Chapter 3

Elasticity of demand and supply

Elasticity of demand
 How much change in quantity demanded occurs due to percentage change in other factors
 The symbol  is used to represent elasticity
Types of elasticity of demand
 Price elasticity of demand
 Income elasticity of demand
 Cross-price elasticity of demand or elasticity of demand between related goods
Price elasticity of demand
 Proportionate change in quantity demanded due to proportionate change in price
 Ed = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 demande𝑑 / 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 in its price
 𝐸d= 𝑄2 − 𝑄1 / 𝑄2 + 𝑄1 / 2 ÷ 𝑃2 − 𝑃1 / 𝑃2 +𝑃1 / 2
Degrees of price elasticity of demand
 They are all used to calculate how a change in the price of the good affects the quantity demanded
Elastic demand
 Percentage change in quantity demanded is greater than percentage change in its price
 An increase in price will decrease revenue due to the decrease in quantity demanded more than
increase in price
 A decrease in price will increase revenue due to the increase in quantity demanded more than
offsetting the decrease in price
 Price and revenue move in opposite directions
Inelastic demand
 Percentage change in quantity demanded is lesser than percentage change in its price
 An increase in price will increase revenue due to the decrease in quantity being more than
compensated by the increase in price
 A decrease in price will decrease revenue as the increase in quantity demanded fails to
compensate the fall in price
 Price and revenue move in the same direction
Unit elastic
 Percentage change in quantity demanded is equal to the percentage change in its price
 Revenue remains unchanged by price change because the change in price is cancelled by the
change in quantity. The total expenditure method offers a simple solution to ascertaining whether
or not a good has elastic, inelastic or unitary demand
Perfectly elastic
 Smallest price change will affect the quantity demanded largely
Perfectly inelastic
 Quantity demanded is unaffected by price changes totally

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Methods for measuring elasticity of demand
 Total expenditure method Total outlay (expenses) method or Total revenue method
 Percentage method
 Geometric method
Total expenditure method Total outlay (expenses) method or Total revenue method
 Compares the total revenue (price  quantity) at one price level to the total revenue at another
Categories of elasticity of demand
Relatively elastic demand
 A small decrease in price will increase the total consumer’s expenditure due to the large increase
in quantity demanded
Symbolic representation
 η>1
Table representation
Price Quantity demanded Total consumer’s expenditure
2 3 6
1 8 8
Graphical representation

Relatively inelastic demand

 A large increase in price will decrease the total consumer’s expenditure due to the small decrease
in quantity demanded
Symbolic representation
 η<1
Table representation
Price Quantity demanded Total consumer’s expenditure
3 2 6
5 1 5
Graphical representation

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Unit elastic demand
 An equal change in price and demand will keep the total consumer’s expenditure constant
Symbolic representation
 η=1
Table representation
Price Quantity demanded Total consumer’s expenditure
1 2 2
2 1 2
Graphical representation

Quantity
Percentage method
 Explains that, how much elastic the demand is due to price
 Describes the ratio between percentage change in quantity demanded to percentage change in its
price
Formula
 Elasticity of demand = percentage change in quantity demanded / percentage change in price
 η = 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑚 𝑜𝑓𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑖𝑒𝑠 / 2 ÷ 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑠𝑢𝑚 𝑜𝑓𝑝𝑟𝑖𝑐𝑒𝑠/2
Relatively elastic demand
 Percentage change in quantity demanded is greater than percentage change in its price
Symbolic representation
 η > 1
Relatively inelastic (less elastic) demand

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  Percentage change in quantity demanded is lesser than percentage change in its price
Symbolic representation
 η < 1
Unit elastic demand
 Percentage change in quantity demanded is equal to the percentage change in its price
Symbolic representation
 η = 1
Types of percentage method
 Point elasticity of demand
 Arc elasticity of demand
Point elasticity of demand
 Measures elasticity of demand on a very small change in price
 There is small change in the quantity demanded of a product due to a small change in its price
 There will appear just a point on the demand curve
 Nominal changes occur
Formula
 η = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 / 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐e
 η = 𝑄1−𝑄0 / 𝑄0 ×100 / 𝑃1−𝑃0 / 𝑃0 ×100
Graphical representation

Arc elasticity of demand

 Measures elasticity of demand on a large change in price
 There is large change in the quantity demanded of product due to a small change in its price
 There will appear two points on the demand curve
 Considerable changes occur
Formula
 η = Q1 − Q0 / Q1 + Q0 × 𝑃1 +𝑃0 / 𝑃1 −𝑃0
Graphical representation

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Geometric method
 Measure elasticity of demand at any pint on the demand curve
Formula
 η = 𝐿𝑜𝑤𝑒𝑟 𝑝𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒 / 𝑈𝑝𝑝𝑒𝑟 𝑝𝑎𝑟𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣e
Graphical representation

Relatively elastic demand

 lower part of demand curve is greater than upper part of demand curve
Relatively inelastic demand
 Lower part of demand curve is smaller than upper part of demand curve
Unit elastic demand
 Lower part of demand curve is equal to the upper part of demand curve
Perfectly elastic demand
 Small change in price causes a large change in demand
Perfectly inelastic demand
 Large change in price causes no change in demand
Types of elasticity of demand
 Price elasticity of demand Proportionate change in quantity demanded due to proportionate
change in price
 Income elasticity of demand Proportionate change in quantity demanded due to proportionate
change in income
 Cross-elasticity of demand or elasticity of demand between related goods
Proportionate change in quantity demanded for good X due to proportionate change in price of
good Y
Cross price elasticity of demand
 Proportionate change in quantity demanded of good x due to proportionate change in price of
good y
Formula

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Types of cross price elasticity of demand
 Positive cross price elasticity of demand (in case of substitutes)
 Negative cross price elasticity of demand (in case of complements)
Positive cross price elasticity of demand
 Proportionate increase in demand of good x due to proportionate increase in price of good y
 There is a direct relationship between demand of good x and price of good y. Therefore, it is
called positive cross price elasticity of demand
Negative cross price elasticity of demand
 Proportionate decrease in demand of good x due to proportionate increase in price of good y
 There is an inverse relationship between demand of good x and price of good y
Income elasticity of demand
 Proportionate change in demand of goods due to proportionate change in income of consumer
Formula

Types of income elasticity of demand

 Positive income elasticity of demand (in case of normal goods)
 Negative income elasticity of demand (in case of inferior goods)
Positive income elasticity of demand
 Proportionate increase in demand of goods due to proportionate increase in income of consumer
 There is direct relationship between demand of normal goods and income of consumer.
Therefore, it is called positive income elasticity of demand
Negative income elasticity of demand
 Proportionate decrease in demand of inferior goods due to proportionate increase in income of
consumer
 There is an inverse relationship between demand of inferior goods and income of consumer.
Therefore, it is called negative income elasticity of demand
Determinants / factors affecting elasticity of demand
 Availability of substitutes and complements
 Demand for necessities is inelastic and for luxuries is elastic
 Demand of good is inelastic due to brand loyalty
 Demand of good is inelastic on which smaller proportion of income of consumer is spent
 Time period for switching from one product to another product
Practical importance of elasticity of demand
Consumers
 Price of goods having elastic demand is not high because people can go towards their substitute
 Price of goods having inelastic demand can be high because people cannot go to other goods due
to being necessities
Producers
 Price of goods having elastic demand is kept low to retain the buyers

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  Price of goods having inelastic demand is kept high because producer know people cannot go to
any other good due to being necessities
Government
 Tax on goods having elastic demand can decrease the revenue
 Tax on goods having inelastic demand can increase the revenue
Transportation
 Demand of transport having substitute is elastic. Therefore fare is low
 Demand of transport not having substitute is inelastic. Therefore fare is high
Balance of payments
 Price of goods having inelastic demand internationally are high
 Prices of goods having elastic demand internationally are low
Economic recessions
 Elasticity helps firms to predict, that which product with what intensity will hit during recession,
when the income shrinks. Accordingly, firm can change their decision to avoid their losses
Elasticity of supply
 How much change in quantity supplied occurs due to percentage change in other factors
Price elasticity of supply
 Proportionate in supply due to proportionate change in its price
Formula
 E𝑠 = 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 / 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑡𝑠 𝑝𝑟𝑖𝑐e
 𝐸𝑠 = 𝑄2 − 𝑄1 / 𝑄2 + 𝑄1 / 2 ÷ 𝑃2 − 𝑃1 / 𝑃2 +𝑃1 / 2
Categories of elasticity of supply
Elastic supply
 Percentage change in quantity supplied is greater than percentage change in price
 PES>1
Graphical representation

Inelastic supply
 Percentage change in quantity supplied is smaller than percentage change in price
 PES<1
Graphical representation

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Unit elastic supply
 Percentage change in quantity demanded is equal to the percentage change in its price
 PES=1
Graphical representation

Perfectly elastic supply

 Smallest price change will affect the quantity supplied largely
 PES= ∞
Graphical representation

Perfectly inelastic
 Quantity supplied is unaffected by price changes totally
 PES=0
Graphical representation

Determinants / factors affecting elasticity of supply

 Supply is elastic due to greater number of firms
 Supply is elastic due to great amount of stock
 Supply is elastic with spare capacity of existing resources
 Supply is elastic with due to ability of firm to switch its factors of production from one good to
another good
 Supply of goods requiring less time for their production is elastic
Elasticity of supply and time
Monetary period Short period Long run
 Supply is inelastic due  Supply is relatively  Supply is highly inelastic
to having very less time inelastic due to having due to having greater
to change the output ability to do little time to do major
alterations in techniques adjustments e,g changing
of production and with the structure of building /
efficient use of plant size etc.

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 resources, supply can be
adjusted to little extent

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