TOPIC 4.

TOPIC “DEMAND AND SUPPLY

ELASTICITY”
 Main Questions

1. Price elasticity and its factors.

2. Types of demand elasticity.
3. Supply elasticity.
 1. Price elasticity and its factors

 The law of demand tells us that, other things equal,

consumers will buy more of a product when its price
declines and less when its price increases. . But how much
more or less will they buy? The amount varies from product
to product and over different price ranges for the same
product. It also may vary over time. And such variations
matter. For example, a firm considering raising prices will
want to know how consumers will respond. If they remain
highly loyal and continue to buy, the firm’s revenue will
rise. But if consumers en masse move to other sellers or
other products, the firm’s revenue will fall.
 1. Price elasticity and its factors
Elasticity is a measure of the relationship
between quantity demanded or supplied and
another variable, such as price or income,
which affects the quantity demanded or
supplied.
Price elasticity measures the responsiveness
(or speed of change) of the quantity
demanded or supplied of a good to a change
in its price.
The responsiveness (or sensitivity) of consumers to a
price change is measured by a product’s price
elasticity of demand. For some products—for
example, restaurant meals—consumers are highly
responsive to price changes. Small price changes
cause very large changes in the quantity purchased.
Economists say that the demand for such products is
relatively elastic or simply elastic.
For other products—for example, toothpaste—
consumers pay much less attention to price changes.
Substantial price changes cause only small changes in
the amount purchased. The demand for such products
is relatively inelastic or simply inelastic.
Economists measure the degree to which demand is price
elastic or inelastic with the coefficient E d, defined as

The percentage changes in the equation are calculated by

dividing the change in quantity demanded by the original
quantity demanded and by dividing the change in price
by the original price. So we can restate the formula as
Price elasticity
The demand elasticity can be
described as
- elastic—or very
responsive;
- unitary elastic;
- inelastic—not very
responsive.
If Ed> 1, then the demand
will be elastic
If Ed <1, then the demand
is inelastic
If Ed = 1, - unitary
elasticity
If Ed = 0 - “absolutely
(perfectly) inelastic
demand”
If Ed = ∞ - “absolutely
(perfectly) elastic demand”
Elastic Demand
If Ed> 1, then the demand will be elastic, that is, the
requested quantity of goods will change faster than
prices, for example, luxury goods, durable goods.
So, in other words, demand is elastic if a specific
percentage change in price results in a larger
percentage change in quantity demanded. Then Ed
will be greater than 1.
Example: Suppose that a 2 percent decline in the
price of cut flowers results in a 4 percent increase in
quantity demanded. Then demand for cut flowers is
elastic and
 Inelastic Demand
If Ed <1, then the demand is inelastic and prices
change faster than the number of goods purchased by
consumers, for example, for essential goods.
If a specific percentage change in price produces a
smaller percentage change in quantity demanded,
demand is inelastic. Then E d will be less than 1.
Example: Suppose that a 2 percent decline in the
price of coffee leads to only a 1 percent increase in
quantity demanded. Then demand is inelastic and
Unit Elasticity
If Ed = 1, - unitary elasticity means that a given
percentage change in price leads to an equal percentage
change in quantity demanded or supplied.
The case separating elastic and inelastic demands
occurs where a percentage change in price and the
resulting percentage change in quantity demanded are
the same. Example: Suppose that a 2 percent drop in the
price of chocolate causes a 2 percent increase in
quantity demanded. This special case is termed unit
elasticity because Ed is exactly 1, or unity. In this
example,
 Extreme Cases
If Ed = 0 - “absolutely (perfectly) inelastic
demand” means an extreme case, if the change
in price does not lead to any changes in the
quantity of products requested (for example, the
demand of diabetes patients for insulin).
If Ed = ∞ - “absolutely (perfectly) elastic
demand” means the second extreme case, if the
slightest change in price prompts buyers to
increase purchases from zero to the limit of
their capabilities (for example, products in a
We know from the downsloping demand curve that price and
quantity demanded are inversely related. Thus, the price-elasticity
coefficient of demand Ed will always be a negative number.
As an example, if price declines, then quantity demanded will
increase. This means that the numerator in our formula will be
positive and the denominator negative, giving a negative Ed. For
an increase in price, the numerator will be negative but the
denominator positive, again giving a negative Ed .
So we ignore the minus sign in the coefficient of price elasticity
of demand and show only the absolute value.
Incidentally, the ambiguity does not arise with supply because
price and quantity supplied are positively related. All elasticity of
supply coefficients therefore are positive numbers.
The factors of demand elasticity

- the number of substitutes;

- proportion of income;
- degree of utility to the consumer;
- the duration of the research
period.
 The number of substitutes
Various brands of candy bars are generally
substitutable for one another, making the demand for
one brand of candy bar, say Snickers, highly elastic.
Toward the other extreme, the demand for tooth repair
(or tooth pulling) is quite inelastic because there
simply are no close substitutes when those procedures
are required.
The elasticity of demand for a product depends on
how narrowly the product is defined.
 Proportion of income
Other things equal, the higher the price of a good relative
to consumers’ incomes, the greater the price elasticity of
demand. A 10 percent increase in the price of low-priced
pencils or chewing gum amounts to a few more pennies
relative to one’s income, and quantity demanded will
probably decline only slightly. Thus, price elasticity for
such low-priced items tends to be low. But a 10 percent
increase in the price of relatively high-priced
automobiles or housing means additional expenditures of
perhaps $3000 or $20,000, respectively.
Price elasticity for such items tends to be high.
 degree of utility to the consumer (luxuries versus
necessities)
In general, the more that a good is considered to be a “luxury” rather
than a “necessity,” the greater is the price elasticity of demand.
Electricity is generally regarded as a necessity; it is difficult to get
along without it. A price increase will not significantly reduce the
amount of lighting and power used in a household. An extreme case: a
person does not decline an operation for acute appendicitis because the
physician’s fee has just gone up.
On the other hand, vacation travel and jewelry are luxuries, which, by
definition, can easily be forgone. What about the demand for a common
product like salt? It is highly inelastic on three reasons: Few good
substitutes are available; salt is a negligible item in the family budget;
and it is a “necessity” rather than a luxury.
 -the duration of the research period
Generally, product demand is more elastic the longer the time period
under consideration. Consumers often need time to adjust to changes
in prices. For example, when the price of a product rises, time is
needed to find and experiment with other products to see if they are
acceptable. Consumers may not immediately reduce their purchases
very much when the price of beef rises by 10 percent, but in time
they may shift to chicken, pork, or fish.
Another consideration is product durability. Studies show that
“short-run” demand for gasoline is more inelastic than is “long-run”
demand. In the short run, people are “stuck” with their present cars
and trucks, but with rising gasoline prices they eventually replace
them with smaller, more fuel-efficient vehicles. They also switch to
mass transit where it is available.
Selected Price Elasticities of Demand Coefficient of Price
 2. Types of demand elasticity

1. Price elasticity of demand (PED)

point elasticity midpoint elasticity

 2. Types of demand elasticity

2. Cross elasticity of demand (XED)

3. Income elasticity of demand (YED)

The cross elasticity of demand measures how sensitive consumer
purchases of one product (say, X) are to a change in the price of some
other product (say, Y).We calculate the coefficient of cross elasticity of
demand Exy just as we do the coefficient of simple price elasticity,
except that we relate the percentage change in the consumption of X to
the percentage change in the price of Y:

This cross-elasticity (or cross-price-elasticity) concept allows us to

quantify and more fully understand substitute and complementary
goods. Unlike price elasticity, we allow the coefficient of cross
elasticity of demand to be either positive or negative.
Substitute Goods If cross elasticity of demand is positive, meaning that
sales of X move in the same direction as a change in the price of Y, then X
and Y are substitute goods. An example is Bon Aqua water (X) and
Morshinskaya (Y). An increase in the price of Bon Aqua causes consumers to
buy more Morshinskaya, resulting in a positive cross elasticity. The larger the
positive cross-elasticity coefficient, the greater is the substitutability between
the two products.
Complementary Goods When cross elasticity is negative, we know that X
and Y “go together”; an increase in the price of one decreases the demand for
the other. So the two are complementary goods. For example, a decrease in
the price of digital cameras will increase the number of memory sticks
purchased. The larger the negative crosselasticity coefficient, the greater is
the complementarity between the two goods.
Independent Goods A zero or near-zero cross elasticity suggests that the
two products being considered are unrelated or independent goods. An
example is salt and toilet paper: We would not expect a change in the price of
ncome elasticity of demand measures the degree to
I

which consumers respond to a change in their incomes

by buying more or less of a particular good. The
coefficient of income elasticity of demand E i is
determined with the formula
Normal Goods For most goods, the income-elasticity coefficient
Ei is positive, meaning that more of them are demanded as incomes
rise. Such goods are called normal or superior goods. But the value
of Ei varies greatly among normal goods. For example, income
elasticity of demand for automobiles is about 3, while income
elasticity for most farm products is only about 0.20.
Inferior Goods A negative income-elasticity coefficient designates
an inferior good. Retread tires, used clothing, and muscatel wine
are likely candidates. Consumers decrease their purchases of
inferior goods as incomes rise.
Coefficients of income elasticity of demand provide insights into
the economy. For example, when recessions (business downturns)
occur and incomes fall, income elasticity of demand helps predict
which products will decline in demand more rapidly than others.
Cross and Income Elasticities of Demand
 Applications of Price Elasticity of Demand
The concept of price elasticity of demand has great practical
significance, as the following examples suggest.
Large Crop Yields The demand for most farm products is
highly inelastic; E d is perhaps .20 or .25. As a result,
increases in the output of farm products arising from a good
growing season or from increased productivity tend to
depress both the prices of farm products and the total
revenues (incomes) of farmers. For farmers as a group, the
inelastic demand for their products means that large crop
yields may be undesirable. For policymakers it means that
achieving the goal of higher total farm income requires that
farm output be restricted.
Excise Taxes The government pays attention to elasticity
of demand when it selects goods and services on which
to levy excise taxes. If a $1 tax is levied on a product and
10,000 units are sold, tax revenue will be $10,000 (= $1
* 10,000 units sold). If the government raises the tax to
$1.50 but the higher price that results reduces sales to
4000 because of elastic demand, tax revenue will decline
to $6000 (= $1.50 * 4000 units sold). Because a higher
tax on a product with elastic demand will bring in less
tax revenue, legislatures tend to seek out products that
have inelastic demand—such as liquor, gasoline, and
cigarettes—when set excises.
 QUICK REVIEW
•The price elasticity of demand coefficient Ed is the ratio of
the percentage change in quantity demanded to the
percentage change in price. The averages of the two prices
and two quantities are used as the base references in
calculating the percentage changes.
• When Ed is greater than 1, demand is elastic; when Ed is
less than 1, demand is inelastic; when Ed is equal to 1,
demand is of unit elasticity.
• Price elasticity of demand is greater (a) the larger the
number of substitutes available; (b) the higher the price of a
product relative to one’s budget; (c) the greater the extent to
which the product is a luxury; and (d) the longer the time
period involved.
 3. Supply elasticity

The elasticity of supply establishes a

quantitative relationship between the supply of a
commodity and its price.
The price elasticity of supply
 Elasticity from a Supply Curve
Along with the method mentioned above, there are two
more ways to calculate the price elasticity of supply,
both of which make use of the supply curve. We can
either calculate the elasticity at a specific point on the
supply curve, known as point elasticity or between two
prices, known as arc-elasticity.
The supply elasticity can be described as elastic, unitary
elastic and inelastic.
Also, Es is never negative, since price and quantity
supplied are directly related. Thus, there are no minus
signs to drop, as was necessary with elasticity of
demand.
 The factors of supply elasticity

1) features of the production process;

2) a time factor;
3) availability of resources;
4) technology innovation;
5) the number of competitors;
6) flexibility;
7) ability of good to long-term storage.
 Types of Elasticity of Supply
1. Perfectly Inelastic Supply The market period is the
period that occurs when the
time immediately after a
change in market price is too
short for producers to
respond with a change in
quantity supplied.

Within the boundaries of the immediate market period, the

manufacturer does not have enough time to change the volume
of production. Therefore supply is absolutely (perfectly)
inelastic.
Suppose the owner of a small farm brings to market one truckload
of tomatoes that is the entire season’s output. The supply curve for
the tomatoes is perfectly inelastic (vertical); the farmer will sell the
truckload whether the price is high or low. He or she might like to
offer more tomatoes, but tomatoes cannot be produced overnight.
Another full growing season is needed to respond to a higher-than-
expected price by producing more than one truckload. Similarly,
because the product is perishable, the farmer cannot withhold it
from the market. If the price is lower than anticipated, he or she
will still sell the entire truckload.
However, not all supply curves need be perfectly inelastic
immediately after a price change. If the product is not perishable
and the price rises, producers may choose to increase quantity
supplied by drawing down their inventories of unsold, stored
goods.
The supply of exclusive items, like the painting of Mona Lisa, falls
into this category. Whatever might be the price on offer, there is no
 2. Relatively Less-Elastic Supply
The short run in microeconomics is
a period of time too short to change
plant capacity but long enough to use
the fixed-sized plant more or less
intensively. In the short run, our
farmer’s plant (land and farm
machinery) is fixed. But he does have
time in the short run to cultivate
tomatoes more intensively by
applying more labor and more
fertilizer and pesticides to the crop.
The result is a somewhat greater output in response to a presumed
increase in demand; this greater output is reflected in a more elastic
supply of tomatoes, as shown by S s in Figure B.
 3. Relatively Greater-Elastic Supply
The long run in
P
  S1 microeconomics is a time
period long enough for firms to
P0 adjust their plant sizes and for
D new firms to enter (or existing
D1
firms to leave) the industry. In
0
Q0 Q1 Q the “tomato industry,”

for example, our farmer has time to acquire additional land and buy
more machinery and equipment. Furthermore, other farmers may, over
time, be attracted to tomato farming by the increased demand and
higher price. Such adjustments create a larger supply response, as
represented by the more elastic supply curve SL in Figure С.
 4. Unitary Elastic For a commodity with
a unit elasticity of
supply, the change in
quantity supplied of a
commodity is exactly
equal to the change in
its price. In other
words, the change in
both price and supply
of the commodity are
proportionately equal
to each other.

To point out, the elasticity of supply in such a case is equal to one.

Further, a unitary elastic supply curve passes through the origin.
 5. Perfectly Elastic supply
In the end, over the long run,
P the manufacturer can increase
 
production capacity and his
supply approaches absolutely
P0 S0
elastic.

D
A commodity with a perfectly
D1
elastic supply has an infinite
0
Q0 Q1 Q elasticity.
In such a case the supply becomes zero with even a slight fall in the
price and becomes infinite with a slight rise in price. This is indicative
of the fact that the suppliers of such a commodity are willing to supply
any quantity of the commodity at a higher price. A perfectly elastic
supply curve is a straight line parallel to the X-axis.
 Applications of Price Elasticity of Supply
The idea of price elasticity of supply has widespread applicability, as
suggested by the following examples.
Antiques and Reproductions
The high price of an antique results from strong demand and limited,
highly inelastic supply. Because a genuine antique can no longer be
reproduced, its quantity supplied either does not rise or rises only
slightly as its price goes up. So the supply of antiques and other
collectibles tends to be inelastic. For one-of-a- kind antiques, the supply
is perfectly inelastic.
Contrast the inelastic supply of original antiques with the elastic supply
of modern “made-to-look-old” reproductions. Such faux antiques are
quite popular and widely available at furniture stores and knickknack
shops. When the demand for reproductions increases, the firms making
them simply boost production. Because the supply of reproductions is
highly elastic increased demand raises their prices only slightly.
Volatile Gold Prices The price of gold is quite volatile, sometimes
shooting upward one period and plummeting downward the next. The
main sources of these fluctuations are shifts in demand and highly
inelastic supply. Gold production is a costly and time-consuming
process of exploration, mining, and refining. Moreover, the physical
availability of gold is highly limited. For both reasons, increases in
gold prices do not elicit substantial increases in quantity supplied.
Conversely, gold mining is costly to shut down and existing gold bars
are expensive to store. Price decreases therefore do not produce large
drops in the quantity of gold supplied. In short, the supply of gold is
inelastic.
The demand for gold is partly derived from the demand for its uses,
such as for jewelry, dental fillings, and coins. But people also demand
gold as a speculative financial investment. They increase their demand
for gold when they fear general inflation or domestic or international
turmoil that might undermine the value of currency and more
traditional investments. They reduce their demand when events settle
down.
 QUICK REVIEW

Price elasticity of supply measures the sensitivity of

suppliers to changes in the price of a product. The price-
elasticity-of-supply coefficient Es is the ratio of the
percentage change in quantity supplied to the percentage
change in price. The elasticity of supply varies directly
with the amount of time producers have to respond to
the price change.