Elasticity of demand and supply

Sunil Kumar School of Economics

Key Concepts
Defining elasticity Explaining: price elasticity of demand income elasticity of demand cross elasticity of demand price elasticity of supply Understanding how a tax burden and elasticity are related

The Concept of Elasticity

Elasticity is the term used in economics to explain the sensitivity or responsiveness of one variable to changes in another variable. Elasticity is useful for business decision-making (e.g. pricing, marketing) and policymaking.

Price Elasticity of Demand

Price elasticity of demand measures the sensitivity of quantity demanded by consumers to changes in price. The formula for price elasticity of demand is: Ed = percentage change in quantity demanded percentage change in price

Price elasticity of demand (cont.)

Example: A concert raises ticket prices from $25 to $30, and the number of seats sold falls from 20,000 to 10,000.
10 000 20 000 50% % Q 20 000 d= = = = 2.5 30 25 % P 25% 25

Price Elasticity of Demand

When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve. When the price is lowered from $30 to $25, the elasticity is calculated as follows:
20 000 10 000 100% % Q 10 000 d= = = = 5 .9 25-30 % P 17% 30

The Midpoint Formula for Elasticity

Q 2 Q1 % Q (Q 1 + Q 2 ) / 2 = d= P 2P1 % P (P 1 + P 2 ) / 2

Recalculating our previous example yields Ed = 3.7. Effectively it means price elasticity of demand at the quantity of 15,000 and price of $27.50.

Elasticity Coefficients
At introductory levels, it is conventional to ignore the minus sign that should result from calculations. The elasticity coefficient could be: elastic (Ed > 1) inelastic (Ed < 1) unitary elastic (Ed = 1)

Elastic Demand (Ed > 1)

Elastic demand indicates that the percentage change in quantity demanded is greater than the percentage change in price. This means consumers are sensitive to the price change.

Example of Elastic Demand

A rock group decreases its prices from $30 to $20, and quantity demanded rises from 10,000 to 30,000 tickets. Using the percentage change method:
20 000 10 000 % Q 100% 10 000 d= = = = 5.9 25 - 30 % P 17% 30

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Example Calculations
Using the midpoint formula:

Q 2 Q1 (Q1 + Q 2 ) / 2 d= P 2P1 (P 1 + P 2 ) / 2

30000 10000 (30000 +10000 ) / 2 d= 30 20 (30 + 20 ) / 2

Ed = 2.5 demand is price elastic.

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Elastic Demand Coefficients

Other Coefficients
Inelastic: When the percentage change in the quantity demanded is smaller than the percentage change in the price. Consumers are not sensitive to the price change. Unitary elastic: When the percentage change in the quantity demanded is equal to the percentage change in price.

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Other coefficients (cont.)

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The total revenue test

Total revenue is the revenue a firm earns from sales it is equal to price multiplied by quantity demanded. Depending on the elasticity coefficient, a decrease in price may lead to: increase in total revenue (elastic) decrease in total revenue (inelastic) no change in total revenue (unitary).

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Perfectly elastic demand & perfectly inelastic demand

Perfectly elastic demand: a small percentage change in price brings about an infinite percentage change in the quantity demanded. Perfectly inelastic demand: the quantity demanded does not change as the price rises.

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Perfectly elastic demand & perfectly inelastic demand

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Variations along a straight-line demand curve

The price elasticity of demand varies as we move along the demand curve. Any straight line demand curve has three ranges: a price elastic range (at high prices) a unitary elastic point a price inelastic range (at low prices).

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Variations along a straight-line demand curve (cont.)

Notice how TR reflects the variation in elasticity along the demand curve.

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Determinants of price elasticity of demand

A number of factors influence the price elasticity of a good or service: the availability of substitutes the proportion of the consumers budget that is spent on that product adjustments to price changes over time.

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Availability of substitutes
Demand is more price-elastic for goods that have close substitutes because consumers can switch to alternative products. Price elasticity depends upon how broadly (or narrowly) we define the good or service. For example, the Ed of Ford cars is greater than the Ed for cars in general.

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Share of budget spent on the product

Consumers are more sensitive to a price change, and the demand curve is more elastic, when the good or service takes a larger proportion of their income. This is because consumers think more carefully about alternatives when prices change.

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Adjustment to price change over time

The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve.

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Other elasticity measures

Income elasticity of demand Cross price elasticity of demand

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Income elasticity of demand

The ratio of the percentage change in the quantity demanded of a good to a given percentage change in income:

Ey =

percentage change in quantity demanded percentage change in income

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Income elasticity of demand (cont.)

Income increases from $1000 to $1250 per week. Ticket sales rise from 10,000 to 15,000
15 00010 000 % Q 10 000+15 000 .20 = = = =1.8 1 250-1 000 .11 % I 1 000+1 250

Ey

Ticket sales are responsive to a change in income.

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Income Elasticity Coefficients

If the income elasticity coefficient is positive, then this is a normal good consumers purchase more when their income rises. If the income elasticity coefficient is negative, then this is an inferior good consumers purchase less when their income rises.

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Cross-price Elasticity of Demand

The ratio of the percentage change in quantity demanded of a good to a given percentage change in price of another good:

Ex = % change in quantity demanded of good A % change in price of good B

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Substitutes and Cross-elasticity

Cross-elasticity calculations reveal whether goods are substitutes or complements in use. For example, if the price of Coke rose by 10%, the quantity of Pepsi might rise 5%. Because the % change in Q is positive, Pepsi is a substitute for Coke.

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Complements and Cross-elasticity

Cross price elasticity calculations reveal whether goods are substitutes or complements in use. For example, if the price of motor oil rose by 50%, the quantity of petrol might fall by 5%. Because the % change in Q is negative, petrol and oil are complements in use.

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Price elasticity of supply

The ratio of the percentage change in the quantity supplied of a product to the percentage change in its price.

Es =

percentage change in quantity supplied percentage change in price

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Coefficients of Elasticity of Supply

Supply is: elastic when Es > 1 perfectly elastic when Es = infinity unit elastic when Es = 1 inelastic when Es < 1 perfectly inelastic when Es = 0

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Coefficients of Elasticity of Supply

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Price elasticity and the impact of taxation

Taxes imposed on price inelastic goods are an important source of revenue for governments. Excise taxes are typically levied on goods such as petrol, alcohol and cigarettes. The study of the incidence of tax shows us who bears the burden.

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The incidence of a tax on petrol

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Taxes and Markets

Excise taxes raise revenue for government, and they can be put to good use. They also distort markets and lead to an inefficient outcome.

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