Elasticity of Demand and Supply

PRINCIPLES OF MICROECONOMICS—Notes

ECO101—

Elasticity of Demand and Supply

Overview

In this chapter, we will examine the

price elasticity of demand

—a crucial concept in economics as it has direct

connection with business revenues—(and to a lesser extent

cross elasticity,

income elasticity, and elasticity of

supply

), and illustrate how to use this concept to specific situations, such as the pricing of airline tickets for first

class or economy, bad harvests (for instance coffee or orange frost) and its impact on prices, or the imposition

of excise taxes on cigarettes or alcohol. We will also make the distinction between long-run and short-run price

elasticity.

Price Elasticity of Demand

All sellers (small or large, educated or street-wise) know very well the law of demand—that there is an inverse

relationship between price and quantity demanded. They know that if they lower their prices—

ceteris paribus

,

or other things being the same—most probably their sales will increase, and vice-versa. The critical question is:

Is it enough for a businessperson to know simply in which direction quantity would change as a result of a

change in price?

The answer is that it is not enough! They also need to know by

how much

. They need to know, in other words,

the

responsiveness

(or sensitivity) of sales (quantity demanded) to price changes. The reason is that for the

businessperson, what is important is the impact of prices changes on total revenue.

In order to measure this responsiveness of quantity to price changes—and ultimately the impact on total

revenue—economists have devised the concept of

elasticity.

It is defined as:

Price elasticity = (% change in quantity) / (% change in price) = % Q / % P

(where stands for "change in")

To find the percentage change in quantity (or price) we divide the change in quantity (or price) by the level of

quantity (or price): i.e, Q / Q (for quantity) and P / P (for price). We can therefore rewrite the expression for

price elasticity as:

÷

E

= ( Q / Q)

( P / P) or E

= ( Q / P) X (P / Q)

P

P

Calculating Elasticity

Looking at the graph below lets see how we calculate elasticity. Lets take for instance the case of moving from

point A to point B. The percentage (or proportionate) change in quantity (from 2 unit to 4 units) is 100%. Thus

the value of the numerator in the elasticity expression is 100. The percentage change in price (from £5 to £4) is

-20%, thus the value of the denominator is 20.

Therefore, the price elasticity is:

100 / -20 = -5

Note that since price and quantity move in opposite direction for the majority of goods (normal goods), the

value of price elasticity of demand usually has a negative value—since either the denominator or the numerator

would have a negative value.

A result of greater than 1 denotes a

price