ELASTICITY OF DEMAND AND

SUPPLY

Prepared by
Ms. Dorie Gatus, MBA

© 2007 Thomson South-Western

 Elasticity . . .
• … allows us to analyze supply and demand
with greater precision.

• … is a measure of how much buyers and

sellers respond to changes in market
conditions
 THE ELASTICITY OF
DEMAND
• The price elasticity of demand is a measure of how
much the quantity demanded of a good responds to a
change in the price of that good.
• Elasticity is the responsiveness is always measured in
percentage terms.
• Specifically, the price elasticity of demand is the
percentage change in quantity demanded due to a
percentage change in the price.
 The Price Elasticity of Demand and Its Determinants

• Availability of Close Substitutes

• Necessities versus Luxuries
• Definition of the Market
• Time Horizon
 The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic:
– the larger the number of close substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
 Elasticity

• Elasticity is a general
concept that can be used to
quantify the response in one
variable when another
variable changes. % A
elasticity o f A w ith resp ect to B 
% B

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 Calculating Elasticities
• Calculating percentage
changes:
P2  P1
% c h a n g e in p ric e  x 100%
P1

Q 2  Q1
% change in quantity dem anded  x 100%
Q1

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Price Elasticity of Demand
• A popular measure of elasticity is
price elasticity of demand
measures how responsive
consumers are to changes in the
price of a product.
% ch an g e in q u an tity d em an d ed
p rice elasticity o f d em an d 
% ch an g e in p rice
• The value of demand elasticity is
always negative, but it is stated in
absolute terms. 8 of 42
 Computing the Price Elasticity of Demand
• Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:

Percentage change in quantity dem anded

Price elasticity of dem and =
Percentage change in price
 (8-10)
%∆QD= -------------- X 100% = -02
10
----------------------------
(2.20-2.00)
%∆P = ----------------- X 100% = .10
2.00

-0.2%
Ed = ---------- = -2
.10 %
 SW
1. If the price of an burger increases from P45.00 to
P50 and the amount you buy falls from 20 to 10
burgers, Compute the elasticity of demand
considering this situation.
2. The price of grains decreases from P35 to P30 per
kilo and the quantity demanded is still the same
as 40 kilos. Compute the elasticity of this product.
 Types of Elasticity
Hypothetical Demand Elasticities for Four Products

% CHANGE % CHANGE IN QUANTITY

IN PRICE ELASTICITY
DEMANDED (%DQD)
PRODUCT (%DP) (%DQD d %DP)

Insulin +10% 0% 0.0 Perfectly inelastic

Basic telephone service +10% -1% -0.1 Inelastic

Beef +10% -10% -1.0 Unitarily elastic

Bananas +10% -30% -3.0 Elastic

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 The Variety of Demand Curves
• Inelastic Demand
– Quantity demanded does not respond strongly to
price changes.
– Price elasticity of demand is less than one.
• Elastic Demand
– Quantity demanded responds strongly to changes in
price.
– Price elasticity of demand is greater than one.
 The Variety of Demand Curves
• Perfectly Inelastic
– Quantity demanded does not respond to price changes.
• Perfectly Elastic
– Quantity demanded changes infinitely with any change
in price.
• Unit Elastic
– Quantity demanded changes by the same percentage as
the price.
Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
 Perfectly Elastic and
Perfectly Inelastic Demand Curves

• When demand does not • Demand is perfectly elastic

respond at all to a change when quantity demanded
in price, demand is drops to zero at the slightest
perfectly inelastic. increase in price.
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 Calculating Elasticities
• A more accurate way of
computing elasticity than
percentage changes is the
midpoint formula:
Q 2  Q1
x 100%
%  Q d ( Q1  Q 2 ) / 2

% P P2  P1
x 100%
( P1  P2 ) / 2
10  5 5
x 100% x 100%
%  Q d (5  1 0 ) / 2 7 .5 6 6 .7 %
  =   1.6 7
% P 23 -1 -4 0 .0 %
x 100% x 100%
(3  2) / 2 2 .5 21 of 42
 Calculating Elasticities
Here is how to interpret two different values of
elasticity:
• When e = 0.2, a 10% increase in price leads to
a 2% decrease in quantity demanded.
• When e = 2.0, a 10% increase in price leads to
a 20% decrease in quantity demanded.

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 Elasticity Changes along
a Straight-Line Demand Curve

• Price elasticity of
demand decreases
as we move
downward along a
straight line demand
curve.
• Demand is elastic in
the upper range and
inelastic in the lower
range of the line. 23 of 42
Other Important Elasticities
• Income elasticity of demand –
measures the responsiveness of
demand to changes in income.
% ch an g e in q u an tity d em an d ed
in co m e elasticity o f d em an d 
% ch an g e in in co m e

24 of 42
 Other Important Elasticities
• Cross-price elasticity of demand: A measure
of the response of the quantity of one good
demanded to a change in the price of another
good.
% change in quantity of Y dem anded
cross - price elasticity of dem and 
% change in price of X

25 of 42
 Other Important Elasticities
• Elasticity of supply: A measure of the
response of quantity of a good supplied to a
change in price of that good. Likely to be
positive in output markets.
% change in quantity supplied
elasticity of supply 
% change in price
26 of 42
 Other Important Elasticities
• Elasticity of labor supply: A measure of the
response of labor supplied to a change in the
price of labor.

% change in quantity of labor supplied

elasticity of labor supply 
% change in the w age rate

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 Elasticity and Total Revenue
TR  P  Q

Effect of an
Type of Change in quantity versus increase in price Effect of a decrease in
demand Value of Ed change in price on total revenue price on total revenue
Elastic Greater than 1.0 Larger percentage change in Total revenue Total revenue increases
quantity decreases

Inelastic Less than 1.0 Smaller percentage change Total revenue Total revenue decreases
in quantity increases

Unitary Equal to 1.0 Same percentage change in Total revenue does Total revenue does not
elastic quantity and price not change change

• When demand is inelastic, price and total revenues are directly

related. Price increases generate higher revenues.
• When demand is elastic, price and total revenues are indirectly
related. Price increases generate lower revenues. 28 of 42
 Elasticity and Total Revenue
 Total revenue is the amount paid by buyers
and received by sellers of a good.
 Computed as the price of the good times the
quantity sold.

TR = P x Q
 Elasticity and Total Revenue
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q
 Slope and Elasticity
23 1 23 1
slope   slope  
10  5 5 160  80 80

• Changing the units of measure yields a very different

value of the slope, yet the behavior of buyers in both
diagrams is identical. 31 of 42
The Total Revenue Test for Elasticity
Increase in Decrease in
Total Revenue Total Revenue

Increase in INELASTIC ELASTIC

Price DEMAND DEMAND

Decrease in ELASTIC INELASTIC

Price DEMAND DEMAND
 References:
• Case, Karl and Fair, Ray, Principles of Economics 6th
edition, Prentice Hall Business Publishing 2002
• Mc Eachern, William, Microeconomics: A Contemporary
Introduction ( 6th edition) USA: South Western College
Publishing, c 2003.
• Samuelson, Paul A. and Nordhaus, William D., Economics
( 18th edition) Singapore: McGraw-Hill/Irwin c 2005.

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