Price elasticity of demand and price elasticity of supply |...

Price elasticity of demand and price elasticity of supply

Posted 2023-04-11 18:43:15

Key points

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the percentage change in price.
Elasticity can be described as elastic—or very responsive—unit elastic, or inelastic—not very responsive.
Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price changes in a greater than proportional manner.
An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied.
Unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.

What is price elasticity?

Both demand and supply curves show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded, start text, Q, end text, start subscript, d, end subscript, or supplied, start text, Q, end text, start subscript, s, end subscript, and the corresponding percent change in price.

The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

Elasticities can be usefully divided into five broad categories: perfectly elastic, elastic, perfectly inelastic, inelastic, and unitary. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. An inelastic demand or inelastic supply is one in which elasticity is less than one, indicating low responsiveness to price changes. Unitary elasticities indicate proportional responsiveness of either demand or supply.

Perfectly elastic and perfectly inelastic refer to the two extremes of elasticity. Perfectly elastic means the response to price is complete and infinite: a change in price results in the quantity falling to zero. Perfectly inelastic means that there is no change in quantity at all when price changes.

If . . .	It Is Called . . .
start fraction, percent, space, c, h, a, n, g, e, space, i, n, space, q, u, a, n, t, i, t, y, divided by, percent, space, c, h, a, n, g, e, space, i, n, space, p, r, i, c, e, end fraction, equals, infinity	Perfectly elasti
start fraction, percent, space, c, h, a, n, g, e, space, i, n, space, q, u, a, n, t, i, t, y, divided by, percent, space, c, h, a, n, g, e, space, i, n, space, p, r, i, c, e, end fraction, is greater than, 1	Elastic
start fraction, percent, space, c, h, a, n, g, e, space, i, n, space, q, u, a, n, t, i, t, y, divided by, percent, space, c, h, a, n, g, e, space, i, n, space, p, r, i, c, e, end fraction, equals, 1	Unitary
start fraction, percent, space, c, h, a, n, g, e, space, i, n, space, q, u, a, n, t, i, t, y, divided by, percent, space, c, h, a, n, g, e, space, i, n, space, p, r, i, c, e, end fraction, is less than, 1	Inelastic
start fraction, percent, space, c, h, a, n, g, e, space, i, n, space, q, u, a, n, t, i, t, y, divided by, percent, space, c, h, a, n, g, e, space, i, n, space, p, r, i, c, e, end fraction, equals, 0	Perfectly inelastic

Using the midpoint method to calculate elasticity

To calculate elasticity, instead of using simple percentage changes in quantity and price, economists sometimes use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity:

start text, M, i, d, p, o, i, n, t, space, m, e, t, h, o, d, space, f, o, r, space, e, l, a, s, t, i, c, i, t, y, end text, equals, start fraction, start fraction, Q, start subscript, 2, end subscript, minus, Q, start subscript, 1, end subscript, divided by, left parenthesis, start fraction, Q, start subscript, 2, end subscript, plus, Q, start subscript, 1, end subscript, divided by, 2, end fraction, right parenthesis, end fraction, divided by, start fraction, P, start subscript, 2, end subscript, minus, P, start subscript, 1, end subscript, divided by, left parenthesis, start fraction, P, start subscript, 2, end subscript, plus, P, start subscript, 1, end subscript, divided by, 2, end fraction, right parenthesis, end fraction, end fraction

The advantage of the midpoint method is that we get the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base for both cases. The midpoint method is referred to as the arc elasticity in some textbooks.

Using the point elasticity of demand to calculate elasticity

A drawback of the midpoint method is that as the two points get farther apart, the elasticity value loses its meaning. For this reason, some economists prefer to use the point elasticity method. In this method, you need to know what values represent the initial values and what values represent the new values.

start text, P, o, i, n, t, space, e, l, a, s, t, i, c, i, t, y, space, end text, equals, start fraction, start fraction, start text, n, e, w, space, end text, Q, minus, start text, i, n, i, t, i, a, l, space, end text, Q, divided by, start text, i, n, i, t, i, a, l, space, end text, Q, end fraction, divided by, start fraction, start text, i, n, i, t, i, a, l, space, end text, P, minus, start text, n, e, w, space, end text, P, divided by, start text, i, n, i, t, i, a, l, space, end text, P, end fraction, end fraction

Calculating price elasticity of demand

First, apply the formula to calculate the elasticity as price decreases from $70 at point start text, B, end text to $60 at point start text, A, end text:

% c h a n g e i n q u a n t i t y % c h a n g e i n p r i c e Price elasticity of demand = = = = = = = = ( 3 , 000 + 2 , 800 ) /2 3 , 000-2 , 800 \times 100 2 , 900 200 \times 1006.9 ( 60 + 70 ) /2 60-70 \times 100 65 -10 \times 100-15.4 -15.4% 6.9% 0.45

The elasticity of demand between point start text, A, end text and point start text, B, end text is start fraction, space, space, space, space, 6, point, 9, percent, divided by, –, 15, point, 4, percent, end fraction, or 0.45. Because this amount is smaller than one, we know that the demand is inelastic in this interval.

[Wait a minute! Shouldn't the price elasticity of demand be negative here?]

This means that, along the demand curve between point start text, B, end text and point start text, A, end text, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded.

[I'd like to do another practice problem.]

Calculating the price elasticity of supply

Now let's try calculating the price elasticity of supply. We use the same formula as we did for price elasticity of demand:

Price elasticity of supply = % c h a n g e i n p r i c e % c h a n g e i n q u a n t i t y

Assume that an apartment rents for $650 per month and, at that price, 10,000 units are rented—you can see these number represented graphically below. When the price increases to $700 per month, 13,000 units are supplied into the market.

By what percentage does apartment supply increase? What is the price sensitivity?

We'll start by using the Midpoint Method to calculate percentage change in price and quantity:

% c h a n g e i n q u a n t i t y % c h a n g e i n p r i c e = = = = = = ( 13 , 000 + 10 , 000 ) /2 13 , 000-10 , 000 \times 100 11 , 500 3 , 000 \times 10026.1 ( $700 + $650 ) /2 $700-$650 \times 100 675 50 \times 1007.4

Next, we take the results of our calculations and plug them into the formula for price elasticity of supply:

P r i c e e l a s t i c i t y o f s u p p l y = = = % c h a n g e i n p r i c e % c h a n g e i n q u a n t i t y 7.4 26.1 3.53

Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more. It is read as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change.

[Hang on! This sounds familiar. Is the elasticity the slope?]

Summary

Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded—or supplied—divided by the percentage change in price.
Elasticity can be described as elastic—or very responsive—unit elastic, or inelastic—not very responsive.
Elastic demand or supply curves indicate that the quantity demanded or supplied responds to price changes in a greater than proportional manner.
An inelastic demand or supply curve is one where a given percentage change in price will cause a smaller percentage change in quantity demanded or supplied.
Unitary elasticity means that a given percentage change in price leads to an equal percentage change in quantity demanded or supplied.