3

ELASTICITY OF
DEMAND AND SUPPLY

CHAPTER MAP
1 INTRODUCTION
2 PRICE ELASTICITY OF DEMAND
2.1 Measurement and Interpretation of Price Elasticity of Demand
2.2 Applications of Price Elasticity of Demand
2.3 Determinants of Price Elasticity of Demand

3 INCOME ELASTICITY OF DEMAND

3.1 Measurement and Interpretation of Income Elasticity of Demand
3.2 Applications of Income Elasticity of Demand
3.3 Determinants of Income Elasticity of Demand

4 CROSS ELASTICITY OF DEMAND

4.1 Measurement and Interpretation of Cross Elasticity of Demand
4.2 Applications of Cross Elasticity of Demand
4.3 Determinants of Cross Elasticity of Demand

5 PRICE ELASTICITY OF SUPPLY

5.1 Measurement and Interpretation of Price Elasticity of Supply
CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

5.2 Determinants of Price Elasticity of Supply

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6 LIMITATIONS OF THE CONCEPTS OF ELASTICITY OF DEMAND

7 EFFECTS OF ELASTICITY ON PRICE AND QUANTITY

1 INTRODUCTION
In Chapter 2, we learnt that a fall in price will lead to an increase in quantity demanded and vice
versa. However, given any change in price, in addition to the direction of the change in quantity
demanded, economists are interested to find the magnitude of the change. In other words, they are
interested to find the degree of responsiveness of consumers to a change in price. To measure this,
they use the concept of price elasticity of demand. Furthermore, economists are also interested to
find the degree of responsiveness of consumers to a change in income and a change in the prices
of related goods. To measure this, economists use the concepts of income elasticity of demand and
cross elasticity of demand. This chapter provides an exposition of the concepts of price elasticity
of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply.

2 PRICE ELASTICITY OF DEMAND

2.1 Measurement and Interpretation of Price Elasticity of Demand
The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of
the quantity demanded to a change in the price, ceteris paribus.
The PED for a good is calculated by dividing the percentage change in the quantity demanded by
the percentage change in the price.


% Quantity Demanded

PED = ------------------------------------------------------------------------
% Price
Due to the law of demand, the PED for a good is always negative. However, the common practice
among economists is to omit the negative sign.

Special Cases: If the PED for a good is zero, the demand is perfectly price inelastic which means
that a change in the price will not lead to any change in the quantity demanded. A good with a
perfectly price inelastic demand has a vertical demand curve. If the PED for a good is infinity,
the demand is perfectly price elastic which means that a rise in the price will lead to an infinite
decrease in the quantity demanded. In theory, this means that the quantity demanded will fall from
infinity to zero. A good with a perfectly price elastic demand has a horizontal demand curve.

Note: It is important to understand that the concept of elasticity is about relative changes
and not about absolute changes. This is because although price is measured in dollars, quantity
demanded is measured in units. Due to the difference in the units of measurement, we can
only compare the changes in price and quantity demanded in relative terms. For example, it is
wrong to say, If demand is price elastic, a fall in price will lead to a large increase in quantity
demanded.. The correct way to say it is, If demand is price elastic, a fall in price will lead
to a larger percentage/proportionate increase in quantity demanded.. Students should not
confuse relative changes with absolute changes.

2.2 Applications of Price Elasticity of Demand

The concept of PED allows a firm to determine how to change price to increase total revenue.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

If the PED for a good is greater than one, the demand is price elastic which means that a change in
the price will lead to a larger percentage/proportionate change in the quantity demanded. A good
with a price elastic demand has a relatively flat demand curve. If the PED for a good is less than
one, the demand is price inelastic which means that a change in the price will lead to a smaller
percentage/proportionate change in the quantity demanded. A good with a price inelastic demand
has a relatively steep demand curve. If the PED for a good is equal to one, the demand is unit price
elastic which means that a change in the price will lead to the same percentage/proportionate
change in the quantity demanded. The demand curve for a good with a unit price elastic demand
is a rectangular hyperbola.

41

If the demand for the good produced by a firm is price elastic, the firm can decrease the price to
increase total revenue as the quantity demanded will increase by a larger percentage.
Price

P0

P1

C
Quantity Demanded
Q0

Q1

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

In the above diagram, the initial total revenue is area A plus area B and the new total revenue
is area B plus area C. Area C is the gain in revenue resulting from the increase in the quantity
demanded (Q) from Q 0 to Q 1 and area A is the loss in revenue resulting from the fall in the price
(P) from P0 to P1. Since area C is greater than area A, the gain exceeds the loss and hence the
total revenue rises.

42

If the demand for the good produced by a firm is price inelastic, the firm can increase the price to
increase total revenue as the quantity demanded will decrease by a smaller percentage.

Price

P1

A
P0

D
Quantity Demanded

Q1

Q0

In the above diagram, the initial total revenue is area B plus area C and the new total revenue is
area A plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P0
to P1 and area C is the loss in revenue resulting from the decrease in the quantity demanded (Q)
from Q 0 to Q1. Since area A is greater than area C, the gain exceeds the loss and hence the total
revenue rises.

In addition to firms, the concept of price elasticity of demand may be useful to the government.
The main source of revenue for the government is tax revenue. If the government imposes a tax
on a good, the cost of production will rise which will lead to a decrease in the supply. When
this happens, the price will rise which will lead to a fall in the quantity demanded. If the demand
for the good is price elastic, the quantity demanded is likely to fall by a large extent. As the
tax revenue is the product of the tax per unit of the good and the quantity, a large decrease in
the quantity demanded is likely to limit the amount of tax revenue which the government can
collect. Therefore, if the government wants to collect a large amount of tax revenue from imposing
taxes on goods, it should do so for goods with a price inelastic demand. Examples of goods
with a price inelastic demand include tobacco and alcohol due to their addictive nature. The
government may also impose taxes on goods to reduce the consumption. These are generally
goods which society deems undesirable and the government thinks people should be discouraged
to consume, commonly known as demerit goods. Examples of demerit goods include tobacco and
alcohol. However, due to the addictive nature of tobacco and alcohol which makes the demand
price inelastic, the government should ensure that the taxes are sufficiently large to reduce the
consumption to the desired levels.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

If the demand for the good produced by a firm is unit price elastic, the firm cannot change the price
to increase total revenue as the quantity demanded will change by the same percentage.

43

Note: When we are discussing the effects of a tax on a good on the consumption or tax
revenue, it is wrong to say, If the demand for the good is price elastic, the quantity demanded
will fall by a larger percentage/proportion.. The correct way to say it is, If the demand for
the good is price elastic, the quantity demanded will fall by a large extent.. This is because
we are not comparing the changes in the price and the quantity demanded.
Apart from the microeconomic level, price elasticity of demand can be useful to the government
at the macroeconomic level. The usefulness of price elasticity of demand to the government at
the macroeconomic level will be explained in greater detail in Chapter 13.

2.3 Determinants of Price Elasticity of Demand

Number of Substitutes
The PED for a good will be higher the larger the number of substitutes. Conversely, the PED for
a good will be lower the smaller the number of substitutes. For example, the demand for a brand
of smartphones is likely to be price elastic due to the large number of substitute brands in the
market such as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc. The number of substitutes for a
good depends, in part, on how narrowly, and for that matter, how broadly the good is defined. The
more broadly a good is defined, the smaller the number of substitutes and hence the less price
elastic the demand for the good. Conversely, the more narrowly a good is defined, the larger the
number of substitutes and hence the more price elastic the demand for the good. For example,
the demand for beef is more price elastic than the demand for food because, unlike food, there
are substitutes for beef.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Closeness of Substitutes

44

The PED for a good will be higher the closer the substitutes. Conversely, the PED for a good will
be lower the further the substitutes. For example, the demand for residential properties is price
inelastic due to lack of close substitutes, apart from the high degree of necessity. In contrast, the
demand for the mobile network services provided by an operator in Singapore such as SingTel is
likely to be price elastic due to the presence of close substitutes which include the mobile network
services provided by other operators such as M1 and StarHub.

Degree of Necessity
The PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a
good will be lower the higher the degree of necessity. For example, the demand for oil is price
inelastic due to the high degree of necessity, apart from lack of close substitutes.

Proportion of Income Spent on the Good

The PED for a good will be higher the larger the proportion of income spent on the good. Conversely,
the PED for a good will be lower the smaller the proportion of income spent on the good. For
example, the demand for private cars is likely to be price elastic due to the large proportion of
income spent on the goods as they are generally expensive. In contrast, the demand for stationery

is likely to be price inelastic due to the small proportion of income spent on the good as it is
generally cheap, apart from the high degree of necessity.

Time Period
The PED for a good will be higher the longer the time period under consideration. Conversely,
the PED for a good will be lower the shorter the time period under consideration. This is because
consumers need time to adjust their consumption patterns and find substitutes. For example, given
any increase in the price of petrol, the quantity demanded will not fall significantly in the short run
as people need to drive their cars. However, the quantity demanded will fall more significantly over
time as more fuel-efficient cars can be developed and people can switch to smaller cars which
consume less fuel.

Note:

Students should avoid arguing that the demand for a good is likely to be price
elastic due to the low degree of necessity. This is because saying this would suggest that
the demand for most goods is likely to be price elastic as there are more non-essential goods
than essential goods.
Students should avoid arguing that the demand for a good is likely to be price inelastic due
to the small number of substitutes. This is because the substitutes for the good may be close
which is likely to make the demand for the good price elastic.

3 INCOME ELASTICITY OF DEMAND

3.1 Measurement and Interpretation of Income Elasticity of Demand

The YED for a good is calculated by dividing the percentage change in the demand by the
percentage change in income.

% Demand

YED = ------------------------------------------------------------------------
% Income
If the YED for a good is positive, the good is a normal good. A normal good is a good whose
demand rises when consumers income rises. There are two types of normal goods: necessity
and luxury. A necessity is a normal good with a YED between zero and one. In other words, the
demand for a necessity is income inelastic. An example of a necessity is agricultural products. A
luxury is a normal good with a YED greater than one. In other words, the demand for a luxury is
income elastic. An example of a luxury is private cars. If the YED for a good is negative, the good
is an inferior good. An inferior good is a good whose demand falls when consumers income rises.
An example of an inferior good is public transport.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness of
the demand to a change in income, ceteris paribus.

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3.2 Applications of Income Elasticity of Demand

The concept of YED allows a firm to determine the future size of the market for the good and hence
its production capacity. Suppose that the YED for a good is positive. If a firm predicts an economic
expansion which is a period of time during which national income is rising, it should increase its
production capacity in order to be able to meet the higher demand when the economic expansion
comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and
hence the larger the extent the firm should increase its production capacity. Conversely, if the
firm predicts an economic contraction which is a period of time during which national income is
falling, it should decrease its production capacity to minimise excess capacity when the economic
contraction comes.
The concept of YED may enable a firm to determine how to formulate its marketing strategy. Suppose
that a firm sells two goods. Further suppose that one of the goods is a normal good and the other
good is an inferior good. If the economy is expanding and hence national income is rising, the firm
should focus its marketing strategy on the normal good. Conversely, if the economy is contracting
and hence national income is falling, the firm should focus its marketing strategy on the inferior good.

Note:

It is important to note that increasing production capacity is not the same as

increasing production. Increasing production capacity does not lead to an increase in current
output. Rather, it enables the firm to increase future output.

3.3 Determinants of Income Elasticity of Demand

Nature of the Good

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

The YED for a good will be higher the more luxurious the good. Conversely, the YED for a good will
be lower the less luxurious the good. For example, the YED for high-end private cars is higher than
those for mid-range and low-end private cars as high-end private cars are more luxurious than
mid-range and low-end private cars.

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Level of Income
The YED for a good will be higher the lower the level of income. Conversely, the YED for a good
will be lower the higher the level of income. For example, the YED for private cars in the Philippines
is higher than that in Singapore as the level of income in the Philippines is lower than that in
Singapore.

4 CROSS ELASTICITY OF DEMAND

4.1 Measurement and Interpretation of Cross Elasticity of Demand
The cross elasticity of demand (XED) for a good with respect to another good is a measure of the
degree of responsiveness of the demand for the first good to a change in the price of the second
good, ceteris paribus. Let the two goods be good A and good B.

The XED for good A with respect to good B is calculated by dividing the percentage change in the
demand for good A by the percentage change in the price of good B.

% Demand for Good A

XEDAB = -----------------------------------------------------------------------

% Price of Good B
If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed
in place of one another such as Coke and Pepsi. If the price of good B rises, consumers will
buy less of it. Since good A and good B are substitutes, they will buy more good A. If XEDAB is
negative, good A and good B are complements. Complements are goods which are consumed in
conjunction with one another such as car and petrol. If the price of good B rises, consumers will
buy less of it. Since good A and good B are complements, they will buy less good A.

Note: Students should understand that the concept of XED can be used to explain the effect
of a change in the price of a related good on the demand for a good only when the change in
the price of the related good is due to a movement along the demand curve.
4.2 Applications of Cross Elasticity of Demand

The concept of XED may enable a firm that produces two or more goods which are complements
to increase total revenue. For example, a telecommunications firm may reduce the price of its
mobile devices even if the demand is price inelastic. Although the revenue from the sale of its
mobile devices will fall as the quantity demanded will rise by a smaller proportion, the demand and
hence the revenue from the provision of its mobile network services will rise due to the negative
XED between mobile network services and mobile devices. Therefore, the total revenue of the
telecommunications firm may increase.

4.3 Determinants of Cross Elasticity of Demand

The XED between two goods will be higher the more closely they are related. For example, the XED
between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer
substitutes than coffee and tea are.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

The concept of XED allows a firm to determine how a change in the price of a related good produced
by another firm will affect the demand for its good. For example, if a rival firm decreases its price,
the demand for the good produced by the first firm will fall due to the positive XED between
substitutes. To avoid a decrease in sales, the firm may need to decrease its price. However, if
this is likely to lead to a price war, the firm may consider engaging in non-price competition such
as product promotion and product development instead of decreasing its price. If a rival firm
increases its price, the demand for the good produced by the first firm will increase if it keeps
its price constant. However, the firm may not experience an increase in sales if it has no or little
excess capacity.

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5 PRICE ELASTICITY OF SUPPLY

5.1 Measurement and Interpretation of Price Elasticity of Supply
The price elasticity of supply (PES) of a good is a measure of the degree of responsiveness of the
quantity supplied to a change in the price, ceteris paribus.
The PES of a good is calculated by dividing the percentage change in the quantity supplied by the
percentage change in the price.

% Quantity Supplied

PES = ------------------------------------------------------------------------
% Price
Due to the law of supply, the PES of a good is always positive.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

If the PES of a good is greater than one, the supply of the good is price elastic which means that
a change in the price of the good will lead to a larger percentage/proportionate change in the
quantity supplied. A good with a price elastic supply has a relatively flat supply curve. If the PES of
a good is less than one, the supply of the good is price inelastic which means that a change in the
price of the good will lead to a smaller percentage/proportionate change in the quantity supplied.
A good with a price inelastic supply has a relatively steep supply curve. If the PES of a good is
equal to one, the supply of the good is unit price elastic which means that a change in the price of
the good will lead to the same percentage/proportionate change in the quantity supplied.

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Special Cases: If the PES of a good is zero, the supply of the good is perfectly price inelastic which
means that a change in the price of the good will not lead to any change in the quantity supplied.
A good with a perfectly price inelastic supply has a vertical supply curve. If the PES of a good
is infinity, the supply of the good is perfectly price elastic which means that a fall in the price of
the good will lead to an infinite decrease in the quantity supplied. In theory, this means that the
quantity supplied will fall from infinity to zero. A good with a perfectly price elastic supply has a
horizontal supply curve.

5.2 Determinants of Price Elasticity of Supply

Production Time and Stockability of the Good
When the price of a good rises, firms can increase the quantity supplied in two ways: increase
production and draw from stock. Therefore, if the production time of a good is long and if it
cannot be stocked in large quantities, the supply is likely to be price inelastic, and vice versa.
The stockability of a good depends on the size of the good and whether it is perishable. Goods
that are small in size and non-perishable can be stocked in large quantities, and vice versa. For
example, the production time of agricultural products is long due to the long gestation period
and they cannot be stocked due to the perishable nature. Therefore, the supply of agricultural
products is price inelastic. In contrast, the supply of manufactured goods is more price elastic as
the production time is shorter and they generally can be stocked. The supply of luxuries is likely to
be price inelastic as the production time is likely to be long because they are typically high quality

goods that normally undergo stringent quality control. In contrast, the supply of necessities and
inferior goods is likely to be price elastic as the production time is likely to be short due to the
limited focus on the quality.

Excess Capacity
Given any increase in the price of a good, the lower the output level and hence the larger the
amount of excess capacity, the slower the marginal cost of production will rise as firms increase
output. The slower the marginal cost of production for a good rises as firms increase output in
response to a rise in the price, the larger the increase in output. Therefore, the lower the output
level of a good and hence the larger the amount of excess capacity, the more price elastic the
supply of the good. Conversely, the higher the output level of a good and hence the smaller the
amount of excess capacity, the less price elastic the supply of the good.

Definition of the Good

The more broadly a good is defined, the less price elastic the supply. Conversely, the more
narrowly a good is defined, the more price elastic the supply. For example, the supply of a crop is
more price elastic than the supply of crops as a whole as it is easier to obtain factor inputs from
within the agricultural sector to produce a crop than to obtain factor inputs from other industries
to produce crops as a whole.

The longer the time period after an increase in the price of a good, the more price elastic the
supply of the good as firms are able to increase the production by a larger amount with more time.
Time period can be divided into the immediate run, the short run and the long run. The immediate
run is the time period that is so short that the output level is fixed. The supply of the good is
perfectly price inelastic, assuming firms do not keep stock of the good. The short run is the time
period during which at least one of the factor inputs used in the production process is fixed. In
the short run, when the price of a good rises, firms can increase the production only by employing
more of the variable factor inputs used in the production process. The long run is the time period
after which all the factor inputs used in the production process are variable. The supply of a good
is more price elastic in the long run than in the short run as firms can increase the production by
employing more of all the factor inputs used in the production process.

Mobility of Factors of Production

The ease with which factors of production can be moved from the production of one good to
another will influence the price elasticity of supply of a good. The supply of a good will be more
price elastic the higher the mobility of factors of production. Conversely, the supply of a good will
be less price elastic the lower the mobility of factors of production. For example, if a manufacturing
firm in the city is able to swiftly employ rural farmers to increase output, the supply of the good is
likely to be price elastic.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Time Period

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6 LIMITATIONS OF THE CONCEPTS OF ELASTICITY OF

DEMAND
Irrelevant and Unreliable Data
The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data
from past records may no longer be relevant to calculating elasticities of demand as some of
the determinants of demand may have changed. Although data from current market surveys are
relevant to calculating elasticities of demand, they may not be reliable as the respondents may not
be truthful in their responses. Furthermore, if the sample sizes of the market surveys are small, the
results may not be reliable as they may not be reflective of the actual markets for the goods.

Unrealistic Assumption
The assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to
hold in reality. In reality, many factors such as the level of income, the price of the good and the
prices of related goods are changing simultaneously.

Omission of Total Cost

Although PED may be useful for increasing total revenue, this is not true for increasing profit due to
the omission of total cost. For example, if demand is price elastic, a fall in price will lead to a larger
proportionate increase in quantity demanded resulting in an increase in total revenue. However, if
total cost rises by a larger extent, profit will fall.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Omission of Production Capacity

50

PED and XED do not take production capacity into consideration. For example, if demand is price
elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in
an increase in total revenue. However, total revenue will not rise if there is no excess capacity to
increase production.

7 EFFECTS OF ELASTICITY ON PRICE AND QUANTITY

When demand increases, price and quantity will rise. If supply is price elastic, the increase in price
is likely to be small and the increase in quantity is likely to be large.

Price

S0

P1
P0

D1
D0
Quantity
Q0

Q1

In the above diagram, due to the elastic supply which gives rise to the flat supply curve (S 0), an
increase in the demand (D) from D 0 to D1 leads to a large rise in the quantity (Q) from Q 0 to Q1 and
a small rise in the price (P) from P0 to P1. However, if supply is price inelastic, the increase in price
is likely to be large and the increase in quantity is likely to be small.
Price

P1

P0
D1

D0
Q0

Quantity

Q1

In the above diagram, due to the inelastic supply which gives rise to the steep supply curve (S 0),
an increase in the demand (D) from D 0 to D1 leads to a large rise in the price (P) from P0 to P1 and
a small rise in the quantity (Q) from Q 0 to Q1.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

S0

51

When supply decreases, price will rise and quantity will fall. If demand is price elastic, the increase
in price is likely to be small and the decrease in quantity is likely to be large.
Price
S1

S0

P1
P0
D0

Quantity
Q1

Q0

In the above diagram, due to the elastic demand which gives rise to the flat demand curve (D 0), a
decrease in the supply (S) from S 0 to S1 leads to a large fall in the quantity (Q) from Q 0 to Q1 and a
small rise in the price (P) from P0 to P1. However, if demand is price inelastic, the increase in price
is likely to be large and the decrease in quantity is likely to be small.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Price

52

S1

S0
P1

P0

D0
Quantity
Q1

Q0

In the above diagram, due to the inelastic demand which gives rise to the steep demand curve (D 0),
a decrease in the supply (S) from S 0 to S1 leads to a large rise in the price (P) from P0 to P1 and a
small fall in the quantity (Q) from Q 0 to Q1.
Based on the above analysis, we can see that a large rise in price may be due to four factors.
Apart from a large increase in demand and a large decrease in supply, a large rise in price may
also be due to an inelastic demand and an inelastic supply. Similarly, a large increase in quantity
may be due to four factors. Apart from a large increase in demand and a large increase in supply,
a large increase in quantity may also be due to an elastic demand and an elastic supply.

The above analysis is based on the assumption that demand and supply change simultaneously in
the same direction. However, if demand and supply change simultaneously in opposite directions,
a consideration of the relative price elasticities of demand and supply will be necessary, in addition
to a consideration of the relative changes in demand and supply. Suppose that demand rises
and supply falls simultaneously. An increase in demand will lead to a rise in price and quantity.
A decrease in supply will lead to a rise in price and a fall in quantity. Therefore, price will rise
and quantity will be indeterminate. In this case, one may think that if the increase in demand is
greater than the decrease in supply, quantity will rise and vice versa. However, this is erroneous.
To determine the effect on quantity, one should not only consider the relative changes in demand
and supply. This is because the relative price elasticities of demand and supply will also have
an effect on quantity and to understand this, we can simply consider the case of Certificate of
Entitlement (COE) in Singapore. As the supply of COEs in Singapore is determined entirely by
the Land Transport Authority (LTA), it is perfectly inelastic which gives rise to a vertical supply
curve. If the demand rises, even if the increase is large, the quantity will not rise. However, if the
supply falls, even if the decrease is small, the quantity will fall. Therefore, even if the increase in
the demand is greater than the decrease in the supply, the quantity will fall. This example shows
that if demand and supply change simultaneously in opposite directions, the directional change
in quantity will depend on two factors: the relative price elasticities of demand and supply and the
relative changes in demand and supply.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

In Chapter 2, we learnt that when demand and supply change simultaneously in the same
direction, although quantity will be determinate, the effect on price will depend on the relative
changes in demand and supply. For example, when demand and supply rise simultaneously,
although quantity will rise, price will fall if the increase in supply is greater than the increase in
demand. However, if the increase in demand is greater than the increase in supply, price will rise.
Similarly, when demand and supply fall simultaneously, although quantity will fall, price will rise
if the decrease in supply is greater than the decrease in demand. However, if the decrease in
demand is greater than the decrease in supply, price will fall. One thing we can see here is that
when demand and supply change simultaneously in the same direction, a consideration of the
relative price elasticities of demand and supply is not necessary. This is because if the increase
in demand is greater than the increase in supply, or the decrease in supply is greater than the
decrease in demand, a shortage will occur at the initial price which will lead to a rise in price,
regardless of the price elasticities of demand and supply. Conversely, if the increase in supply is
greater than the increase in demand, or the decrease in demand is greater than the decrease in
supply, a surplus will occur at the initial price which will lead to a fall in price, regardless of the
price elasticities of demand and supply.

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Suppose that demand increases and supply decreases simultaneously. Further suppose that
demand is price elastic and supply is price inelastic. When demand is price elastic, a decrease in
supply is likely to lead to a large decrease in quantity. When supply is price inelastic, an increase in
demand is likely to lead to a small increase in quantity. Therefore, quantity is likely to fall, assuming
the changes in demand and supply are equal.
Price
S1

S0

P1
P0

D1
D0

Quantity

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Q1

54

Q0

In the above diagram, an increase in the demand (D) from D 0 to D1 and the same decrease in the
supply (S) from S 0 to S1 lead to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from
Q 0 to Q1. If the decrease in supply is greater than the increase in demand, quantity will almost
certainly fall. However, if the increase in demand is greater than the decrease in supply, quantity
may rise. In this case, quantity will be indeterminate.
Suppose that demand increases and supply decreases simultaneously. Further suppose that
demand is price inelastic and supply is price elastic. When demand is price inelastic, a decrease in
supply is likely to lead to a small decrease in quantity. When supply is price elastic, an increase in
demand is likely to lead to a large increase in quantity. Therefore, quantity is likely to rise, assuming
the changes in demand and supply are equal.

Price

S1
S0
P1
P0

D1
D0
Quantity
Q0

Q1

In the above diagram, an increase in the demand (D) from D 0 to D1 and the same decrease in the
supply (S) from S 0 to S1 lead to a rise in the price (P) from P0 to P1 and a rise in the quantity (Q)
from Q 0 to Q1. If the increase in demand is greater than the decrease in supply, quantity will almost
certainly rise. However, if the decrease in supply is greater than the increase in demand, quantity
may fall. In this case, quantity will be indeterminate.
If demand and supply are both price elastic or price inelastic, the effect of a
simultaneous increase in demand and a decrease in supply on quantity will depend to a large
extent on the relative changes in demand and supply. If the increase in demand is greater
than the decrease in supply, quantity is likely to rise. However, if the decrease in supply is
greater than the increase in demand, quantity is likely to fall.

CHAPTER 3 ELASTICITY OF DEMAND AND SUPPLY

Note:

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