Elasticity of Demand and Supply

Meaning, Price elasticity and measurement, Cross elasticity of demand,

Income elasticity of demand, (Determinants of elasticity of demand,
Importance of elasticity of demand),
Elasticity of Supply– (measurement and determinants)
 Elasticity of Demand

• Refers to degree of responsiveness of demand of a good to changes in its

price, income and prices of related goods
• Elasticity of demand: three main types
1. Price elasticity
2. Income elasticity
3. Cross elasticity
Also have elasticity of substitution

Concept of elasticity pertains to relative changes in Q.D. with change in

price of good or income or price of related goods – not to be confused
with price effect , income effect or substitution effect which actually
measure absolute changes in QD
Price elasticity of demand and its measurement
Response of quantity demanded of a good to changes in price given
consumers income, taste and prices of other goods
• Measure of relative change in quantity purchased due to relative
change in price
• Definition “the proportionate change in quantity demanded in
response to a small change in price, divided by the proportionate
change in price” - Mrs. Joan Robinson
Price elasticity = Proportionate change in quantity demanded
Proportionate change in price
e = Change in quantity demanded/quantity demanded ÷ Change in price/price
Putting it in symbols, we get
e p = Δq/q ÷ Δp/p
= Δq/q p/p
=
Where Δ stands for infinitesimal change, - price elasticity, q - quantity
purchased, p – price
In terms of mathematics, Elasticity is negative concept since change in quantity
demanded is in opposite direction to change in price but for sake of
convenience, we ignore the negative sign and take into account only the
numerical value.
Marshall who introduced the concept of elasticity into economic theory
remarked that the elasticity or responsiveness of demand in the market is
great or small according as the amount demanded increases much or little for
a given fall in price and diminishes much or little for a given rise in price.
1. Demand is said to be elastic if is greater than one
2. Demand is called inelastic if is less than one
3. Unit elasticity of demand or = 1 represents the dividing line
between elastic and inelastic demand
Less elastic DC More elastic DC
or inelastic demand
 Measurement of elasticity on a point on the
straight-line demand curve

=
=
= …(1)
Price falls from OP to OP’ then q.d. rises from OQ to OQ’
Change in price = = PP’
Change in Quantity demanded = = QQ’
From (1) = = …….(2)
We can prove that = lower segment /upper segment
Elasticity at a point on any demand curve can be similarly calculated
after drawing tanget to the curve at that point touching both the axes.
• Elasticity at different points on a demand curve

e=
 Total Outlay Method

• Changes in total outlay or expenditure made on the good as a result

of changes in its price, will also tell us if e is greater than 1, equal to 1
or less than 1 ( but again this method does not tell us the exact and
precise coefficient of elasticity.)
• If with change in price, total expenditure is same ---– ed = 1
• If with fall in price, total expenditure increases --- ed 1
if with rise in price total expenditure falls --- ed 1
• If with fall in price, expenditure on good decreases ---- ed 1
if with rise in price, expenditure increases -------- ed 1
 Arc elasticity of demand
• When price change is somewhat large elasticity is measured over an arc of the
demand curve. The point elasticity formula will not work in this case.
• To calculate elasticity, we use average of the two price figures and the average of
the two quantity figures.
• So, = =
= = .
Greater the convexity of the curve,
greater will be the divergence between
dashed line AB and arc AB.
So less approximation of true measure of elasticity
 Slope and price elasticity of demand curve

We know that =
Of this, is the reciprocal of the demand curve but the term brings about a
difference in slope and elasticity as it is different at different points.
In fact, even if slope is different, on two curves can be shown to be the same at any
given price.
In ODA, PE ll OA, so =
In ODB, PF ll OB, so =
So, = =
Or elasticity at E = elasticity at F, even though slopes are different.
• Similarly, we can show that elasticity declines as demand curve shifts
to the right.

• ( show OP/PA is greater than OP/PC)

 Cross elasticity of demand
Cross elasticity = Proportionate change in quantity demanded of X
Proportionate change in price of Y
ec = (Change in quantity demanded of X/quantity demanded of X) ÷ (Change in price of Y/price
of Y)

=
 Cross elasticity of substitutes or competing goods is positive (increase in
price of Y will lead to increase in quantity purchased of X)
 Cross elasticity of complement goods is negative (increase in price of Y will
lead to decrease in quantity purchased of X)
 Idea of cross-elasticity is used in defining market structure:
 Perfect competition - =
 Pure monopoly -
 Monopolistic competition -
• But one issue faced is that we can get negative cross elasticity when
income effect is also very strong. For strong income effect due to fall
in price of X, the quantity demanded of Y will increase even if X and Y
are not complements.
• The case of Giffen goods: If X is a Giffen good and Y is a superior
substitute , the quantity demanded of Y increases with fall in price of
X so is negative even though the two goods are not complements.
• Inherent flaw of cross elasticity approach to classification of goods is
that it is based on total price effect of the quantity demanded of one
good due to change in price of another good without compensating
for the change in real income ( without eliminating the income effect).
 Income elasticity
Shows the degree of responsiveness of quantity demanded of a good to a
small change in the income of consumers.
Income elasticity = Proportionate change in purchases of a good
Proportionate change in income
ei = (Change in quantity purchased/initial quantity purchased) ÷ (Small change
in income/initial income)

=
Instead of change in quantity purchased, we can also use changes in
expenditure made on the good. (expenditure = quantity purchased of the
good * price of the good). So, if X denotes expenditure and is change in
expenditure then,
= =
 Determinants of Price elasticity of demand
1. The number and kinds of substitutes: if close substitutes are available for a commodity, then its demand
tends to be elastic. When the price of a certain commodity goes up people will shift to its close substitutes
so the demand for that commodity will decline. The greater the possibility of substitution, the greater
than price elasticity of demand for it. If substitutes are not available people will have to buy it even when
its price rises, therefore, its demand would tend to be inelastic.
2. The position of a commodity in a consumer’s budget: the greater the proportion of income spent on
commodity, the greater will be its elasticity of demand and vice versa. Example - Clothing versus soap –
demand for soap is less elastic than clothing.
3. The number of uses of a commodity: the greater the number of uses a commodity can be put to, the
greater will be its price elasticity of demand. If the price of the commodity having several uses very high,
its demand will be small, and it will be put to the most important use and if the price of such a commodity
falls, it will be put to less important to uses also and so its quantity demanded will rise significantly.
4. Complementarity between goods: Households are generally less sensitive to the changes of price in goods
that are complementary with each other, or which are jointly used than in case of changes in prices of
those goods which have independent demand or used alone.
5. Time and elasticity: demand tends to be more elastic if the time involved is long. This is because
consumers can substitute goods in the long run. In the short run, substitution of one commodity with
another is not so easy. So, the longer the time period the greater is the ease with which commodities can
be substituted so greater will be the elasticity.
 Importance of the concept of elasticity
1. Pricing decisions of Business Firms: change in the price of a product will bring about a change
in the quantity demanded depending upon the coefficient of elasticity. Change in quantity
demanded due to a price rise by a firm will affect the total consumer expenditure and will
therefore affect the earnings of the firm. The demand for a product of a firm happens to be
elastic then if the firm attempts to increase the price of its product, there will be a fall in its
revenue. Instead of gaining from the increase in price, it will lose if the demand for product
happens to be elastic. On the other hand, if the demand for the product happens to be
inelastic, then the increase in price by it will raise its total revenue.
2. Uses in Economic policy regarding price regulation, especially of farm products : governments
of many countries, regulate the prices of farm products. This price regulation involves the
increase in the prices of farm products with the expectations that the demand for the farm
products inelastic. By restricting the supply in the market, the government succeeds in raising
the prices of farm products. The demand for these products being inelastic, the quantity
demanded does not fall very much. So, expenditure on farm products increases, raising the
incomes of the agriculturists.
3. Explanation of the ‘Paradox’ of plenty: A bumper crop reaped by farmers brings a smaller
income to them. This is because with greater supply prices drop drastically, but demand being
inelastic the total expenditure declines. So, farmers see a fall in incomes.
4. Uses in international trade: When a currency is devalued, the price of the imported goods rises, and the prices of exports are lowered. If
the demand for a country's exports is inelastic, the fall in prices of exports as a result of devaluation will lower their foreign exchange
earnings rather than increasing them. This is because demand being inelastic, as a result of the fall in prices, quantity demanded of the
exported products will increase very little and the country will suffer because of the lower prices. On the other hand, if the demand for a
country's exports is elastic, then the fall in prices of these exports due to devaluation will bring about a large increase in their quantity
demanded which will increase the foreign exchange earnings of the country and will help in solving the balance of payments problem.
Similarly, if the objective of devaluation is to reduce the imports of a country, then this will be realised only when the demand for imports
is elastic. Imports will decline very much as a result of rise in prices brought about by devaluation and the country will save a good
amount of foreign exchange. If the demand for imports is inelastic, the increase in prices as a result of devaluation will adversely affect
the balance of payments, because at higher prices of the imports and almost the same quantity of imports, the country would have to
spend more on the imports than before.
5. Importance in Fiscal Policy: The imposition of an indirect tax raises the price of the commodity. If the demand for the commodity is
elastic, then rise in price caused by the tax will bring about a large decline in the quantity demanded and as a result, the government
revenue will decline rather than increase. The government can succeed in increasing its revenue by the imposition of commodity taxes
only if the demand for the commodity is inelastic. Elasticity of demand also determines to what extent a tax on a commodity can be
shifted to the consumer. If the demand for commodity is perfectly inelastic, the whole of the burden of the commodity tax will fall on the
consumer. If the demand for commodity is perfectly elastic, then the imposition of the tax will not cause any rise in its price so the whole
burden of the tax will be borne by the manufacturers or sellers.
6. Determination of wages: when a trade union demands higher wages for the workers the elasticity of demand becomes important. The
rise in wages will raise the price of the commodity produced by them. If the demand for the product is elastic the rise in price will bring
about a large reduction in the quantity demanded which will induce the firm to reduce production. the fall in production will lower the
number of workers employed. So, an attempt by the trade union to raise wages will cause unemployment among the workers.
7. Theoretical importance: elasticity of demand is used as a tool of analysis to explain many economic theories and problems such as the
theory of price determination, price discrimination by a monopoly, measuring the degree of monopoly power, classification of substitutes
and complements on the basis of cross price elasticity of demand, explaining the incidence of indirect tax such as excise duty and sales
tax, elasticity of substitution is used in the theory of distributive shares which explains the aggregative shares of different factors of
production in their national income of work country.
 Elasticity of supply

The elasticity of supply is a relative measure of the responsiveness of

quantity supplied of a commodity to the changes in its price.
The greater the responsiveness of quantity supplied of a commodity to
the changes in its price, the greater is its elasticity
elasticity of supply = Proportionate change in quantity supplied
Proportionate change in price
es = Δq/q ÷ Δp/p = Δq/q p/ Δp
Es = Δq/Δp p/q
1. = = = = ( greater than one)

2. = (less than unity )

3. = ( equal to one)

For a curve, to get elasticity at a point, draw a tangent touching the x-

axis and calculate elasticity with above formula.
 Determinants of elasticity of supply
1. Change in cost of production: elasticity of supply of a commodity depends upon the ease with
which increases in output can be obtained without bringing about rise and cost of production. If
with increase in production the marginal cost of production goes up, the elasticity of supply to that
extent would be less. In the short run, with some factors of production being fixed, the increase in
amount of variable factor eventually causes diminishing marginal returns and as a result, with the
expansion of output, marginal cost of production rises. This causes elasticity of supply in the short
run to be relatively less but in the long run, the firm can increase output by varying all factors and
new firms can enter the industry adding to the supply, so the long run supply curve of a commodity
is more elastic than in the short run.
2. Responsiveness of producers: If producers do not respond positively to the increase in prices, the
quantity supplied of a product would not increase as a result of rise in its price. For example, it has
been seen that sometimes farmers in developing countries respond negatively to the rise in price of
their agricultural products – at higher agricultural prices, the need for fixed money income is met by
selling smaller quantities of food grains - so at higher prices they sell smaller quantities of
foodgrains rather than more of them.
3. Availability of the facilities for expanding output: farmers would not be able to raise the supplies of
agricultural products in response to rise in prices if there is lack of fertilizers or irrigation facilities
etc. Similarly, in the industrial field, if there is shortage of power, fuel essential raw materials, the
expansion in supply will not be forthcoming in response to rise in prices of industrial goods