1. Elasticity of Demand and Supply
Chapter 4
Elasticity of Demand and Supply
Both the elasticity coefficient and the total revenue test for measuring price elasticity of demand are presented in the chapter. The text attempts to sharpen students’ ability to estimate price elasticity by discussing its major determinants. The chapter reviews a number of applications and presents empirical estimates for a variety of products. Cross- and income elasticities of demand and price elasticity of supply are also addressed.
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved

2. Price Elasticity of Demand
Measures buyers’ responsiveness to price changes
Elastic demand
Sensitive to price changes
Large change in quantity
Inelastic demand
Insensitive to price changes
Small change in quantity
Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.
If demand is elastic, there is a large change in quantity demanded even when price changes by a small amount. When demand is inelastic, there is a very small change in quantity demanded even when there is a large change in price.
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3. Price-Elasticity Coefficient Formula
Formula for price elasticity of demand
Percentage change in quantity
demanded of product X
Ed =
Percentage change in price
of product X
Quantitative measure of elasticity Ed = percentage change in quantity/percentage change in price.
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4. Price-Elasticity Coefficient Formula
Use the midpoint formula
Ensures consistent results
Change in quantity
Change in price
Ed = ÷
Sum of quantities / 2
Sum of prices / 2
Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down, or the lower price and goes up. The midpoint formula calculates the average elasticity over a range of prices to alleviate that problem.
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5. Price-Elasticity Coefficient Formula
Use percentages
Unit-free measure
Compare responsiveness across products
Eliminate the minus sign
Easier to compare elasticities
Absolute changes depend on the choice of units. For example, a change in the price of a $10,000 car by $1 is very different than a change in the price a of $1 can of beer by $1. The auto’s price is rising by a fraction of a percent while the beer’s price is rising 100 percent.
Percentages also make it possible to compare elasticities of demand for different products.
Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value. This makes it less confusing to interpret the elasticity coefficient.
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6. Interpretation of Elasticity of Demand
Ed > 1: demand is elastic
Ed = 1: demand is unit elastic
Ed < 1: demand is inelastic
Extreme cases
Perfectly inelastic
Perfectly elastic
When the elasticity coefficient is greater than 1, it means that the percentage change in quantity demanded is greater than the percentage change in price (based on the formula), indicating that consumers are sensitive to the change in price, so demand is elastic.
When the elasticity coefficient is less than 1, the percentage change in quantity demanded is less than the percentage change in price (based on the formula), indicating that consumers are not very sensitive to price changes.
When the elasticity coefficient equals 1, this is a special case called unit elasticity. This means that the percentage change in price and the percentage change in quantity are exactly equal.
Perfectly inelastic demand means that consumers will buy exactly the same amount no matter how high or low the price. Perfectly elastic demand means that nothing will be purchased if there is any deviation from the current price.
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7. Perfectly inelastic demand
Extreme Cases
Extreme Cases P D1
Perfectly inelastic demand
(Ed = 0)
This extreme situation is called perfectly inelastic demand and it is very rare. The demand curve would be vertical and graphs as a line parallel to the vertical axis. The elasticity coefficient is 0. An example of a perfectly inelastic demand might be a diabetic’s demand for insulin.
Perfectly inelastic demand
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8. Extreme Cases Perfectly elastic demand P D2 Perfectly elastic demand
(Ed = ∞)
This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal. The elasticity coefficient is infinite. An example of a perfectly elastic demand is the demand curve in a purely competitive industry of a firm that is unable to change the price.
Perfectly elastic demand
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9. Total Revenue Test Total revenue = Price × Quantity Inelastic demand
P and TR move in the same direction
Elastic demand
P and TR move in opposite directions
Total revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. The total revenue test is important to understand the relationship between price elasticity and total revenue.
Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue.
Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue.
Demand is unit elastic if total revenue does not change when the price changes.
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10. Lower price and elastic demand Blue gain exceeds yellow loss
Total Revenue Test
Lower price and elastic demand
Blue gain exceeds yellow loss $3 2 1 Q P a
A lower price and elastic demand mean that total revenue will rise. Blue gain (extra total revenue from extra sales) exceeds yellow loss (the loss in total revenue from the higher price). b D1
LO2
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11. Lower price and inelastic demand Yellow loss exceeds blue gain
Total Revenue Test
Lower price and inelastic demand
Yellow loss exceeds blue gain $4 3 2 1 Q P c
A lower price and inelastic demand mean that total revenue will fall. Blue gain (extra total revenue from extra sales) is less than the yellow loss (the loss in total revenue from the higher price). d D2
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12. Lower price and unit elastic demand Blue gain equals yellow loss
Total Revenue Test
Lower price and unit elastic demand
Blue gain equals yellow loss $3 2 1 Q P e
A lower price and unit elastic demand mean that total revenue is unchanged. Blue gain (extra total revenue from extra sales) is exactly equal to the yellow loss (the loss in total revenue from the higher price). f D3
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13. Total Revenue Test
Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total Revenue Test
(1)
Total Quantity of Tickets Demanded per Week, Thousands
(2)
Price per Ticket
(3)
Elasticity Coefficient (Ed)
(4)
Total Revenue
(1) × (2)
(5)
Total Revenue Test 1 $8
$8,000 2 7
5.00
14,000
Elastic 3 6
2.60
18,000 4 5
1.57
20,000
1.00
Unit Elastic
0.64
Inelastic
0.38 8
0.20
8,000
Notice that in the high-price region, demand for movie tickets is elastic and revenues increase as price falls. Midway demand for movie tickets is unit elastic and revenues stay the same as price falls. In the low-price region, elasticities of demand are inelastic and revenues fall as the price falls.
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14. Elasticity and Total Revenue
Ed > 1 8 7 6 5 4 3 2 1
Unit Elastic
Ed = 1
Price $
Inelastic
Ed < 1
This graph shows the relationship between price elasticity of demand for movie tickets and total revenue. Demand curve D in (a) is based on Table 4.1 and is marked to show that the hypothetical weekly demand for movie tickets is elastic at higher price ranges and inelastic at lower price ranges. The total-revenue curve, TR, in (b) is derived from demand curve D. When price falls and TR increases, demand is elastic; when price falls and TR is unchanged, demand is unit elastic; and when price falls and TR declines, demand is inelastic.
You can see from the graph that elasticity changes along a demand curve. Demand tends to be more elastic in the upper-left portion of demand and more inelastic in the lower-right portion of demand. D
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15. Determinants of Elasticity of Demand
Substitutability
More substitutes, demand is more elastic
Proportion of income
Higher proportion of income, demand is more elastic
Luxuries versus necessities
Luxury goods, demand is more elastic
Time
More time available, demand is more elastic
With more substitutes available, consumers have more alternative options, so when there is a change in price, there is a greater percentage change in quantity demanded, making the demand more elastic. The broader the definition of the market, the more elastic the demand. With a more narrow definition of the market, demand is more inelastic.
The greater the proportion of income needed to buy the good, the more elastic the demand. Consumers will be more sensitive to changes in prices because the price change can result in thousands of dollars’ difference.
Since luxuries are goods that consumers can go without, they will change the amount they purchase by a greater amount even if the price changes by a small amount.
It takes time to alter the amount being purchased, so the more time available, the more elastic the demand. A person doing his/her Christmas shopping on Christmas Eve has a very inelastic demand because he/she doesn’t have the time to look around for alternative purchases.
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16. Price Elasticity of Demand
Selected Price Elasticities of Demand
Product or Service
Price Elasticity of Demand (Ed)
Newspapers
.10
Milk
.63
Electricity (household)
.13
Household appliances
Bread
.15
Liquor
.70
MLB tickets
.23
Movies
.87
Telephone service
.26
Beer
.90
Cigarettes
.25
Shoes
.91
Sugar
.30
Motor vehicles
1.14
Medical care
.31
Beef
1.27
Eggs
.32
China, glassware
1.54
Legal services
.37
Residential land
1.60
Automobile repair
.40
Restaurant meals
2.27
Clothing
.49
Lamb and mutton
2.65
Gasoline
.60
Fresh peas
2.83
Some of the elasticities of the goods in this table are surprising. Use the determinants of demand to discuss why major league baseball tickets are not only inelastic, but they are more inelastic than gasoline. What makes newspapers, movies, and beer inelastic?
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17. Applications of Ed College tuition Large crop yields
Inelastic demand, lower total revenue
Excise taxes
Inelastic demand, more total revenue
Decriminalization of illegal drugs
Large crop yields mean that the supply of crops increases and shifts to the right. When this occurs the equilibrium price falls. Since demand is inelastic, the lower price actually leads to lower revenue for farmers. Farmers are worse off when there is a large crop yield.
When government wants to impose taxes on goods, it is important for them to understand the elasticity of demand for the good. If they place a tax on a good with an inelastic demand, the higher price won’t decrease the quantity purchased by much, thereby increasing the amount of tax revenue that government collects.
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18. Price Elasticity of Supply
Measures sellers’ responsiveness to price changes
Elastic supply: producers are responsive to price changes
Inelastic supply: producers are not responsive to price changes
We know that at higher prices firms are willing and able to produce more, whereas at lower prices firms are willing and able to produce less. Price elasticity of supply measures how sensitive firms are to price changes. This means that even for small changes in price, firms will greatly alter the quantity being produced. On the other hand, when supply is inelastic, this means that the firm is unresponsive to price changes and therefore will not change the amount being produced by much, even when the change in price is large.
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19. Price Elasticity of Supply
Formula to compute elasticity
Es > 1: supply is elastic
Es < 1: supply is inelastic
Percentage change in quantity
supplied of product X
Percentage change in price
of product X
Es =
We use percentages so it doesn’t matter which unit of measure we are using. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula. Just like with price elasticity of demand, we will compute the price elasticity of supply using the midpoint formula.
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20. Price Elasticity of Supply
Time is primary determinant of elasticity of supply
Time periods considered
Market period
Short run
Long run
The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries.
The market period means that there is no time to adjust output in response to a price change. Some industries may not have a market period.
The short run means that there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs.
The long run means that there is enough time to adjust output by increasing or decreasing all inputs.
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21. Elasticity of Supply: The Market Period
Perfectly inelastic supply P Q Sm Pm
There is no time to adjust to a price change, making the supply perfectly inelastic. With a perfectly inelastic supply, the increase in demand does not change the quantity at all.
If we look at the case of the tomato farmer, we can see that on market day he or she loads the truck and goes to the market where, upon arriving, discovers the price is much higher (lower) than anticipated. The farmer cannot increase (decrease) the amount supplied, this is the market period. P0 D2 D1 Q0
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22. Elasticity of Supply: The Short Run
Supply is more elastic than in market period P Q Ss Ps
In the short run there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs. Supply is more elastic than in the market period, thereby resulting in a smaller increase in price but also an increase in quantity.
In the short run, the tomato farmer can increase (decrease) the supply somewhat by increasing (decreasing) the variable inputs like labor, fertilizer, irrigation, etc. However, the tomato farmer cannot increase (decrease) the size of the farm in this time period because farm size is fixed. P0 D2 D1 Q0 Qs
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23. Elasticity of Supply: The Long Run
Supply is even more elastic than in
the short run P Q Sl
In the long run there is enough time to adjust output by increasing or decreasing all inputs since all inputs are variable by this time. This means that supply will be even more elastic and with the same increase in demand, there is an even greater increase in the quantity than in the short run, but a smaller increase in price.
In the long run all inputs are variable, even the farm size. The tomato farmer can expand (reduce) the size of the farm in regards to long-run price increases. Pl P0 D2 D1 Q0 Ql
LO3
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24. Applications of Elasticity of Supply
Antiques
Inelastic supply
Reproductions
More elastic supply
Volatile gold prices
Antiques and other nonreproducible commodities have an inelastic supply; sometimes the supply is perfectly inelastic. This makes their prices highly susceptible to fluctuations in demand. The more inelastic the supply, the greater the changes in price when demand changes.
Reproductions, on the other hand, have a much more elastic supply so the prices tend to remain lower even when there is an increase in demand.
Gold prices are volatile because the supply of gold is highly inelastic, and unstable demand from speculation causes prices to fluctuate significantly.
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25. Income Elasticity of Demand
Measures responsiveness of buyers to changes in income
Normal goods — positive sign
Inferior goods — negative sign
Percentage change
in quantity demanded
Ei =
Percentage change in income
Income elasticity of demand refers to the percentage change in quantity demanded that results from some percentage change in consumer income.
A positive income elasticity indicates a normal or superior good.
A negative income elasticity indicates an inferior good.
Those industries that are income elastic will expand at a higher rate as the economy grows.
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26. Income Elasticity Insights
High income elasticities
Most affected by a recession
Low or negative income
Least affected by a recession
Income elasticity helps us understand which products and industries will be most affected when household incomes fall during economic downturns.
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27. Cross-Elasticity of Demand
Measures responsiveness of sales to change in the price of another good
Substitutes — positive sign
Complements — negative sign
Independent goods — zero
Percentage change in quantity demanded of product X
Ex,y =
Percentage change in price of product Y
We know that if the price of Pepsi increases, it not only impacts the quantity of Pepsi that is purchased, but it also impacts the quantity of related goods that are purchased. Cross-elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. If the goods are substitutes, they will have a positive cross-elasticity of demand since the change in the price of one good and the change in the demand for its substitute move in the same direction. If the goods are complements, they will have a negative cross-elasticity of demand since the change in the price of one good and the demand for its complement move in opposite directions.
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28. Cross-Elasticity of Demand
Application
Change the price?
Allow a merger?
Companies can use cross-price elasticity to determine whether raising the price of one of their products will affect sales of another of their products.
Government can use it to determine whether to allow a proposed merger of two companies. If there is a high cross-price elasticity between the two companies’ products, the government will likely not allow the merger.
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