TOPIC 6
Elasticities of Demand
and Supply
MEASURING THE CHANGES IN
EQUILIBRIA
• We have analysed changes in equilibrium.
• To be precise about the strength of observed
changes we need to know how sensitive
supply & demand are to price changes.
• This brings us to the concept of elasticity.
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ELASTICITY
• Measures how much buyers and sellers
respond to changes in market conditions.
• The concept of elasticity helps economists to
measure the quantitative changes brought
about by a shift in the demand or supply
curve.
• We will talk about buyers first then talk about
elasticity measures for sellers.
PRICE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that good.
• Tends to be more elastic:
– the greater the number of close substitutes
– if the good is a luxury rather than a necessity
– the more narrowly defined the market
– the longer the time period
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PRICE ELASTICITY OF DEMAND
• Price elasticity of demand is calculated as the
percentage change in quantity demanded
divided by the percentage change in price.
PRICE ELASTICITY OF DEMAND:
EXAMPLE
• Suppose that the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then using the
simple formula:
(10 - 8) *100
10 = -2
(2.00 - 2.20) *100
2.00
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PRICE ELASTICITY OF DEMAND:
EXAMPLE
• In this example, the elasticity is -2.
• The change in the quantity demanded is
proportionately twice as large as the change in the
price
• in the opposite direction.
• The common practice is dropping the minus sign
and reporting all price elasticities as absolute
values.
THE MID-POINT METHOD
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of change.
(Q2 – Q1)/[(Q2 + Q1)/2]
Price elasticity of demand =
(P2 – P1)/[(P2 + P1)/2]
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PRICE ELASTICITY OF DEMAND:
EXAMPLE
• Suppose that the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then using the
mid point method:
ELASTIC AND INELASTIC DEMAND
• When quantity demanded does not respond
strongly to price changes – demand is
inelastic.
– -1 < price elasticity of demand < 0
• When quantity demanded responds strongly to
changes in price – demand is elastic.
– price elasticity of demand < -1 .
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ELASTIC AND INELASTIC DEMAND:
EXAMPLE
Price
(100 - 50)
(100 + 50)/2
ED =
(4.00 - 5.00)
(4.00 + 5.00)/2
$5
4 Demand 67 percent
= = -3
- 22 percent
Demand is price elastic
0 50 100 Quantity
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ELASTIC AND INELASTIC DEMAND:
EXAMPLE
Price (50 - 25)
(50 + 25)/2
ED =
(5.00 - 10.00)
(5.00 + 10.00)/2
$10
5
Demand 67 percent
= = -1
- 67 percent
Demand is unit elastic
0 25 50 Quantity
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ELASTIC AND INELASTIC DEMAND:
EXAMPLE
Price
(25 - 15)
$20 (25 + 15)/2
ED =
(10.00 - 20.00)
10 (10.00 + 20.00)/2
Demand 50 percent
= = -0.75
- 67 percent
Demand is price inelastic
0 15 25 Quantity
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PRICE ELASTICITY OF DEMAND
• Consider price elasticity of demand for various
special demand curves.
• Idea is to firm up your intuition about elasticity.
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PERFECTLY INELASTIC DEMAND
(ED=0)
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PERFECTLY INELASTIC DEMAND
(ED=0)
• When demand has zero elasticity, it is said to be
perfectly inelastic.
• There probably is no such good
– even people with Type 1 Diabetes can reduce their
need for insulin by changing their diet and by exercise
if prices get high enough.
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INELASTIC DEMAND (-1<ED<0)
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INELASTIC DEMAND (-1<ED<0)
• Using the mid-point formula, the price elasticity
of demand between points A and B is 0.47
(0.1053/0.2222).
• When demand has elasticity less than 1, it is
said to be inelastic.
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UNIT ELASTIC DEMAND (ED=-1)
Price
$5
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1. A 22% Demand
increase
in price ...
0 80 100 Quantity
2. ... leads to a 22% decrease in quantity demanded.
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UNIT ELASTIC DEMAND (ED=-1)
• Using the mid-point formula, the price elasticity
of demand between points A and B is exactly 1
(0.2222/0.2222).
• When demand has elasticity equal to 1, it is
said to be unit elastic.
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10
ELASTIC DEMAND (ED<-1)
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ELASTIC DEMAND (ED<-1)
• Using the mid-point formula, the price elasticity
of demand between points A and B is 3
(0.6667/0.2222).
• When demand has elasticity greater than 1, it
is said to be elastic.
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PERFECTLY ELASTIC DEMAND
(ED=∞)
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PERFECTLY ELASTIC DEMAND
(ED=∞)
• The price elasticity of demand is infinity.
• When demand has infinite elasticity, it is said to
be perfectly elastic.
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TOTAL REVENUE AND PRICE
ELASTICITY OF DEMAND
• Total revenue (in a market) is amount paid by
buyers (received by sellers) of a good
– calculated as the price of the good times the quantity
sold (P × Q).
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ILLUSTRATING TOTAL REVENUE
ON A GRAPH
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ILLUSTRATING TOTAL REVENUE
ON A GRAPH
• The height of the box under the demand curve
is equal to the market price.
• The width of the box is equal to the quantity
demanded.
• Therefore, the total revenue (in the market) is
equal to the area of the box.
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CHANGES IN TOTAL REVENUE WITH
INELASTIC DEMAND
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CHANGES IN TOTAL REVENUE WITH
ELASTIC DEMAND
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TOTAL REVENUE AND THE PRICE
ELASTICITY OF DEMAND
• In the special case of unit elastic demand (a
price elasticity exactly equal to 1), a change in
price has no effect on total revenue (P × Q)
because the change in price is proportionate to
the change (in opposite direction) in quantity
demanded.
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TOTAL REVENUE AND THE PRICE
ELASTICITY OF DEMAND
• Often you cannot directly observe elasticity but
you can observe how revenue changes when
price changes.
• Hence (important!) you can indirectly infer what
elasticity is.
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PRICE ELASTICITY OF DEMAND
ALONG A LINEAR DEMAND CURVE
Per cent Per cent
Total change in change in
Price Quantity revenue price quantity Elasticity Description
$0 14 $0
1 12 12 200% -15% -0.1 Inelastic
2 10 20 67 -18 - 0.3 Inelastic
3 8 24 40 - 22 -0.6 Inelastic
4 6 24 29 -29 -1.0 Unit elastic
5 4 20 22 -40 -1.8 Elastic
6 2 12 18 - 67 -3.7 Elastic
7 0 0 15 -200 -13.0 Elastic
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PRICE ELASTICITY OF DEMAND
ALONG A LINEAR DEMAND CURVE
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INCOME ELASTICITY OF DEMAND
• Income elasticity of demand measures how the
quantity demanded changes as consumer
income changes.
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NATURE OF GOODS AND INCOME
ELASTICITY OF DEMAND
• Normal goods have positive income elasticities
(income elasticity >0)
– Normal Necessities tend to have small income
elasticities (0< income elasticity <1).
– Normal Luxuries tend to have large income
elasticities (income elasticity >1).
• Inferior goods have negative income
elasticities (income elasticity <0).
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NATURE OF GOODS AND INCOME
ELASTICITY OF DEMAND
• Necessary goods tend to be income inelastic
– Examples - food, fuel, clothing, utilities & medical.
• Goods regarded as luxuries are income elastic.
– Examples - sports cars, furs & expensive foods.
• Cheap, low-quality goods tend to be inferior.
– Examples - second-hand clothing
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NATURE OF GOODS AND INCOME
ELASTICITY OF DEMAND
• Income elasticities also show how budget
shares change as income increases:
– For luxury goods – share of income spent on these
increases as income increases.
– For normal (non-luxury) goods – share of income
spent decreases though amount of income spent
increases.
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CROSS-PRICE ELASTICITY OF
DEMAND
• Cross-price elasticity of demand measures
how the quantity demanded of one good
responds to changes in the price of another
good.
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CROSS-PRICE ELASTICITY OF
DEMAND
• Substitutes have positive cross-price
elasticities
– an increase in the price of one good increases the
quantity demanded of its substitute.
– Coke and Pepsi
• Complements have negative cross-price
elasticities
– an increase in the price of one good decreases the
quantity demanded of its complement.
– Software and hardware
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PRICE ELASTICITY OF SUPPLY
• Price elasticity of supply measures how much
the quantity supplied of a good responds to a
change in the price of that good
– calculated as the percentage change in quantity
supplied divided by the percentage change in price.
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PERFECTLY INELASTIC SUPPLY
(E =0)
S
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INELASTIC SUPPLY(E <1)
S
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UNIT ELASTIC SUPPLY(E =1)
S
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ELASTIC SUPPLY(E >1)
S
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PERFECTLY ELASTIC SUPPLY(E =∞) S
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DETERMINANTS OF ELASTICITY OF
SUPPLY
• Ability of sellers to change the amount of the
good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are elastic.
• Time horizon.
– Supply is more elastic in the long run.
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APPLICATION OF COMPARATIVE
STATICS & ELASTICITY
• Can good news for farming be bad news for
farmers?
– Imagine yourself as a wheat farmer.
– One day, researchers devise a new hybrid
of wheat that raises the amount farmers can produce
from each hectare of land by 20 per cent.
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CAN GOOD NEWS FOR FARMING BE
BAD NEWS FOR FARMERS?
• Does this discovery make you better off or
worse off than you were before?
• Solution involves the following steps
– Examine whether the supply or demand curve
shifts.
– Determine the direction of the shift of the curve.
– Use the supply-and-demand diagram to see how
the market equilibrium changes.
• Determine that demand is likely to be price-
inelastic or elastic.
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SUMMARY
• To analyse how any event influences a market,
we use the supply-&-demand diagram to
examine how the event affects equilibrium
price & quantity.
• To quantify the extent of comparative static
change we need to measure the sensitivity of
supplies & demand to price changes using the
elasticity idea.
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SUMMARY
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
• The income elasticity of demand measures
how much the quantity demanded responds to
changes in consumers’ income.
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SUMMARY
• The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to
changes in the price.
– In most markets, supply is more elastic in the long
run than in the short run.
– The price elasticity of supply is calculated as the
percentage change in quantity supplied divided by
the percentage change in price.
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