Elasticity: Demand and
Supply
BY
Hopkins Kawaye
(BsocEco,[Link])
Lecture 2
Perfectly Elastic Demand
• One extreme case is given by a perfectly elastic demand curve, as
appears in the diagram on next slide.
• Demand is perfectly elastic only in the special case of a horizontal
demand curve.
• The elasticity measure in this case is infinite (notice that the
denominator of the elasticity measure equals zero).
• The closest we get to observe a perfectly elastic demand curve is the
demand curve facing a firm that produces a very small share of the
total quantity produced in a market.
• In this case, the firms is such a small share of the market that it must
take the market price as given.
• An individual farmer, for example, has no control over the price that it
receives when it brings its product to market.
• Whether it supplies 100 or 20,000 bushels of wheat, the price that it
received per bushel is that day's market price.
Perfectly Inelastic Demand
• At the other extreme, a vertical demand curve is said to be perfectly
inelastic.
• Such a demand curve appears in the diagram below.
• Note that the price elasticity of demand equals zero for a perfectly
inelastic demand curve since the % change in quantity demanded
equals zero.
• In practice, we do not expect to see demand curves that are perfectly
inelastic.
• For some range of prices, the demand for insulin, dialysis, and other
such medical treatments, is likely to be close to being perfectly
inelastic.
• As the price for these commodities rises, however, we would
eventually expect to see the quantity demanded fall because
individuals have limited budgets.
Elasticity along a Linear Demand curve
• Students considering elasticity for the first time often believe that
demand is more elastic when the demand curve is flat and less elastic
when it is steep.
• Unfortunately, it is not quite as simple as that... In particular, if we
consider the case of any downward sloping linear demand curve, we
will see that elasticity varies continuously along this curve.
• It is true that a one-unit change in price always results in a constant
change in quantity demanded along a linear demand curve (since the
slope is constant).
• The ratio of the percentage change in quantity demanded to the
percentage change in price, however, changes continuously along such
a curve.
• To see why this occurs, it is necessary to consider the distinction
between a change in the level of a variable and the percentage change
in the same variable. Suppose we consider the distinction by
discussing the percentage change that results from a MK1 increase in
the price of a good.
A price increase from MK1 to MK2 represents a 100% increase in price,
A price increase from MK2 to MK3 represents a 50% increase in price,
A price increase from MK3 to MK4 represents a 33% increase in price, and
A price increase from MK10 to MK11 represents a 10% increase in price.
Notice that, even though the price increases by MK1 in each case, the percentage
change in price becomes smaller when the starting value is larger. Let's use this
concept to explain why the price elasticity of demand varies along a linear demand
curve.
• At the top of the curve, the percentage change in quantity is large
(since the level of quantity is relatively low) while the percentage
change in price is small (since the level of price is relatively high).
• Thus, demand will be relatively elastic at the top of the demand curve.
• At the bottom of the curve, the same change in quantity demanded is a
small percentage change (since the level of quantity is large) while the
change in price is now a relatively large percentage change (since the level
of price is low).
• Thus, demand is relatively inelastic at the bottom of the demand curve.
• More generally, we can note that elasticity declines continuously along
a linear demand curve.
• The top portion of the demand curve will be highly elastic and the
bottom is highly inelastic.
• In between, elasticity gradually becomes smaller as price declines and
quantity rises.
• At some point, demand changes from being elastic to inelastic.
• The point at which that occurs, of course, is the point at which demand
is unit elastic. This relationship is illustrated in the diagram above.
Arc elasticity measure
• Suppose that we wish to measure the elasticity of demand in the
interval between a price of MK4 and a price of MK5.
• In this case, if we start at MK4 and increase to MK5, price has
increased by 25%.
• If we start at MK5 and move to MK4, however, price has fallen by
20%.
• Which percentage change should be used to represent a change
between MK4 and MK5?
• To avoid ambiguity, the most common measure is to use a concept known
as arc elasticity in which the midpoint of the interval is used as the base
value in computing elasticity.
• Under this approach, the price elasticity formula becomes:
• where:
• Let's consider an example. Suppose that quantity demanded falls from
60 to 40 when the price rises from MK3 to MK5. The arc elasticity
measure is given by:
In this interval, demand is inelastic (since Ed < 1).
Determinants of price elasticity of demand
1. Close substitutes are available
• When there is a large number of substitutes available, consumers
respond to a higher price of a good by buying more of the substitute
goods and less of the relatively more expensive commodity.
• Thus, we would expect a relatively high price elasticity of demand for
goods or services with many close substitutes, but would expect a
relatively inelastic demand for commodities such as insulin or AZT
with few close substitutes.
2. The good or service is a large share of the consumer's budget
• If the good is a small share of a consumer's budget, a change in the
price of the good will have little impact on the individual's purchasing
power.
• In this case, a price change will have relatively little impact on the
quantity consumed.
• A doubling of the price of salt, for example, would not have much of
an impact on a typical consumer's budget.
• But, when a good is a relatively large share of a person's spending, a
price increase has a larger effect on their purchasing power.
• To take an extreme example, suppose that a person spends 50% of his
or her income on a commodity and the price doubled.
• It's likely that the individual will substantially reduce their spending in
response to the higher price when spending on the good comprises a
larger share of a consumer's budget.
• Thus, demand will tend to be more elastic for goods that are a large
share of a typical consumer's budget.
3. A longer time period is considered
• Consumers often have more possibilities for substitutes for a good when
a longer time period is considered.
• Consider, for example, the effect of a higher price for fuel oil or natural
gas.
• In the short run, individuals may lower the temperature and wear
warmer clothes, but are unlikely to reduce their energy consumption by
very much.
• Over a longer time period, however, consumers may install more energy
efficient furnaces, better insulation, and more energy efficient windows and
doors.
• Thus, we would expect that the demand for either fuel oil or natural gas
would be more elastic in the long run than in the short run.
