Elasticity of Demand

and Supply

Chapter 4
The demand and supply analysis helps us
to understand the direction in which price
and quantity would change in response to
shifts in demand or supply.
What economists would like to know is
‘what will happen to demand/supply when
price changes?’

Introduction
Here we extend our understanding of supply
and demand and consider the following:
 How the sensitivity of quantity demanded to a change
in price is measured by the elasticity of demand and
what factors influence it.
 How elasticity is measured at a point or over a range.
 How income elasticity is measured and how it varies
with different types of goods.
 How elasticity of supply is measured and what it tells
us about conditions of production.
 Some of the difficulties that arise in trying to estimate
various elasticities from sales data.

Learning Outcomes
Demand elasticity is measured by a ratio:
the percentage change in quantity
demanded divided by the percentage
change in price that brought it about.
For normal, negatively sloped demand
curves, elasticity is negative, but the
relative size of two elasticities is usually
assessed by comparing their absolute
values.

Price elasticity of demand

 Q / Q Q P
Point Definition EP   
P / P P Q

P
Linear Function EP  a1 
Q

a1 is the estimated coefficient of P in

regression equation
Price elasticity of demand -
formula
 Calculation of Two Demand Elasticities

Good A Original New % Change Elasticity

Quantity 100 95 -5%

-5%/10% = -0.5%
Price £1 £1.10 -10%

Good B

Quantity 200 140 -30%

-30%/20%=-1.5%
Price £5 £6 20%
 Calculation of Two Demand Elasticities

 Elasticity is calculated by dividing the percentage

change in quantity by the percentage change in
price.
 Consider good A
 A rise in price of 10p on £1 or 10 percent causes a fall in
quantity of 5 units from 100, or 5 percent.
 Dividing the 5 percent deduction in quantity by the 10
percent increase in price gives an elasticity of -0.5.
 Consider good B
 A 30 percent fall in quantity is caused by a 20 percent
rise in price, making elasticity –1.5
The value of price elasticity of demand
ranges from zero to minus infinity.
In this section, however, we concentrate
on absolute values, and so ask by how
much the absolute value exceeds zero.
Elasticity is zero if quantity demanded is
unchanged when price changes, namely
when quantity demanded does not
respond to a price change.

Interpreting price elasticity

As long as there is some positive response
of quantity demanded to a change in
price, the absolute value of elasticity will
exceed zero. The greater the response,
the larger the elasticity.

Demand is said to be ‘elastic’

Whenever this value is less than one,
however, the percentage change in
quantity is less than the percentage
change in price and demand is said to be
inelastic.
When elasticity is equal to one, the two
percentage changes are then equal to
each other.
This is called unit elasticity.
Summary
◦ 1. When elasticity of demand exceeds unity
(demand is elastic), a fall in price increases
total spending on the good and a rise in price
reduces it.
◦ 2. When elasticity is less than unity (demand is
inelastic), a fall in price reduces total spending
on the good and a rise in price increases it.
◦ 3. When elasticity of demand is unity, a rise or
a fall in price leaves total spending on the good
unaffected.

Note!
The main determinant of elasticity is the
availability of substitutes.
Closeness of substitutes—and thus
measured elasticity —depends both on
how the product is defined and on the
time period under consideration.

What determines elasticity of

demand?
A product with close substitutes tends
to have an elastic demand; one with
no close substitutes tends to have an
inelastic demand.

Note!
Factors affecting Elasticity of Demand
•Perception of the good by the consumer : Necessities have inelastic demand while
luxuries have elastic demand.

•Availability of substitutes : Commodity which has number of substitutes to it will

have elastic demand while commodity which has no substitutes has inelastic
demand.

•Share in total expenditure : Commodities which have a higher share in total

expenditure will generally have elastic demand while those with lesser share have
inelastic demand.

•Timeframe : In the short run it might not be possible to substitute the commodities
as it might take time to find substitutes while in the long run it might be easier to
switch over.

•Possibility of postponing the consumption

•Several uses of a commodity

 Importance of Elasticity of Demand :
• Importance to a monopolist: A monopolist cannot determine
the price of his product arbitrarily. He considers the demand
in the market while fixing the price of the product. In case
where the demand for the product is inelastic, he can fix a
higher price, while in case the demand is elastic he would not
fix a higher price.
• Important in regulating prices especially of agricultural
products: As demand for certain products especially
agricultural products is inelastic, the government in order to
increase the income of farmers, may regulate the supply and
increase the price.
• International Trade: If the demand for the country’s exports is
elastic, a fall in their prices would cause an increase in their
demand and thus improve the foreign exchange earnings of
the county.
• Taxes: The more inelastic the product the larger the
proportion of the tax is paid by the buyer.
Constant-elasticity Demand Curves

D3 D1

D2
Price

Quantity
 Three Constant-elasticity Demand Curves

 Curve D1 has zero elasticity: the quantity demanded

does not change at all when price changes.
 Curve D2 has infinite elasticity at the price p0: a small
price increase from p0 decreases quantity demanded
from an indefinitely large amount to zero.
 Curve D3 has unit elasticity: a given percentage
increase in price brings an equal percentage
decrease in quantity demanded at all points on the
curve.
 Curve D3 is a rectangular hyperbola for which price
times quantity is a constant.
 Elasticity on a Linear Demand Curve

D
Price

p
A

q

Quantity
0 q
 Point price Elasticity on a Linear Demand Curve

 Starting at point A and moving to point B, the ratio

p/q is the slope of the line.
 Its reciprocal q/p is the first term in the
percentage definition of elasticity.
 The second term in the definition is p/q, which is
the ratio of the coordinates of point A.
 Since the slope p/q is constant, it is clear that
the elasticity along the curve varies with the ratio
p/q.
 This ratio is zero where the curve intersects the
quantity axis and ‘infinity’ where it intersects the
price axis.
 Arc Elasticity on a Linear Demand Curve

 More frequently, than point price elasticity, arc

price elasticity is calculated.
 In arc price elasticity, the average of the two
prices and average of the two quantities is taken
in the calculations.

Q2  Q1 P2  P1
EP  
P2  P1 Q2  Q1
 Price, Elasticity, Total Revenue and Marginal Revenue

 There is an important relation between the price

elasticity of demand and the firm’s total revenue
and marginal revenue.
 Total revenue =P*Q
 MR = change in TR /change in quantity
 With a decline in price, TR increases if demand is
elastic, TR is unchanged if demand is unit elastic
and TR declines if demand is inelastic

 1 
MR  P 1  
 EP 
 Price, Elasticity, Total Revenue and Marginal Revenue

 If demand is elastic, a price decline leads to a

proportionately larger increase in quantity demanded
and so TR increases.
 If demand is unit elastic, a price decline leads to an
equal proportionate increase in quantity demanded
and so TR remains unchanged.
 If demand is inelastic, a price decline leads to a
proportionately smaller increase in quantity demanded
and so TR decreases.
 If the firm is a perfect competitor it faces a horizontal
or infinitely elastic demand curve for the commodity.
 Thus, the change in TR in selling each additional unit of
the commodity (MR) equals price
Marginal Revenue and
Price Elasticity of Demand
Elasticity of demand varies from
infinite to one to zero.
So, what should happen if you
were to reduce prices?
From zero to the midpoint your
total revenues increase because
the elasticity of demand is greater
than one, reaches its maximum at
this point where elasticity of
demand is equal to one and
thereafter, revenues continue to
decrease as you lower prices even
further and it reaches zero at this
point where elasticity of
demand is equal to zero.
Marginal Revenue and
Price Elasticity of Demand
PX
EP  1
EP  1

EP  1

QX
MRX
 Marginal Revenue and
Price Elasticity of Demand
If like before, you wanted to raise prices but worried about
the effect on revenue or income, the price elasticity of
demand will come to your rescue.

That depends on how far an increase in price P leads to a

decrease in Q. In particular, if the percentage change in Q
is less than the percentage change in P, then R will
increase. This is just another way of saying that R will
increase if the demand is inelastic.

Suppose P goes up and now the percentage change in Q is

higher than the percentage change in P in which case
demand is elastic and you would expect the revenues to
go down.
 Marginal Revenue and
Price Elasticity of Demand

Thus, if demand is elastic at a given price

level, then the company should cut its price,
because the percentage drop in price will result
in an even larger percentage increase in the
quantity sold—thus raising total revenue.

However, if demand is inelastic at the

original quantity level, then the
company should raise its prices, because
the percentage increase in price will result in a
smaller percentage decrease in the quantity sold
—and total revenue will rise.
 Two Intersecting Demand Curves

p1
p2
A
Price

p
p

Ds Df
q
0

Quantity
 Two Intersecting Demand Curves

 At the point of intersection of two demand curves, the

steeper curve has the lower elasticity.
 At the point of intersection p and q are common to both
curves, and hence the ratio p/q is the same on both
curves.
 Therefore, elasticity varies only with q/p.
 The absolute value of the slope of the steeper curve,
p2/q, is larger than the absolute value of the slope,
pl/q, of the flatter curve.
 Thus, the absolute value of the ratio q/p2 on the
steeper curve is smaller than the ratio q/p1 on the
flatter curve.
 So that elasticity is lower.
 Elasticity on a Nonlinear Curve

E
Price

Demand

A
p

B C

0 q Quantity
 Elasticity on a Nonlinear Demand Curve

 Elasticity measured from one point on a nonlinear demand

curve and using the percentage formula varies with the
direction and magnitude of the change being considered.
 Elasticity is to be measured from point A, so the ratio p/q is
given.
 The ratio plq is the slope of the line joining point A to the
point reached on the curve after the price has changed.
 The smallest ratio occurs when the change is to point C.
 The highest ratio when it is to point E.
 Since the term in the elasticity formula, q/p, is the
reciprocal of this slope, measured elasticity is largest
when the change is to point C and smallest when it is
to point E.
 Elasticity by the Exact Method

D
Price

p

q b” b’

Quantity
0
 Elasticity by the Exact Method

 In this method the ratio q/p is taken as the

reciprocal of the slope of the line that is tangent to
point a.
 Thus there is only one measure elasticity at point a.
 It is p/q multiplied by q/p measured along the
tangent T.
 There is no averaging of changes in p and q in this
measure because only one point on the curve is
used.
 Short-run and Long-run Demand Curves

E2 E’2
p2
E1
p1 E’1

E0
p0
Price

Dl

Ds2 Ds1 Dso

q2 q’2 q1 q’1 q0 Quantity

 Short-run and Long-run Demand Curves
 As it takes time to adjust fully to a price range, a demand that is
inelastic in the short run may prove elastic in the long run. Eg:
Changes in prices of petrol – OPEC oil price shocks, initially
demand for petrol was inelastic due to absence of substitutes,
however in the long run more fuel efficient cars were manufactured

 DL is the long-run demand curve showing the quantity that will be

bought after consumers become fully adjusted to each given price.
 Through each point on DL there is a short-run demand curve.
 It shows the quantities that will be bought at each price when
consumers are fully adjusted to the price at which that particular short-
run curve intersects the long-run curve.
 So at every other point on the short-run curve consumers are not fully
adjusted to the price they face, possibly because they have an
inappropriate stock of durable goods.
 Short-run and Long-run Demand Curves

 For example, when consumers are fully adjusted to

price p0 they are at point E0 consuming q0.
 Short-run variations in price then move them along
the short-run demand curve DS0.
 Similarly, when they are fully adjusted to price p1,
they are at E1 and short-run price variations move
them along DS1.
 The line DS2 shows short-run variations in demand
when consumers are fully adjusted to price p2.
Quantity The Relation Between Quantity Demanded and Income

0
Income
 The Relation Between Quantity Demanded and Income

qm

Zero income
Quantity

elasticity

0 y1 y2
Income
 The Relation Between Quantity Demanded and Income

qm

Positive income elasticity

Zero income
Quantity

elasticity

0 y1 y2
Income
 The Relation Between Quantity Demanded and Income

qm

Positive income elasticity

Zero income
Quantity

elasticity
Negative income elasticity
[inferior good]

y1 y2 Income
0
 The Relation Between Quantity Demanded and Income

 Normal goods have positive income elasticities.

Inferior goods have negative elasticities.
 Nothing is demanded at income less than y1, so for
incomes below y1 income elasticity is zero.
 Between incomes of y1 and y2 quantity demanded
rises as income rises, making income elasticity
positive.
 As income rises above y2, quantity demanded falls
from its peak at qm, making income elasticity
negative.
 An inferior good is a good that decreases in demand when
consumer income rises, unlike normal goods, for which the
opposite is observed.
 As a consumer's income increases the demand of the cheap cars
will decrease, while demand of costly cars will increase, so cheap
cars are inferior goods.

 A Giffen good is one which people paradoxically consume more

as the price rises, violating the law of demand. In normal
situations, as the price of a good rises, the substitution effect
causes consumers to purchase less of it and more of substitute
goods. In the Giffen good situation, the income effect dominates,
leading people to buy more of the good, even as its price rises.

 The classic example given by Marshall is of inferior quality staple

foods, whose demand is driven by poverty that makes their
purchasers unable to afford superior foodstuffs. As the price of
the cheap staple rises, they can no longer afford to supplement
their diet with better foods, and must consume more of the staple
food.
The concept of demand elasticity can be
broadened to measure the response to
changes in any of the variables that
influence demand.
◦ Income elasticity of demand
◦ Cross elasticity of demand

Other demand elasticities

The responsiveness of demand for a
product to changes in income is termed
income elasticity of demand, and is
defined as

Q / Q Q I
Point Definition EI   
I / I I Q

I
Linear Function EI  a3 
Q
a3 is the estimated coefficient of I in regression
equation
Income elasticity
 Q2  Q1 I 2  I1
Arc Definition EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0

Income elasticity
Ifthe resulting percentage change in
quantity demanded is larger than the
percentage increase in income, hy
will exceed unity.

The product’s demand is then said to
be income-elastic. If the
percentage change in quantity
demanded is smaller than the
percentage change in income, hy will
be less than unity.
The product’s demand is then said to
be income-inelastic.
 The responsiveness of quantity demanded
of one product to changes in the prices of
other products is often of considerable
interest.
QX / QX QX PY
Point Definition E XY   
PY / PY PY QX

Linear Function PY
E XY  a4 
QX
a4 is the estimated coefficient of I in regression equation
Cross-elasticity
 QX 2  QX 1 PY 2  PY 1
Arc Definition E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements
E XY  0 E XY  0

Cross-elasticity
Concept of cross demand elasticity is a very important
concept in managerial decision making.
Firms use this concept to measure the effect of changing
the price of a product they sell on the demand for other
related products that the firm also sells.
Eg: Maruti can use cross price elasticity to measure the
effect of change in the price of Swift on the demand for
WagonR.
Since WagonR and Swift are substitutes lowering the
price of the former, will reduce the demand for the latter.
However, in case of razor and razorblades, if the firm
reduced the price of razor, there would be an increase in
demand for razor blades.

Cross-elasticity
A firm needs elasticity estimates to determine the optimal
operational policies and the most effective way to
respond to the policies of competing firms.
If the demand for the product is price inelastic, the firm
will not want to lower its price, as that would reduce its
TR, increase its total costs (as more units of the
commodity are being sold at the lower price).
If the elasticity of the firm wrt advertising is positive and
higher than its expenditure on quality and customer
service, then the firm will concentrate its sales efforts on
advertising rather than customer service and quality.
If the firm has estimated that the cross price elasticity for
its product wrt the price of competitor’s product is high,
it will be quick to respond to a competitor’s price
reduction, or it will lose substantial sales.

Elasticity
 Changes in demand for newspaper

Price Average daily sales Percent change

Pre-Sep.’93 Post-Sep.’93 Pre-Sep.’93 Post-Sep.’93 Price Sales

The Times 45p 35p 376,836 2,196,464 -40.0 +17.5

Guardian 45p 45p 420,154 401,705 0.0 -4.50

Daily Telegraph 45p 45p 1,137,375 1,017,326 0.0 -1.95

Independent 50p 50p 362,099 362,099 0.0 -15.20

2,196,464 2,179,039
 A firm with the demand function defined below
expects a 5% increase in income (M) during
the coming year. If the firm cannot change its
rate of production, what price should it charge?
Demand: Q = – 3P + 100M
◦ P = Current Real Price = 1,000
◦ M = Current Income = 40

Example: Using Elasticities in

Managerial Decision Making
Elasticities
◦ Q = Current rate of production = 1,000
◦ P = Price = - 3(1,000/1,000) = - 3
◦ I = Income = 100(40/1,000) = 4
Price
◦ %ΔQ = - 3%ΔP + 4%ΔI
◦ 0 = -3%ΔP+ (4)(5) so %ΔP = 20/3 = 6.67%
◦ P = (1 + 0.0667)(1,000) = 1,066.67

Example: Using Elasticities in

Managerial Decision Making
The price elasticity of supply is defined
as the percentage change in quantity
supplied divided by the percentage
change in price that brought it about.
 Three Constant-elasticity Supply Curves

Price
[ii]. Infinite Elasticity
Price

S1 [i]. Zero Elasticity

S2
p1

Price

Quantity

q1 Quantity S3

p [iii]. Unit Elasticity

q p

Quantity
 Three Constant-elasticity Supply Curves

 Curve S1, has a zero elasticity, since the same

quantity q1, is supplied whatever the price.
 Curve S2 has an infinite elasticity at price p1; nothing
at all will be supplied at any price below p1, while an
indefinitely large quantity will be supplied at the
price of p1.
 Curve S3, as well as all other straight lines through
the origin, has a unit elasticity, indicating that the
percentage change in quantity equals the percentage
change in price between any two points on the curve.
 Factor influencing Elasticity of Supply
 Nature of commodity : Perishable goods as they cannot be stored for long, have inelastic
supply, whilst durable goods have elastic supply

 It depends on how easily can producers shift from the production of other products to the
one whose price has risen.

 Length of time: Elasticity of supply depends on the ease with which increases in production
can be made without bringing any increase in cost of production. In the short run, when
increase in production is brought about by increasing the variable factors, diminishing
returns eventually result, thereby supply becomes relatively inelastic. In the long run, when
all factors are variable, the supply curve tends to be more elastic.

 Technique of Production : Simple techniques of production more elastic is supply, complex

techniques have inelastic supply as technology would need time to be installed and thus it
would be difficult to respond immediately to increase in price.

 Estimate of future prices : If firms expect price to rise in future, inelastic is the supply and
vice versa.