RISE School of Accountancy (Islamabad & Rawalpindi) POE (PRC-03) Notes

Chapter 3: Elasticity of Demand and Supply

Elasticity of Demand
The elasticity of demand explains the level of change in quantity demanded in response to change in price.
❖ Although, there exist an inverse relationship between price and quantity demanded but there some other
factors which determine the degree of responsiveness of change in demand to change in its price.
❖ To know the degree of responsive of change in demand to the change its price is called elasticity of
demand.

Types of Demand Elasticity

a) Price Elasticity of Demand: Proportionate change in quantity demanded/Proportionate change in
price
b) Income Elasticity of Demand: Proportionate change in quantity demanded/Proportionate change in
income.
c) Cross-Elasticity of Demand or Elasticity of Demand Between Related Goods: It is the
proportionate change in quantity demanded for X product / proportionate change in price of Y
product

Interpretation of Elasticity
Elasticity refers to the sensitivity of demand to price change.
• Elastic demand = sensitive to price changes
• Inelastic demand = insensitive to price changes

Degree Condition Characteristics

Elastic demand If percentage change in A decrease in price will increase revenue due to the
quantity demanded is greater increase in quantity demanded more than offsetting
than percentage change in its the decrease in price.
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 percentage change in A decrease in price will decrease revenue as the
quantity demanded is lesser increase in quantity demanded fails to compensate the
than percentage change in its fall in price.
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.
Unit elastic Demand responds in exact Revenue remains unchanged by price change because
proportion to price the change in price is offset by the change in quantity.
Price changes do not affect The total expenditure method offers a simple solution
revenue to ascertaining whether or not a good has elastic,

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inelastic or unitary demand.

Perfectly elastic Smallest price change will
affect the demand largely
Perfectly inelastic Demand totally unaffected by
price changes

Methods to Measure Elasticity of Demand

a. Total expenditure method Total outlay method or Total revenue 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  quantity) at one price level to the total revenue at
another.
The following are true:
• If total consumer expenditure increases in response to a price fall, demand is relatively elastic.
• If total consumer expenditure decreases in response to a price fall, demand is relatively inelastic.
• If total consumer expenditure remains constant or unchanged in response to a price fall, elasticity of
demand said to be unity.

Perfectly Inelastic Demand (η=0)

D
P

P1

P2

Q0 Q

Relatively Inelastic Demand (η<1)

Price Quantity Total Expenditures
200 30 6,000
400 25 10,000

P2
Price in Rs. Per liter

P1

Q2 Q1 Quantity demanded in liters

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Unit Elastic Demand (η=1)

Price Quantity Total Expenditures
200 30 6000
400 15 6000

Price in Rs. Per liter P2

P1

Q2 Q1
Quantity demanded in liters

Relatively elastic demand (η>1)

Price Quantity Total Expenditures
200 30 6,000
400 10 4,000
Price in Rs. Per liter

P2
P1

Q2 Q1 Quantity demanded in liters

Perfectly Elastic demand

P

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b. Percentage method
The possible outcomes are:
i. If Percentage change in quantity demanded (i.e is numerator) is greater than percentage change in
its price (i.e is denominator), then the demand is relatively elastic.
ii. If Percentage change in quantity demanded (i.e is numerator) is lesser than percentage change in its
price (i.e is denominator), then the demand is relatively less elastic.
iii. If Percentage change in quantity demanded (i.e is numerator) is equal to the percentage change in
its price (i.e is denominator), then the demand is unit elastic.

Elasticity of demand = percentage change in quantity demanded / percentage change in price

change in quantity change in price
η= ÷
sum of quantities / 2 sum of prices/2

Elastic Demand: If η > 1; the percentage rise in quantity demanded is more than the percentage fall in price.
Quantity demanded decreases from 30 to 10 as price of the product increases from 200 to 400.
10−30 400−200
η = 10+30 / 2 ÷ 400+200/2
η = -1.5 by taking absolute value we will get η = 1.5>1

Inelastic Demand: If η < 1; the percentage rise in quantity demanded is less than the percentage fall in price.
Quantity demanded decreases from 30 to 25 as price of the product increases from 200 to 400.
25−30 400−200
η = 25+30 / 2 ÷ 400+200/2
η = - 0.27 and the absolute value is η = 0.27<1

This method can be used in two cases:

i. Point Elasticity of Demand: When elasticity of demand is to be measured for a very small change in
price, we use point elasticity of demand.
When there is a small change in the quantity demanded of a product in response to a small change in its
price, there will appear as just a point on the demand curve.
percentage change in quantity
η =
percentage change in price
Q1−Q0
×100
Q0
η = P1−P0
×100
P0
ΔQ P
So, we can write this formula as: ×Q
ΔP

Price Rs. Q.D kg

12 100
11.75 101
Q1−Q0
×100
Q0
η = P1−P0
×100
P0
1 12
η = ×
−0.25 100
η = -0.48 or inelastic

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ii. Arc Elasticity of Demand: When elasticity of demand is to be measured for a significant change in
price, it is said to be arc elasticity of demand.
If quantity demanded of a product and its price change considerably such that there appear two distinct
points on the demand curve:
Q1 − Q0 P1 + P0
η = ×
Q1 + Q0 P1 − P0

Price Rs. Q.D kg

8 300
12 100
100 − 300 9 + 12
η = ×
100 + 300 9 − 12

η = --2.5 or elastic

c. Geometric method
This method enables us to measure elasticity of demand at any pint on the demand curve.
P

M
a η>1

b η=1

P*
c η<1

Q
Q N
lower part of the demand curve *
η = upper part of the demand curve

Income Elasticity of Demand

The income elasticity of demand measures how demand responds to a change in income.
❖ The income elasticity of demand is positive for Normal goods whereas is negative for Inferior goods.
❖ In other words, income elasticity of demand measures the degree to which consumer respond to a
change in their income by buying more or less of a commodity.
To estimate the income elasticity of demand we will use the formula;
percentage change in quantity demanded
η =
percentage change in income

D1 − D0 I1 + I0
η = ×
D1 + D0 I1 − I0

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• Normal Goods: Those goods for which, consumers buy more quantity as their income increases. For
such goods the income elasticity coefficient is positive. Normal goods are also categorized as superior or
luxurious goods.
• Inferior Goods: Those goods for which, consumers buy relatively less quantity or less attractive, as
they switch over to other superior goods. Income elasticity coefficient is negative for inferior goods, the
quantity demanded decreases along with an increase in income the consumer.

A person’s income increases from Rs. 10,000 to Rs.15,000. As a result, their demand for a product goes from
50 units to 40 units

Percentage change in quantity 40 − 50 −10

= = 0.222 = −22.2%
demanded (40 + 50)/2 45

Percentage change in level of 15 − 10 5

= = 0.4 = 40%
income (15 + 10)/2 12.5

Income elasticity (η) −22.2%

= −0.56
40%

Cross-Elasticity of Demand or Cross Price Elasticity of Demand

The cross price elasticity of demand measures how sensitive consumer purchases of one product are to change
in the price of some other product.

percentage change in quantity demanded for product A

η = percentage change in pirce of product B
△ Qa Pb
Ec = ×
Qa △ Pb
Pb △ Qa
Ec = ×
Qa △ Pb
Where:
Pb = Original price of Product B
△Pb = Change in price of Product B
Qa = Original quantity demanded of Product A
△Qa = Change in quantity demanded of Product A.

Cross elasticity of demand for Substitutes

If the coefficient of cross elasticity of demand is positive, then the products are graded as substitutes, as the
demand for one product moves in the same direction to the change in price of other product.

Price (Rs.) Q.D (units)

of A product For B product
110 200
100 150

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change in quantity B change in price of A

η = ÷
sum of quantities B/ 2 sum of prices of A/2

150 − 200 100 − 110

η = ÷
150 + 200 / 2 100 + 110/2

η = - 0.286 ÷ - 0.095
η = +3.01 elastic demand
Positive sign shows that the products are substitutes.

Cross elasticity of demand for complements

Goods, which are consumed or purchased together, are known as complementary goods. For complementary
products, coefficient of cross elasticity of demand is negative, as the demand for one product moves in the
opposite direction to the change in price of other product.

Price (Rs.) Q.D (units)

of A product For B product
100 200
110 150
change in quantity B change in price of A
η = ÷
sum of quantities B/ 2 sum of prices of A/2
150 − 200 110 − 100
η = ÷
150 + 200 / 2 110 + 100/2

η = - 0.286 ÷ 0.095
η = - 3.01 elastic demand
Negative sign shows that the products are complements.

Determinants of Elasticity of Demand

• The possibility of substitution: If there are close substitutes for a good, its demand is likely to be more
elastic. In contrast, if there are no close substitutes within the same price range, the demand for a
commodity is more likely to be inelastic as people do not have any option to switch.
• The case of complementary goods: If the price of one product decreases, its demand become inelastic
as the price of its complement increases.
• Necessities or Luxuries: Demand for necessities is inelastic, while for luxuries it is relatively elastic.
• Habit of brand loyalty: Degree of brand loyalty is another important determinant of degree of elasticity
of demand. People may be used to of buying a particular good or brand of a product and may be
unwilling to a change even if price increases. Demand will be inelastic for such cases.
• Proportion of income spent for a product: The smaller the proportion of total income spent on a
commodity, the more inelastic will be demand for it.
• Time-period: The longer the time-period involved, the greater the elasticity of demand is likely to be.

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Application or Importance of Elasticity of Demand

i. Price determination: In the case of products having relatively elastic demand, the price will not be so
high. Otherwise consumers will not consume more of these products. If the prices would be high the
consumers would go for the substitutes. However, in the case of inelastic demand, price of these
products may be quite high because these goods are usually necessaries.
ii. For finance minister (taxation): Elasticity of demand also helps government (finance minister) to tax
different commodities. If authorities increase taxes on a good with inelastic demand such as tobacco,
electricity, luxury cars or luxury apartments etc., demand will remain the same to some extent and
increase the tax revenue. However, if they tax a good with elastic demand, this may cause demand to
decrease to a great extent and tax revenue will be less than before.
iii. Guidance for monopolists: This is another important aspect of application of elasticity of demand. In
the case of inelastic goods, price will be higher and it will be sold in a smaller quantity as the
monopolists know that the consumer will buy the product at any price as demand is inelastic. In case of
market demand for elastic goods, price will be kept low intentionally to retain the maximum buyers with
the product and demand for the good is stimulated through some other activities such as promos,
exhibitions, or advertisement etc.
iv. Determination of fares: For those means of transportation whose demand is elastic, such as buses, taxis
etc., the fare has to be low as these are the main means of transportation on land. Therefore, if price on
transport were increased there would be some substitute, like, railways, uber, etc. However, for inelastic
transport, such as airways, the fare is quite high as there is no other alternative for a person to get to one
place form another as quickly as by air.
v. For Balance of Trade and Payments: If the demand for a product in the international market is elastic,
export earnings will remain low and the balance of trade will remain unfavourable for the country. To
make it favorable, a country always desires to make the demand for its products inelastic in the
international market which will allow it to raise the price and boost its export.
vi. Decision making during economic recessions: Elasticity has a great role for the firms to take rational
decisions during recessions. Elasticity helps firms to predict, that which product with what intensity will
hit during recession, when the income shrinks. Accordingly, firm can change their decision to avoid
their losses.

Elasticity of Supply
In case of elasticity of supply, if quantity supplied by the producers is price sensitive, then the supply is elastic.
Conversely if quantity supplied is price less sensitive, then the supply is said to be inelastic.

percentage change in quantity supplied

Es =
percentage change in its price
Q 2 − Q1 P2 − P1
Es = ÷
Q2 + Q1 / 2 P2 + P1 / 2
As we know that there is a direct relationship between price and quantity supplied, the coefficient of
elasticity supply will be positive ever.
i. If a linear supply curve intersects the price axis, the curve is elastic at all points.
ii. If a linear supply curve intersects the quantity axis, the curve is inelastic at all the points.
iii. If a linear supply curve intersects the origin, the elasticity is unity at all pints along supply curve.

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Estimation of Elasticity of Supply

Perfectly inelastic supply (Es =0)

P S

Q
Q*

Inelastic supply (Es<1)

60−50 200−100
Price Q.S Es = ÷ 200+100/2
60+50 / 2
100 50 Es = 0.18 ÷ 0.66
200 60 Es = + 0.27< 1 (Inelastic)

P S

P1

P1

Q1 Q2 Q

Unit Elastic supply (Es=1)

100−50 200−100
Price Q.S Es = ÷ 200+100/2
100+50 / 2
100 50 Es = 0.66 ÷ 0.66
200 100 Es = + 1 (Unitary Elastic)

P
S

P1

P1

Q1 Q2 Q

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Elastic supply (Es>1)

150−50 200−100
Price Q.S Es = ÷
150+50 / 2 200+100/2
100 50 Es = 1 ÷ 0.66
200 150 Es = + 01.5> 1 (Elastic)

P
S
P1

P1

Q1 Q2 Q

Perfectly Elastic supply (Es =∞)

P

S
P

Determinants or Factors Influencing Elasticity of Supply

• The number of firms in the industry: Usually, the greater the number of firms in an industry, the more
elastic is the industry supply. As firms can respond to change in demand fairly easily.
• The availability of stock: If stocks are available with firms, then supply will be relatively more elastic
because an increase in demand can be met with an increase in supply without any change in structure
etc.
• Existence of spare capacity: If the industry is operating below full capacity or it has spare capacity
within existing structure, then the supply will be more elastic, as it will be able to use up vacant factors
of production in order to meet up with an increase in supply. Conversely, if firm is already using its
available resources at its full capacity, the supply will be inelastic.
• Ease of switching resources: If the firm has ability to switch its factors of production to other products,
the supply will be elastic, because firm can respond to any change of demand in a market. Conversely, if
firm has such resources which cannot be used in production of other goods, the supply will be inelastic.

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• Time: The longer the time period under consideration, the greater the ability of firms to adjust to a price
change. Some goods take short time to complete their production process, have elastic supply.
Conversely some goods take long time to be completed, have inelastic supply.

Elasticity of Supply and Time

The larger the time span producers have to adjust to a change in demand, the greater will be the output response.
i. Monetary period: In monetary period or immediate market period, there is insufficient time to
change output, and so supply is perfectly inelastic.
ii. Short period: In short period of time, although the plant capacity is fixed, with little alterations in
techniques of production or with more efficient use of resources, supply can be adjusted up to a little
extent, and supply is therefore relatively inelastic.
iii. Long run: In long run or long period all required adjustment can be made, including change in
structure of the building, plant size etc., in order to meet any change in demand and therefore supply
will be highly elastic.

P P P
S S
S

Q Q Q

Monetary period Short period Long period

S Ss
M

P
M SL
PS

PL

P0
D
D 1

Q
Q Q Q
M s L

In the above diagram equilibrium is initially at P0Qm, a position of long-run equilibrium. Demand rises from
D to D1 at price P0. In the momentary period the prices rise towards Pm, In the short-run period the increased
elasticity of supply adjusts price towards Ps, In the long run the price adjusts to P1, In above diagram it is
clear that as the amount of time to supply a product into a market in order to meet the demand is increasing,
the elasticity of supply also increasing.

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