ELASTICITY OF DEMAND

AND SUPPLY
 OBJECTIVES
•After reading this chapter, you should be able to:
(i) Define price elasticity of demand and supply, income elasticity of
demand, and cross elasticity of demand and supply.
(ii) Compute price elasticity of demand, income elasticity and cross
elasticity.
(iii) Interpret the coefficients of price, cross and income elasticity of
demand
(iv) Explain the determinants of elasticity of demand and elasticity of
supply.
• Describe the relationship between the price elasticity of demand and
total revenue.
 Introduction
•In previous lectures, among other things, it has been shown that the
demand for a particular commodity depends on the price of that
commodity, consumer’s income and on the prices of other commodities.

•Similarly, supply depends on price, as well as on the variables that

affect the cost of production. Generally, it has been shown that if the
price of a commodity X increases, the quantity demanded of that
particular commodity will fall, ceteris peribus.
• However, quite often we are interested to know by how much the
quantity supplied or demanded for a particular commodity will
rise or fall following the changes in the price of the commodity.
Cont…
• For example, how sensitive is the demand for sugar to its price?
Suppose that the price of sugar is increased by 10 percent, by how
much will quantity demanded change?
•The concept of elasticity is very useful in answering those questions.
Cont..

Elasticity refers to the responsiveness of one variable to changes in another

variables.
When price rises, what happens to demand?
Demand falls
BUT! How much does demand fall?
For instance, If price rises by 10% - what happens to demand?
We know demand will fall; By more than 10%? By less than 10%?
Therefore, Elasticity measures the extent to which demand will change

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 Types of Elasticity of Demand

i.Price elasticity of demand

ii.
Income elasticity of demand
iii.
Cross elasticity of demand
 Price elasticity of demand is defined as the degree measure of responsiveness
of demand for a commodity to the change in its price. It indicates the extent to
which demand changes when price of the commodity changes.
 It can be expressed as follows;

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Cont...

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Cont...
Where;
 ∆Q= Q1 – Q0 represents a change in quantity demanded,
∆P= P1 – P0 shows a change in price.
P0 represents the original price
Q1 represents the current quantity demanded.
Note that, the minus sign is inserted in the formula before the
fraction to make elasticity coefficient a non –negative value.
As we have already seen, the coefficient of price elasticity of
demand has a negative sign due to the inverse relationship
between price and quantity demanded. In terms of
interpretation, the negative sign is ignored and only absolute
value is considered.
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Measurement of Price Elasticity
• There are two ways of measuring the price elasticity of demand
i. point elasticity of demand
ii. arc elasticity of demand

• Point Elasticity of Demand

• The point elasticity of demand is defined as the proportionate change
in the quantity demanded resulting from a very small proportionate
change in price.
Cont…
•Arc Elasticity of Demand
• Arc elasticity is a measure of average elasticity. It is the elasticity
between two points on a demand curve.

•
Example
Point Px (T.Shs) Qx

A 7 500

B 6 750

C 5 1,250

D 4 2,000

F 3 3,250

G 2 4,750

H 1 8,000
Cont…
• What is the point elasticity when the price changes from 5 to 3?
• What is the arc elasticity when the price changes from 5 to 3?
 Interpretation of Price Elasticity Coefficients
 Inelastic demand. Demand is said to be inelastic if a larger change in price leads to
a small change in quantity demanded (Ed<1).
 Elastic demand. Demand is said to be elastic if a small change in price leads to a
greater change in quantity demanded ( Ed>1)

P Inelastic demand P Elastic demand

10
8
6
2
D

D
5 7 4 10 Q
Q
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 Cont...
 Unitary Demand. Demand is said to be unitary when the percentage change in
price and the resulting percentage change in quantity demanded are the same
(Ed=1)
 Perfectly inelastic. Demand is said to be perfectly inelastic when the quantity
demanded do not respond to price changes (Ed=0).i.e. Consumers are very
insensitive to price change.
Perfectly inelastic demand
P Unitary demand P
D

8 8

4
2

3 6 Q 10 Q

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 Cont...
 Perfectly elastic demand. Demand is said to be perfectly elastic when
price does not respond to changes in quantity demanded (Ed=∞).

P
Perfectly elastic demand

10 D

2 8 Q

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 Determinants of Price elasticity of Demand:What determines
whether the demand for a good is elastic or inelastic?

Nature of commodity such as Necessities versus Luxuries.

Necessities tend to have inelastic demands, whereas luxuries
have elastic demands.
Time factor, Goods tend to have more elastic demand over
longer time horizons. When the price of gasoline rises, the
quantity of gasoline demanded falls only slightly in the first few
months. Over time, however, people buy more fuel-efficient
cars, switch to public transportation, and move closer to where
they work.
Availability of Close Substitutes ,Goods with close substitutes
tend to have more elastic demand because it is easier for
consumers to switch from that good to others. Vice versa is
true for goods with no substitutes

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Cont...

Proportional of personal income spent on a commodity. The smaller the

proportion of income spent on a commodity, the more inelastic of demand and
vice versa. e.g. The demand for salt is inelastic because an increase in the price of
salt do not change consumer’s consumption patterns.
Habit forming goods like cigarettes. Goods which affect people’s habit tend to
inelastic as compared to goods that does not affect people’s habit.

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 Income Elasticity of Demand

Income elasticity of demand is defined as the degree measure of responsiveness

of demand for a commodity to change in consumer’s income. It indicates the
extent to which demand changes when consumer’s income change.
Income elasticity of demand is expressed as:

%Q Q Y0
Yed   
%Y Y Q0

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Cont...

Where, Yed= income elasticity, Y=consumer’s income, ∆Q=change in quantity

demanded, ∆Y=change in consumer’s income, Y0 = initial consumer’s income, Q0
= initial quantity demanded
Interpretation of income elasticity is that;
A positive sign denotes a normal goods
A negative sign denotes an inferior goods
For instance,
Yed = - 0.6: Good is an inferior good
Yed = + 0.4: Good is a normal good

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Example

• Suppose quantity demanded increases by 4% when income

rises by 5%. What is the income elasticity of demand for this
good? Indicate if the good is normal or inferior.

• Since the income elasticity of demand is a positive number,

the good is a normal good.
• The income elasticity coefficient = 0.8 means that for every
1% increase in income, quantity demanded increases by 0.8%,
or for every 10% increase in income, quantity demanded
increases by 8%.
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NOTE

• When one’s money income rises (while everything else remains the
same), his demand curve for a normal good Rises.
• When one’s money income falls (while everything else remains the
same), his demand curve for an inferior good Increases.
• If good B is an inferior good, an increase in money incomes of
consumers will cause the demand curve for the good to: Decrease and
thus decrease its price.

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Cross Elasticity of Demand
 Cross Elasticity Is a degree measure of the responsiveness of
demand of one good to changes in the price of substitute or a
complementary good. E.g. Tea and coffee as substitute goods,
Sugar and Tea, as well as petrol and cars as complementary
goods.
Interpretation of cross elasticity of demand
a. If the value of cross elasticity between two goods is positive,
then two goods are said to be substitute.
b. If the value of cross elasticity between two goods is negative,
then two goods are said to be complementary.
c. Zero value means two goods are not related at all.

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Cont..

It can be expressed as;

Exy = Percentage change in Quantity demanded of good X
percentage change in the Price of good Y

Qx Py
E xy  
Py Qx

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Cont...
. Curve,1.shows two goods are
Py compliment: As the price of good Y
rises, the demand for good X falls
3
2 Curve,2.shows two goods are
substitute: As the price of
good Y rises, the demand for
good X rises

Curve,3.shows two goods are

not related: As the price of
good Y rises, the demand for
good X remains constant.
1

Dx

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 Relationship between Elasticity and Total Revenue

The relationship between price elasticity of demand and total

revenue is of particular importance to producers when
setting the price of the commodity.
It tells suppliers how their total revenue will change if their
price changes.
Total revenue equals total quantity sold multiplied by price of
good.

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Cont.…

The concept of price elasticity of demand is of great important to

producers as it helps them to know if an increase in the price will
result in:
an increase in the total amount spent by consumers on the product
in a decrease in the total amount spent by consumers on the
product
 The answers to these questions depend on the price elasticity of
demand.

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 Cont...
 If ED is elastic (ED > 1), a rise in price lowers total revenue (i.e. Price and total
revenue move in opposite directions)
 If ED is inelastic (ED < 1), a rise in price increases total revenue (i.e. Price and total
revenue move in the same direction)

P TR rises if price increases P TR falls if price increases

10 TR=50
TR=40
8
TR=60
TR=35 6
5
D

D
5 7 5 10 Q
Q
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Importance of the concept of elasticity

Importance to producers
Important to the government
Price discrimination by monopolists

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Elasticity of supply

The price elasticity of supply measures how much the quantity

supplied responds to changes in the price.
Supply is said to be inelastic if the quantity supplied responds
only slightly to changes in the price.
Supply of a good is said to be elastic if the quantity supplied
responds largely to changes in the price.
Economists compute the price elasticity of supply as;

Price elasticity of supply (Pes)= %∆ in Quantity Supplied

%∆ in Price

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Cont...

Thus; Qs P0
Pes  
P Q0

Factors Influencing Elasticity Of Supply

Nature of the commodity.
Perishable products can not be stored, and hence their supply does not respond in an
effective manner to the change in their price and thus their supply is inelastic in nature.
Durable products, on the other hand can be stored, hence their supply is generally elastic,
i.e. Supply responds to the changes in prices.

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Cont...
Time factor. In a very short period, the supply of most goods
tend to be fixed and inelastic while in the long run, the supply
of most products tends to be elastic because of increase in and
expansion of firms, new investments, improvement in
technology and greater availability of inputs.
Number of firms in the market. If the number of firms in the
market is small, supply of products tends to be inelastic while
the supply of commodities is said to be elastic if there is a large
number of firms in the market.
Production techniques. If the technique of production of a
commodity is advanced, complex and time-consuming in
nature it may not be possible to change supply in response to
price change and hence its supply will be inelastic.

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Problem

The accompanying table gives a part of the demand schedule for photo frames in
the United States (assume we know that demand is linear).

Price of a 4x6-inch photo Quantity demanded (million)

frame
$12 4

$10 6

$8 8

$6 10

$4 12

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Cont...

a. Calculate the price elasticity of demand when the price increases from $10 to
$12
b. What happens to the total revenue of photo frame producers when prices
increase from $10 to $12?
c. What happens to the total revenue of photo frame producers when prices
increase from $6 to $8?
d. What price should the producers of photo frames set in order to maximize total
revenue?

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 Elasticity involving Demand and Supply Functions:
Numerical Examples
A small technology company in Northern California is developing a tablet PC to
compete with Apple’s Ipad. Based on market surveys, the company believes the
quantity Q (in thousands of units) that will be demanded by consumers is related
to the price P (in thousands of dollars) by the relationship;
Q = 4000 - 250P2
Find the price elasticity of demand when the price of the tablet PC is $3.
To compute the price elasticity of demand, we need to find the derivative of the
demand function Q = 4000 - 250P2

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Cont...
Q
 500P
P

Q P0 P0
e X  500 P 
P Q0 4000  250 P 2

 500 P 2

But P=3 4000  250 P 2
So, Price elasticity of demand at that price = 2.57. The demand
is elastic (because is value is greater than one). As a
consequence, revenue will drop as the price increases.

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Example

Consider the following demand and supply functions;

 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?
Answers : A=10, B=50, C=1, and D=0.6

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 Example

a. Suppose you know that the price elasticity of demand for good X has a value of
2. Suppose that the price in the market is initially $10 and the quantity
demanded is 100 units. If price in this market decreases by 10%, what will be
the percentage change in the quantity demanded given the above information?
b. Find the new quantity that will be demanded as a result of a decrease in price
by 10%

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