THEORY OF DEMAND

AND SUPPLY
ELASTICITY – Part I
A A R U S HI
MANAG ER IAL ECONOMICS
A MI T Y B U S I NES S S CHO O L
Elasticity
• Elasticity is a measure of how much buyers and sellers respond to changes
in market conditions, it allows us to analyze supply and demand with
greater precision.
• Elasticity can be defined as a measure of the responsiveness of quantity
demanded or quantity supplied to one of its determinants (eg. Price,
Income).
• Example, elasticity of your grade with respect to studying, denoted EG,S, is
the percentage change in your grade (%ΔG) that will result from a given
percentage change in the time you spend studying (%ΔS).
%ΔG ΔG ΔS
• EG, S = ; Since %ΔG = and %ΔS = , we can also write it as
%ΔS G S
ΔG S
• EG, S = ×
ΔS G

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Elasticity
If the variable G depends on S according to the functional relationship G = f(S), the
elasticity of G with respect to S may be found using calculus:
𝑑𝐺 𝑆
EG, S = ×
𝑑𝑆 𝐺
❖Two aspects of elasticity are important:
• Whether it is positive or negative and
• Whether it is greater than 1 or less than 1 in absolute value.
❖The sign of the elasticity determines the relationship between two variables.
• If elasticity is positive, increase in S leads to an increase in G.
• If the elasticity is negative, increase in S leads to a decrease in G.

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Elasticity
❖Whether the absolute value of the elasticity is greater or less than 1
determines how responsive G is to changes in S.
• If absolute value of elasticity is greater than 1, the numerator is larger than
the denominator in elasticity formula, i.e small percentage change in S will
lead to relatively large percentage change in G.
• If absolute value of elasticity is less than 1, the numerator is smaller than
the denominator in elasticity formula, i.e. percentage change in S will lead
to relatively small percentage change in G.

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The Price Elasticity of Demand
• The price elasticity of demand measures how much the quantity
demanded responds to a change in price.
• Demand for a good is said to be elastic if the quantity demanded
responds substantially to changes in the price.
• Demand is said to be inelastic if the quantity demanded responds
only slightly to changes in the price.
• Managers can use this measure to determine the quantitative impact
of price hikes or cuts on the firm’s sales and revenues (relationship
b/w price elasticity and revenue).
• What determines the price elasticity of demand?

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Determinants of Price Elasticity of Demand
Necessities versus Luxuries Availability of Close Substitutes
Necessities tend to have inelastic Goods with close substitutes tend to
demands, whereas luxuries have have more elastic demand because
elastic demand. it is easier for consumers to switch
from that good to others.
Examples –
Example –
Necessities – Doctor visits
Butter and ghee (clarified butter) are
Luxuries – Purchasing a sailboat easily substitutable.
Whether a good is a necessity or a By contrast, eggs are a food without
luxury depends not on the intrinsic a close substitute, the demand for
properties of the good but on the eggs is probably less elastic than the
preferences of the buyer. demand for butter.

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Determinants of Price Elasticity of Demand

Definition of the Market Time Horizon

Elasticity of demand in any market Goods tend to have more elastic
depends on boundaries of market. demand over longer time horizons.
Narrowly defined markets tend to have Example –
more elastic demand than broadly
defined markets, as it is easier to find When price of gasoline rises, the
close substitutes for narrowly defined quantity of gasoline demanded falls
goods. slightly in first few months.

Example – Over time, people buy more fuel-

efficient cars or switch to public
Food, broad category - inelastic demand transportation.
Ice cream, narrow category - elastic Within several years, quantity of
demand gasoline demanded falls substantially.
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Computing The Price Elasticity Of Demand
Percentage change in quantity demanded
• Price elasticity of demand =
Percentage change in price
• Price elasticity of demand for good X, denoted E Qx, Px –
%∆Qdx
• E Qx, Px =
% ∆Px

• Price elasticity of demand for a good with a demand function

• Qdx = f(Px, Py, M, H) may be found using calculus:
dQx Px
• E Qx, Px = ×
dPx Qx

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Example – Price Elasticity of Demand
• Let there be a 10 percent increase in the product’s price, which leads to a 20
percent decline in the quantity demanded of the good,
−20%
• Since = −2 = Price elasticity of demand
10%
• Recall that two aspects of elasticity are important: (1) its sign and (2)
whether it is greater or less than 1 in absolute value.
• By the law of demand, there is an inverse relation between price and
quantity demanded; thus, the price elasticity of demand is a negative
number.
• The absolute value of price elasticity of demand can be greater or less than
1.

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Computing The Price Elasticity Of Demand
Percentage change in quantity demanded
• Price elasticity of demand =
Percentage change in price
• If we calculate price elasticity of demand between two points on a demand
curve, we find that the elasticity from point A to point B differs from elasticity
from point B to point A. To avoid this problem, we use midpoint method for
calculating elasticities.
• The midpoint method computes a percentage change by dividing the change
by the midpoint of the initial and final levels. the price elasticity of demand
between two points, denoted (Q1, P1) and (Q2, P2) can be calculated as -

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Classification – Price Elasticity of Demand
• Demand is said to be elastic if the absolute value of the price elasticity is
greater than 1:
• | EQx, Px| > 1
• Demand is said to be inelastic if the absolute value of the price elasticity is
less than 1:
• | EQx, Px| < 1
• Demand is said to be unitary elastic if the absolute value of the own price
elasticity is equal to 1:
• |EQx, Px| = 1

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Classification – Price Elasticity of Demand
• Demand is said to be perfectly elastic if the absolute value of the price
elasticity is equal to infinity.
• Demand is said to be perfectly inelastic if the absolute value of the price
elasticity is equal to zero:
• | EQx, Px| = 0

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Interpretation – Price Elasticity of Demand
• Conceptually, the quantity consumed of a good is relatively responsive to a change
in the price of the good when demand is elastic and relatively unresponsive to
changes in price when demand is inelastic.
• This means that price increases will reduce consumption very little when demand is
inelastic.
• However, when demand is elastic, a price increase will reduce consumption
considerably.
• Price elasticity of demand is closely related to the slope of the demand curve.
• Rule of thumb - The flatter is the demand curve that passes through a given point,
the greater is the price elasticity of demand. The steeper is the demand curve that
passes through a given point, the smaller is the price elasticity of demand.

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 In the extreme case of a zero
elasticity, demand is perfectly
inelastic, and the demand curve
is vertical. In this case, regardless
of the price, the quantity
demanded stays the same.

Reference: Mankiw, N. G. (2016). Principles of Microeconomics. Eighth edition.

Cengage Learning.
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 Demand is inelastic when the
elasticity is less than 1, so that
quantity moves proportionately
less than the price.

Eg. Food, Prescription drugs

Reference: Mankiw, N. G. (2016). Principles of Microeconomics. Eighth edition.

Cengage Learning.
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 If the elasticity is exactly 1,
so that quantity moves
the same amount
proportionately as price,
demand is said to have
unit elasticity.

Reference: Mankiw, N. G. (2016). Principles of Microeconomics. Eighth edition.

Cengage Learning.
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 Demand is elastic when the
elasticity is greater than 1, so
that quantity moves
proportionately more than the
price.

Reference: Mankiw, N. G. (2016). Principles of Microeconomics. Eighth edition.

Cengage Learning.
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 At the opposite extreme,
demand is perfectly elastic. This
occurs as the price elasticity of
demand approaches infinity
and the demand curve becomes
horizontal, reflecting the fact
that very small changes in the
price lead to huge changes in
the quantity demanded.

Eg. Producers of homogenous

generic products, such as
paracetamol (Brand names –
Dolo, Calpol, Crocin etc.)

Reference: Mankiw, N. G. (2016). Principles of Microeconomics. Eighth edition.

Cengage Learning.
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