Elasticity of Demand and Supply Joudrey

Elasticity of Demand The formula that measures the actual change in quantity demanded for a product whose price has changed is the price elasticity of demand. Coefficient of demand elasticity = % change in quantity demanded % change in price

Example Gas sells for $0.50/liter and quantity demanded is 10 million liters each month. Then gas went up to $0.54/liter and quantity demanded went down to 9.5 million liters. Is gas considered elastic or inelastic? To Solve: Step 1: calculate the % change in quantity demanded: Difference in quantity x 100% = 5.13% Average quantity(9.5+10)/2 We dropped the negative becasue we are interested in the change not the direction

Example Cont. Step 2: find the % change in price Difference in price x100=7.69% Average price( )/2

Example Cont. Step 3: plug in the answers you found in Step 1 and Step 2 into your formula: Coefficient of demand elasticity = % change in quantity demanded % change in price Coefficient of demand elasticity = 5.13%= %

Making Sense of your Answer Any coefficient between 0 and 1 has an Inelastic Coefficient. This means that given a percentage change in price there will be a smaller percentage change in quantity demanded. In our example a 7.69% change in price resulted in a 5.13% change in quantity demanded. As prices change for inelastic items the quantity demanded does not change as much (ex. Think of essential items or items that are inexpensive like a pencil).

Another Example If price rose from $0.66/liter to $0.70/liter and demanded decreased from 8 million liters to 7.5 million liters determine the coefficient of demand elasticity to determine if this product has an inelastic or elastic coefficient. Remember elastic coefficients are greater than 1 Unitary coefficients are equal to 1 Inelastic coefficients are less than 1

Answer Step 1: % change in Q Demanded =7.5-8 = -0.5 x100 = 6.45% (7.5+8)/ Step 2: % change in Price = 0.7 – 0.66 = 0.04x 100%=5.88% ( )/ Step 3: Coefficient of Demand Elasticity = 6.45%= % Since the coefficient of demand elasticity is greater than 1 this item has an elastic demand. 5.88% change in price results in a 6.45% change in quantity demanded.

An elastic coefficient (greater than one) means a percentage change in price causes a greater percentage change in quantity demanded. Elastic items (ex. Luxury, expensive items, items with substitutes or alternatives) Unitary coefficient – when it is equal to one. Meaning a percentage change in price results in an equal percentage change in quantity demanded.

Coefficient Related to Revenue The coefficient will also tell you if the revenue will increase, decrease or stay the same. Inelastic coefficient (between 0 and 1) revenue will rise Elastic coefficient (greater than 1) revenue will decrease Unitary coefficient (exactly one) revenue will stay the same

Proof Inelastic: 10 million liters x $0.50/liter = $5 million 9.5 million liters x $0.54/liter = $5.13 million Resulting in an increase in revenue Elastic: 8 million liters x $0.66/liter = $5.28 million 7.5 million liters x $0.70/liter = $5.25 million Resulting in an decrease in revenue

Elasticity of Supply The concept of elasticity applies to the demand side as well as the supply side. Generally as prices rise sellers will want to supply more because this will increase their profits. The concept of elasticity of supply measures how responsive the quantity supplied by a seller is to a rise of fall in price. This is determined by the formula: Coefficient of supply elasticity = % change in quantity supplied % change in price

Example The market price of steel increases from $120/tonne to $140/tonne. The steel manufacturing company increases production from 1 million tonnes per day to 1.2 million tonnes. Step 1: calculate the percentage change in quantity supplied: = difference in quantity supplied = x100%= 18.18% Average quantity (1.2+1)/2

Example Continued Step 2: Calculate the % change in price: Difference in price= x 100%= 15.38% Average price ( )/2 Step 3: Plug the two answers you just found into your formula: Coefficient of supply elasticity= % change in Q. Supplied=18.18%=1.18 % change in price 15.38% If coefficient is: less than one – inelastic Greater than one – elastic Equal to one - unitary

Making Sense of the Answer The steel manufacturer’s ability to increase production supplied is elastic within this price range. This means that when price increases by a certain % (in our example 15.38%) then manufacturer is able to increase quantity supplied at an even greater rate (in our example 18.18%)

In General A seller with an elastic supply can take more of an advantage of price increases than a seller with an inelastic supply. This means when the price of what company A is selling goes up, if company A has an elastic supply they can make more items to sell at the higher price, increasing their revenue.

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