Microeconomics Chapter 6: Elasticity
Whether the changes in demand and supply are reflected in price or in quantity depends upon the extent to which demand and supply are sensitive to the change in market conditions.
Price elasticity of demand
Elasticity, generally, is a measure of the sensitivity of one variable to changes in another variable. The price elasticity of demand, written as PED, measures the sensitivity of quantity demanded to a change in the good’s own price.
The formula is the percentage change in quantity demanded divided by the percentage change in price of the good. When the absolute (modulus) value is greater than one, demand is called elastic, meaning that a change in price causes a larger than proportional decrease in quantity demanded of the good. When the absolute value is smaller than one, demand is called inelastic, meaning that an increase in price causes a lower proportionate decrease in quantity demanded. When the absolute value is exactly one, demand is called unit elastic, meaning the quantity demanded change is proportionate to the change in price.
Price elasticity of demand (PED) | Economic meaning | Plain example |
|---|---|---|
|PED| > 1 | Demand is elastic because quantity changes by a larger percentage than price. | A ten percent fall in the price of restaurant meals raises the number sold by fifteen percent. |
|PED| = 1 | Unit elasticity occurs when the percentage change in quantity matches the percentage change in price. | A five percent cut in cinema ticket price leads to a five percent rise in tickets sold. |
0 < |PED| < 1 | Demand is inelastic because quantity changes by a smaller percentage than price. | A ten percent rise in petrol price reduces litres bought by three percent. |
|PED| = 0 | Perfectly inelastic because quantity stays fixed, whatever happens to price. | A lifesaving drug is purchased in the same amount even when its price doubles. |
|PED| → ∞ | Perfectly elastic because even the tiniest price rise wipes out all demand. | At the competitive world wheat price millers can buy any quantity but pay even one cent more for none at all. |
To calculate a PED, start with the initial price and quantity, then find the new price and quantity after the change. Next, calculate the two percentage changes and form the ratio. Suppose the price of a good falls from forty pence to thirty pence, and the quantity demanded rises from twenty units to thirty units. The percentage change in price is -25%. The percentage change in quantity demanded is +50%. The ratio is -2, which shows elastic demand.
There are two critical things to notice about this. First, because the demand curve is downward sloping, the elasticity will always be negative. This is because the changes in price and quantity are always in opposite directions. Second, you should try to calculate the elasticity only for a relatively small change in price, as it becomes unreliable for very large changes. When demand is not very sensitive to price, the percentage change in quantity demanded will be smaller than the original percentage change in price, and the elasticity will then be between 0 and -1. For example, if a 2% change in price leads to a 1% change in quantity demanded, then the value of the elasticity will be -1 divided by 2 = -0.5. In this case, demand is referred to as being inelastic.
Secondly, it is also important to understand that elasticity varies along the demand curve itself.
Because price and quantity in the elasticity formula are used as percentage changes, the upper part of the curve starts at a high price and a small quantity, so a one-pence change is a small percentage change in price and a one-unit change is a large percentage change in quantity. Demand is elastic in that range. Moving down the curve reverses the relationship. A one-pence change is now a large percentage change in price, and a one-unit change is a small percentage change in quantity. Demand is inelastic at the lower end. The midpoint divides the two regions at which point percentage changes are equal.
Two extreme cases complete the picture. A vertical demand curve shows perfectly inelastic demand. Quantity demanded is the same regardless of price; for example, insulin could be an example of such a good. The numerical value of the elasticity is zero. A horizontal demand curve shows perfectly elastic demand; for example, some commodity markets display such demand behaviour. Buyers are willing to purchase any amount at the going price, but none at a price even slightly higher. The numerical value of the elasticity is infinite.
Total revenue and the role of elasticity for firms
Total revenue equals price multiplied by quantity. A drop in price has two effects. It cuts the revenue on each unit yet raises the number of units sold. Which effect dominates depends on PED. When demand is elastic the percentage rise in quantity is larger than the percentage fall in price, so total revenue rises as price falls. When demand is inelastic the percentage rise in quantity is smaller than the percentage fall in price, so total revenue falls as price falls. The turning point sits at unit elasticity where a small change in price leaves total revenue unchanged.
Price x Quantity comparison | Total Revenue Analysis |
|---|---|
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Firms use the pattern to guide pricing. A manager who faces inelastic demand sees that a higher price raises revenue, provided costs do not offset the gain. A manager who faces elastic demand realises that raising prices would lower revenue and instead looks for ways to cut costs, improve quality, or enlarge the market.
Factors that influence PED
Brand loyalty affects the responsiveness of quantity demanded to a price change, and strong brand attachment makes demand less sensitive to price. A dedicated Coca-Cola drinker will often keep buying Coke even when Pepsi is cheaper, so the numerical value of the price elasticity of demand falls toward zero.
The availability of substitutes is another influence. When buyers can switch quickly to close alternatives, a rise in price leads to a large fall in quantity demanded, and the elasticity is high in absolute value. Chocolate bars illustrate this point because many nearly identical brands sit side by side on the shelf. Petrol, with few practical substitutes for most motorists, shows the opposite case and exhibits low elasticity.
The proportion of income spent on the product also matters. A product that takes only a tiny share of the household budget, like table salt, attracts little attention when its price moves. Demand therefore changes only slightly and the elasticity is low in absolute value. A new car absorbs a large part of annual income, so a similar price movement triggers a much bigger percentage change in quantity demanded and the elasticity is high.
Whether the good is viewed as a necessity or a luxury shapes elasticity as well. Buyers consider bread, milk, gas, and electricity essential for daily life and continue to buy them even when prices rise, so the elasticity remains low. Items that people can easily postpone or forgo, such as foreign holidays or designer shoes, have a high elasticity because quantity demanded reacts strongly to price.
Timeframe is also important. In the short run consumers face habits, contracts and limited information, so quantity demanded cannot respond fully to a price change and elasticity is low. Given more time they can compare alternatives, reorganise routines or adopt new technologies, and quantity demanded becomes much more responsive, so the absolute value of the elasticity rises.
Income elasticity of demand
Income elasticity of demand, written YED, compares the percentage change in quantity demanded with the percentage change in consumer income.
Income elasticity of demand (YED) a measure of the sensitivity of quantity demanded to a change in consumer income. A positive YED identifies a normal good because quantity demanded moves in the same direction as income. A negative YED identifies an inferior good because quantity demanded moves in the opposite direction. Values between zero and one describe normal necessities because quantity rises less than proportionally with income. Values above one describe superior or luxury goods because quantity rises more than proportionally with income.
Income elasticity of demand (YED) | Economic meaning | Plain example |
|---|---|---|
YED > 1 | Superior or luxury good because quantity rises more than proportionally with income. | When average income climbs by ten percent, sales of high-end smartphones jump by twenty-five percent. |
0 < YED ≤ 1 | Normal good because quantity rises less than proportionally with income. | A ten percent rise in income nudges bread consumption up by two percent. |
YED = 0 | Quantity is insensitive to income so demand is income neutral. | Extra income leaves salt purchases unchanged. |
YED < 0 | An inferior good because quantity falls as income rises. | When income increases by eight percent, demand for bargain coach travel slips by three percent. |
If income rises by ten percent and demand for digital cameras rises by twenty percent, the YED is plus two and the good is a superior normal good. If income rises by ten percent and demand for coach travel falls by three percent, the YED is minus zero point three and coach travel is an inferior good. The sign and size help firms to forecast sales during booms and recessions.
Cross elasticity of demand
Cross elasticity of demand, written XED, compares the percentage change in quantity demanded of good X with the percentage change in price of good Y. Cross elasticity of demand (XED) a measure of the sensitivity of quantity demanded of a good or service to a change in the price of some other good or service.
A positive XED means the two goods are substitutes because a rise in the price of Y raises demand for X. A negative XED means the two goods are complements because a rise in the price of Y lowers demand for X. A value close to zero means the goods are unrelated.
Cross elasticity of demand (XED) | Economic meaning | Plain example |
|---|---|---|
XED > 0 | Goods are substitutes because a price rise in one raises demand for the other. | A fifteen percent rise in beef price lifts demand for chicken by six percent. |
XED = 0 | Goods are unrelated because the price of one has no material effect on the other. | A change in gold price leaves the demand for chocolate essentially unchanged. |
XED < 0 | Goods are complements because a price rise in one lowers demand for the other. | A ten percent increase in printer price trims ink-cartridge demand by eight percent. |
If the price of beef rises and the quantity demanded of lamb rises, the XED is positive and beef and lamb are substitutes. If the price of ink cartridges rises and the quantity demanded of printers falls, the XED is negative and the two items are complements. Knowing XED helps a firm to identify its competitive set and to anticipate how pricing decisions in neighbouring markets will affect its own sales.
Price elasticity of supply
Price elasticity of supply, written PES, compares the percentage change in quantity supplied with the percentage change in price. Price elasticity of supply (PES) is a measure of the sensitivity of the quantity supplied of a good or service to a change in the price of that good or service.
Supply curves slope upward, so PES is normally positive. A PES greater than one identifies elastic supply because producers are able to expand output by a larger percentage than the price rise. A PES between zero and one identifies inelastic supply because producers expand output by a smaller percentage than the price rise.
Price elasticity of supply (PES) | Economic meaning | Plain example |
|---|---|---|
PES > 1 | Supply is elastic because quantity supplied responds more than proportionally to price. | A five percent rise in the market price of carrots prompts farmers to raise weekly output by eight percent. |
PES = 1 | Unit elasticity because quantity supplied responds in the same proportion as price. | A ten percent increase in timber price brings a ten percent rise in logs brought to market. |
0 < PES < 1 | Supply is inelastic because quantity supplied responds less than proportionally to price. | A twenty percent jump in copper price moves mine output up by only five percent in the short run. |
PES = 0 | Perfectly inelastic because quantity supplied is fixed over the relevant period. | A vineyard can supply only this year’s harvest of vintage wine whatever the auction price may be. |
PES → ∞ | Perfectly elastic because firms stand ready to supply any quantity at the ruling price but none at a lower price. | Firms will deliver any amount of identical memory chips at £2 each yet none at £1.99. |
Producers can increase elastic responsiveness by keeping spare machinery, holding inventory, improving factor mobility, and extending the time horizon. In the short run, a factory may be working at full capacity, so supply is inelastic. In the long run, the firm can build a new plant, train workers, and source additional inputs, which shifts supply toward elasticity.
Perfectly inelastic supply appears as a vertical line. Quantity supplied is fixed, perhaps because only a certain stock of vintage wine exists. Perfectly elastic supply appears as a horizontal line. Firms can supply any quantity at the going price, perhaps because they can purchase inputs at constant prices in a competitive industry.
What makes the price elasticity of supply vary?
Producers do not all react to price changes in the same way. Five practical conditions determine how quickly output can increase when the market offers a higher price.
1 Mobility of factors of production
When labour, machinery, and space can be reassigned quickly from one line to another, supply is flexible, and the price elasticity of supply is high. A footwear firm that can divert workers and cutting equipment from trainers to hiking boots will raise boot output soon after the boot price climbs. Lack of mobility pins resources in their original uses, so supply is slow to expand and elasticity is low.
2 Availability of essential inputs
Output can grow only if the raw materials are on hand. When leather, metal eyelets, and waterproof fabrics are plentiful, manufacturers can step up production as soon as the price signal arrives, and supply is price elastic. Scarcity of inputs holds expansion back and keeps elasticity low.
3 Ability to build and hold inventories
If finished goods store well without loss of quality, firms can accumulate stocks in advance or keep unsold units on hand. When demand jumps, they release the inventory and the market sees an immediate surge in supply, which makes the elasticity high. Fresh berries that spoil in days cannot be stockpiled, so growers must wait for the next harvest before extra supply reaches the shelves, and elasticity remains low.
4 Spare productive capacity
Idle machines and underused shifts act like a buffer. When the price rises, managers run the plant for longer hours or bring dormant equipment back into service, and output rises at low marginal cost, which gives a high elasticity. A factory already running at full tilt must build new lines before it can expand, so its short-run elasticity is low.
5 Time
The clock is the most general constraint. In the short term, after a price increase, farmers cannot plant and harvest additional avocados overnight, and car makers cannot open a new assembly line in a week. As months pass, contracts are renegotiated, capital is installed, and labour is trained. The longer the time horizon, the more fully firms can adjust every factor of production, and the higher the price elasticity of supply becomes.
Practical use of PES
Governments rely on PES when setting taxes or subsidies. A tax placed on a good with an inelastic supply raises less distortion because quantity falls only a little. A subsidy aimed at a good with elastic supply and inelastic demand lowers the price to buyers and raises the quantity traded. The ultimate burden of a tax divides according to elasticity. The side with the smaller elasticity bears the larger share because it cannot escape easily.
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