Chapter 4

Price Elasticity of Supply and

Demand
 ELASTICITY
Both supply and demand tell us a good deal about how
a change in the price of a good affects behavior.

• But knowing the direction of a change is not enough:

• We need to know the magnitude of the change.

• Economists measure market responsiveness using

the concept of Elasticity.
A. Price elasticity of demand:
• The ratio of the percentage change in quantity
demanded to the percentage change in price

• It measures the responsiveness of quantity

demanded to changes in price.
• Note: Since it is understood that demand
elasticities are negative (demand curves have a
negative slope), they are thus often reported
without the negative sign...i.e in absolute
 Types of Elasticities:

1. Perfectly Inelastic demand

– Demand in which quantity demanded does not respond at all to any change
in price.
– Price elasticity of demand = Zero (!" = $)
– Demand curve is vertical.
– Example: Demand curve for “Insulin” by diabetic people.
2. Perfectly Elastic demand
– Demand in which quantity drops to zero at the slightest increase in price.
– !" =∞
– Demand curve is horizontal.
– Example: Demand curve facing wheat farmers.
A good way to remember the difference between the two perfect
elasticities is:
 Perfectly Inelastic and Perfectly Elastic Demand Curves

• Panel (a) shows a perfectly inelastic demand curve for insulin. Price elasticity of
demand is zero. Quantity demanded is fixed; it does not change at all when
price changes.
• Panel (b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny
price increase drives the quantity demanded to zero. In essence, perfectly
elastic demand implies that individual producers can sell all they want at the
going market price but cannot charge a higher price.
 Types of Elasticities:

3. Elastic demand
– A demand relationship in which the percentage change in quantity
demanded is larger than the percentage change in price
– A demand elasticity with an absolute value greater than 1, (!" > $).

4. Inelastic demand
– Demand that responds somewhat, but not a great deal, to changes in price.
– Inelastic demand always has a numerical value between 0 and 1 (!" < $).

5. Unitary elasticity
– A demand relationship in which the percentage change in quantity
demanded is the same as the percentage change in price.
– A demand elasticity with an absolute value of 1, (&' = $).
Types of Demand Elasticities:
Determinants behind Price Elasticity of Demand:
1. Availability of Substitutes
• Perhaps the most obvious factor affecting demand elasticity is the
availability of substitutes.
• Goods that have ready substitutes tend to have more elastic
demand than those that have no substitutes.
• Example: If the price of Coke was to rise 20% tomorrow,
consumers would turn to Pepsi. Therefore, Coke shows a high
price elasticity.

2. The Importance of Being Unimportant

• The share of the good in your income.
• When an item represents a relatively small part of our total
budget, we tend to pay little attention to its price.
• Elasticities are lower for goods that constitute a small proportion
of one’s income and higher for goods that constitute a big
proportion of one’s income.
• Example: matches versus cars
Determinants behind Price Elasticity of Demand:
3. Luxuries versus Necessities
• Luxury goods (e.g., diamond rings) tend to have relatively elastic
demand, while necessities (e.g., food) have inelastic demand.

4. The Time Dimension

• Length of time for people to respond (SR versus LR)
• In the longer run, demand is likely to become more elastic because
households make adjustments over time.
• Example: If the price of gasoline increased by 20%. In the SR, the demand
for gasoline may be very inelastic.
• In the long run, however, you can adjust your behavior:
• Buy an electric car,
• ride a bicycle,
• Use public transportation,
• move closer to university/work
• carpool with other people.
• Check the next example.
 ECONOMICS IN PRACTICE
Elasticities at a Bakery in the Short Run and Long Run

This graph shows the expected

relationship between long-run
and short-run demand for TBS
sandwiches.
Notice that if you raise prices
above the current level, the
expected quantity change read
from the short-run curve is less
than that from the long-run curve.
Calculating Elasticities:
I. First Method: Use of Initial Value as Base:

Step I: Calculating Percentage Changes

• Here is how we calculate percentage change in quantity
demanded using the initial value as the base:
Calculating Elasticities:

• We can calculate the percentage change in price in a similar

way.
• By using P1 as the base, the percentage of change in P is:
Step II: Recall the formal definition of elasticity:
 Calculating Elasticities (cont’d):

II. Second Method: Midpoint/average formula

• A more precise way of calculating percentages is by using the
value halfway between P1 and P2 (i.e (#$ %#& )!() for the base in
calculating the percentage change in price
• and the value halfway between Q1 and Q2 (i.e ()$ %)& )!() as the
base for calculating the percentage change in quantity demanded.
789:;< =: >?9:@=@A B<C9:B<B
• %∆ ,- ./0-1,12 3450-343 = (D$ ED& )! ×100
&

• Look at the next example for clarification.

 Example: Calculating Elasticity along a Straight-Line Demand Curve
TABLE: Demand Schedule for
Office Dining Room Lunches

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

To calculate price elasticity of demand between points A and B on the demand curve, first
calculate the percentage change in quantity demanded:

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TABLE: Demand Schedule for FIGURE: Demand Curve for Lunch at the Office Dining
Office Dining Room Lunches Room

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

Next, calculate the percentage change in price:

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TABLE: Demand Schedule for FIGURE: Demand Curve for Lunch at the Office
Office Dining Room Lunches Dining Room

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

Finally, calculate elasticity:

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 Note that Elasticity Changes along a Straight-Line Demand Curve
TABLE 5.1 Demand Schedule FIGURE 5.3 Demand Curve for Lunch at the Office
for Office Dining Room Lunches Dining Room

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
A: 10 2
B: 9 4
8 6
7 8
6 10
5 12
4 14
C: 3 16
D: 2 18
1 20
0 22

Exercise:
Between points A and B, demand is quite elastic, at −6.33.
Between points C and D, demand is quite inelastic, at −.294.

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 Calculating Elasticities (cont’d):

III. Third Method: Point Elasticity

• A measure of elasticity that makes use of the following:
– Slope of the demand curve.
– Specific point on the demand curve.
• Remember: Elasticity is the percentage change in quantity demanded divided
by the percentage change in price, i.e.,

where ∆ denotes a small change and Q1 and P1 refer to the original

price and quantity demanded.
• The previous formula can be rearranged and written as:

• Notice that ∆Q/∆P is the reciprocal/inverse of the slope, and

"#
!$# is a specific point on the demand curve.
• Important note: which method to be used depends on the
information given in the question.
Point Elasticity Changes along a Demand Curve
 Elasticity Is Not the Same as Slope
• We must always remember not to confuse the
elasticity of a curve with its slope, for the
following reasons:
1. Case I: Linear demand curve:
– slope is constant, however, price elasticity is not.
– along a straight-line demand curve, the price
elasticity varies from zero to infinity.
– The next table shows that linear demand curves
start out with high price elasticity, where price is
high and quantity is low, and end up with low
elasticity, where price is low and quantity is high
– i.e The straight-line demand curve has elastic
demand in the top region and inelastic demand in
the bottom region, as shown in the previous graph.
2. Case II: The Unit-elastic demand curve.
– This demand curve is clearly not a straight line with
constant slope.
– Yet it has a constant demand elasticity, !" = 1 , because
the percentage change in price is equal everywhere to the
percentage change in quantity.
3. Case III:
– The slope is not the same as the elasticity
because the demand curve’s slope depends upon
the changes in P and Q , whereas the elasticity
depends upon the percentage changes in P and
Q .
– This makes slopes less accurate as they get
affected by the unit of measurement used for the
variable.
– Check the next example.
Note that 1 pound = 16 ounces