Elasticities of Demand and Supply

Introduction

Elasticity is a fundamental concept in microeconomics that measures how responsive the quantity demanded or supplied of a good is to changes in price, income, or the price of related goods. Understanding elasticity helps explain consumer and producer behavior, and is crucial for analyzing market outcomes and policy effects.

Price Elasticity of Demand

Definition and Calculation

• Price elasticity of demand quantifies the responsiveness of the quantity demanded to a change in the price of a good.

• It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• To avoid ambiguity from direction of change, the midpoint method is used:

• Absolute values are used to compare changes, ignoring negative signs.

Types of Demand Elasticity

• Elastic Demand: Percentage change in quantity demanded > percentage change in price ().

• Unit Elastic Demand: Percentage change in quantity demanded = percentage change in price ().

• Inelastic Demand: Percentage change in quantity demanded < percentage change in price ().

• Perfectly Elastic Demand: Quantity demanded changes infinitely for a tiny change in price.

• Perfectly Inelastic Demand: Quantity demanded does not change as price changes.

Examples

• Spring water: Perfectly elastic demand.

• Sony PlayStation: Elastic demand (10% price rise, 20% decrease in quantity).

• Trips: Unit elastic demand (10% price rise, 10% decrease in quantity).

• Gum: Inelastic demand (20% price rise, 10% decrease in quantity).

• Doses of medicine: Perfectly inelastic demand (quantity unchanged as price rises).

Influences on Price Elasticity of Demand

• Availability of Substitutes: More substitutes make demand more elastic.

• Luxury vs. Necessity: Necessities have inelastic demand; luxuries have elastic demand.

• Narrowness of Definition: Narrowly defined goods (e.g., specific brands) have more elastic demand than broadly defined goods (e.g., food).

• Time Elapsed Since Price Change: Demand becomes more elastic over time as consumers adjust.

• Proportion of Income Spent: Goods that take up a larger share of income have more elastic demand.

Elasticity Along a Linear Demand Curve

• Slope is constant, but elasticity varies along the curve.

• Above the midpoint: Demand is elastic.

• At the midpoint: Demand is unit elastic.

• Below the midpoint: Demand is inelastic.

Total Revenue and Price Elasticity of Demand

• Total revenue = Price × Quantity sold.

• Total revenue test:

  • If price and total revenue move in opposite directions, demand is elastic.

  • If price change leaves total revenue unchanged, demand is unit elastic.

  • If price and total revenue move in the same direction, demand is inelastic.

Example Table: Total Revenue and Elasticity

Applications

• Agricultural Products: Inelastic demand (e.g., oranges, elasticity = 0.4). A decrease in supply leads to a larger price increase and higher total revenue.

• Addictive Substances: Nonusers have elastic demand; existing users have inelastic demand. High taxes reduce new users but have little effect on established users.

Price Elasticity of Supply

Definition and Calculation

• Price elasticity of supply measures the responsiveness of the quantity supplied to a change in price.

• Calculated as the percentage change in quantity supplied divided by the percentage change in price.

Types of Supply Elasticity

• Perfectly Elastic Supply: Tiny price change leads to infinite change in quantity supplied.

• Elastic Supply: Percentage change in quantity supplied > percentage change in price ().

• Unit Elastic Supply: Percentage change in quantity supplied = percentage change in price ().

• Inelastic Supply: Percentage change in quantity supplied < percentage change in price ().

• Perfectly Inelastic Supply: Quantity supplied does not change as price changes.

Examples

• Books: Elastic supply (10% price rise, 20% increase in quantity supplied).

• Fish: Unit elastic supply (10% price rise, 10% increase in quantity supplied).

• Hotel rooms: Inelastic supply (20% price rise, 10% increase in quantity supplied).

• Beachfront lots: Perfectly inelastic supply (quantity unchanged as price rises).

Influences on Price Elasticity of Supply

• Production Possibilities: Goods produced at constant or gently rising opportunity cost have elastic supply; goods produced in fixed quantity have perfectly inelastic supply.

• Time Elapsed Since Price Change: Supply becomes more elastic as producers adjust over time.

• Storage Possibilities: Storable goods have highly elastic supply; cost of storage is a key factor.

Computing Price Elasticity of Supply

• If elasticity > 1: Supply is elastic.

• If elasticity = 1: Supply is unit elastic.

• If elasticity < 1: Supply is inelastic.

Cross Elasticity and Income Elasticity

Cross Elasticity of Demand

• Cross elasticity of demand measures how the demand for a good changes when the price of a substitute or complement changes.

• For substitutes, cross elasticity is positive: a fall in the price of a substitute decreases demand for the good.

• For complements, cross elasticity is negative: a fall in the price of a complement increases demand for the good.

Example Table: Cross Elasticity

Income Elasticity of Demand

• Income elasticity of demand measures how the demand for a good changes when income changes.

• Normal goods: Demand increases as income increases (positive income elasticity).

• Inferior goods: Demand decreases as income increases (negative income elasticity).

Case Study: Elasticity at the Coffee Shop

Substitutes and Elasticity

• When Starbucks raises the price of a latte, consumers may switch to Dunkin’ Doughnuts if prices there remain lower.

• Demand for Starbucks lattes is elastic due to close substitutes.

• If all coffee shops raise prices, demand for lattes in general becomes inelastic due to poor substitutes.

Summary Table: Elasticity Types

Additional info: Elasticity concepts are essential for understanding consumer and producer responses to price changes, and for evaluating the effects of taxes, subsidies, and market interventions.