Price Elasticity of
Demand and Supply
• Key Concepts
• Summary
©2005 South -Western College Publishing
What will this chapter
teach me?
This chapter teaches you to
calculate the percentage
change in the quantity
demanded when the price
changes by a given
percentage. Then you will
see how this relates to
total revenue.
2
How is the percent
increase or decrease
of two numbers
calculated?
Percent change is the
difference between the
two numbers divided by
the original number
3
What is elasticity?
A term economists use to
describe responsiveness,
or sensitivity, to a change
in price
5
Suppose the price of
a rock concert
increases by 10%,
what effect will this
have on sales?
That all depends on the
price elasticity of demand
for this rock concert
4
What is price
elasticity of demand?
The ratio of the
percentage change in the
quantity demanded of a
product to a percentage
change in its price
6
1
Price Elasticity of Demand
% ∆ in Q demanded
% ∆ in price
Ed =
Supposing a university’s
enrollment drops by 20%
because tuition rises by
10%, what is the price
elasticity of demand?
7
8
Why is elasticity 2 in
the previous example
and not -2?
Ed =
-.20
-20%
=
=
+10%
+.10
2
9
If there is an
increase from 3 units
to 5, what is the
percentage increase?
2/3 = 66%
Economists drop the
negative sign because we
know from the law of
demand that quantity
demanded and price are
inversely related
10
If there is a decrease
from 5 units to 3, what
is the percentage
decrease?
2/5 = 40%
11
12
2
P
Problem - When we
move along a demand
curve between two points,
we get different answers to
elasticity depending on
whether we are moving up
or down the demand curve
A
2
B
D
3
Q
13
Economists can solve this
problem of different base
points by using the midpoints
as the base points of
changes in prices and
quantity demanded
14
Price elasticity equals the
∆ in quantity demanded
sum of quantities/2
divided by
∆ in price
sum of prices/2
15
16
P
What is elastic demand?
$40
A condition in which the
percentage change in
quantity demanded is
greater than the
percentage change in price
$30
17
Elastic Demand Ed > 1
A
B
$20
$10
10
20
30
40
Q
18
3
Elastic Demand
Why is the demand
curve in the previous
slide elastic?
Increase in
total revenue
The percentage change
in the quantity
demanded is greater
than the percentage
change in price
Price
decrease
19
% change in Q = 10 = .66
15
% change in P = 10 = .40
25
%
change
in
Q .66
Ed =
=
% change in P
.40
Ed = 1.65
21
Why is the demand
curve in the previous
slide inelastic?
The percentage change in
the quantity demanded is
less than the percentage
change in price
23
20
$40
$30
Inelastic Demand Ed < 1
A
B
$20
$10
10
20
30 40
22
Inelastic Demand
Decrease in
total revenue
Price
decrease
24
4
5
= .38
13
10
% change in P =
= .40
25
% change in Q .38
Ed =
% change in P = .40
% change in Q =
What is a unitary
elastic demand curve?
The percentage change in
the quantity demanded is
equal to the percentage
change in price
25
Unitary Elastic Demand E d = 1
$40
$30
26
Unitary Elastic Demand
No change in
total revenue
E
F
$20
D
Price
decrease
$10
10
20
30 40
27
What is a perfectly
elastic demand curve?
29
$40
$30
$20
$10
Perfectly Elastic Demand Ed =
8
A condition in which a
small percentage
change in price brings
about an infinite
percentage change in
the quantity demanded
28
10
20
30 40
30
5
Perfectly Elastic Demand
What is a perfectly
inelastic demand curve?
Infinite change in
quantity demanded
A condition in which the
quantity demanded
does not change as
the price changes
Price change
31
Perfectly Inelastic Demand Ed = 0
$40
$30
32
Perfectly Inelastic Demand
Zero change in
quantity demanded
$20
$10
Price change
10
20
30 40
33
If a college raises
tuition, what happens
to revenue?
If demand is elastic total revenue goes down
If demand is inelastic total revenue goes up
35
34
If price increases and
the revenue gained is
greater than the
revenue lost, the
demand curve is price
inelastic, < 1
36
6
If total revenue does
not change when
price increases, the
demand curve is
unitary elastic,
value equals 1
If price increases and
the revenue gained is
less than the revenue
lost, the demand curve
is price elastic, > 1
37
5 10 15 20 25 30 35 40 45
39
What factors influence
demand sensitivity?
• Availability of substitutes
• Share of budget on the
product
• Adjustment to a price
change over time
41
Total Revenue Curve
Ela
sti
c
$400
$350
$300
$250
$200
$150
$100
$50
tic
las
Ine
Price Elasticity of
$40
Ela Demand Ranges
$35
sti
c
$30
$25
Ine
$20
las
Un
$15 e ita
tic
$10 lasti ry
c
$5
38
Unitary
Elastic
5 10 15 20 25 30 35 40 45
40
What do substitutes
have to do with a
price change?
The more substitutes a
product has, the more
sensitive consumers are
to a price change, and
the more elastic the
demand curve
42
7
A
P
P
D
D
0
Q
B
0
Q
Which demand curve is for a vital
medicine and which is for candy?
43
Why is B the demand
curve for candy?
Because candy has
many substitutes, a
price change can bring
about a big change in
the quantity demanded
45
What does time have
to do with sensitivity?
The longer consumers
have to adjust, the more
sensitive they are to a
price change, and the
more elastic the
demand curve
47
Why is A the demand
curve for medicine?
Because medicine is a
necessity with few
substitutes, and the
price can change with
little effect on the
quantity demanded
44
What does the share
of one’s budget
have to do with a
price change?
The larger the purchase is
to one’s budget, the
more sensitive
consumers are to a price
change, and the more
elastic the demand curve
46
What are other
elasticity measures?
Income elasticity of demand
Cross-elasticity of demand
48
8
What is Income
elasticity of demand?
The ratio of the percentage
change in the quantity
demanded of a good to a
given percentage change
in income
Income Elasticity of Demand
Ed =
% ∆ in Q demanded
% ∆ in income
49
What is crosselasticity of demand?
The ratio of the
percentage change in
quantity demanded of a
good to a given
percentage change in
price of another good
50
Cross-elasticity of Demand
% ∆ Q demanded of good A
% ∆ price of good B
Ec =
51
What is the price
elasticity of supply?
52
Price Elasticity of Supply
The ratio of the percentage
change in the quantity
supplied of a product to
the percentage change in
its price
53
Es =
% ∆ in Q supplied
% ∆ in price
54
9
$40
$30
$40
$30
$20
8
$20 Perfectly Elastic Supply =
$10
$10
10
$40
$30
$20
Perfectly Inelastic Supply Es = 0
20
30 40
Unit Elastic Supply Es = 1
S
.5%
.5%
$10
10
20
30 40
20
30 40
56
Who pays the tax
levied on sellers of
goods such as
gasoline, cigarettes,
and alcoholic
beverages?
It all depends; the
corporation pays all, some,
or very little of the tax
57
58
Partially shifted tax to buyers
What decides who
pays what part of
the tax increase?
The more elastic the
demand, the more the
corporation pays; the
less elastic the
demand, the more the
consumer pays
10
55
$2.00
$1.7
$1.50
5
$1.25
$1.00
$.75
$.50
$.25
59
s2
Buyers
Sellers
s1
D
5 10 15 20 25 30 35 40 45
60
10
Fully shifted tax to buyers
$2.00
$1.75
$1.50
$1.25
$1.00
$.75
$.50
$.25
Consumers and
suppliers share
burden of tax
Decrease in
supply
Increase in
gasoline tax
61
s2
s1
Buyers
D
5 10 15 20 25 3035 40 45
62
Consumers bear
full burden of tax
Summary
Decrease in
supply
Increase in
gasoline tax
63
Price elasticity of demand is a
measure of the responsiveness of
the quantity demanded to a change
in price. Specifically, price elasticity
of demand is the ratio of the
percentage change in quantity
demanded to the percentage
change in price.
65
64
Price Elasticity of Demand
Ed =
% ∆ in Q demanded
% ∆ in price
66
11
Price elasticity equals the
∆ in quantity demanded
sum of quantities/2
What is the midpoint formula for the
price elasticity of demand?
divided by
∆ in price
sum of prices/2
67
Elastic demand is a change of more
than one percent in quantity
demanded in response to a one
percent change in price. Demand is
elastic when the elasticity
coefficient is greater than one and
total revenue (price time quantity)
varies inversely with the direction of
the price change.
68
Elastic Demand
$40
$30
$20
$10
10
69
Inelastic demand is a change of
less than one percent in quantity
demanded in response to a one
percent change in price. Demand
is inelastic when the elasticity
coefficient is less than one and
total revenue varies directly with
the direction of the price change.
71
20
30 40
70
Inelastic Demand
$40
$30
$20
$10
10
20
30 40
72
12
Unitary elastic demand is a one
percent change in quantity
demanded in response to a one
percent change in price. Demand is
unitary elastic when the elasticity
coefficient equals one and total
revenue remains constant as the
price changes.
Unitary elastic Demand
$40
$30
$20
$10
10
73
74
$40
$30
$20 Perfectly Elastic Supply =
$10
10
75
Perfectly inelastic demand is no
change quantity demanded in
response to price changes. This is
an extreme case in which the the
demand curve is vertical and the
elasticity coefficient equals zero.
30 40
8
Perfectly elastic demand is a
decline in quantity demanded to
zero for even the slightest rise or
fall in price. This is an extreme case
in which the demand curve is
horizontal and the elasticity
coefficient equals infinity.
20
$40
20
30 40
76
Perfectly Inelastic Supply Es = 0
$30
$20
$10
77
10
20
30 40
78
13
Determinants of price elasticity of
demand include (a) the availability
of substitutes, (b) the percentage of
budget spent on the product, and
(c) the length of time allowed for
adjustment. Each of these factors is
directly related to the elasticity
coefficient.
Income elasticity of demand is the
percentage change in quantity
demanded divided by the
percentage change in income. For
a normal good or service, income
elasticity of demand is positive. For
an inferior good or service, income
elasticity of demand is negative.
79
80
Cross elasticity of demand is the
percentage change in the quantity
demanded of one product caused
by a change in the price of another
product. When the cross-elasticity
of demand is negative, the two
products are complements.
Price elasticity of supply is a
measure of the responsiveness of
the quantity demanded to a
change in price. Price elasticity of
supply is the ratio of the
percentage change in quantity
supplied to the percentage
change in price.
81
82
Tax incidence is the share of a
tax ultimately paid by buyers and
sellers. Facing a downwardsloping demand curve and an
upward-sloping supply curve,
sellers cannot raise the price by
the full amount of the tax. If the
demand curve is vertical, sellers
will raise the price by the full
amount of a tax.
83
$2.00
$1.75
$1.50
$1.25
$1.00
$.75
$.50
$.25
Fully shifted tax to buyers
Buyers
s2
s1
D
5 10 15 20 25 3035 40 45
84
14
Partially shifted tax to buyers
$2.00
$1.75
$1.50
$1.25
$1.00
$.75
$.50
$.25
Buyers
Sellers
s2
s1
END
D
5 10 15 20 25 30 35 40 45
85
15