Professional's Academy of Commerce IEF (CAF-02)

Chapter 3: Demand and Supply: Elasticities

1. Elasticity of Demand
Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of
the variables on which demand depends. More precisely, elasticity of demand is the percentage change in
quantity demanded divided by the percentage change in one of the variables on which demand depends.

1.1. Price Elasticity of Demand

A measure of the extent of changes in the market demand for a good in response to a change in price.

1.1.a. Factors Determining Price Elasticity of Demand

1. Nature of the commodity: The elasticity of demand for necessities of life is generally inelastic because
due to increase in price, the demand for necessary commodities does not contract generally
proportionately. However, for comforts and luxuries the elasticity of demand is elastic because even a
smaller change in price brings bigger changes in quantity demanded.
2. Number of substitutes: If more substitutes are available for a product it would be easier for consumers
to shift from one product to another and consequently more elastic their demand would be. On the other
hand, electricity has no close substitute. Therefore, demand for electricity would be inelastic.
3. Goods having several uses: The more the possible uses of a commodity, the greater will be its price
elasticity and vice versa. When the price of a commodity which has multiple uses decreases, people tend
to extend their consumption to its other uses. Elasticity will be measured depending upon the use. More
important the use is more inelastic the demand would be and less important the use is, more elastic the
demand would be.
4. Durable Goods and perishable goods: Demand elasticity is determined on the basis whether a good is
durable or perishable. Generally, demand for durable goods is elastic. while perishable goods have
inelastic demand.
5. Price Level: Elasticity of demand for those goods which are either high priced or low priced is inelastic.
An increase or decrease in price of high-priced goods does not have greater impact on rich class while
lower middle class cannot purchase very high-priced commodities already. However, if the commodity
is low priced then it is already purchased in sufficient quantity so further fall in price does not cause an
increase in demand.
6. Income Level: For rich, elasticity of demand for different commodities is inelastic as an increase in
price does not affect their consumption expenditure. For poor, elasticity of demand is elastic because
even a smaller change in price brings greater change in demand.
7. Consumer’s Loyalty: Some goods and services are addictive in nature for example alcohol, drugs,
cigarettes etc. Any rise in price will be unable to stop the use of these goods by addicted consumers. So,
their demand will be inelastic. Similarly, some firms try to make their customers more and more brand
loyal by excessive and persuasive advertisement. Their advertisement activities help them to develop
habits of their brand. For example, branded cellular phones and tablets.
8. Time: Some goods are demanded in emergency for example lifesaving medicines. Their demand cannot
be postponed. Therefore, demand elasticity is inelastic. However, goods like houses, motor cars have
elastic demand because consumers can take enough time to adjust their demand.

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9. Proportion of Income spent on the good: Goods like “match box” are those goods on which
consumers spend a very small proportion of income. Therefore, consumers remain indifferent to any
change in price. But goods like LED TV, Houses, motor cars etc. are those goods on which a large
proportion of consumers’ income is spent and therefore, these become elastic towards the price changes.

1.1.b. Interpretation
Elasticity refers to the sensitivity of demand to price change.
• Elastic demand = sensitive to price changes
• Inelastic demand = insensitive to price changes
.
Numerical value of elasticity of demand
The numerical value of elasticity of demand can assume any value between zero and infinity.
Perfectly elastic: Value of infinity
Elastic: Value between 1 and infinity
Unit elasticity: Value of 1
Inelastic: Value between 0 and 1
Perfectly inelastic: Value of 0

Interpretation of the numerical values of elasticity of demand

Perfectly elastic: Elasticity is infinite, when a ‘small price reduction raises the demand from zero to infinity.
Under such a case, consumers will buy all that they can obtain of the commodity at some price. If there is a
slight increase in price, they would not buy anything from the particular seller. This type of demand curve is
found in a perfectly competitive market.
Elastic: Elasticity is greater than one when the percentage change in quantity demanded is greater than the
percentage change in price. In such a case, demand is said to be elastic.
Unit elasticity: Elasticity is one, or unitary, if the percentage change in quantity demanded is equal to the
percentage change in price.
Inelastic: Elasticity is less than one when the percentage change in quantity demanded is less than the
percentage change in price. In such a case, demand is said to be inelastic.
Perfectly inelastic: Elasticity is zero, if there is no change at all in the quantity demanded when price changes
i.e. when the quantity demanded does not respond at all to a price change.

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1.1.c. Methods of Measuring Price Elasticity of Demand

There are number of different methodologies of measuring price elasticity of demand.
a. Total Expenditure Method: This way of determining elasticity is to inspect the total expenditure of the
consumer, or total revenue to the firm, after a change in price. The method simply compares the total revenue
(price X quantity) at one price level to the total revenue at another.
Elastic demand:
• A decrease in price will increase revenue due to the increase in quantity demanded more than offsetting
the decrease in price.
• An increase in price will decrease revenue due to the decrease in quantity demanded more than
offsetting the increase in price.
• Price and revenue move in opposite directions.
Inelastic demand:
• A decrease in price will decrease revenue as the increase in quantity demanded fails to compensate the
fall in price.
• An increase in price will increase revenue due to the decrease in quantity being more than compensated
by the increase in price.
• Price and revenue move in the same direction.
Unitary demand: Revenue remains unchanged by price change because the change in price is offset by the
change in quantity.

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b. Percentage Method: Percentage method expresses the response of quantity demanded of a good to a change
in its price
E = Percentage change in quantity demanded
Percentage change in price
Where:
Percentage change in quantity demanded = New demand – old demand
Average demand
Percentage change in price = New price – old price
Average price

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Elastic demand: If E > 1; the percentage rise in quantity demanded is more than the percentage fall in price.
• A decrease in price will increase revenue due to the increase in quantity demanded more than offsetting
the decrease in price.
• An increase in price will decrease revenue due to the decrease in quantity demanded more than
offsetting the increase in price.
• Price and revenue move in opposite directions.
Inelastic demand: If E <1; the percentage rise in quantity demanded is less than the percentage fall in price.
• Revenue will decrease owing to the decline in price not being offset by the relatively small increase in
quantity demanded.
• Price and revenue move in the same direction.
Unitary demand: If E =1; the percentage rise in quantity demanded equals the percentage fall in price.
Revenue remains unchanged because the decline in the price is offset by the increase in quantity.

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c. Arc Elasticity Method: The elasticity at two different points on the demand curve is Arc Elasticity of
demand, or arc elasticity is the measure of the average responsiveness to price changes exhibited by a demand
curve over some finite stretch of the curve". The formula to measure Arc Elasticity of demand is

d. Point Elasticity Method: The elasticity of demand on a single point on a demand curve is called point
elasticity of demand. Point elasticity of demand measure is used for very small changes in price and quality
whereas Arc elasticity measure is used for higher changes in demand and price. Point elasticity of demand can
be measured in two ways:

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1.1.d. Usefulness of Price Elasticity of Demand

• For making production profitable, it is essential that the quantity of goods and services should be
produced corresponding to the demand for that product. Since the changes in demand is due to the
change in price, the knowledge of elasticity of demand is necessary for determining the output level.
• The elasticity of demand for a product is the basis of its price determination. The ratio in which the
demand for a product will fall with the rise in its price and vice versa can be known with the knowledge
of elasticity of demand. If the demand for a product is inelastic, the producer can charge high price for it,
whereas for an elastic demand product he will charge low price. Thus, the knowledge of elasticity of
demand is essential for management in order to earn maximum profit.
• Under monopoly discrimination the problem of pricing the same commodity in two different markets
also depends on the elasticity of demand in each market. In the market with elastic demand for his
commodity, the discriminating monopolist fixes a low price and in the market with less elastic demand,
he charges a high price.
• The concept of elasticity for demand is of great importance for determining prices of various factors of
production. Factors of production are paid according to their elasticity of demand. In other words, if the
demand of a factor is inelastic, its price will be high and if it is elastic, its price will be low.
• The concept of price elasticity of demand is important for formulating government policies, especially
the taxation policy. Government can impose higher taxes on goods with inelastic demand, whereas, low
rates of taxes are imposed on commodities with elastic demand.

1.2. Income Elasticity of Demand

A measure of the responsiveness of demand for a good in relation to a change in the level of money income
amongst consumers.
E = Percentage change in quantity demanded
Percentage change in level of income
Where:
Percentage change in quantity demanded = (New demand – Old demand)/ Average demand
Percentage change in level of income = (New level of income – Old level of income)/ Average level of income

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There is a useful relationship between income elasticity for a good and the proportion of income spent on it.
1. If the proportion of income spent on a good remains the same as income increases, then income elasticity for
the good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the income elasticity for the
good is greater than one.
3. If the proportion of income spent on a good decrease as income rises, then income elasticity for the good is
less than one.
• A normal good will always have a positive income elasticity of demand, because as income increases,
demand for the product increases also.
• An inferior good will always have a negative income elasticity of demand, because as income increases,
demand for the product will decrease, as consumers switch to other alternatives.

1.3. Cross Price Elasticity of Demand

A measure of the responsiveness of demand for a good A in relation to a change in price of good B.
E = Percentage change in quantity of Good A demanded
Percentage change in quantity of Good B demanded
Where:
Percentage change in quantity of Good A demanded = New demand for good A – Old demand for good A
Average demand for good A
Percentage change in price of Good B demanded = New price for good B – Old price for good B
Average price for good B

Complement Good: A good where demand for Good A is increased, by a rise in demand for Good B.

Substitute Good: A good where demand for Good A is increased, by a fall in demand for Good B.

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10.4. Elasticity of Supply

what is the percentage change in the quantity supplied, in relation to a percentage change in the price.

10.4.a. Price Elasticity of Supply

A measure of the responsiveness of quantity supplied to a change in the price of the good.

E = Percentage change in quantity supplied

Percentage change in price
Where:
Percentage change in quantity supplied = New quantity supplied – old quantity supplied
Average quantity supplied
Percentage change in price = New price – old price
Average price

10.4.b. Degrees of Price Elasticity of Supply

a) Perfectly elastic supply

b) Elastic supply

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c) Unitary elasticity of supply

d) Inelastic supply

e) Perfectly inelastic supply

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10.4.c. Determinants of the Price Elasticity of Supply

1. Greater availability of stocks
• If back stocks exist then these will be sold if demand increases without the need for price to rise.
• If demand falls then goods will be withdrawn from sale and stored. This avoids surpluses pushing prices
down.
2. Greater ability for firms to switch resources to and from substitutes in production
3. Increased ease of entry and exit to and from the market
4. Shorter length of production process
5. The length of time

10.4.d. The Length of Time and Supply

Since the change in demand conditions changed also has an effect on the elasticity of supply. If demand rises,
firms will need time to bring forward additional supply. Therefore, the analysis of elasticity is commonly
divided into three periods:
Momentary (or market) period: Immediately following the demand change when supply has had no chance
to respond. Here, supply is perfectly inelastic.
Short run period: An intermediate stage when supply has begun to change but has not fully incorporated the
demand change. Here, supply is inelastic.
Long run period: The time period in which supply has fully adjusted to the change in demand. Here, supply is
most elastic

10.5. Dynamic Supply and Demand

Market dynamics are forces that will impact prices and the behaviors of producers and consumers. In a market,
these forces create pricing signals which result from the fluctuation of supply and demand for a given product or
services. Economic and business models associated with market dynamics as goods and services are bought and
sold. However, market dynamics can impact any industry or government policy.

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10.5.a. Price Stability

Price stability in an economy means that the general price level in an economy does not change much over time.
In other words, prices neither go up or down; there is no significant degree of inflation or deflation. Certain
markets have particularly volatile price changes, whereas in others, the price remains more or less stable.

10.5.b. Milk Market

One of the characteristics of the milk market is that it is fiercely competitive in terms of supply. There are lots
of firms able to supply to the market, and consequently if the price increases slightly, quantity will increase. The
demand for milk is neither spectacularly elastic nor inelastic.

This shows how even if demand were to increase dramatically (for example, a health campaign is begun
promoting the benefits of milk in one’s diet) then, because of the type of supply, the price of milk would remain
relatively stable.

10.5.c. Corn Market

The international market for corn fluctuates greatly throughout the year, and also from year to year.
• On the supply side, there is uncertainty with regard to whether there will be a good harvest or not. This
means that output could be greater, or less than planned.
• On the demand side, it can also be faced with inelastic demand because many food processes rely on
corn, and cannot substitute other grains for it.

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As we can see, just a small shift backwards in supply and, because of the inelasticity of both curves, the price
has increased significantly. A consequence of this is that if ever there is a slight change in either the supply or
demand of corn, the price would fluctuate considerably.
Causes of instability
• Weather conditions: can dramatically influence the size of harvest
• Constant, inelastic demand for produce – must be bought whatever the price
• Competition to produce other goods i.e. biofuels for energy

10.5.d. Government Policies to Increase Price Stability in Agriculture

A stable price of agricultural commodities is often a political objective for most governments. The price of a
good is the main source of income for those individuals and firms that work in the agriculture sector. Therefore,
in order to ensure that these people receive a stable, predictable income, the government often acts to stabilise
the price. This is usually done through a buffer stock scheme.
Buffer stock scheme: A measure that uses commodity storage for the purpose of stabilizing prices in a market.
The government agrees to pay a fixed price, above the market rate, for the commodity. This means that buyers
and sellers interact to the market equilibrium, and then the government intervenes to purchase the surplus.

• In the above diagram supply shifts outwards from S1 to S2 meaning (with no intervention) the price will
fall to Pe.
• However, because the government guarantees the price at Pmin it buys the surplus stock: Q2 – Q3
• The fact that farmers receive this price, naturally means that the price is stable, thus achieving the policy
goal
• Should there be a commodity shortage in a future period, these stock levels could be used to release onto
the market and reduce the upward pressure on price

Disadvantages of Buffer Stock Scheme

• The main disadvantage that comes from this policy is the upfront cost of purchasing excess stock above
the market price. This requires capital that, as we have seen through the concept of opportunity cost,
could be spent meeting other policy objectives.

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• It can also encourage over-production of certain commodities, as the pricing signal of the market
mechanism is no longer in action.
• There are also a lot of administrative, and storage costs associated with the maintaining levels of buffer
stocks.

10.5.e. Cobweb Theory

This theory looks to offer an explanation as to why prices periodically fluctuate, especially in agriculture, and
traces the movement through changes in supply and demand.
When we say that market equilibrium has been reached (where supply is equal to demand), it doesn’t
necessarily happen instantaneously. There will be some interactions between supply and demand which
eventually settle on the equilibrium price and quantity. The cobweb theory offers an explanation as to how the
market reaches equilibrium, from a point that started off-equilibrium.

The key aspect to grasp is that there is a time difference between each market, and also the choice a farmer has
of how many cows to supply at the next market based on his knowledge of the price of cows in the current
market.
• The price received is always found by tracing the quantity (Q) up to the demand curve.
• Suppose a farmer is evaluating how many cows to rear to take to market and sell. At the market he is at
currently, the quantity is Q* and the price is P*.
• Before the next market, there is a disease that kills a number of cows. This means that the quantity at the
market is just Q1 (less than Q*), and consequently the price is P1. The new, short term equilibrium is at
A1.
• At this market then, the price received for each cow is higher than the last. How then will the farmers
respond? Seeing a higher price for their stock, at the next market, the quantity of cows produced will be
what is expected at P1, and is therefore Q2.
• However, because the market price is determined by tracing the quantity up to the demand curve, the
price at the market is P2.

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• Seeing that price has now dropped below equilibrium price, the producers will supply less to the next
market (Q3). The fall in supply means that the price becomes P3 and as such will supply more to the
following market.
• Each time P is too high, it follows that Q will be high, causing P to move the other way, causing Q to be
low as well. As this oscillation continues, the trail of movement mimics that of a spider cobweb circling
in towards the centre.
The important point to note is that with each iteration, the price is getting closer to the equilibrium, the long run
equilibrium will eventually be reached.

10.5.f. Importance of Elasticities

where the slope of the supply curve is flatter than that of the demand, then we find that with a few interactions,
the short run equilibriums do not tend to the long run. if supply was more elastic, the price changes would cause
such a swing in the quantity supplied in the next period that demand will effectively die out.

Consequently, if the slope of the demand curve is steeper than that of the supply curve, the points are
dynamically unstable.

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