ELASTICITY OF SUPPLY

ELASTICITY OF SUPPLY

Elasticity of supply measures the change in the amount that a firm supplies in 

response to a change in price. It is measured as follows

percentage change in quantity supplied / percentage change in price

Again the Q is on top, remember QPR.

VALUES OF PRICE ELASTICITY OF SUPPLY

•  Elasticity is greater than one - the good is elastic and is highly 

responsive to changes in price. A percentage change in price leads to 

a larger percentage change in the quantity supplied. A straight line 

supply curve will intersect the price axis.

•  Elasticity is equal to one - the good has unitary elasticity, a percentage 

change in price will lead to an equal percentage change in the quantity 

supplied. Any straight line supply curve that intersects the origin will 

have unitary elasticity.

•  Elasticity is less than one - the good is inelastic and not very 

responsive to changes in price. A percentage change in price leads to 

a smaller percentage change in quantity. . A straight line supply curve 

will intersect the quantity axis. 

•  Elasticity is equal to zero - the good is perfectly inelastic and a change 

in price lead to no change in the quantity supplied.

•  Elasticity is equal to infinity - the good is perfectly elastic and any 

decrease in price will cause the quantity supplied to fall to zero. 

The different supply curves are shown below: 

INCOME ELASTICITY OF DEMAND

The demand for a good will change if consumers' incomes change, income
elasticity of demand measures that change. If the demand for housing were to
increase by 20% in response to a 5% increase in income, the income
elasticity of demand would be positive and relatively high.


If the demand for corned beef fell by 8% in response to the 5% increase in
income, then income elasticity of demand would be negative and relatively
small.


If the demand for food remained unchanged in response to an increase in
income, then the income elasticity of demand would be zero.


It is important to note that the distinction between income elasticity of demand
and price elasticity of demand here. Whether income elasticity has a positive
or negative sign is of vital importance. A positive income elasticity of demand
means that an increase in income will lead to an increase in demand for the
good in question. Conversely a negative income elasticity of demand means
that an increase in income will lead to a fall in demand for the good in
question.

The formula for measuring income elasticity of demand is:

%percentage change in quantity demanded/%percentage change in income  

(Not quite QPR, but Q is still on the top!)

Some simple calculations are shown below.

VALUES OF INCOME ELASTICITY

•  Income elastic demand - a good or service has an income elastic 

demand if income elasticity is greater than 1. A 1% change in income 

causes a greater than 1% change in quantity demanded. These are 

called luxury goods, e.g. foreign holidays.

•  Income inelastic demand - the value of income elasticity is between 0 

and 1. A 1% change in incomes causes a less than 1% change in 

quantity demanded. As the quantity demanded doesn't change a great 

deal in response to income we can assume the good is a necessity, 

e.g., food and clothes.

•  Negative income elasticity - in this case a change in income will bring 

about an opposite change in quantity demanded. If income goes up the 

quantity demanded will go down. The good is described as inferior, 

e.g., happy shopper bread.

Different income elasticities of demand are shown in the table below: 

CROSS ELASTICITY OF DEMAND

CROSS ELASTICITY OF DEMAND

The quantity demanded of a particular good varies according to the price of 

other goods. Cross elasticity of demand measures the responsiveness of the 

quantity demanded of one good to changes in the price of another. 

The formula for measuring cross elasticity of demand for good X is:

% change in quantity demanded of good X/% change in price of another good Y   OR  

% change in quantity demanded of good X DIVIDED BY% change in price of another good Y 

Two goods which are substitutes will have a positive cross elasticity. An 

increase in the price of one good (e.g. mars bars) will lead to an increase in 

the quantity demanded of a substitute (e.g. snickers).

Two goods which are complements will have a negative cross elasticity. An 

increase in the price of one good (e.g. computers) will lead to a fall in demand 

of a complement (e.g. computer games). 

The cross elasticity of two goods which have no relationship to each other 

would be 0 (e.g. jelly and pot plants). 

PRICE ELASTICITY OF DEMAND

The quantity demanded of a good is affected by changes in the price of the
good, changes in prices of other goods, changes in income and changes in
other relevant factors. Elasticity is a measure of just how much the quantity
demanded will be affected by a change in price, income, price of other goods
etc..


If the price of steak increases by 1% and the quantity demanded then falls by
20% we can see there has been a very large drop in the amount demanded in
comparison to the change in price. The price elasticity of demand for steak is
said to be high.


If the quantity of steak demanded was to only fall by 0.01%, we can see this is
a fairly insignificant fall in quantity in response to the 1% increase in price. In
this case the price elasticity of demand for steak is low.

It can be calculated using the following formula:



percentage change in quantity demanded/percentage change in price


(To help you remember quantity is on top of price think of the football team
QPR).The table below shows a number of calculations of price elasticity of
demand.

            % change in price     % change in quantity      elasticity 

                    10                                  20                                2   

                    50                                  25                               0.5 

                     7                                   28                                4 

                     9                                    3                                0.33 

Elasticity figure are actually negative, but economists forget this point in the 

name of simplicity.  

ELASTIC AND INELASTIC DEMAND

Different values of price elasticity are given special names:

•  Demand is price elastic, if the value of elasticity is greater than one. If 

demand for a good is price elastic then a percentage change in price 

will lead to an even larger percentage change in the quantity 

demanded. For example if a 10% rise in the price of CDs leads to a 

20% fall in the demand, then price elasticity is 20% / 10% or 2 and the 

demand for CDs is therefore elastic.

SPECIAL CASES OF ELASTICITY

•  Demand is infinitely inelastic if the value of elasticity is zero (zero 

divided by any number). Any change in price would have no effect on 

the quantity demanded.

•  Demand has unitary elasticity if the value of elasticity is exactly 1. This 

means that a percentage change in the price of a good will lead to an 

exact and opposite change in the quantity demanded. For example a 

good would have unitary elasticity if a 10% increase led to a 10% fall in 

the quantity demanded.

•  Demand is infinitely elastic if the value of elasticity is infinity (any 

number divided by zero). A fall in price would lead to an infinite 

increase in quantity demanded (i.e. increasing from zero), whilst an 

increase in price would lead to the quantity demanded falling to zero

The case of unitary elasticity is the curve (known as a rectangular hyperbola).
The perfectly inelastic curve looks like an I and the perfectly elastic curve
looks like an E (without the top!).


Knowing these special cases it makes it easier to spot whether a demand
curve is relatively elastic or inelastic. The demand curve on the left is
relatively elastic (as it looks more like the E) and the demand in the centre is
relatively inelastic (as it looks more like an I).

CHANGES IN ELASTICITY ALONG THE DEMAND CURVE

We mentioned earlier that a good is infinitely elastic if a fall in price leads to 

an infinite rise in quantity. This must occur if quantity was previously zero and 

rises to in response to a fall in price - this can be seen at the top of the 

demand curve.

The opposite occurs at the bottom of the demand curve leading to an 

elasticity of zero.

Also shown on the diagram is the point where elasticity is unitary (equal to 

one), this by definition occurs exactly halfway along the demand curve.

If elasticity is infinite where the demand curve crosses the price axis, but is 

equal to zero when it crosses the quantity axis, then elasticity must change as 

you move along the demand curve. Demand is price inelastic if it has a value 

less than 1 and elastic if greater than 1, these regions are shown above.

IMPORTANCE OF ELASTICITY FOR A BUSINESS

•  If the business is producing on the price elastic section of the demand 

curve, a small percentage change in price leads to a large percentage 

change in quantity demanded. Lowering the price will have the effect of 

increasing total revenue and raising the price will decrease total 

revenue, e.g., if the price of Mars Bars increased by 25% ceteris 

paribus, we would expect their sales to fall dramatically as consumers 

shift to other chocolate bars. This would have the effect of reducing 

their total revenue.

•  If the business is producing on the unitary price elasticity section of the 

demand curve, small changes in price do not change total revenue as 

a percentage change in price will be exactly offset by an inverse 

change in quantity.

•  If the business is producing on the price inelastic section of the 

demand curve, a small percentage change in price leads to a small 

percentage change in quantity demanded. This will have the effect of 

decreasing total revenue when the price is increased and increasing 

total revenue when the price falls. For example if a firm invented a 

miracle cure for the common cold and decided upon a price of 50p a 

pack. The firm sold 10 million packs in the first year of sales. Next year 

they decide to raise prices by 25% and sales fall to 9 million (10% fall), 

the level of sales have dropped, but the total revenue has increased.

It is important to note that the revenue maximising level of production occurs 

when elasticity is unitary, but this isn't necessarily the level where profit is 

maximised. We don't know the firm's costs at different levels of output. 

Furthermore elasticities are notoriously difficult to calculate and errors in the 

elasticity figures could lead to incorrect pricing decisions. 

FACTORS AFFECTING THE PRICE ELASTICITY OF DEMAND

Two factors are usually highlighted by economists:

•  The availability of substitutes. If a product has many substitutes then its 

price elasticity is likely to be high. An increase in price will lead to 

consumers shifting demand to one of its many substitutes (e.g., 

chocolate bars). However if the good has few substitutes, consumers 

will find it harder to replace that good, so its price elasticity is likely to 

be low (e.g. salt).The more widely a product is defined the fewer 

substitutes it is likely to have. Spaghetti has many substitutes, but food 

has none.

•  Time. The longer the period of time, the more price elastic is the 

demand for the product. For example if the price of leaded petrol was 

to increase by 50% my demand for it would not change in the shirt run. 

However as time goes on I would change my car to one that used 

unleaded petrol, therefore in the longrun elasticity becomes greater.

ENTRY AND EXIT OF FIRMS

ENTRY AND EXIT OF FIRMS

Firms entering the market will shift the supply curve to the right, thereby 

lowering the equilibrium price and increasing the equilibrium quantity. Firms 

leaving the market will shift the supply curve to the left, causing the 

equilibrium price to rise and the equilibrium quantity to fall.

SHORTRUN AND LONGRUN

In the shortrun producers are faced with a problem if they wish to increase 

their output. They can increase the number of hours their employees work 

and buy more raw materials, in other words labour and land (raw materials) 

are variable in the shortrun. The amount of factory space and machinery 

(capital) are fixed as they can't simply be added. In the shortrun land and 

labour are variable and capital is fixed.

In the longrun all economic resources are variable as land, labour and capital 

can all be changed. The only variable that is fixed is the level of technology, 

but this can be introduced in the very long run, e.g., new IT or production 

techniques are introduced.

There is no standard measure for these time periods as they vary greatly from 

industry to industry, e.g., a market trader can increase its capital (the market 

stall) a lot quicker than ICI (a new chemical plant). 

CONSUMER SURPLUS

Consumer surplus measures the welfare that consumers derive from their 

consumption of goods and services, or the benefits they derive from the 

exchange of goods.  Consumer surplus is the difference between what 

consumers are willing to pay for a good or service (indicated by the position of 

the demand curve) and what they actually pay (the market price).  The level of 

consumer surplus is shown by the area under the demand curve and above 

the ruling market price

Consider the demand for public transport shown in the diagram. The initial 

fare is price P1 for all passengers and at this price, Q1 journeys are demanded 

by local users.  At price P1the level of consumer surplus is shown by the area 

AP1B. If the bus company cuts price to P2 the demand for bus journeys 

expands to Q2 and the new level of consumer surplus rises to AP2C. This 

means that the level of consumer welfare has increased by the area P1P2CB. 

Consumer surplus = total willingness to pay for a good or service - the total 

amount consumers actually do pay.  ]

If a zero fare is charged, consumers will demand bus journeys up to the point 

where the demand curve cuts the x-axis. When demand for a product is 

perfectly elastic, the level of consumer surplus is zero since the price that 

people pay matches the price they are willing to pay. There must be perfect 

substitutes in the market for this to be the case.  When demand is perfectly 

inelastic the amount of consumer surplus is infinite. Demand is invariant to a 

price change.

DYNAMIC PRICING AND CONSUMER SURPLUS

Dynamic pricing is becoming more common place with the diffusion of 

information technology in the economy. Dynamic pricing is when the price the 

firm charges to customers is sensitive to very short run changes in demand. 

For example, Coca Cola is experimenting in raising the price of cans from 

vending machines when the average temperature increases. Hotel bookings 

systems can change room rates on offer in response to fluctuations in 

occupancy rates. Changes in price to reflect certain market conditions can 

take advantage of variations in consumers' willingness to pay for certain 

items. 

PRODUCER SURPLUS

Producer surplus is used as a measure of producer welfare. It is defined as 

being the difference between what producers are willing and able to supply a 

good for (indicated by the position of the supply curve) and the price they 

actually receive.

The level of producer surplus is shown by the area above the supply curve 

and below the market price.  

EQUILIBRIUM

                                         EQUILIBRIUM

We can see on the diagram overleaf there is only one price where planned 

demand equals planned supply, this is known as the equilibrium price. This 

price is also known as the market clearing price, because all of the goods 

supplied to the market are bought (or cleared), but no buyer is left frustrated 

by his wish to buy. 

We can state that equilibrium occurs when demand equals supply. This can 

be shown on the graph where the demand curve crosses the supply curve

In the diagram below the price is above the equilibrium price. At this price 

firms are willing to supply more than consumers demand, giving rise to excess 

supply. When a shop holds a sale it implies there has been excess supply in 

the past, firms tried to sell the goods at a higher price in the past and failed. 

 In the diagram overleaf the price is below the equilibrium price. A this price 

consumers demand more than firms are willing to supply, leading to excess 

demand. This can occur in the sports car market where there is often a 

waiting list than can run into years.

SHIFTS IN EQUILIBRIUM

Shifts in demand and supply will cause the equilibrium position to change. In 

the diagram below demand has increased and shifted to the right. This will 

lead to an excess demand of a-b, suppliers will realise that they can charge 

higher prices. Price will keep rising until equilibrium is reached at P2  Q2 at 

point c. The opposite would occur for a shift in demand to the left.

In the diagram below supply has decreased and shifted to the left. This will 

lead to an excess demand of a-b, the resulting surplus will allow firms to raise their prices. Price will keep rising until equilibrium is reached at P2 Q2 at point 

c. The opposite would occur for a shift in supply to the right. 

If demand and supply both shift the resulting equilibrium will depend upon the 

size of their relative shifts.  It is possible to derive a number of different 

outcomes.

DEMAND AND SUPPLY

                                             DEMAND

Our wants become a demand when we have the money to back up our 

desires. We call this effective demand, i.e., how much consumers will be 

prepared to buy at a particular price.  

Assuming ceteris paribus, as price increases demand will fall and as prices 

decreases demand will rise. This leads to a downward sloping demand curve.

A change in price will lead to a movement along the demand curve. An 

increase in price will lead to demand contracting and a decrease in price will 

cause demand to expand 

A number of factors will cause the demand curve to shift, either to the right 

(increase in demand) or left (decrease in demand): 

•  Income - when income rises demand for a normal good will also rise.

•  The price of other goods - if the price of a substitute good falls then 

demand will fall (e.g., Coca-Cola and Pepsi). If the price of a 

complement good falls then demand will rise (e.g., computers and 

computer games). 

•  Population - an increase in population is likely to lead to an increase in 

demand. 

•  Changes in fashion - as goods go out of fashion demand for them will 

fall.

•  Changes in legislation - e.g., demand for gun in the UK decreased 

after it became illegal to own one.

•  Advertising - this aims to influence consumer choice.

•  The time of the year - e.g., demand for holidays in Spain will be lower 

in the winter and demand for gas will be higher during the winter. 

                                             SUPPLY

If the price of a good increases, ceteris paribus then firms are likely to be 

more willing to supply larger amounts. This leads to an upwards sloping 

supply curve. A change in price will lead to a movement along the supply 

curve, whilst a change in any other factor will lead to a shift in the supply 

curve.

We are able to identify two main reasons for the supply curve being upwards 

sloping: 

•  Incentives for increasing production - if the price of particular good 

rises then producers will find it more financially rewarding to devote 

resources to that good and away from others.

•  Theory of increasing costs - due to the increasing opportunity costs of 

production as less and less well suited resources are switched to it, a 

higher price must be available in the market place to make it 

economically viable to use these resources.