Demand and Elasticity
Modules 46-48
What’s behind the Demand Curve?
• Substitution effect
– As price decreases, consumers are more likely to
use the good as a substitute for other relatively
more expensive ones
• Income effect
– As price decreases, consumers feel like they have
more money, since their purchasing power has
increased
Elasticity
How sensitive one variable
is to changes in another
variable
Elastic – very sensitive
Inelastic – somewhat
insensitive
Price Elasticity of Demand
How much the quantity demanded changes with
change in price:
Coefficient of Elasticity =
%ΔQD
%ΔP
Calculate the elasticity:
Price increases from $10 to $12. Quantity falls from 100 to 90.
%ΔQ =(90-100)/100 = -10% %ΔP =(12-10)/10 = 20%
Coefficient of Elasticity = 0.5
Price Elasticity of Demand
If the coefficient of elasticity > 1, it is considered
elastic
If the coefficient of elasticity < 1, it is considered
inelastic
If the coefficient of elasticity = 1, it is considered
unit elastic
When we discuss price elasticity, we typically
mean price elasticity at a particular price. This is
because price elasticity usually varies along a
demand curve.
However, the simple method of calculating
elasticity can yield a different result from
the opposite direction
The Mid-Point Formula
Use the average of the two end points:
Coefficient of Elasticity =
Q2-Q1
(Q1+Q2)/2
P2-P1
(P1+P2)/2
Elasticity and Total Revenue
• Depending on elasticity, an increase in price
can generate more or less total revenue
• If demand is inelastic, an increase in price
yields and increase in total revenue
• If demand is elastic, an increase in price yields
and decrease in total revenue
How Elastic are these Goods?
Inelastic
Elastic
Cross Price Elasticity of Demand
How much quantity demanded of Good A will
change with respect to change in the price of
Good B.
%ΔQDA
%ΔPB
If the value is negative, A and B are complements
If the value is positive, A and B are substitutes
Income Elasticity of Demand
How much the demand for a good will change
with respect to change in income.
%ΔQD
%Δ Income
If the value is negative, the good is inferior
If the value is positive, the good is normal
Price Elasticity of Supply
How much the quantity supplied changes with
change in price:
Coefficient of Elasticity =
%ΔP
If elasticity is:
>1, supply is elastic
< 1, supply is inelastic
= 1, supply is unit elastic
%ΔQS
Factors that Determine
Supply Elasticity
• Availability of resources
– If a firm can get labor, capital and materials into or
out of production quickly, supply will be more
elastic
• Time
– Production takes lead time – the more time to
make a change, the more elastic
– Agriculture