A Guide to Supply and Demand Elasticities in Economics

Economists introduce the concept of elasticity. This concept measures how responsive consumers and producers are to changes in price and income. Understanding elasticity is crucial for businesses and governments, allowing them to make informed decisions regarding pricing, taxation, resource allocation, and predicting market behavior.

Four main types of elasticity exist: 

• Price elasticity of demand (PED)
• Price elasticity of supply (PES)
• Cross-price elasticity of demand (XED)
• Income elasticity of demand (YED)

Each type sheds light on a specific aspect of how markets react to price and income fluctuations.

Price elasticity of demand (PED)

Price elasticity of demand (PED) measures how much consumers adjust their purchases of a good in response to price fluctuations. It reveals how sensitive consumers are to price changes. Businesses can leverage PED to identify optimal pricing strategies that maximize total revenue.

Calculating and interpreting price elasticity of demand (PED)

A formula calculates PED:

• PED = (% Change in Quantity Demanded) / (% Change in Price)

Let’s use an example to illustrate this calculation. Imagine movie ticket prices increase from $10 to $12, and the quantity demanded drops from 100 tickets to 80 tickets.

• Calculate the percentage change in quantity demanded: [(80 tickets – 100 tickets) / 100 tickets] x 100% = -20%
• Calculate the percentage change in price: [( $12 – $10) / $10] x 100% = 20%
• Now calculate PED: (-20%) / (20%) = -1

Interpreting the PED Value

The PED value, in this case, -1, is negative because the price and quantity demanded move in opposite directions (law of demand). However, we typically focus on the absolute value of PED for easier interpretation. Here’s a breakdown of PED interpretations:

PED < 1 (inelastic demand): Small changes in price lead to relatively small changes in quantity demanded. Consumers are less responsive to price changes for inelastic goods (e.g., gasoline in the short run).

PED > 1 (elastic demand): Small changes in price lead to significant changes in quantity demanded. Consumers are highly responsive to price changes for elastic goods (e.g., streaming services).

PED = 0 (perfectly inelastic demand): Even significant price changes have no impact on the quantity demanded. It is rare but applies to essential goods with no close substitutes (e.g., insulin for diabetics).

PED = 1 (unit elastic demand): The percentage change in quantity demanded is equal to the percentage change in price.

PED approaches positive or negative infinity (perfectly elastic demand): A tiny price change leads to an infinite increase or decrease in quantity demanded (a hypothetical scenario).

The movie ticket example: inelastic demand

In our example, the absolute value of PED is 1, indicating inelastic demand. This means that even though the price of movie tickets increased by 20%, the quantity demanded only decreased by 20%. Consumers are relatively insensitive to the price change within this range, suggesting movie tickets might be a necessity or have few close substitutes for entertainment.

By understanding PED, businesses can make informed pricing decisions. For inelastic goods like movie tickets, businesses might consider small price increases to maximize total revenue, as the quantity demanded won’t significantly decrease. However, for elastic goods, even small price hikes could lead to a substantial drop in sales.

The determinants of price elasticity of demand (PED)

Several factors influence PED, shaping how sensitive consumers are to price changes for a particular good:

• Substitutes: The availability of substitutes plays a key role. When numerous substitutes exist (e.g., different streaming services), a price increase for one option likely leads consumers to switch, resulting in elastic demand. Conversely, with few substitutes (e.g., gasoline in the short run), demand becomes more inelastic as consumers have limited choices.
• Proportion of income: Goods that represent a significant portion of a consumer’s income tend to have elastic demand. For instance, a price hike for essential medication might significantly impact a household’s budget, leading to reduced consumption.
• Necessity vs. luxury: Necessity goods, like insulin for diabetics, have inelastic demand. Consumers are less likely to forgo such essential items even with price increases. Conversely, luxury goods, like designer handbags, have elastic demand. Consumers can easily adjust their purchases based on price fluctuations.
• Addiction: Addictive products, like cigarettes, often exhibit inelastic demand in the short run. Consumers might be willing to pay a premium despite price increases due to the addictive nature of the product.
• Time horizon: The time frame plays a role. In the short run, consumers might have limited options to adjust their consumption patterns. However, in the long run, as they find substitutes or adjust their budgets, demand becomes more elastic.

Applying price elasticity of demand in the decisions

Understanding PED benefits both businesses and governments:

Businesses: Businesses can leverage PED to set optimal prices. For elastic goods, lowering prices can attract new customers and potentially increase total revenue. Conversely, for inelastic goods, small price increases might not significantly impact sales volume, potentially leading to higher profits.

For instance, they might employ price discrimination strategies for goods with inelastic demand (e.g., charging higher prices to business customers than individual consumers). They might also implement price skimming for new products with elastic demand, gradually lowering the price as the market matures. Understanding PED allows businesses to optimize their pricing strategies for different products and market conditions.

Governments: Governments use PED to design effective tax policies. Inelastic goods, like cigarettes, typically generate higher tax revenue compared to elastic goods, like gasoline. This is because even with price increases due to taxes, consumers might not significantly reduce their consumption of inelastic goods. Governments can leverage PED to design tax policies that achieve their desired balance between revenue generation and potential economic impacts.

Deadweight loss refers to the economic inefficiency caused by a tax that reduces overall consumer and producer surplus. By taxing elastic goods, governments might discourage consumption and production, leading to a net loss in economic welfare. Understanding PED allows policymakers to design tax structures that minimize deadweight loss.

Cross-price elasticity of demand (XED) 

We explore cross-price elasticity of demand (XED), a concept that quantifies how a price change in one good impacts the demand for another good. This reveals whether the goods are substitutes or complements.

XED tells us how responsive consumers of one good (Good A) are to a price change in a related good (Good B). Imagine a price hike for streaming service A (Good A). XED predicts the percentage change in demand for cable TV (Good B) resulting from this price increase. Are they substitutes or complements?

Calculating and interpreting cross-price elasticity of demand (XED)

The formula for XED is:

• XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B)

Example: streaming service A and cable TV

Suppose the price of streaming service A increases by 10%, and the number of cable TV subscriptions decreases by 5%. Let’s calculate the XED:

• XED = ((-5%) / (10%))

Similar to PED, we focus on the absolute value of XED:

• 0-1 (Inelastic): Consumers might be relatively unresponsive to the price change of streaming service A. A small price increase for A might lead to a small decrease in cable TV demand (less than 5%).
• 1 (Unit Elastic): Consumers might be equally responsive to price changes. A 10% increase for A could lead to a 10% decrease in cable TV demand.
• >1 (Elastic): Consumers might be highly responsive to the price change of streaming service A. A small price increase for A could lead to a significant decrease in cable TV demand (more than 5%).

In this scenario, without knowing the exact percentage change, we can only determine that the XED is positive (between 0 and 1), suggesting cable TV and streaming service A are likely substitutes. A positive XED indicates that when the price of one substitute increases, the demand for the other substitute rises.

XED: positive for substitutes, negative for complements

XED can be positive or negative depending on the good relationship:

• Positive XED (substitutes): When the price of one substitute (Good A) increases, the demand for the other substitute (Good B) rises. For example, a price increase for smartphones (Good A) might lead to higher demand for tablets (Good B) due to a positive XED.
• Negative XED (complements): When the price of one complement (Good A) increases, the demand for the other complement (Good B) falls. For example, a pizza price increase might lead to lower demand for soda (Good B) due to a negative XED.

By understanding XED, businesses can make informed decisions. For instance, streaming service A might use the XED with cable TV to determine its optimal pricing strategy. A high positive XED suggests that a price increase for streaming service A could significantly benefit them by attracting more customers who switch from cable TV.

Income elasticity of demand (YED)

Income elasticity of demand (YED) measures how responsive consumers are to changes in their income when it comes to purchasing a particular good or service. It essentially tells businesses whether a good is normal, inferior, or neutral in relation to income levels.

Imagine a recession hits, causing a 4% drop in average household income. You observe bike sales rise by 8% while car sales fall by 3%. YED helps us understand how responsive consumer demand for these products is to income changes.

Calculating income elasticity of demand (YED) 

The formula for YED is:

YED = (% Change in Quantity Demanded of a Good) / (% Change in Consumer Income)

Take bikes vs. cars as the examples:

• Bike YED: With a rise in bike sales (8%) despite a fall in income (4%), we can calculate the YED for bikes: YED = 8% / -4% = -2. This negative value indicates elastic demand. As income falls, demand for bikes increases significantly, suggesting bikes might be an inferior good.
• Car YED: Car sales see a 3% drop, resulting in a YED of -3% / -4% = 0.75. The positive value (though less than 1) suggests inelastic demand. Even with a fall in income, the decrease in car sales is relatively smaller, indicating cars might be a normal good.

Interpreting YED values

Similar to PED and XED, we focus on the absolute value of YED:

• 0-1 (inelastic): Demand changes are relatively small compared to income changes. (e.g., Cars in our example)
• 1 (unit elastic): Demand changes proportionally to income changes.
• >1 (elastic): Demand changes are significant compared to income changes. (e.g., Bikes in our example)

Similar to PED and XED, we focus on the absolute value of YED:

• 0-1 (inelastic): Demand changes are relatively small compared to income changes. (e.g., Cars in our example)
• 1 (unit elastic): Demand changes proportionally to income changes.
• >1 (elastic): Demand changes are significant compared to income changes. (e.g., Bikes in our example)

YED: positive or negative? Normal vs. inferior goods

YED can be positive or negative, revealing the good’s category:

• Positive YED (normal good): Demand rises as income rises (e.g., restaurant meals). A positive YED coefficient for cars suggests they might be a normal good.
• Negative YED (inferior good): Demand falls as income rises (e.g., instant noodles). The negative YED for bikes suggests they might be an inferior good as consumers shift towards better alternatives with higher incomes.

Where do luxuries fit in?

Luxuries are typically normal goods with a high-income elasticity. This means that as income increases, demand for luxuries increases at a greater rate than the increase in income itself. For example, someone with a significant income increase might not just buy one new outfit; they might invest in a designer wardrobe.

A special case: Giffen goods and Veblen goods

Within economic theory, the concept of Giffen goods presents a unique challenge. Giffen goods are a subclass of inferior goods characterized by a peculiar response to price changes. Unlike most goods, where a price decrease leads to increased demand, a decrease in the price of a Giffen good can actually lead to a decrease in the quantity demanded, resulting in an upward-sloping demand curve. This seemingly paradoxical behavior stems from the interplay between two key economic concepts: the income effect and the substitution effect.

Meanwhile, Veblen goods stand in stark contrast to Giffen goods. These luxury items, such as expensive jewelry, derive value from their high price tags. The association with status and exclusivity makes them more desirable as their prices climb. Unlike Giffen goods, which are inferior and see a decrease in demand with rising income, Veblen goods are not inferior. An increase in income wouldn’t necessarily lead to a drop in demand for Veblen goods.

Price elasticity of supply (PES)

Price elasticity of supply (PES) measures how responsive producers are to changes in the market price of a good or service. It tells us how much the quantity supplied changes when the price fluctuates. This information is crucial for businesses and governments to understand how price movements might impact production levels and product availability.

Calculating price elasticity of supply (PES)

Similar to price elasticity of demand (PED), PES is calculated using a formula that divides the percentage change in quantity supplied by the percentage change in price:

• PES = (% Change in Quantity Supplied) / (% Change in Price)

PES values, similar to PED, fall into three groups:

• 0-1 (Inelastic): Producers are relatively unresponsive to price changes.
• 1 (Unit Elastic): Producers adjust their supply proportionally to price changes.
• >1 (Elastic): Producers are highly responsive to price changes.

For example, imagine the price of tablets increases from $400 to $500, and the quantity supplied rises from 1 million to 1.1 million units in the following week. The PES in this short-run scenario would be:

• PES (short-run) = ((1.1 million – 1 million) / 1 million) / ((500 – 400) / 400) = 0.1 / 0.25 = 0.4

Short-run vs. Long-run elasticity

PES is significantly impacted by the time frame considered. In the short run, producers might have limited capacity to adjust production in response to price changes. This limited flexibility leads to a relatively inelastic supply (low PES). In our tablet example, the short-run PES was 0.4, indicating a somewhat inelastic response to the price increase.

However, in the long run, producers can take steps to adjust their production capacity. This might involve expanding facilities, hiring more workers, or acquiring new equipment. These adjustments lead to a more elastic supply (higher PES). Let’s revisit our tablet example. If we consider a longer period (3 months after the price increase), and the quantity supplied rises to 2 million units, the long-run PES would be:

PES (long-run) = ((2 million – 1 million) / 1 million) / ((500 – 400) / 400) = 1 / 0.25 = 4

As evident, the PES for tablets is significantly higher in the long run (4) compared to the short run (0.4), showcasing the increased responsiveness due to production adjustments.

Factors affecting price elasticity of supply (PES)

Several factors influence PES beyond the time frame:

• Mobility of resources: High mobility (low-skilled labor, adaptable production) allows producers to adjust supply to price changes (elastic supply) easily. Conversely, low mobility (specialized skills, complex processes) makes supply adjustments difficult (inelastic supply). Imagine a bakery (elastic) vs. a car factory (inelastic) responding to a price increase.
• Ability to store stocks: Storable goods (canned vegetables) can be stockpiled to meet demand fluctuations, making supply more elastic. Perishable goods (lettuce) have limited storage options, making supply more inelastic in the short run.

Point elasticity vs. Arc elasticity: understanding the difference

When calculating the elasticity of demand, we encounter two main approaches: point elasticity and arc elasticity. Each serves a distinct purpose and provides different insights.

Point elasticity measures the responsiveness of demand (or supply) to a price change at a specific point on the demand (or supply) curve. It essentially tells us how much quantity demanded (or supplied) changes in response to a small price change at that particular price and quantity level.

Arc elasticity, on the other hand, focuses on the average elasticity over a segment of the demand (or supply) curve. Unlike point elasticity, which looks at a specific point, arc elasticity considers the initial and final price and quantity values within a certain range.

Calculating point elasticity and arc elasticity

Scenario: We’re examining the price elasticity of demand for a good, considering a price decline from $4 to $3 and a corresponding increase in quantity demanded from 200 units to 300 units.

Point elasticity (A to B):

Point elasticity helps us understand the responsiveness of demand at a specific point on the demand curve. In this case, we might be interested in the elasticity at the initial price of $4, which is where the price change originates.

• Quantity change: The quantity demanded increases by 100 units (300 units—200 units), which translates to a percentage change of (100 units / 200 units) * 100% = 50%.
• Price change: The price falls by $1 (from $4 to $3). This represents a percentage change of ($1 / $4) * 100% = -25% (negative because it’s a decrease).

Here, we use the original price as the reference point for the percentage change calculation:

• PED (point elasticity) = (% Change in Quantity) / (% Change in Price) PED = 50% / -25% ≈ -2.0 (absolute value ≈ 2.0)

We follow the same steps as before to calculate the arc elasticity:

• Midpoint calculation: We calculate the average price and quantity for the entire range:
  • Midpoint Price = ($4 + $3) / 2 = $3.50
  • Midpoint Quantity= (200 units + 300 units) / 2 = 250 units
• Percentage changes:
  • % Change in Quantity = (300 units – 200 units) / 250 units = 0.40 (or 40%)
  • % Change in Price = ($4 – $3) / $3.50 = -0.2857 (or -28.57%)

Calculating arc elasticity:

• PED (arc elasticity) = (% Change in Quantity) / (% Change in Price) PED = 0.40 / -0.2857 ≈ -1.40 (absolute value ≈ 1.40)