in the market.
iii. The number of buyers.
iv. The tastes and preferences of consumers.
6 . Which of the figures below would best describe the impact i. A.
of an increase in the wages and input prices firms must pay ii. B.
in order to produce output?
iii. C.
iv. D.
9 . Refer to the figures below. In which of the markets below
does the good in question appear to be relatively scarcer?

i. A.
ii. B. i. A.
iii. C. ii. B.
iv. D. iii. C.
7 . Refer to the figures below. In 1973, the Arab oil embargo iv. D.
resulted in a severe shortage of oil in the United States, and 10 . Refer to the figures below. When demand is high,
long lines at the gas pump. Which of the figures below equilibrium price is high. Choose the most applicable.
would best describe the impact of the oil embargo on gas
prices?

i. A.
ii. B.
iii. C.
i. A. iv. D.
ii. B. 11 . Refer to the figure below. Which of the following
iii. C. statements describing this figure is entirely correct?
iv. D.

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BUSINESS ECONOMICS-I

i. Point g.
ii. Point d.
i. An increase in price has shifted the supply curve, and the iii. Point h.
price is likely to fall. iv. Point f.
ii. After the increase in supply from S2 to S3, at a price of $8, 15 . Refer to the figure below. An increase in demand
there is an excess of quantity demanded over quantity accompanied by a decrease in supply moves equilibrium to:
supplied, which will cause the market price to increase.
iii. After the shift in supply, from S2 to S3, quantity
demanded is likely to increase, arriving at a lower
equilibrium price.
iv. After the shift in supply, quantity supplied will likely
increase along the new supply curve, and the market will
likely settle at equilibrium at a higher price and quantity.
12 . Refer to the figure below. Which of the following i. Point c.
statements is correct? ii. Point i.
iii. Point d.
iv. Point b.
16 . Refer to the figure below. To get to point g from point a,
you need:

i. At $8, there is excess demand after the demand curve

shifts from D2 to D3.
ii. After the market settles in equilibrium, quantity supplied
i. A decrease in demand and an increase in supply.
will have increased.
ii. Only a decrease in demand.
iii. The shift in demand will create upward pressure on
price. iii. A decrease in demand and a decrease in supply.
iv. All of the above. iv. Only a decrease in supply.
13 . Refer to the figure below. Starting at point a, an increase in 17 . If the supply and the demand for a good both rise, one
demand with no change in supply moves equilibrium to: thing is for sure:
i. Market price will increase.
ii. Equilibrium quantity will increase.
iii. A surplus will result.
iv. Nothing. Nothing is for sure.
18 . Refer to the figure below. This figure shows that:

i. Point e.
ii. Point c.
iii. Point h.
iv. Point b.
14 . Refer to the figure below. Start at point a. A decrease in
quantity demanded can be best exemplified by a move to:

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 BUSINESS ECONOMICS-I
i. When the magnitude of a decrease in supply is greater
than the magnitude of an increase in demand,
equilibrium price will fall, and quantity will rise.
ii. When the magnitude of an increase in supply is greater
than the magnitude of an increase in demand,
equilibrium price will fall, and quantity will rise.
iii. When supply and demand both increase, price always
decreases.
iv. In equilibrium, quantity demanded is not always equal
to quantity supplied. i. $8 is a price that results in a shortage, or a price above
19 . Refer to the figure below. Start at point a. This figure equilibrium price.
demonstrates that: ii. $8 represents an imposed minimum price that creates a
surplus.
iii. $8 is a price that generates an excess of quantity
demanded over quantity supplied.
iv. All of the above.
22 . Refer to the figure below. According to the text, which of
the following statements is correct about the effects of
school vouchers on the figure below?

i. An increase in demand alone may move equilibrium to

either point b or c.
ii. Both supply and demand must change in order to get
to point d.
iii. Higher supply and higher demand result in higher
prices.
iv. To get from point a to point d, there must be an
increase in supply and an increase in quantity demanded.
20 . Refer to the figure below. Assume that the government has i. Vouchers increase both the price and the quantity
imposed the $8 price in this market. Which of the following demanded of private schooling.
statements is entirely correct concerning this figure? ii. Vouchers cause the supply of private schooling to shift
to the right.
iii. Vouchers increase the demand for government-owned
public schools.
iv. Vouchers increase the demand for both private
schooling and public schooling.
23. Use the information on the figure below to determine the
slopes of the supply and demand lines.

i. $8 is a minimum imposed price.

ii. $8 is a maximum imposed price.
iii. $8 is too low for equilibrium, therefore, both
consumers and producers would benefit if the price
rose to equilibrium.
iv. $8 creates an excess of quantity supplied over quantity
demanded.
21 . Refer to the figure below. Assume that the government has i. The slopes of the supply and demand lines are 1.67 and
imposed the $8 price in this market. Which of the 25.00 respectively.
following statements is entirely correct concerning this ii. The slopes of the supply and demand lines are +6 and
figure? – 4, respectively.
iii. The slopes of the supply and demand lines are +0.166
and – 0.25, respectively.
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BUSINESS ECONOMICS-I
24 . Refer to the figure below. According to the information on
the figure, the algebraic expression of the demand and
supply lines are, respectively.

i. P = 25 – 56Q and Qs = 1.67 + 0.166Q

ii. Q = 100 – 4P and Q = –10 + 6P
iii. Q = 25 – 0.25P and Q = 1.67 + 0.166P
iv. P = 25 – 0.25Q, and P = 1.67 + 0.166Q.
25.Refer to the figure below. If the government imposes a
maximum price of ten dollars in this market, there will be:

i. A shortage of 10 units.
ii. A surplus of 10 units.
iii. A shortage of roughly 19 units.
iv. A shortage of output, but there is insufficient
information to estimate how much the shortage is.

Notes

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