Chapter 5

Elasticity of Demand and

Supply

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© 2006 Thomson/South-Western
 Price Elasticity of Demand

Price elasticity of demand measures how

responsive consumers are to price
change; elasticity is another word for
responsiveness
Price elasticity of demand = Percentage
change in quantity demanded /
Percentage change in price

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 Exhibit 1: Demand Curve for Tacos
For the price
elasticity to be a
useful measure, we $1.10 a
should come up with

Price
the same result 0.90 b
between points a and
b as we get between b
and a.
To do this we must
take the average of
the initial price and
the new price and D
use that as the base
in computing the
percent change in 0 95 105
price Thousands per day
Price elasticity between a and b =
10% / - 20% = - 0.5
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 Price Elasticity of Demand

 Generalize the price elasticity formula

∆q
ED =
(q + q′) / 2
∆p
(p + p′) / 2

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 Price Elasticity of Demand

 Because the average quantity and average price

are used as a base for computing percent
change, the same elasticity results whether
going from the higher price to the lower price
or the other way around

 Since the focus is on the percent change, we

need not be concerned with how output or price
is measured

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 Price Elasticity of Demand

Because price and quantity demanded are

inversely related, the price elasticity of demand
has a negative sign
This tends to be cumbersome, thus it is
commonplace to discuss the price elasticity of
demand as an absolute value  positive
number
For example, absolute value of the elasticity for
tacos computed earlier will be referred to as 0.5
rather than –0.5

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Categories of Price Elasticity

Three general categories

Percent change in quantity demanded is smaller than the
percent change in price, the price elasticity has an absolute
value between 0 and 1.0  demand is inelastic  quantity
demanded is relatively unresponsive to a change in price
Percent change in quantity demanded just equals the percent
change in price  a price elasticity with an absolute value of
1.0  unit-elastic demand
Percent change in quantity demanded exceeds the percent
change in price, the price elasticity has an absolute value
exceeding 1.0  demand is said to be elastic  quantity is
responsive to changes in price

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Elasticity and Total Revenue

Total revenue (TR) is the price (p) multiplied by

the quantity demanded (q) at that price  TR = p
xq
What happens to total revenue when price
decreases?
Lower price  producers get less for each unit sold
 total revenue declines
Lower price  increases quantity demanded 
total revenue increases
Overall impact of lower price on total revenue
depends on the net result of these opposite effects
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Elasticity and Total Revenue

When demand is elastic, the percent increase in

quantity demanded exceeds the percent
decrease in price  total revenue increases
When demand is unit elastic, the two are equal
 total revenue remains unchanged
When demand is inelastic, the percent increase
in quantity demanded is more than offset by
the percent decrease in price  total revenue
decreases

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Exhibit 2: Demand, Price Elasticity and Total
Revenue

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 Exhibit 2: Demand, Price Elasticity and Total Revenue
(a) Demand and Price Elasticity
$100
Panel (a) shows the 90
80
linear demand curve 70
and panel (b) shows the

Price per unit

60
total revenue generated 50
40
by each price-quantity 30
combination along the 20
demand curve 10
D
Because the demand 0 100 200 500 800 900 1,000
curve is linear, its slope Quantity per period
is constant: a given (b) Total Revenue
decrease in price
TR = p x q
always causes the same $25,000
unit increase in price
Total revenue

However, the price

elasticity of demand is Total
revenue
larger on the high end
of the demand curve
than it is on the low
price end 0 500 1,000
Quantity per period
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Exhibit 2: Demand, Price Elasticity and Total Revenue
Consider a movement
from point a to point b
on the demand curve.
(a) Demand and Price Elasticity
The 100-unit increase in $100
quantity demanded is a 90
a
percent change of 80
100/150 = 0.67% while 70
b
the $10 drop in price is a
60
percent change of 10/85
= 12%  the price 50
c
elasticity of demand here 40
Price per unit

is 5.6 30
Between points d and 20
e, the 100 quantity d
10
increase is a 12% change e D
and the $10 price
decrease is a 67% price 0 100 200 500 800 900 1,000
decrease  price Quantity per period
elasticity of 0.2
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Exhibit 2: Demand, Price Elasticity and Total Revenue
$100 (a) Demand and Price Elasticity
When demand is 90 a Elastic ED > 1
80
elastic, a decrease in price 70 b
(from a to b) will increase

Price per unit

60 Unit elastic ED = 1
total revenue because the 50 c
gain in revenue from 40
30
Inelastic ED < 1
selling more units (blue
20
box) exceeds the loss in d
10 e
revenue from selling all D
units at a lower price (red 0 100 200 500 800 900 1,000
box) Quantity per period
When demand is
(b) Total Revenue
elastic, a price decrease
(from d to e) reduces total $25,000
TR = p x q
revenue because the gain
Total revenue

in revenue from selling

more units (blue box) is
Total
less than the loss in revenue
revenue at the lower price
(red box)

0 Quantity per period 500 1,000

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 Exhibit 3: Constant Elasticity Demand Curves

(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

demand curve demand curve demand curve
D'
Price per unit

Price per unit

Price per unit

E D= 1
E D= ∞ D
p E D= 0
$10 a

6 b
D"

0 Quantity 0 Q Quantity 0 60 100 Quantity

per period per period per period

This demand curve This demand curve This demand curve is

indicates consumers will indicates that quantity unit-elastic everywhere:
demand all that is offered demanded does not vary any percent change in
at the given price, p. If the when the price changes; no price results in an
price rises above p, matter how high the price, identical offsetting
quantity demanded drops consumers will purchase the percent change in
to zero. same quantity. quantity demanded.
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 Availability of Substitutes

The greater the availability of substitutes for a

good and the closer the substitutes, the greater
the good’s price elasticity of demand

The number and similarity of substitutes

depend on how we define the good  the more
broadly we define a good, the fewer the
substitutes and the less elastic the demand

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Proportion of Consumer’s Budget

Because spending on some goods represents a large

share of the consumer’s budget, a change in the
price of such a good has a substantial impact on
the amount consumers are able to purchase

Generally, the more important the item is as a

share of the consumer’s budget, other things
constant, the greater will be the income effect of a
change in price, the more price elastic will be the
demand for the item

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 Exhibit 5: Demand Becomes More Elastic over Time

Suppose the price

increases from the initial
price of $1.00 to $1.25. $1.25

Price per unit

Dw shows that one week
1.00
after the price increase, the
quantity demanded has not
changed much, from 100 to Dy
95
After one month, Dm, it
has declined to 75, and Dm
Dw
after one year, Dy, to 50
The longer the time 0 50 75 95 100
period the larger the Quantity per period
response to a given price
change
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 Price Elasticity of Supply

The price elasticity of supply measures how

responsive producers are to a price change

Equals the percent change in quantity supplied

divided by the percent change in price

Since the higher price usually results in an

increased quantity supplied, the percent change
in price and the percent change in quantity
supplied move in the same direction  the
price elasticity of supply is usually a positive
number
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Exhibit 7: Price Elasticity of Supply

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Exhibit 7: Price Elasticity of Supply

 If the price increases from p to p', the

quantity supplied increases from q to q‘
 The price elasticity of Es is
∆q
Es =
(q′+q) / 2
∆p
(p′+p) / 2

 Where ∆ q is the change in quantity

supplied and ∆ p is the change in price.

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 Categories of Supply Elasticity

 The terminology for supply elasticity is the

same as for demand elasticity
If supply elasticity is less than 1.0, supply is inelastic
If it equals 1.0, supply is unit elastic
If it exceeds 1.0, supply is elastic

Exhibit 8 illustrates some special cases of

supply elasticity to consider

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 Exhibit 8: Constant-Elasticity Supply Curves

(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

S'
Price per unit

Price per unit

Price per unit
S"
ES= ∞ ES= 1
p S ES= 0 $10

0 Quantity per period 0 Quantity per period 0 10 20 Quantity

Q per period

At one extreme is the The most unresponsive Any supply curve that
horizontal supply curve. relationship is where there is a straight line from
Here producers will is no change in the quantity the origin such as
supply none of the good at supplied regardless of the shown above is a
a price below p, but will price where the supply unit-elastic supply
supply any amount at a curve is perfectly vertical. curve.
price of p 22
 Determinants

 The responsiveness of sellers depends on how

easy it is to alter output when price changes
If the cost of supplying additional units rises
sharply as output expands, then a higher price
will elicit little increase in quantity supplied
But if the marginal cost rises slowly as output
expands, the lure of a higher price will prompt a
large increase in output

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 Length of Time

 Supply also becomes more elastic over time as

producers adjust to price changes

 The longer the time period under

consideration, the more able producers are to
adjust to changes in relative prices

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 Exhibit 9: Supply Becomes More Elastic over
Time

Sw is the supply

Sw Sm
curve when the period
of adjustment is a Sy
week.
Sm is the supply $1.25
Price
curve when the 1.00
adjustment period is
one month; supply
more elastic and
quantity supplied
increases to 140
After one year the
supply curve becomes
Sy and the quantity 0
supplied increases to 100 140 200 Quantity per period
200 110

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 Income Elasticity of Demand

 Measures how responsive demand is to a

change in income

 Equals the percent change in demand divided

by the percent change in income

 Categories
Goods with income elasticities less than zero are
called inferior goods  demand declines when
income increases
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Income Elasticity of Demand

Normal goods have income elasticities greater

than zero  demand increases when income
increases
Normal goods with income elasticities greater than
zero but less than 1 are called income inelastic goods
 demand increases but not as much as does
income
Goods with income elasticity greater than 1 are
called income elastic  demand not only increases
when income increases but increases by more than
does income

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Exhibit 11: The Demand for Grain

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 Exhibit 12: Effect of Increases in Supply and
Demand on Farm Revenue

Over time, technological

advances in farming have
S
sharply increased the

Price per bushel

supply of grain S'
In addition, increases in
household income over time
have increased the demand $8
for farm products

But because increases in 4

the supply of grain have
exceeded increases in
demand, the combined D'
effect has been a drop in the D
market price and a fall in 0
total farm revenue 10 14
Billions of bushels per year 29
Cross-Price Elasticity of Demand

Since firms often produce an entire line of

products, it has a special interest in how a
change in the price of one product will affect
the demand for another

The responsiveness of the demand for one good

to changes in the price of another good is called
the cross-price elasticity of demand

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 Cross-Price Elasticity of Demand

 Defined as the percent change in the demand of

one good divided by the percent change in the
price of another good
If an increase in the price of one good leads to an
increase in the demand for another good, their
cross-price elasticity is positive  the two goods are
substitutes

 Ifan increase in the price of one good leads to a

decrease in the demand for another, their cross-
price elasticity is negative  the two goods are
complements

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