Elasticity and

its Applications
Supply and
Demand
Market
Equilibrium
 The Elasticity of Demand

Elasticity – a measure of the responsiveness of quantity

demanded or quantity supplied to one of its
determinants.
– It measures how much buyers and sellers respond to
changes in the conditions; allows us to analyze supply
and demand with greater precision.

Price Elasticity of Demand and Its Determinants

 The price elasticity of demand measures how much quantity
demanded responds to a change in price.
 Demand for a good (product) is said to be elastic if the quantity
demanded responds substantially to changes in the price.

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 Price Elasticity of Demand

 Demand is inelastic if the quantity demanded responds only

slightly to changes in the price.
 The price elasticity of demand for any good measures how
willing consumers are to move away from the good as its price
rises.
 Elasticity reflects the many economic, social and psychological
forces that shape consumer tastes.
Determinants of Price Elasticity of Demand
1. Availability of Close Substitutes. Goods with close substitutes
tend to have more elastic demand because it is easier for
consumers to switch from that good to others. Ex: butter and
margarine are easily substitutable. By contrast, eggs are food
without a close substitute, the demand for egg is less elastic
than the demand for butter.
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 Price Elasticity of Demand

2. Necessities versus Luxuries. Necessities tend to have

inelastic demands, whereas luxuries have elastic demands. When
the price for a visit to the doctor rises, people will not dramatically
alter the number of visits to the doctor, although they might go
somewhat less often. By contrast, when the price of sailboats rises,
the quantity of sailboats demanded falls substantially.
 Whether a good is a necessity or a luxury depends not on the
intrinsic properties of the good but on the preferences of the
buyer.
3. Definition of the Market. The elasticity of demand in any market
depends on how we draw the boundaries of the market. Narrowly
defined market tend to have more elastic demand than broadly
defined markets because it is easier to find close substitutes for
narrowly defined goods.
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 Price Elasticity of Demand

3. Time Horizon. Goods tend to have more elastic demand over

longer time horizons. When the price of gasoline rises, the quantity
of gasoline demanded falls only slightly in the first few months.
Over time, however, people buy more fuel-efficient cars, switch to
public transportation, move closer to where they work. Within
several years, the quantity of gasoline demanded falls substantially.

Computing the Price Elasticity of Demand

- The price elasticity of demand as the percentage change in the
quantity demanded divided by the percentage change in the price:

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

Price elasticity of demand 𝐸𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

5
 Price-Elasticity Coefficient and Formula

Economists measure the degree of price elasticity or inelasticity of

demand with the coefficient of 𝐸𝑑 defined as:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑥
𝐸𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑥

The % changes in the equation above are calculated by dividing the change
in quantity demanded by the original quantity demanded, and by dividing
the change in price by the original price. So the formula above becomes
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋
𝐸𝑑 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑋
÷ 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

Midpoint Formula: 𝐸𝑑 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑖𝑒𝑠 ÷ 𝑠𝑢𝑚 𝑜𝑓 𝑝𝑟𝑖𝑐𝑒𝑠/2
𝑠𝑢𝑚 𝑜𝑓
2

6
 Interpretations of 𝐸𝑑

Elastic Demand: Demand is elastic if a specific % change in price

results in a larger % change in quantity demanded. Then 𝐸𝑑 >1.
Ex: Suppose that a 2% decline in the price of fruit juice results in a 4%
increase in quantity demanded. Demand for fruit juice is elastic, and
.04
𝐸𝑑 = =2
.02
Inelastic Demand: If a specific % change in price produces a smaller
change in quantity demanded, demand is inelastic. 𝐸𝑑 <1.
Ex: If a 2% decline in the price of coffee leads to only a 1% increase in
quantity demanded, demand is inelastic and
.01
𝐸𝑑 = = .5
.02

7
 Price Elasticity of Demand
Example: Suppose that a 10 percent increase in the price of ice-cream
cone causes the amount of ice-cream to fall by 20 percent.
20 𝑝𝑒𝑟𝑐𝑒𝑛𝑡
price elasticity of demand = 10 𝑝𝑒𝑟𝑐𝑒𝑛𝑡 = 2.
Because the quantity demanded of a good (or product) is negatively
related to its price, the percentage change in quantity will have the
opposite sign as the percentage change in price. Thus the percentage
change in price is a positive 10 percent (reflecting an increase), and
the percent change in quantity demanded is a negative 20 percent
(reflecting a decrease).
 Demand is elastic when the elasticity is greater than 1, so that the
quantity moves proportionately more than the price.
 Demand is inelastic when the elasticity is less than 1, so that the
quantity moves proportionately less than the price.
8
Price Elasticity of Demand

9
Price Elasticity of Demand
 Extreme Cases:
Perfectly Inelastic and Elastic Demands
 When we say demand is “inelastic,” we do not mean that
consumers are completely unresponsive to a price change
 Demand is perfectly inelastic: extreme situation where a price
change results in no changeType whatsoever in the quantity
equation here.
demanded.
 Price elasticity coefficient is zero, because there is no response
to a change in price.
 Conversely, demand is perfectly elastic when a small price
reduction causes buyers to increase their purchases from zero
to all they can obtain, the elasticity coefficient is infinity (∞).

11
 Extreme Cases:
Perfectly Inelastic and Elastic Demands
P
𝐷1

Demand curve 𝐷1 in (a) represents Perfectly

inelastic
perfectly inelastic demand (𝐸𝑑 = 0). demand
A price increase will result in no (𝐸𝑑 = 0)
change in quantity demanded

0 (a) Q
P
Demand curve 𝐷2 in (b) represents 𝐷2
perfectly elastic demand. A price
increase will cause quantity Perfectly
demanded to decline from infinite elastic
demand
amount to zero (𝐸𝑑 = ∞).
(𝐸𝑑 = ∞)
0 Q
(b)
Total Revenue and the Price Elasticity of Demand

Total-Revenue (TR) Test

= the total amount the seller receives from the sale of a
product in a particular time period;
= P (price of the good) x Q (quantity of the good sold)

Price Demand Total Revenue

The total amount paid by
buyers, and received as
revenue by sellers, equals
• the area of the box under
$4 the demand curve, P x Q.
At a price of $4, the
P x Q = $400 quantity demanded is 100
(revenue) and total revenue is $400.

O 100 Quantity

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 Total Revenue and Price Elasticity of Demand

Total revenue (TR) and price elasticity are related. What happens
to total revenue when price changes:
 If total revenue (TR) changes in the opposite direction from
price, demand is elastic. If demand is elastic, a decrease in
price will increase total revenue.
 If total revenue (TR) changes in the same direction as price,
demand is inelastic, i.e., a price decrease will reduce total
revenue.
 If TR does not change when price changes, demand is unit-
elastic.
 Unit elasticity: an increase or decrease in prices leaves total
revenue unchanged. The loss in revenue from a lower unit
price is exactly offset by the gain in revenue from the
accompanying increase in sales.

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 Total-Revenue test for price elasticity

P
$3

a
2

b
1
𝐷1

0
10 20 30 40 Q
Elastic
Price declines from $2 to $1, and total revenue (TR) increases from
$20 to $40. So demand is elastic. The gain in revenue ($30) exceeds
the loss of revenue
15
 Total-revenue test for price elasticity

P
𝐷2
Inelastic
c
$4
Price declines from $4 to
$1, and total revenue falls 3
from $40 to $20. Hence,
demand is inelastic. The
gain in revenue is less 2
than the loss of revenue

1 d

0 10 20 Q

Copyright © 2015 Pearson Education, Inc. 16

 Total-revenue test for price elasticity

Price declines from $3 to $1, and total revenue does not change. Demand
is unit-elastic. The gain in revenue (green area) equals the loss of revenue
(yellow area).
P

$3 e
unit-elastic
2
f
1 𝐷3

o Q
10 20 30

17
 Elastic Demand (Slide 15)

 If demand is elastic, a decrease in price will increase total

revenue. Even though a lesser price is received per unit, enough
additional units are sold to more than offset for the lower price.
 At point 𝑎 in the 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒 𝐷1 , total revenue is $20. If the
price declines from $2 to $1 (point b), the quantity demanded
becomes 40 units and total revenue is $40.
 The analysis for elastic demand is reversible: If demand is
elastic, a price increase will reduce total revenue. The revenue
gained on the higher-priced products will be more than offset by
the revenue lost from the lower quantity sold.
 Bottom line: Other things equal, when price and total revenue
move in opposite directions, demand is elastic.
 𝐸𝑑 is greater than 1, meaning the percentage change in quantity
demanded is greater than the percentage change in price.

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Inelastic Demand (Slide 16)

19
Unit Elasticity (Slide 17)

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 Price Elasticity of Supply

The concept of price elasticity also applies to supply. If producers

are relatively responsive to price changes, supply is elastic.
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑥
𝐸𝑠 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 𝑥

Ex: Suppose an increase in the price of a good from $4 to $6 increases

the quantity supplied from 10 units to 14 units. The % change in price
would be 2Τ5 or 40% and the % change in quantity would be 4Τ12 or .33
or 33%.
.33
𝐸𝑠 = = .83 In this case, supply is inelastic, since the price
.40
elasticity coefficient is less than 1.
 If 𝐸𝑠 is greater than 1, supply is elastic. If it is equal to 1, supply is
unit-elastic. Also 𝐸𝑠 is never negative, since price and quantity
supplied are directly related.

21
 Price Elasticity of Supply

The degree of price elasticity of supply depends on how easily –

and therefore how quickly – producers can shift resources
between alternative uses.
 The easier and more rapidly producers can shift resources
between alternative uses, the greater the price elasticity of
supply.
 And shifting of resources takes time: The longer the time, the
greater the resource “shiftability.”
 So we can expect a greater response, and therefore greater
elasticity of supply, the longer a firm has to adjust to a price
change.
 In analyzing the impact of time on elasticity, economists
distinguish among the immediate market period, the short
run, and the long run.
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The Market Period - is the period that occurs when the time
immediately after a change in the market price is too short for
producers to respond with a change in quantity supplied.
 Suppose the owner of a small firm brings to market one
truckload of tomatoes that is the entire season’s output. The
supply curve for the tomatoes is perfectly inelastic (vertical );
the farmer will sell the truckload whether the price is high or
low. (fig a).
Why? Because the farmer can offer only one truckload of
tomatoes even if the price of tomatoes is much higher than
anticipated. He might like to offer more tomatoes, but tomatoes
cannot be produced overnight.
 Another full growing season is needed to respond to a higher-
than expected price by producing more than one truckload.

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 Price Elasticity of Supply: The Market Period

 And because the product is perishable, the farmer cannot

withhold it from the market. If the price is lower than anticipated,
he will still sell the entire truckload.
 The farmer’s cost of production, incidentally will not enter into
this decision to sell. Though the price of tomatoes may fall short
of production costs, the farmer will nevertheless sell out to avoid
a total loss through spoilage.
P 𝑆𝑚

Figure a: Price Elasticity of 𝑃𝑚

Supply: Market Period

𝑃0
𝐷2
𝐷1
0 Q
𝑄0
24
 Price Elasticity: The Short Run

The Short Run - in microeconomics is a period of time too short

to change plant capacity but long enough to use fixed plant more
or less intensively. In the short run, the farmer’s plant (land and
farm machinery)is fixed. But he does have time in the short run to
cultivate tomatoes more intensively by applying more labor and
more fertilizer and pesticides to the crop.
 The result is greater output in response to a presumed increase
in demand; this greater output is reflected in am more elastic
supply of tomatoes (figure b).
 The increase in demand from 𝐷1 to 𝐷2 is met by an increase in
quantity from 𝑄0 to 𝑄𝑠 , so there is a smaller price adjustment
from 𝑃0 to 𝑃𝑠 than would be the case in the market period. The
equilibrium price is therefore lower in the short rune than in the
market period.

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Price Elasticity of Supply: The Short Run

Fig b: Price Elasticity of Supply in the Short Run

P
𝑆𝑠
Increase in demand from 𝐷1 to 𝐷2
is met by an increase in quantity
from 𝑄0 to 𝑄𝑠 , so there is a smaller
𝑃𝑠 price adjustment from 𝑃0 to 𝑃𝑠 .
𝑃0

𝐷2
𝐷1
0 𝑄0 𝑄𝑠 Q

26
 Price Elasticity of Supply: The Long Run

The long run in Microeconomics is a time period long enough

for firms to adjust their plant sizes and for new firms to enter
(or existing firms to leave) the industry.
 In the “tomato industry,” for example, the farmer has time to
acquire additional land and buy more machinery and equipment.
 Also other farmers may, over time be attracted to tomato farming
by the increased demand and higher price. Such adjustments
create a larger supply response, as represented by the more
supply curve 𝑆𝐿 (figure c). The outcome is a smaller price rise
(𝑃0 to 𝑃1 ) and a larger output increase (𝑄0 to 𝑄1 ) in response to
the increase in demand from 𝐷1 to 𝐷2 .
 There is no total-revenue test for elasticity of supply. Supply
shows a positive or direct relationship between price and the
amount s; the supply curve is upsloping (i.e., sloping upward).
27
 Price Elasticity of Demand: The Long Run

 Regardless of the degree of elasticity or inelasticity, price and

total revenue always move together.
P

𝑺𝑳

Figure c: Price
Elasticity of Supply: 𝑷𝟏
The Long Run 𝑷𝟎

𝑫𝟏
𝑫𝟏
0 Q
𝑸𝟎 𝑸𝟏

28
 Income Elasticity of Demand

Income elasticity of demand measures the degree to which

consumers respond to a change in their incomes by buying
more or less of a particular good. The coefficient of income
elasticity of demand 𝐸𝑖 is determined by:
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝐸𝑖 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

 Normal Goods. For most goods, income elasticity coefficient 𝐸𝑖 is

positive; i.e., that more of them are demanded as incomes rise.
 Such goods are called normal or superior goods. But the value of
𝐸𝑖 varies greatly among normal goods.
 Ex: income elasticity of demand for automobiles is about +3, while
income elasticity for most farm products is only about +0.20.

29
 Income Elasticity of Demand

 Inferior Goods. A negative income-elasticity coefficient

designates an inferior good.
 Retread tires, cabbage, long-distance bus tickets, used clothing
(ukay-ukay) are likely candidates.
 Coefficients of income elasticity of demand provide insights into
the economy. Ex: income elasticity helps explain the expansion
and contraction of industries in the U.S.
 On average, total income in the economy has grown 2 to 3
percent annually.
 As income has expanded industries, producing products for
which demand is quite income-elastic have expanded their
outputs.
 Thus automobiles (𝐸𝑖 = +3), housing (𝐸𝑖 = +1.5), books (𝐸𝑖 = +1.4)
and restaurant meals (𝐸𝑖 = +1.4) have all experienced strong
growth of output.
Income Elasticity of Demand

8-31
The Supply Curve

The Supply Curve:

Shows the price and
the quantity supplied
by firms are positively
related.

Copyright © 2015 Pearson Education, Inc.

8-32
 Shifts in Supply Curve

 The supply curve is a relationship between price and the

quantity supplied drawn on the assumption that all other
things are held constant. If any of these other things
changes, the supply curve shifts.
 For example, suppose a new machine is invented that
makes it possible to produce bicycle frames at less cost;
then firms would have more incentive at any given price to
produce and sell more bicycles.
 Supply would increase; the supply curve would shift to the
right (see next slide).
 The supply curve for bicycles would shift to the right
because of a new cost-reducing machine.
 The supply curve would shift to the left if there were a
decrease in supply. 33
Shift in Supply Curve

Shift in the Supply

Curve
Supply curve shows
the relationship
between the
quantity supplied of
a good, all other
things being equal.

Copyright © 2015 Pearson Education, Inc. 8-34

 Shifts in Supply Curve… What Causes It

 Supply would decrease, for example, if bicycle-producing

firms suddenly found that their existing machines unless
they were oiled with expensive lubricant each time a
bicycle was produced. This would raise costs, lower
supply, and shift the supply curve to the left.
Many things can cause the supply curve to shift:
 Technology. Anything that changes the amount a firm can
produce with a given amount of inputs to production can
be considered a change in technology.
 Suppose an improvement in technology enables Toyota to
reduce the time to produce a car by 6 hours per vehicle.
This improvement causes an increase in supply, a shift in
the supply curve to the right.
35
 What Causes the Supply Curve to Shift

 Weather Conditions. Droughts, earthquakes, and typhoons

also affect how much of certain types of goods can be
produced with given inputs. A drought can reduce the
amount of wheat than can be produced in the Midwest; an
unusually cold weather in 2006 destroyed over a billion
dollars worth of citrus fruit in California. Hurricanes Katrina
and Rita disrupted oil drilling and refining activities in Texas
and Louisiana that caused a drop in the supply of oil, that
shifted the supply curve to the left.
 The Price of Inputs Used in Production. If the prices of
inputs to production – raw materials, labor, and capital –
increase, it becomes costlier to produce goods, and firms
will produce less at any given price; the supply curve will
shift to the left.
36
 What Causes the Supply Curve to Shift

 The Number of Firms in the Market. The supply curve refers

to all the firms producing the product. If the number of firms
increases, more goods can be produced at each price; supply
increases, and the supply curve shifts to the right. A decline n
the number of firms on the other hand, would shift the supply
curve to the left.
 Expectation of Future Prices. If the firms expect the price of
the good they produce to rise in the future, then they will hold
off selling at least part of their production until the price rises.
For example, farmers in the U.S. who anticipate an increase in
wheat prices because of political turbulence in Russia may
decide to store more wheat in silos and sell it later, when the
price rises. Thus, expectation of future price increases tend to
reduce supply.
Copyright © 2015 Pearson Education, Inc. 37
 What Causes the Supply Curve to Shift

 Government Taxes, Subsidies, and Regulations. The

government can affect the supply of particular goods
produced by firms. When a government imposes taxes on
firms to pay for services like education, police and national
defense, these taxes increase firms’ costs and reduce supply.
The supply curve shifts to the left when a tax on what firms
sell in the market increases.
 The government also makes payments – subsidies – to firms
to encourage them to produce certain goods. Such subsidies
have the opposite effect of taxes on supply. An increase in
subsidies reduces firms’ costs and increases supply.
 If the U.S. government provided subsidies for corn produc-
tion to encourage the use of ethanol, an alternative fuel for

38
 … cars that is produced from corn, this would increase the
production of corn. On the other hand, when the U.S.
government imposes a tax on cigarettes, there will be a
decrease in the supply of cigarettes.
 Governments also regulate firms. In some cases, such
regulations can change the firms’ costs of production or their
ability to produce goods and thereby affect supply.
 For example, if the city government of Makati decides that
only vendors who successfully pass a health and sanitation
inspection are allowed to sell food from street carts, the
supply curve for street-vendor food will shift to the left.

Copyright © 2015 Pearson Education, Inc. 39

 Movements Along versus Shifts of the Supply
Curve
It is important to understand how to distinguish between shifts of
the supply curve and movements along the supply curve (see
next slide).
 A movement along the supply curve occurs when the quantity
supplied changes as a result of a change in the price of the
good. If a copper mine in Zambia increases its production
because the price of copper has increased in the world market,
that is a movement along the supply curve. The same situation
occurs with the price of crude oil in the world market.
 In the bicycle example earlier, an increase in the price of
bicycles from $200 to $220 would increase the quantity
supplied from 9 million to 11 million bicycles (see next slide).
This can be shown as movement along the supply curve as a
change in the quantity supplied.
8-40
 Movements Along versus Shifts in the Supply Curve

 A shift of the supply curve, on the other hand, occurs if there is

a change due to any source except the price. An unexpected
winter freeze in California will mean that farmers will be able to
produce fewer oranges at any given price. This means that the
supply curve of oranges will shift to the left. When the supply
curve shifts, economists say that there is a change in supply.
 Students should be able to tell whether a change in something
causes (1) a change in supply or (2) a change in the quantity
supplied; or, equivalently, (1) a shift in the supply curve or (2) a
movement along the supply curve.

41
Movements Along v. Shifts of the Supply
Curve

8-42
Overview of Supply and Demand

Copyright © 2015 Pearson Education, Inc.

8-43
 Determination of the Market Price

Finding the Market Price

Shortage (or excess demand): a situation in which
quantity demanded is greater than the quantity
supplied. A shortage is created when buyers
demand more of a product at a given price than
producers are willing to supply.
Surplus (or excess supply): a situation in which
the quantity supplied is greater than the quantity
demanded. A surplus is created when producers
supply more of a product at a given price than
buyers demand.
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 Equilibrium Price

Equilibrium Price (market-clearing price): The price at

which the quantity supplied equals the quantity demanded. It
is the price where the intentions of buyers and sellers match.
Equilibrium Quantity: The quantity traded at the
equilibrium price. It is the quantity demanded and quantity
supplied at the equilibrium price in a competitive market.
Market Equilibrium: The situation in which the price is
equal to the equilibrium price and the quantity traded equals
the equilibrium quantity. When quantity demanded and
quantity supplied are in perfect balance at a given price, the
product market is said to be in equilibrium.

8-45
Equilibrium Price and Quantity

46
Price of
ice cream
cone

47
Equilibrium Price and Equilibrium
Quantity
When buyers and
sellers interact in the
market, the
equilibrium price is
at the point of
interaction of the
supply curve and
the demand curve.
The equilibrium
quantity is also at
that point

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