Elasticity of Demand & Supply

Dr. Ashok Panigrahi

 The Concept of Elasticity
• Definition: “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.”

• These variables are price of the commodity, prices of the

related commodities, income of the consumer & other various
factors on which demand depends. Thus, we have Price
Elasticity, Cross Elasticity, Elasticity of Substitution & Income
Elasticity. It is always price elasticity of demand which is
referred to as elasticity of demand

• Elasticity is a measure of the responsiveness of one variable

to another.
• The greater the elasticity, the greater the responsiveness.
 Price Elasticity
• The price elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in price. The price elasticity of
demand so measured is called elasticity coefficient.

• Price elasticity of demand measures how much the

quantity demanded of a good changes when its
price changes.

Percentage change in quantity demanded

ED =
Percentage change in price
The Price Elasticity of Demand
 When price rises to $21 per
barrel, world demand falls to
9.9 million barrels per day
(point B).

At a price of $20 per barrel,

the world quantity of oil
demanded is 10 million
barrels per day (point A).
Calculating the price elasticity of demand
for oil
 Coefficient of Price Elasticity -
Example
• Compute the Coefficient of Price Elasticity of Demand and comment on
the Type of Elasticity of Demand between each of the three situations:
• Scenario I: Between A—B
• Scenario 2: Between B - C
• Scenario 3: Between C—D
•
Scenario Quantity Demanded Price
• A 30 2
• B 20 3
• C 10 7
• D 5 12
•
 Price Elasticity of Demand …
• Minus Sign – While calculating the price elasticity of demand,
we drop the minus sign from the numbers by treating all %
changes as positive.

• Classifications of Price Elasticity of Demand:

– Inelastic demand ( |ED| < 1 ): a change in price brings about
a relatively smaller change in quantity demanded (ex.
gasoline).
• Total Revenue = P×Q rises as a result of a price increase
– Unitary elastic demand ( |ED| = 1 ): a change in price brings
about an equivalent change in quantity demanded.
• TR= P×Q remains the same as a result of a price increase
– Elastic demand ( |ED| > 1 ): a change in price brings about a
relatively larger change in quantity demanded (ex. expensive
wine).
• TR = P×Q falls as a result of a price increase
 The Arc/Midpoint Elasticity
Method
The arc method should
always be used when there is
a proportionally large price
change. It averages the
elasticity over the distance
that is under consideration
on the demand curve.

9
Using the Arc/Midpoint Method to
Calculate Elasticities

The midpoint method is a technique for

calculating the percent change. In this
approach, we calculate changes in a
variable compared with the average, or
midpoint, of the starting and final
values.
 The Arc/Midpoint Method
• q1 is the original quantity demanded
• q2 is the quantity demanded after the price
change
• P1 is the original price
• P2 is the new price

11
 The Arc Method
• The formula for finding the coefficient of arc
elasticity is:
• e= q1 - q2 p1 - p2

q1 + q2 p1 + p2

2 2

12
Using the Arc/Midpoint Method to
Calculate Elasticities
Using the Midpoint Method to Calculate
Elasticities – numerical example

= %20

= %20

=1
 The Point Method
• The formula for finding the coefficient of point
elasticity is:

• e=

15
 The Point Method
• Q is the quantity demanded
• Q is the change in the quantity demanded
• P is the price
• P is the change in price

16
 The Point Method
• When 100 units are demanded at $5 and
90 units are demanded at $6, the point
coefficient is:
• e=

1 1

• e = 10/100 1/5
• e = 10/100 x 5/1 = 0.5
• Elasticity is therefore Inelastic < 1 17
 Some Estimated Price Elasticities of
Demand

Good Price elasticity

Inelastic demand
Eggs 0.1 Price elasticity of
Beef 0.4 demand < 1
Stationery 0.5
Gasoline 0.5
Elastic demand
Housing 1.2
Restaurant meals 2.3 Price elasticity of
Airline travel 2.4 demand > 1
Foreign travel 4.1
Interpreting the Price Elasticity of Demand:
How Elastic Is Elastic?

Two Extreme Cases of Price Elasticity of Demand

Demand is perfectly inelastic when the quantity

demanded does not respond at all to the price. When
demand is perfectly inelastic, the demand curve is a vertical
line.

Demand is perfectly elastic when any price increase will

cause the quantity demanded to drop to zero. When
demand is perfectly elastic, the demand curve is a horizontal
line.
 Interpreting the Price Elasticity of
Demand : How Elastic Is Elasticity?

Unit-Elastic Demand, Inelastic Demand,

and Elastic Demand
Demand is elastic if the price elasticity
of demand is greater than 1, inelastic if
the price elasticity of demand is less than
1, and unit-elastic if the price elasticity of
demand is exactly 1.
Highway department
charges for crossing a
bridge
 Types of Price Elasticity
Ep= ∞ Ep=0
Ep=1
pric
e

Ep> 1 Ep<1
price

Quantity
demanded 26
Why does it matter whether demand is
unit-elastic, inelastic, or elastic?

Because this classification predicts how

changes in the price of a good will affect the
total revenue earned by producers from the
sale of that good.

The total revenue is defined as the total

value of sales of a good, i.e.
Total revenue = Price × quantity sold
 Elasticity and Total Revenue

When a seller raises the price of a good, there

are two countervailing effects in action (except
in the rare case of a good with perfectly elastic
or perfectly inelastic demand):

■ A price effect: After a price increase, each

unit sold sells at a higher price, which tends to
raise revenue.

■ A sales effect: After a price increase, fewer

units are sold, which tends to lower revenue.
 Elasticity and Total Revenue
If demand for a good is elastic (the price elasticity
of demand is greater than 1), an increase in price
reduces total revenue. In this case, the sales effect is
stronger than the price effect.
If demand for a good is inelastic (the price
elasticity of demand is less than 1), a higher price
increases total revenue. In this case, the price effect is
stronger than the sales effect.
If demand for a good is unit-elastic (the price
elasticity of demand is 1), an increase in price does
not change total revenue. In this case, the sales effect
and the price effect exactly offset each other.
The Price Elasticity of
Demand Changes
Along the Demand
Curve
 Price Elasticity of Supply

• The price elasticity of supply is the

proportional change in quantity demanded
relative to the proportional change in price.

Percentage change in quantity supplied

ES =
Percentage change in price
 Income Elasticity of Demand

 Is the degree of responsiveness of quantity

demanded of a good to a small change in the income
of the consumer.
• 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.
• If the proportion spent on a good increases, then the
income elasticity for the good is greater than one.
• If the proportion decreases as income rises, then
income elasticity for the good is less than one.
 Income Elasticity of Demand

• Income elasticity of demand – the percentage

change in demand divided by the percentage
change in income.

Percentage change in demand

EIncom e =
Percentage change in income
 Income Elasticity of Demand
• Income elasticity of demand tells us the responsiveness of
demand to changes in income.
• An increase in income generally increases one’s consumption
of almost all goods.
• The increase may be greater for some goods than for others.
• For example, if the quantity demanded for a good increases
for 15% in response to a 10% increase in income, the income
elasticity of demand would be 15% / 10% = 1.5. The degree to
which the quantity demanded for a good changes in response
to a change in income depends on whether the good is a
necessity or a luxury.
 Income Elasticity of Demand
• Normal goods have a positive income elasticity of demand.
• As incomes rise, more goods are demanded at each price
level. The quantity demanded for normal necessities will
increase with income, but at a slower rate than luxury goods.
• This is because consumers, rather than buying more of the
necessities, will likely use their increased income to purchase
more luxury goods and services.
• During a period of increasing incomes, the quantity
demanded for luxury products tends to increase at a higher
rate than the quantity demanded for necessities.
 Income Elasticity of Demand
• Normal goods are divided into luxuries and necessities.
• Luxuries are goods that have an income elasticity greater than
one.
• Their percentage increase in demand is greater than the
percentage increase in income.
• A necessity has an income elasticity less than 1.
• The consumption of a necessity rises by a smaller
proportion than the rise in income.
• Inferior goods are those whose consumption decreases when
income increases.
• Inferior goods have income elasticity less than zero.
 Cross Elasticity
 A change in the demand for one good in response to
a change in the price of another good represents
cross elasticity of demand of the former good for the
latter good.

• If two goods are perfect substitutes for each other

cross elasticity is infinite and if the two goods are
totally unrelated, cross elasticity between them is
zero.
• Goods between which cross elasticity is positive can
be called Substitutes, the good between which the
cross elasticity is negative are not always
complementary as this is found when the income
effect on the price change is very strong.
 Cross-Price Elasticity of Demand

• Cross-price elasticity of demand – the

percentage change in demand divided by the
percentage change in the price of another
good.

Percentage change in demand

ECross - Price =
Percentage change in price
of a related good
 Cross-Price Elasticity of Demand
• Cross-price elasticity of demand tells us the
responsiveness of demand to changes in prices of
other goods.
• Substitutes are goods that can be used in place of
another.
• Substitutes have positive cross-price elasticities.
• Complements are goods that are used in conjunction
with other goods.
• Complements have negative cross-price
elasticities.
 Factors affecting Elasticity of Demand
• Nature of Commodity : Ordinarily, necessaries like salt,
Kerosene, oil, match boxes, textbooks, seasonal vegetables,
etc. have less than unitary elastic demand. Luxuries like air
conditioner, costly furniture, fashionable garments etc. have
greater than unitary elastic demand. The reason being that
change in their price has a great effect on their demand.
Comforts like milk, transistor cooer, fans etc have neither very
elastic nor very inelastic demand. Jointly Demanded Goods
like car & petrol, pen & ink, camera & films etc. have
ordinarily in elastic demand for example rise in price of
petrol will not reduce its demand if the demand for cars
has not decreased.
 Factors affecting Elasticity of Demand
• Availability of Substitutes : Demand for those goods
which have substitute are relatively more elastic. The reason
being that when the price of commodity falls in relation to its
substitute, the consumer will go in for it and so its demand
will increase. Commodities have no substitute like cigarettes,
liquor etc. have inelastic demand.
• Different Uses of Commodity : Commodities that can be put
to a variety of uses have elastic demand, for instance,
electricity has multiple uses. It is used for lighting, room-
heating, air-conditioning, cooking etc. If the tariffs of
electricity increase, its use will be restricted to important
purpose like lighting. It will be with drawn from unimportant
uses. On the other hand, if a commodity such as paper has
only & a few uses, its demand is likely to be inelastic.
 Factors affecting Elasticity of Demand
• Postponement of the Use : Demand will be elastic for those
commodities whose consumption can be postponed for
instance demand for constructing a house can be
postponed. As a result demand for bricks, cement, sand etc.
will be elastic. Conversely goods whose demand can not be
postponed, their demand will be inelastic.
• Income of Consumer : People whose incomes are very high or
very low, their demand will ordinarily be inelastic. Because
rise or fall in price will have little effect on their demand.
Conversely middle income groups will have elastic demand.
• Habit of Consumer : Goods to which a person becomes
accustomed or habitual will have in elastic demand like
cigarette, coffee, tobacco, etc. It is so because a person
cannot do without them.
 Factors affecting Elasticity of Demand
• Proportion of Income Spent on a Commodity : Goods on
which a consumer spends a very small proportion of his
income, e.g. toothpaste, needles etc. will have an inelastic
demand. On the other hand goods on which the consumer
spends a large proportion of his income e.g. cloth etc. their
demand will be elastic.

• Price Level : Elasticity of demand also depends upon the level

of price of the concerned commodity. Elasticity of demand
will be high at higher level of the price of the commodity and
low at the lower level of the price.

• Time Period : Demand is inelastic in short period but elastic in

long period. It is so because in the long run, a consumer can
change his habits more conveniently in the short period.
Thanks