Chapter 4: Elasticity of
Demand and Supply
Price Elasticity of Demand
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According to the law of demand, when price
goes up, consumers demand fewer quantities
of a product. If the price of a product falls,
quantity demanded will rise.
But when the price of a product changes, by
how much more (or less) will consumers
buy?
To help answer this question, we will use a
measurement called the Price Elasticity of
Demand.
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Price Elasticity of Demand
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For some products, consumers are highly
responsive to price changes. Demand for
such products is relatively elastic or simply
elastic.
For other products, consumers’
responsiveness is only slight, or in rare cases
non-existent. Demand is said to be relatively
inelastic, or simply inelastic.
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The Price-Elasticity Coefficient
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Economist measure the degree of price
elasticity or inelasticity of demand with the
coefficient Ed.
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Ed is defined as the percentage change in
quantity demanded of good X divided by the
percentage change in price of X.
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The Ed Formula
percentage change in quantity demanded of X
Ed =
percentage change in price of X
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Generally, when calculating percentage changes in the
equation, we divide the change in quantity demanded by
the original quantity demanded and the change in price
by the original price.
However, because the resulting percentage change value
differs with the direction of the change, using averages as
the reference points ensures the same percentage
change regardless of the direction of the change.
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Using Averages: An Example
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Consider the following example:
Suppose that at a price of $10, quantity
demanded is 200 units. When the price
drops to $5, quantity demanded rises to 300
units.
Price
$10
Demand
$5
200
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300
Quantity
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Using Averages: An Example
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The percentage change in quantity demanded
from 200 to 300 is a 50 percent (=100/200)
increase, while the opposing change in quantity
demanded from 300 to 200 is a 33 percent
(=100/300) decrease.
Likewise, the percentage change in price from
$10 to $5 is a 50 percent (=$5/$10) decrease,
while the opposing change in price from $5 to
$10 is a 100 percent (=$5/$5) increase.
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Using Averages: An Example
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Using averages eliminates the “up versus
down” problem.
change in quantity change in price
Ed =
sum of quantities/2 sum of prices/2
 For the quantity range 200-300, the quantity
reference is 250 units [=(200+300)/2].
 For the same price range $5-$10, the price
reference is $7.50 [=($5 + $10)/2]
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Using Averages: An Example
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The percentage change in quantity
demanded is now 100/250, or a 40 percent
increase, and the percentage change in
price is now -$5/$7.50, or about a 67
percent decrease.
Ed = 0.4/-.67 = -0.597
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Elimination of the Minus Sign
Because the demand curve slopes
downward, Ed will always be a negative
number. Therefore, we take the absolute
value and ignore the minus sign.
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Interpretations of Ed
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The coefficient of price elasticity of demand can
be interpreted as follows:
Elastic Demand: Product demand for which
price changes cause relatively larger changes in
quantity demanded; Ed > 1
Inelastic Demand: Product demand for which
price changes cause relatively smaller changes
in quantity demanded; Ed < 1
Unit Elasticity: Product demand for which price
changes and changes in quantity demanded are
equal; Ed = 1
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Interpretations of Ed
Extreme Cases
 Perfectly Inelastic: Product demand for which
quantity demanded does not respond to a
change in price.
 Perfectly Elastic: Product demand for which
quantity demanded can be any amount at a
particular price.
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Interpretations of Ed
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The Total-Revenue Test
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Elasticity is important to firms because
when the price of their products change,
so does their profit (total revenue minus
total costs).
Total revenue (TR) = price x quantity = P x Q
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This represents the total number of dollars
received by a firm from the sale of a
product in a particular period.
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The Total-Revenue Test
Total revenue and the price elasticity of
demand are related. The total-revenue
test can determine elasticity by examining
what happens to total revenue when price
changes.
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The Total-Revenue Test
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If demand is elastic, a decrease in price
will increase total revenue, and an
increase in price will reduce total revenue.
If demand is inelastic, a price decrease
will decrease total revenue, while an
increase in price will increase total
revenue.
If demand is unit elastic, total revenue
remains constant when prices rise or fall.
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The Total-Revenue Test
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Price Elasticity along a
Linear Demand Curve
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Along a linear demand curve, elasticity
varies over the different price ranges.
Because elasticity involves relative or
percentage changes in price and quantity,
as you move along a demand curve, the
percentage changes in price and quantity
will vary.
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Determinants of Price
Elasticity of Demand
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In general, there are four determinants
that can affect the price elasticity of
demand:
Substitutability
Proportion of Income
Luxuries versus Necessities
Time
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Determinants of Price
Elasticity of Demand
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Price elasticity of demand is greater:
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the larger the number of substitute goods that
are available
the higher the price of a product relative to
one’s income
the more that a good is considered to be a
“luxury” rather than a “necessity”
the longer the time period under consideration
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Price Elasticity of Supply
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Price elasticity of supply measures the
responsiveness of sellers to changes in
the price of a product.
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If producers are relatively responsive, supply
is elastic.
If producers are relatively insensitive to price
changes, supply is inelastic.
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Price Elasticity of Supply
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The price elasticity of supply coefficient Es
is defined as:
percentage change in quantity supplied of X
Es =
percentage change in price of X
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To calculate Es, we employ the midpoint
approach to determine the percentage
changes.
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Price Elasticity of Supply
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If Es < 1, supply is inelastic.
If Es > 1, supply is elastic.
If Es = 1, supply is unit-elastic.
Since price and quantity supplied are
directly related, Es is never negative.
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Price Elasticity of Supply
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The amount of time it takes producers to
shift resources between alternative uses to
alter production of a good can determine
the degree of price elasticity of supply.
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The easier and more rapid the transfer of
resources, the greater is the price elasticity of
supply.
The longer a firm has to adjust to a price
change, the greater the elasticity of supply.
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Price Elasticity of Supply and
Time Periods
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The market period is a period in which
producers of a product are unable to
change the quantity produced in response
to a change in price.
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During this time period, the supply of a
product is fixed, or supply is perfectly inelastic.
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Price Elasticity of Supply and
Time Periods
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In the short run, producers are able to
change the quantities of some but not all
the resources they employ.
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This time period is too short to change plant
capacity but long enough to use fixed plant
more or less intensively.
The supply of a product is more elastic than
the market period.
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Price Elasticity of Supply and
Time Periods
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In the long run, producers are able to
change all the resources they employ.
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This time period is long enough for firms to
adjust their plant sizes and for new firms to
enter (or existing firms to exit) the industry.
The supply of a product is more elastic than in
the short run.
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Price Elasticity of Supply and
Time Periods
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Income Elasticity of Demand
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Income elasticity of demand measures the
responsiveness of consumer purchases to
changes in consumer income.
The coefficient of income elasticity of
demand Ei is determined with the formula
percentage change in quantity demanded
EI =
percentage change in income
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Income Elasticity of Demand
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Normal Goods will have an income
elasticity of demand that is positive. More
of them are demanded as income
increases. Ei > 0
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Inferior goods have a negative income
elasticity of demand. As income rises, the
demand for them falls. Ei < 0
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