ELASTICITY OF DEMAND AND SUPPLY

Dr USHA NORI
 INTRODUCTION

• 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?’
• Elasticity is an economics concept that measures
responsiveness of one variable to changes in another
variable.
 ELASTICITY OF DEMAND

• The percentage change in a dependent variable resulting from a one percent

change in an independent variable is known as elasticity.
• Elasticity is the measure of responsiveness of a dependent variable to a given
change in an independent variable.
• y = f(x)
• Elasticity of Y = Percentage change in Y
• Percentage change in X
• Point elasticity = ∆Y/Y
• ∆X/X
• = ∆Y . X
• ∆X Y
ARC ELASTICITY
 P R I C E E LA S TI C I TY O F D EM A N D A N D P R I C E
EL A S TI C I T Y O F
SU PP LY

• Price elasticity is the ratio between the percentage change

in the quantity demanded (Qd) or supplied (Qs) and the
corresponding percent change in price.
• The price elasticity of demand is the percentage change in
the quantity demanded of a good or service divided by the
percentage change in the price.
• The price elasticity of supply is the percentage change in
quantity supplied divided by the percentage change in
price.
 C AT E G O R I E S O F E L A S T I C I T I E S

• An elastic demand or elastic supply is one in which the

elasticity is greater than one, indicating a high responsiveness to
changes in price.
• Elasticities that are less than one indicate low responsiveness to
price changes and correspond to inelastic demand or inelastic
supply.
• Unitary elasticities indicate proportional responsiveness of either
demand or supply
• Midpoint Method for Elasticity, and is represented in the
following equations:
• % change in quantity = Q2 – Q1/Q2 + Q1/2×100
• % change in price = P2 – P1/P2 + P1/2×100
 PRICE ELASTICITY

• calculate the elasticity as price decreases

from $70 at point B to $60 at point A:
• % change in quantity = 3,000 –
2,800/(3,000 + 2,800)/2 × 100
• = 200/2,900 × 100
• = 6.9
• % change in price = 60 – 70/(60 + 70)/2 ×
100
• = –10/65 × 100
• = –15.4
• Price Elasticity of Demand = 6.9%/-15.4%
• = 0.45
• an amount smaller than one, showing -that
the demand is inelastic in this interval.
 P R I C E E L A S T I C I T Y O F S U P P LY

• price elasticity of supply : is the percentage change in quantity

divided by the percentage change in price.
• 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.
 DETERMINANTS OF ELASTICITY

• Availability of substitutes: The more close a substitute(s) a

product has the more elastic is its demand
• Proportion of income spent on the product
• Time frame
If . . . Then . . . And It Is Called . . .

% change in quantity > % % change in quantity/ Elastic

change in price % change in price > 1

% change in quantity = % % change in quantity/ Unitary

change in price % change in price = 1

% change in quantity < % % change in quantity/ Inelastic

change in price % change in price < 1
 C A S E S T U D Y: S H O RT- R U N V S . L O N G - R U N D E M A N D F O R P E T R O L

• Petrol prices increased from 1973 to 1981

• At first, consumers had little choice but to use the same amount of petrol and pay higher
prices
• Options
• Vacation trips cancelled
• 1973-1975- average fuel consumption per vehicle declined from 2782 to 2589 litres per
year.
• Given more time, consumers were able to reduce the impact of higher petroleum prices
• Smaller, fuel efficient cars became popular- average kms. Per litre of petrol for passenger
cars increased from 5.6 in 1973 to 6.7 in 1981.
• People changed jobs or moved closer to their places of work – these changes in driving
habits reduced the average number of kms driven per car from 15,768 to 13,998 over the
same period.
• Net effect- fuel consumption per vehicle in US declined from 2782 to 2098 litres per year ,
a reduction of nearly 25%.
• Clearly, the long-run demand for petrol was more elastic than the short run demand.
•
 POLAR CASES OF ELASTICITY
A N D C O N S TA N T E L A S T I C I T Y

• The horizontal lines show that

an infinite quantity will be
demanded or supplied at a
specific price.
• This illustrates the cases of a
perfectly (or infinitely) elastic
demand curve and supply
curve.
• The quantity supplied or
demanded is extremely
responsive to price changes,
moving from zero for prices
close to P to infinite when
prices reach P.
 ZERO ELASTICITY

• The vertical supply curve and

vertical demand curve show
that there will be zero
percentage change in
quantity (a) demanded or (b)
supplied, regardless of the
price.
 C O N S TA N T U N I TA R Y
ELASTICITY DEMAND CURVE

• Demand curve with constant

unitary elasticity will be a curved
line.
• Price and quantity demanded
change by an identical
percentage amount between
each pair of points on the
demand curve.
 C O N S TA N T U N I TA R Y
E L A S T I C I T Y S U P P LY C U R V E

• Constant unitary elasticity

supply curve is a straight line
reaching up from the origin.
• Between each pair of points,
the percentage increase in
quantity supplied is the same
as the percentage increase in
price.
 ELASTICITY AND PRICING

• Analyze how price elasticities impact revenue

• Evaluate how elasticity can cause shifts in demand and
supply
• Predict how the long-run and short-run impacts of elasticity
affect equilibrium
• Explain how the elasticity of demand and supply determine
the incidence of a tax on buyers and sellers
 ELASTICITY AND PRICING
Goods and Services Elasticity of Price

Housing 0.12

Transatlantic air travel (economy class) 0.12

Rail transit (rush hour) 0.15
Electricity 0.20

Taxi cabs 0.22

Gasoline 0.35

Transatlantic air travel (first class) 0.40

Wine 0.55

Beef 0.59

Transatlantic air travel (business class) 0.62

Kitchen and household appliances 0.63

Cable TV (basic rural) 0.69

Chicken 0.64

Soft drinks 0.70

Beer 0.80

New vehicle 0.87

Rail transit (off-peak) 1.00

Computer 1.44
Cable TV (basic urban) 1.51

Cable TV (premium) 1.77

Restaurant meals 2.27

 DOES RAISING PRICE BRING IN MORE REVENUE

If Then . . .. Therefore
Demand
Is . . .

Elastic % change in Qd > % change in P A given % rise in P will be more than

offset by a larger % fall in Q so that total
revenue (P × Q) falls.

Unitary % change in Qd = % change in P A given % rise in P will be exactly offset

by an equal % fall in Q so that total
revenue (P × Q) is unchanged.

Inelastic % change in Qd < % change in P A given % rise in P will cause a smaller

% fall in Q so that total revenue (P × Q)
rises.
 C A N B U S I N E S S E S PA S S C O S T S O N T O
CONSUMERS?

• Passing along Cost Savings to

Consumers
• Cost-saving gains cause supply to
shift out to the right from S0 to S1;
• that is, at any given price, firms will
be willing to supply a greater quantity.
• If demand is inelastic, as in (a), the
result of this cost-saving
technological improvement will be
substantially lower prices.
• If demand is elastic, as in (b), the
result will be only slightly lower
prices.
• Consumers benefit in either case,
from a greater quantity at a lower
price, but the benefit is greater when
demand is inelastic, as in (a).
 PASSING ALONG HIGHER COSTS TO CONSUM ERS

• Higher costs, like a higher tax on cigarette

companies lead supply to shift to the left.
• This shift is identical in (a) and (b).
• However, in (a),where demand is
inelastic, companies largely can pass the
cost increase along to consumers in the
form of higher prices, without much of a
decline in equilibrium quantity.
• In (b), demand is elastic, so the shift in
supply results primarily in a lower
equilibrium quantity.
• Consumers suffer in either case, but in
(a), they suffer from paying a higher price
for the same quantity,
• while in (b), they suffer from buying a
lower quantity (and presumably needing
to shift their consumption elsewhere).
 E L A S T I C I T Y A N D TA X
INCIDENCE
• An excise tax introduces a wedge
between the price paid by consumers
(Pc) and the price received by producers
(Pp).
• The vertical distance between Pc and Pp
is the amount of the tax per unit.
• Pe is the equilibrium price prior to
introduction of the tax.
• (a) When the demand is more elastic
than supply, the tax incidence on
consumers Pc – Pe is lower than the tax
incidence on producers Pe – Pp.
• (b) When the supply is more elastic than
demand, the tax incidence on
consumers Pc – Pe is larger than the tax
incidence on producers Pe – Pp.
• The more elastic the demand and supply
curves, the lower the tax revenue.
 L O N G - R U N V S . S H O R T-
R U N I M PA C T

• How a Shift in Supply Can Affect Price or

Quantity
• The intersection (E0) between demand
curve Dand supply curve S0 is the same in
both (a) and (b).
• The shift of supply to the left from S0 to S1
is identical in both (a) and (b).
• The new equilibrium (E1) has a higher price
and a lower quantity than the original
equilibrium (E0) in both (a) and (b).
• However, the shape of the demand curve D
is different in (a) and (b), being more elastic
in (b) than in (a).
• As a result, the shift in supply can result
either in a new equilibrium with a much
higher price and an only slightly smaller
quantity, as in (a), with more inelastic
demand, or in a new equilibrium with only a
small increase in price and a relatively larger
reduction in quantity, as in (b), with more
elastic demand.
T O TA L R E V E N U E A N D T H E P R I C E E L A S T I C I T Y O F D E M A N D
I N E L A S T I C D E M A N D .
HOW TR CHANGES WHEN PRICE CHANGES: ELASTIC DEMAND
A L I N E A R D E M A N D C U RV E
 C A S E S T U D Y P R I C I N G A D M I S S I O N T O A M U S E U M

• You are curator of a major art museum. Your director of finance

tells you that the museum is running short of funds and
suggests that you consider changing the price of admission to
increase total revenue. What do you do? Do you raise the price
of admission, or do you lower it?

• The answer depends on the elasticity of demand. If the demand

for visits to the museum is inelastic, then an increase in the
price of admission would increase total revenue. But if the
demand is elastic, then an increase in price would cause the
number of visitors to fall by so much that total revenue would
decrease.
• In this case, you should cut the price. The number of visitors
would rise by so much that total revenue would increase.
• To estimate the price elasticity of demand, you would need to turn to your
statisticians. They might use historical data to study how museum
attendance varied from year to year as the admission price changed. Or they
might use data on attendance at the various museums around the country to
see how the admission price affects attendance.

• In studying either of these sets of data, the statisticians would need to take
account of other factors that affect attendance— weather, population, size of
collection, and so forth—to isolate the effect of price.

• In the end, such data analysis would provide an estimate of the price
elasticity of demand, which you could use in deciding how to respond to
your financial problem.
C O M P U T I N G T H E E L A S T I C I T Y O F A L I N E A R D E M A N D C U RV E
 C A S E S T U D Y: G A S O L I N E : S H O R T- R U N A N D L O N G - R U N
D E M A N D C U RV E S

• In the short run, an increase in price has only a small effect on the
quantity of gasoline demanded. Motorists may drive less, but they will
not change the kinds of cars they are driving overnight.

• In the longer run, however, because they will shift to smaller and
more fuel-efficient cars, the effect of the price increase will be larger.
Demand, therefore, is more elastic in the long run than in the short
run.
 A U T O M O B I L E S : S H O R T- R U N A N D L O N G - R U N D E M A N D C U R V E S

• The opposite is true for automobile demand. If price increases,

consumers initially defer buying new cars; thus annual quantity
demanded falls sharply.

• In the longer run, however, old cars wear out and must be replaced;
thus annual quantity demanded picks up. Demand, therefore, is less
elastic in the long run than in the short run.
 I N E L A S T I C D E M A N D F O R P R E S C R I P T I O N D R U G S

• Many people perceive the demand for prescription drugs and other pharmaceutical
products to be perfectly inelastic.
• After all, a patient needing an expensive cardiovascular drug might die in the
absence of treatment.
• Moreover, in many instances the cost of medication is paid by an insurance
company. These two factors do tend to make the demand for many pharmaceutical
products relatively inelastic.
• However, since surgery and life-style changes are substitutes for many life-saving
drugs, economic theory predicts that the demand for such products is unlikely to be
perfectly inelastic.
• Two recent studies that confirm this prediction
• For instance, the own price elasticity of demand for anti-ulcer
drugs is 0.7, while the own price elasticity of demand for
cardiovascular drugs is slightly more inelastic at 0.4.
Consequently, a 10 percent increase in the price of anti-ulcer
drugs reduces their use by 7 percent. A10 percent increase in
the price of cardiovascular drugs results in only a 4 percent
reduction in quantity demanded.
 I N CR EA S E I N PRI CE O F G A S O LI N E

• Increases in the price of gasoline led to decreases in demand for

products that are complements for gasoline, such as automobiles. The
reason was that higher gasoline prices moved consumers to substitute
toward public transportation, bicycling, and walking.
• An econometric study by Patrick McCarthy provides quantitative
information about the impact of fuel costs on the demand for
automobiles.
• One of the more important determinants of the demand for automobiles
is the fuel operating cost, defined as the cost of fuel per mile driven
• The study reveals that for each 1 percent increase in fuel costs, the
demand for automobiles will decrease by 0.214 percent. A 10 percent
increase in the price of gasoline increases the cost of fuel per mile driven
by 10 percent and thus reduces the demand for a given car by 2.14
percent.
• Increases in the price of gasoline led to decreases in demand for
products that are complements for gasoline, such as automobiles. The
reason was that higher gasoline prices moved consumers to substitute
toward public transportation, bicycling, and walking.
• An econometric study by Patrick McCarthy provides quantitative
information about the impact of fuel costs on the demand for
automobiles.
• One of the more important determinants of the demand for automobiles
is the fuel operating cost, defined as the cost of fuel per mile driven
• The study reveals that for each 1 percent increase in fuel costs, the
demand for automobiles will decrease by 0.214 percent. A 10 percent
increase in the price of gasoline increases the cost of fuel per mile driven
by 10 percent and thus reduces the demand for a given car by 2.14
percent.
 I N C O M E ELA ST I C I T Y O F D E M A N D

• Income elasticity of demand = % change in quantity demanded/%

change in income

• Cross-Price Elasticity of Demand

• Cross-price elasticity of demand = % change in Qd of good A/% change in
price of good B.
 INCOME ELASTICITY

• The responsiveness of demand for a product to changes in income is termed

income elasticity of demand, and is defined as
• If the resulting percentage change in quantity demanded is larger than the
percentage increase in income, e 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, e will be less than unity. The product’s demand is then said
to be income-inelastic.
 The Relation Between Quantity Demanded and Income

qm

Positive income elasticity

Zero income
Quantity

elasticity
Negative income elasticity
[inferior good]

y1 y2 Income
0
 CROSS-ELASTICITY

• The responsiveness of quantity demanded of one product to changes in the

prices of other products is often of considerable interest.
 C A S E S T U D Y: I N C O M E E L A S T I C I T Y
E N G E L’ S L AW A N D T H E P L I G H T O F T H E FA R M E R

• In the 19th century a German Scientist, Ernst Engel carved his

name in economic history by proposing what has become
known as Engel’s law.
• He studied the consumption patterns of many households and
concluded that the percentage of income spent on food
decreases as income increase.
• He determined food is a necessity
• Ex: Beef (1.05), chicken (0.28), pork (0.14) tomatoes (0.24),
potatoes (0.15)- Estimated income elasticities
• Implications of Engel’s law:
• Farmers may not prosper as much as those in other occupations
during periods of economic prosperity.
• Reason is that if food expenditure do not keep pace with
increases in GDP, farm incomes may not increase as rapidly as
incomes in general.
• However, this tendency has been partially offset by the rapid
increase in farm productivity.
 CA S E S T U D Y O N CR O S S P RI C E E L A S TI CI T Y

• What did automakers do during this period to mitigate the

negative impact of rising gasoline prices on the demand for
new automobiles? They made cars more fuel efficient .
• Results- for every 10 percent increase in fuel efficiency
(measured by the increase in miles per gallon), the demand for
automobiles increases by 2.14 percent. Auto manufacturers
could completely offset the negative impact of higher gasoline
prices by increasing the fuel efficiency of new cars by the same
percentage as the increase in gasoline prices.
• In fact, by increasing fuel efficiency by a greater percentage
than the increase in gasoline prices, they would actually
increase the demand for new automobiles.