Lesson 2.

3 Elasticities of Demand and Supply

Objectives:
At the end of this lesson, the students should be able to:
1. Reason effectively how a change in demand or supply or in both can affect equilibrium
price and equilibrium quantity;
2. Apply the principles of demand and supply to illustrate how prices of commodities are
determined; and
3. Distinguish between elastic and inelastic demand and supply.

We have learned how demand and supply respond to changes in their determinants.
Goods, however, differ in terms of how demand and supply respond to changes to changes in
these determinants. The degree of their response to a change is referred to as elasticity. Elasticity
is a measure of how much buyers and sellers respond to changes in market conditions.
The coefficient of elasticity is the number obtained when the percentage change in
demand is divided by the percentage change in the determinant.
In terms of how responsive demand and supply are, degrees of elasticity may either be:
1. Elastic– a change in a determinant will lead to a proportionately greater change in
demand or supply. The absolute value of the coefficient of elasticity is greater than 1. If
the price of LPG increases by 10% and as a result the quantity demanded goes down by
12%, then we say that the demand for LPG is elastic.
 2. Inelastic– a change in a determinant will lead to a proportionately lesser change in
demand or supply. The absolute value of the coefficient of elasticity is less than 1.
Suppose the price of cell phone load goes up by 5% and the quantity demanded goes
down by 3%, then we can say that demand for cell phone load is inelastic.

3. Unitary Elastic– a change in a determinant will lead to a proportionately equal change in

demand or supply.The absolute value of the coefficient of elasticity is equal to 1. Let us
say that the price of string beans goes down by 6% also, we describe the demand for
string beans as unitary elastic.

ELASTICITY OF DEMAND
There are three types of elasticity of demand that deal with the responses to a change in
the price of the good itself, in income, and in the price of a related good, which is a substitute or
a complement.

Price Elasticity of Demand

This measures the responsiveness of demand to a change in the price of the good. The concept
of elasticity is measured in percentage changes. The value of price elasticity may be measured in
two ways:
1. Arc Elasticity – the value of elasticity is computed by choosing two points on the demand
curve and comparing the percentage changes in the quantity and the price on those two
points. The computation of arc elasticity makes use of the following formula:

Ep = {(Q2-Q1)/(Q2+Q1/2)} ÷ {(P2-P1P)/(P2+P1/2)}

Where:

Q2= new quantity demanded

Q1= original quantity demanded
P2 = new price of the good
P1 = original price of the good

Normally, coefficient of the price elasticity of demand has a negative sign because it reflects
the inverse relationship between price and the quantity demanded. The size of the coefficient,
regardless of the negative sign, will signify the nature of the good involved. When price
elasticity of demand is greater than 1, this signifies that the demand is elastic since the
percentage change in the quantity demanded is greater than the percentage change in price.
Therefore, the good is non-essential since costumers will respond greatly to a change in price.
 When price elasticity of demand is less than 1, this signifies that demand is inelastic since the
percentage change in quantity demanded is less than the percentage change in price. Therefore,
the good is essential since consumers will show a slight response to a change in price. When the
coefficient of price elasticity is equal to 1, the demand for the product is unitary elastic,
suggesting proportionate changes in quantity demanded and the price of the good.

2. Point Elasticity – measures the degree of elasticity on a single point on the demand
curve. Changes on a single point are infinitesimally small.

Ep = {(Q2-Q1)/Q1} ÷ {(P2-P1)/P1}
Price elasticity is important to the seller since it gauges how far demand can change
relative to price. The price elasticity of demand measures how far consumers are willing to buy a
good especially when its price rises reflective of the economic, social, and psychological forces
shaping consumer preference.

Income Elasticity of Demand

This measures how the quantity demanded changes as consumer income changes. Income
Elasticity of Demand is equal to (% change in quantity demanded) / (% change in income)
A positive (+) sign for IE signifies that the good demanded is a normal good, which
is what a consumer tends to buy more when his income increases. This is true for steak, pizzas,
and luxury items. The negative (-) sign for IE indicates the demand for inferior goods, which are
goods that are bought when incomes are low because low incomes prevent the consumers from
buying higher priced goods.

Cross Price Elasticity of Demand

This measures how quantity demanded changes as the price of a related good changes.
Cross elasticity (CE) measures the responsiveness of the demand for a good to the change in the
price of a substitute good or complement. Earlier in this chapter, we discussed what substitute
goods are and what complements are. A+ (positive) sign for CE signifies that the two goods
involved are substitute goods which means that as the price of the substitute good increases, the
demand for the other good will increase. This is true for rice and bread, which are substitute
goods. If the price of bread go up, consumers will substitute rice for bread; thus, the demand for
rice increases. The – (negative) sign for CE indicates that the two goods are complements, which
means that the demand for a good will increase when the price of a complement decreases. On
the other hand, CE for cellphones and cellphone loads is negative.
Since these two goods are used together, the price of one will affect the demand for the
other. If the price of cellphone load increases significantly, the demand for cell phones will tend
to decline.
PRICE ELASTICITY OF SUPPLY
With regard to supply, price elasticity of supply determines whether the supply curve is steep or
flat. A steep curve signifies a high degree of elasticity or ability to change, while a flat curve
indicates an inability to change in response to a change in the price of the good. Goods that are
easy to produce have elastic supply while those which need a long time to produce and which are
hard to make have inelastic supply.

References:

Case, Karl E. and FAIR, Ray C. 2007. An Introduction to Principles of Economics. Pearson 6th
Edition, Education International.
Rosemary P. Dinio, PhD., and George A. Villasis. Applied Economics, REX Book Store. First
Edition
Internet Sources:
http://www.investopedia.com