Chapter 5:
Describing
Demand and
Supply: Elasticities
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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1
Chapter Objectives

1. Use the terms price elasticity of demand
and price elasticity of supply to describe the
responsiveness of quantity demanded and
quantity supplied to changes in price.

2. Calculate price elasticity of demand.

3. Interpret price elasticity of demand.
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2
Chapter Objectives

4. Explain the importance of substitution in
determining price elasticity.

5. Relate price elasticity of demand to total
revenue.
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3
Chapter Objectives

6a. Calculate and interpret income elasticity
of demand, cross-price elasticity of demand,
and price elasticity of supply.
6b. State how elasticity concepts are useful
in describing the effect of shift factors on
demand.

7. Calculate and interpret price elasticity of
supply.
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4
Chapter Objectives

8. Explain how the concept of elasticity
makes supply and demand analysis more
useful.
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5
Concept of Elasticity

Elasticity is a measure of the
responsiveness of one variable to another.

The greater the elasticity, the greater the
responsiveness.
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6
Price Elasticity of Demand

The price elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in price.

D
Percentage change in quantity demanded
=
Percentage change in price
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7
What Information Price Elasticity
Provides

Price elasticity of demand gives the exact
quantity response to a change in price.
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8
Things to Note About Elasticity

Price elasticity of demand is always negative
because price and quantity demanded are
inversely related—when price rises, quantity
demanded falls, and vice versa.
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9
Things to Note About Elasticity

By the Law of Demand, as price rises,
quantity demanded falls.


Inverse relationship
Elasticity tells us by how much quantity
falls.
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10
Things to Note About Elasticity

Economists therefore talk about price
elasticity of demand as an absolute value of
the number.

Thus, price elasticity of demand is reported
as a positive number.
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11
Classifying Demand as Elastic or
Inelastic

Demand is elastic if the percentage change
in quantity is greater than the percentage
change in price.
D > 1
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12
Classifying Demand as Elastic or
Inelastic

Demand is inelastic if the percentage
change in quantity is less than the
percentage change in price.
D < 1
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13
Elastic Demand

Elastic demand means that quantity
demanded changes by a greater percentage
than the percentage change in price.

Inelastic demand means that quantity doesn't
change much with a change in price.
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14
Elasticity Is Independent of Units

Elasticity is calculated as a ratio of
percentages.

Percentages allow us to have a measure of
responsiveness that is independent of units.
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Elasticity Is Independent of Units

Having a measure of responsiveness that is
independent of units makes comparisons of
responsiveness of different goods easier.
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16
Calculating Price Elasticity of
Demand

To determine price elasticity of demand,
divide the percentage change in quantity
demanded by the percentage change in
price.
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17
End-Point Problem

The end-point problem – the percentage
change differs depending on whether you
calculate the change as a rise or a decline in
price.
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18
End-Point Problem

Economists use the average of the end
points to calculate the percentage change.
(Q2 - Q1)
Elasticity = (P
2
- P1)
½Q2  Q1 
½P1 + P2 
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19
Graph of Price Elasticity of Demand
B
$26
24
22
20
18
16
14
0
C (midpoint)
A
D
Elasticity of demand
between A and B = .96
7
8
9
Quantity (in thousands)
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20
Graph of Price Elasticity of Demand
$10
9
8
7
6
5
4
3
2
1
B
D = 4
A
C
D = 0.54
D
5 10 15 20 25 30 35 40 45 50 55
Quantity
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21
Calculating Elasticity at a Point

Let us now turn to a method of calculating the
elasticity at a specific point, rather than over
a range or an arc.
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22
Calculating Elasticity at a Point

To calculate elasticity at a point, determine a
range around that point and calculate the arc
elasticity.
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23
Calculating Elasticity at a Point
(28 - 20)
$10
9
8
7
6
5
4
3
2
1
 =
D
(5 - 3)
½28  20
 0.66
½5 + 3
C
A
B
20 24 28
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40
Quantity
24
Calculating Elasticity at a Point
$10
9
8
7
6
5
4
3
2
1
Demand
A
εA = 2.33
ε B = 0.11
B
6
12 18 24 30 36 42 48 54 60 Quantity
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25
Elasticity and Demand Curves

Two important points to consider:

Elasticity is related to, but is not the same as
slope.

Elasticity changes along a straight-line demand
curve.
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26
Elasticity Is Not the Same as Slope

The steeper the curve at a given point, the
less elastic is demand.

There are two limiting examples of this.
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Elasticity Is Not the Same as Slope

When the demand curve is flat, we call the
demand perfectly elastic.

Perfectly elastic demand is a horizontal line in
which quantity changes enormously in
response to any change in price (D = ).
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28
Elasticity Is Not the Same as Slope

When the demand curve is vertical, we call the
demand perfectly inelastic.

Perfectly inelastic demand is a vertical line in
which quantity does not change at all in
response to a change in price (D = 0).
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Perfectly Inelastic Demand Curve
Perfectly inelastic
demand curve
0
Quantity
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Perfectly Elastic Demand Curve
Perfectly elastic
demand curve
0
Quantity
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Elasticity Changes Along Straight-Line
Curves

Elasticity is not the same as slope.

Elasticity changes along straight line demand
curves – slope does not.
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Elasticity and Slope
$10
9
8
7
6
5
4
3
2
1
Over the $3 to $4 price interval,
D (A to C on D1) = 0.47
while D (A to G on D2) = 4.2
G
C
A
D1
D2
10 20 30 40 50 60 70 80 90
Quantity
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33
Elasticity Changes Along Straight-Line
Curves


A demand curve is perfectly elastic ( D = ) at
the vertical (price) intercept.
Elasticity becomes smaller as you move down
the demand curve until it becomes zero ( =
0) at the horizontal (quantity) intercept.
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Elasticity Along a Demand Curve
Ed = 
Ed > 1
Price
$10
9
8
7
6
5
4
3
2
1
Elasticity declines along
demand curve as we move
toward the quantity axis
0
Ed = 1
Ed < 1
Ed = 0
1
2
3
4
5
6
7
8
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9 10 Quantity
35
Interpret Price Elasticity of Demand

We know by the law of demand that
consumers buy less as price rises.

Price elasticity of demand tells us if whether
consumers reduce their purchases by a lot
(elastic demand) or a little (inelastic demand).
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36
Price Elasticity of Demand: Review

Perfectly elastic – quantity responds
enormously to price changes (D = ).

Elastic – the percentage change in quantity
demanded exceeds the percentage change
in price (D > 1).
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Price Elasticity of Demand: Review

Unit elastic – the percentage change in
quantity demanded is the same as the
percentage change in price (D = 1).
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Price Elasticity of Demand: Review

Inelastic – the percentage change in quantity
demanded is less than the percentage
change in price (D < 1).

Perfectly inelastic – quantity does not
respond at all to price changes (D = 0).
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Interpret Price Elasticity of Demand
D
Description of
demand
Interpretation
D=
Perfectly elastic
Quantity responds enormously to
changes in price
D>1
Elastic
Consumers are responsive to price
changes
D=1
Unit elastic
Percent change in price and quantity are
equal
D<1
Inelastic
Consumers are unresponsive to price
changes
D=0
Perfectly inelastic
Consumers are completely unresponsive
to price change
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40
Substitution and Price Elasticity of
Demand

As a general rule, the more substitutes a
good has, the more elastic is its supply and
demand.
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Substitution and Price Elasticity of
Demand

How many substitutes a good has is affected
by many factors:




Time to Adjust
Luxuries versus Necessities
Narrow or Broad Definition
Budget Proportion
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42
Time to Adjust

The larger the time interval considered, or the
longer the run, the more elastic is the good’s
demand curve.

There are more substitutes in the long run than in
the short run.

The long run provides more options for change.
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43
Luxuries versus Necessities

If a good is a necessity, the less elastic its
demand curve.

Necessities tend to have fewer substitutes
than do luxuries.
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Narrow or Broad Definition

Demand becomes more elastic as the
definition of a good becomes more specific.

A broadly defined good like transportation does not
have many substitutes so that demand will be
inelastic.

A more narrowly defined good like bus
transportation will have more substitutes.
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Budget Proportion

Demand for goods that represent a large
proportion of one's budget are more elastic
than demand for goods that represent a small
proportion of one's budget.
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Budget Proportion

Goods that cost very little relative to your total
expenditures are not worth spending a lot of
time figuring out if there is a good substitute.

It is worth spending a lot of time looking for
substitutes for goods that take a large portion
of one’s income.
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47
Empirical Estimates of Elasticities

The following table provides short- and longterm estimates of price elasticities of demand
for a number of goods.
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48
Short-Run and Long-Run Price
Elasticities of Demand
Product
Tobacco products
Electicity (household)
Health Services
Nodurable toys
Movies/motion pictures
Beer
Wine
University tuition
Price Elasticity
Short Run Long Run
0.46
1.89
0.13
1.89
0.20
0.92
0.30
1.02
0.87
3.67
0.56
1.39
0.68
0.84
0.52
—
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49
Price Elasticity of Demand and Total
Revenue

Total revenue is the total amount of money a
firm receives from selling its product.

Revenue equals total quantity sold multiplied by
the price of good.
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50
Price Elasticity of Demand and Total
Revenue

Knowing the price elasticity of demand is
useful to firms because from it they can tell
what happens to total revenue when they
raise or lower their prices.
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51
Price Elasticity of Demand and Total
Revenue


If demand is elastic ( D > 1), a rise in price
lowers total revenue.
Price and total revenue move in opposite
directions.
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Price Elasticity of Demand and Total
Revenue

If demand is unit elastic ( D = 1), a rise in
price leaves total revenue unchanged.
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Price Elasticity of Demand and Total
Revenue


If demand is inelastic ( D < 1), a rise in price
increases total revenue.
Price and total revenue move in the same
direction.
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Elasticity and Total Revenue
(a) Unit Elastic Demand
E=1
$10
TR constant
Price
8
F
6
Gained revenue
C
E
4
A
2
0
1
2
Lost
revenue
B
3
4
5
6
7
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8
9
Quantity
55
Elasticity and Total Revenue
(b) Inelastic Demand
E<1
$10
TR rises
Price
8
6
4
Gained
revenue
Lost
revenue
H
2
0
G
C
A
1
2
B
3
4
5
6
7
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8
9
Quantity
56
Elasticity and Total Revenue
$10
Price
8
6
(c) Elastic Demand
E>1
K
J
C
A
Gained
revenue
B
4
Lost
revenue
2
0
TR falls
1
2
3
4
5
6
7
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8
9
Quantity
57
Total Revenue Along a Demand Curve

With elastic demand – a rise in price lowers
total revenue.

With inelastic demand – a rise in price
increases total revenue.
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58
Total Revenue Changes Along a
Demand Curve
εD = 1
Inelastic range
εD < 1
0
Q0
Quantity
Total revenue
Elastic range εD > 1
0
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Q0
Quantity
59
Elasticity of Individual and Market
Demand

Market demand elasticity is influenced both
by:

The number of people who totally drop out when
price increases.

How much an existing consumer marginally
changes his or her quantity demanded.
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Elasticity of Individual and Market
Demand

Price discrimination occurs when a firm
separates the people with less elastic
demand from those with more elastic
demand.
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Elasticity of Individual and Market
Demand

Firms that price discriminate charge more to
the individuals with inelastic demand and less
to individuals with elastic demands.
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Elasticity of Individual and Market
Demand

Examples of price discrimination include:



Airlines’ Saturday stay-over specials.
The phenomenon of selling new cars.
The almost-continual-sale phenomenon.
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63
Other Elasticities of Demand

Two other demand elasticities are important
in describing consumer behaviour:

Income elasticity of demand.

Cross-price elasticity of demand.
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64
Income Elasticity of Demand

Income elasticity of demand – the percentage
change in demand divided by the percentage
change in income.
Percentage change in quantity demanded
=
Percentage change in income
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65
Income Elasticity of Demand

Income elasticity of demand tells us the
responsiveness of demand to changes in
income.
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66
Income Elasticity of Demand

An increase in income generally increases
one’s consumption of almost all goods.

The increase may be greater for some goods
than for others.
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67
Income Elasticity of Demand

Normal goods are those whose
consumption increases with an increase in
income.

They have income elasticities greater than
zero.
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68
Income Elasticity of Demand

Normal goods are usually divided into two
categories:

Income elastic normal goods

Income inelastic normal goods
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69
Income Elasticity of Demand

Income elastic normal goods are goods
that have an income elasticity greater than
one.

Their percentage increase in demand is
greater than the percentage increase in
income.

Luxuries tend to be income elastic.
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70
Income Elasticity of Demand

An income inelastic normal good has an
income elasticity less than 1.

The consumption of these goods rises by a
smaller proportion than the rise in income.

Necessities tend to be income inelastic.
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71
Income Elasticity of Demand

Inferior goods are those whose
consumption decreases when income
increases.

Inferior goods have income elasticities less
than zero (negative).

Generic (store-brand) cereals tend to be inferior
goods.
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72
Income Elasticities of Selected Goods
Income Elasticity
Product
Short Run Long Run
0.81
3.41
Motion pictures
0.24
3.09
Foreign travel
0.21
0.86
Tobacco products
2.60
0.53
Furniture
1.00
1.64
Jewelry and watches
—
2.50
Hard liquor
—
1.10
Private university tuition
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Interpret Income Elasticity of Demand
Coefficient
Description
Interpretation
0
Normal
good
 I   Qd
Two cases of normal good:
0
0  1
Income inelastic normal good
(“necessity”)
 1
Income elastic normal good
(“superior” good)
Inferior
good
 I   Qd
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Cross-Price Elasticity of Demand

Cross-price elasticity of demand is
computed by dividing the percentage change
in quantity demanded by the percentage
change in the price of another good.

XY
Percentage change in quantity demanded
=
Percentage change in price of another good
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75
Cross-Price Elasticity of Demand

Cross-price elasticity of demand tells us the
responsiveness of demand to changes in
prices of other goods.

Cross-price elasticity measures both how
and how strongly consumers respond to
changes in the price of related products.
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76
Cross-Price Elasticity of Demand

Depending on how consumers respond to
changes in the price of related products,
goods can be classified as

Substitutes

Complements
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77
Complements and Substitutes

Substitutes are goods that can be used in
place of one another.

When the price of a good goes up, the
demand for the substitute good also goes up.

Cross-price elasticity of substitutes is
positive
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Complements and Substitutes

Complements are goods that are used in
conjunction with other goods.

A rise in the price of a good will decrease the
demand for a good, and for its complement.

Complements have negative cross-price
elasticities.
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79
Interpret Cross-Price Elasticity of
Demand
Coefficient
Interpretation
XY > 0
Substitute
Goods
XY < 0
Complementary
Goods
XY = 0
Unrelated Goods
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Ratio
PYQX
PY QX

QX=0
PY
80
Calculating Income and Cross-Price
Elasticities
=6.5
Price
Shift due to
increase in
income
P0
P0
D0 D1
18
25
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Quantity
81
Calculating Income and Cross-Price
Elasticities
XY= - 0.7
Price of
ketchup
Shift due to rise
in price
of hot dogs
P0
P0
D0
D1
3
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4
Quantity of ketchup
82
Cross-Price Elasticities
Cross-Price
Elasticity
Commodities
Beef in response to price change in pork
Beef in response to price change in chicken
U.S. automobiles in response to price changes
in European and Asian automobiles
European automobiles in response to price
changes in U.S. and Asian automobiles
Beer in response to changes in wine
Hard liquor in response to price changes in
beer
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0.11
0.02
0.28
0.61
0.23
- 0.11
83
Price Elasticity of Supply

Price elasticity of supply measures the
responsiveness of firms to a change in the
price of their product.
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84
Price Elasticity of Supply

The price elasticity of supply is calculated
as the percent change in quantity supplied
over the percent change in price.

S
Percentage change in quantity supplied
=
Percentage change in price
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85
Inelastic Supply

Common sense tells us that an inelastic
supply means that the percent change in
quantity is less than the percentage change
in price.

An elastic supply means that quantity
supplied changes by a larger percent than
the percent change in price.
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86
Substitution and Supply

The longer the time period considered, the
more elastic the supply.

In the long run there are more alternatives so it is
easier (less costly) for suppliers to change and
produce other goods.
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87
Substitution and Supply

Economists distinguish three time periods
relevant to supply:



The instantaneous period.
The short run.
The long run.
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88
Substitution and Supply

In the instantaneous period, quantity
supplied is fixed so supply is perfectly
inelastic.

This supply is sometimes called the
momentary supply.
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89
Substitution and Supply

In the short run, some substitution is possible
– the short-run supply curve is somewhat
elastic.

In the long run, significant substitution is
possible – the supply curve becomes very
elastic.
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90
Substitution and Supply

An additional factor to consider in
determining elasticity of supply:

How easy or difficult is it to produce more of
the good?

The easier it is to produce additional units,
the more elastic the supply.
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91
Elasticity and Shifting Supply and
Demand

Elasticity can tell us more precisely the effect
of shifting supply and demand.

The more elastic the demand, the greater the
effect of a supply shift on quantity, and the
smaller effect on price.
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92
Effects of Shifts in Supply on Price
and Quantity

An example of the importance of elasticities
of demand and supply can be illustrated by
the example of the world market for oil
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93
Effects of Shifts in Supply on Price
and Quantity

If oil supply decreases, the world prices will
rise sharply if the demand for oil is inelastic.

Oil prices will not be affected a lot if demand
is elastic.
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94
Effects of Shifts in Supply on Price
and Quantity
Inelastic Supply and Inelastic Demand
Price
S1
Demand
S0
P1
P0
Q1 Q 0
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rights reserved.
Quantity
95
Effects of Shifts in Supply on Price
and Quantity
Inelastic Supply and Elastic Demand
S1
Price
P1
P0
S0
Demand
Q1 Q0
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rights reserved.
Quantity
96
Describing Demand and
Supply: Elasticities
End of Chapter 5
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rights reserved.
97