Introduction to Economics

(Econ. 101)

Janury,2021
Elasticity of Demand and
Supply

 Elasticity is a measure of how much buyers and sellers respond to

changes in market conditions.
2.5.1 Elasticity of Demand
 Elasticity of demand is a measure
of how much the quantity
demanded of a good responds to a
change in the determinants of
demand including price of that
good.

 is the percentage change in quantity

demanded given a percent change in
the determinants of demand including
price.
2.5.1 Elasticity of Demand
 3 types of elasticity of Demand
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross-price elasticity of demand
1.Price elasticity of demand

 It is a concept that measures by

how much percent will quantity
demanded changes when its
price changes by certain percent

Ep = Percentage change in quantity demanded = (Q/Q) x 100

Percentage change in price (P/P) x 100

but Q = Q2 - Q1 and
P = P2 - P1
Where Q2 and Q1 are quantity demanded of a
commodity at price level P2 and P1 respectively
Ep = [(Q2 - Q1)/Q1] x 100
[(P2 - P1)/P1] x 100

Ep = (Q2 - Q1) x P1 = (Q2 - Q1) x P1

Q1 P2-P1 (P2- P1) Q1
Ex. Calculate 'point" price elasticity of demand

Demand schedule for sugar Poin Pric Quantity

t e Demanded
A 15 20
B 10 30
C 5 40

1. Compute Ep Considering movement from point A to B

2. Compute Ep Considering movement from point B to A

One of the problems of using point price elasticity
is that it yields two different values of elasticity
depending on the direction of our movement
Ep (A to B) = Q2 - Q1 x P1 = (30 - 20) x 15 = / -1.5 / = 1.5
P2 - P1 Q1 (10 - 15) 20

Ep (B to A) = Q2 - Q1 x P1 = 20 - 30 x 10 = / -0.67/ = 0.67
P2 - P1 Q1 15-10 30

To avoid this discrepancy in value of elasticity it is

better to use "arc" or "average" elasticity which
takes the average price and average quantity as a
base for computation
(Q2  Q1 ) / Q2  Q1
ep 
2
( P2  P1 ) / P1  P2
2
 (Q2  Q1 ) / Q2  Q1
ep 
2
( P2  P1 ) / P1  P2
2

Ep = 2 (Q2 - Q1) x (P1 + P2)

(Q2 + Q1) 2(P2- P1)

Ep = (Q2 - Q1) x ( P1 + P2 )
(P2 - P1) (Q1 + Q2 )

This formula is an arc elasticity formula and it is widely

used.
The Five Categories of Price Elasticity of Demand

1. Perfectly inelastic demand

P
P1 ep = 0
P2

Q
Q0

Quantity demanded does not respond to price

changes at all. Ex : the demand of car-driver for a road in the
middle of inhabitant land, picasso painting, prescription drug to
save someone’s life. .
 Figure 1 The
(1) Perfectly PriceDemand:
Inelastic Elasticity of Equals 0
Elasticity
Demand
Price Picasso painting
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright©2003 Southwestern/Thomson Learning

 2. Inelastic demand

0 < ep < 1

D Q
Q1 Q2

 Quantity demanded does not respond strongly to price

changes
 Ex: food, gas, health care
 Figure 1 The Price Elasticity of Demand

(2) 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.

Demand tends to be more inelastic. . .
Nature of the good (has to be necessity).
Time: the shorter the time period
(Consumption can’t be postponed).
the fewer the number of close substitutes
Proportion of income spent on the good
(has to be small like that of salt unlike car).
The more broadly defined the market (Ex: The
broader the definition, the lower the elasticity. For example, Company X's doughnut
will have a relatively high elasticity, where as food in general will have an extremely
low elasticity). Question: can you find a close substitute for food?
Number of alternative uses of the good
Addiction (habit forming)
3. Unitary Price Elasticity

P D
P1 ep =1

P2

D
Q
Q1 Q2

Quantity demanded changes by the same

percentage as the price
Figure 1 The Price Elasticity of Demand

(3) 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.

Copyright©2003 Southwestern/Thomson Learning

P D
P1 ep > 1

P2

D
Q
Q1 Q2

Quantity demanded responds strongly to changes

in price (ep>1) . Ex: furniture, soup, shewa bread, cars, etc
 Figure 1 The Price Elasticity of Demand

(4) 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.

 5. Perfectly Elastic demand

P
P0 D ep = 

Q1 Q2 Quantity

Quantity demanded changes infinitely with any change in

price (the good has very large number of close substitutes).
Ex: paper clips
 Figure 1 The Price Elasticity of Demand

(5) 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.
Demand tends to be more elastic. . .
Nature of the good (if it is a luxury).
the longer the time period.
the larger the number of close substitutes.
the more narrowly defined the market.
Linear demand curve and price elasticity of demand
Elasticity Varies with Price Range—more
elastic toward top left; less elastic
Price 4 D
at lower right
ep > 1
3 B
Elastic

2 M ep = 1

Unitary
1 E ep < 1 Elastic
D1
o 1 2 3 4 Quantity
Inelastic

Elasticity of demand and price elasticity of demand

 Price Elasticity
The demand curve can be
Price a range of shapes each of
which is associated with
a different relationship
between price and the
quantity demanded.

Quantity Demanded
2.5.1.2 Income Elasticity of Demand
It measures percentage change in quantity
demanded due to certain percentage change in
income of the consumer

ey = (Qd/Qd ) x 100 Note

If ey >0 = normal good
( y/y)x 100 If ey b/n 0&1 = necessity
ey = [(Q2 - Q1)/Q1)] x 100 Ifey>1= luxury
[(Y2 - Y1)/Y1] x 100 If ey <0 = inferior good

 Q2  Q1   Y1 
ey =   x 
Y  Y   Q 
 2 1   1

where Q1 is quantity demanded at income level Y1

and Q2 is quantity demanded at income level Y2
Examples
 2.5.1.3 Cross Price Elasticity of Demand
Measures the percentage change in quantity
demanded of a commodity, (say X) due to
percentage change in price of the other
commodity, (say Y)

exy = (Qdx) / Qdx = Qdx x Py

 py/py py Qx
 Q
 x 2  Q x 1 
  P y1 
exy =  P
  P 

x 
 Q 
y 2 y 1

 x1 
where Note
If exy >0 = substitute
Qdx is change in quantity demand of x.
If exy <0 = complementary
py is change in price of commodity y
If exy =0--no relation
Qxd is quantity demanded of x at particular price
Ex. Demand schedule for good X and Y
Points Px Py Qx Qy
A 2 3 18 13
B 4 5 12 9
C 5 6x 10 4

 Q  Q 

 P
x 2 x 1

  P y1 
exy =  y 2  P y 1  x  
 Q 
 x1 
Using the above information

1. Compute exy considering movement from A to B

2. Compute exy considering movement from B to A

Results
from A to B
12  18  3 = 6 x 3
e xy    = -½
(5  3  18 2 18
from B to A
5
exy = 18  12 x . = 6/-2 x 5/12 = -5/4
  12
(3  5) 

Arc cross price elasticity is used In order

to avoid the discrepancy

(Q x2 Qdx1) (Py2 Py1)

(exy) = x
(Py2 Py1) (Qdx2 Qdx1)
2.5.3 Application of Elasticity of demand
 A good with elastic demand
 Increase price >>> decreased total revenue
 Decrease price >>> increase total revenue
 A good with inelastic demand
 Increase price >>> increase revenue
 Decrease price >>>> decrease revenue
 A good with unitary elastic demand
 Increase/decrease price >>> no change in revenue
Total Revenue Test for Elasticity
 Total Revenue is the amount the seller receives from the
buyer from the sale of a product; P x Q = TR

 Elasticity and total revenue are related; observe the effect

on total revenue when product price changes
2.5.2. Elasticity of Supply
2.5.2.1.Price Elasticity of Supply
 Elasticity of supply measures %ge change in
quantity supplied (Qs) due to certain %ge change
in the determinants of supply including price of a
commodity.
 Es is positive & it may vary from 0 to  (Law of
Supply tells us this number is generally positive).
s p Q2s Q1s  P 1 (Point price elasticity of
Q x   x
es = = P P  s
supply)
s
P Q  2 1  Q1

Where es = Price elasticity of supply

Qs = Change in quantity supply
P1 = price of a commodity
Qs = quantity supplied at a particular price.
 If es = 0 it is called perfectly inelastic supply
S
P1
Quantity supplied does
Price P2 es = 0 not respond to price
changes at all. Ex hotel
Q Quantity
rooms, Picasso painting
Fig 2.26 perfectly inelastic supply curve
 If es =  i.e p = 0 then it is called a perfectly
elastic supply

P es = 
Quantity supplied changes
P0 S
infinitely with any change in
price. That means at any
price above the price noted,
Q1 Q2 Q Qs is unlimited. Ex. supply of
Fig2.27 perfectly elastic supply curve tickets for sports or musical
venues
 If 0 < es < 1, it is called inelastic supply
P S
 Quantity supplied does not
respond strongly to price
0 < es < 1 changes.
S
Q

 If es = 1 it is called unitary elastic

 Quantity supplied
S
changes by the same
P es = 1 percentage as the
price.

0 Q
 If es > 1, it is called elastic supply

P P
S
es > 1
S
Q

 Quantity supplied responds strongly

to changes in price.
 Factors affecting elasticity of supply
 Generally, anything that can affect a firm’s ability to change
production easily will effect the elasticity of supply.

 Time:
 the market period: occurs when the time immediately after
a change in price is too short for producers to respond with
a change in quantity supplied. The supply will be perfectly
inelastic.
 the short run implies that the plant capacity will be fixed,
but variable costs (labor, materials) can be added to
increase production if price rises.
 the long run is a time period long enough for the firm to
adjust both its fixed plant capacity as well as variable
resources. (The ability to be responsive means that a smaller price
rise can bring forth a larger output increase than in the short run).
 Few facts about elasticity of supply
 Availability of resources: if resource is very scarce then the
supply tends to be more inelastic.

 Number of producers: High no. of producers>>high supply>>

elastic.

 Ease of storing stocks: The type of good that a producer

supplies will affect elasticity. Ex. Perishable vs corrugated iron
sheet.

 Increase in cost of production as compared to output.

 Improvements in Technology.

 Stock availability of finished goods.

Importance of Elasticity of
Demand & Supply
 Relationship between changes
in price and total revenue

 Importance in determining
what goods to tax (tax revenue)

 Importance in analyzing time lags in

production

 Influences the behavior of a firm

 If the good is elastic >>>>producer can increase its
sales by reducing price & the vice versa.
 Consider the following

• Can good news for construction be bad news for

builders/real estate developers?

• What happens to real estate developers and the

market for real estate when university
researchers discover a new building material
that is more cost-effective than existing ones?

• If a mason is considering increasing his price for

a masonry from Birr 200 to Birr 250, will profits
rise or fall?
 Let’s attempt the following!
• The demand function for Noug oil is derived to be:
Q = 1200 – 9.5p +16.2pp + 0.2Y
where Q is the quantity of noug oil demanded in thousands of
metric tons per year, p is the price of noug oil in cents per
kilogram, pp is the price of palm oil in cents per kilogram
and Y is income of consumers. Assume that p is initially
45cents per kilogram, pp is 31 cents per k.g., Y is Birr10,000
and Q is 1,275 thousand metric tons per year.
 
• Calculate the price, cross-price and income elasticities of
demand for coconut oil.
 Let’s attempt the following!
• Answer
 Let’s attempt the following!
• A perfectly competitive industry has identical firms and
identical consumers. Each consumer earns $10,000 a year.
 The demand curve is Q = 100 – 5P.
 The supply curve is Q = 20 + 3P.

A. What is the equilibrium price?

B. What is the equilibrium quantity?
C. What is the price elasticity of demand at the equilibrium price?
D. What is the price elasticity of supply at the equilibrium price?
E. If consumers earn $11,000 a year, their demand curve
changes to Q = 104 – 4P. What is the income elasticity of
demand at an income of $10,000?