An understanding of demand and supply gives us the fundamentals of how markets

operate - the determination of prices and output in the product market for example.
However, responses of output to a change in the price of the good are not uniform
across goods.
In analyzing the consumer's demand curve for a good, we have shown that as the price
of the good rises, our quantity demand for that good decreases. How much, if at all,
our quantity demanded of a good falls when the good's price rises, depends on the
nature of the good. There are some goods that we are reluctant or unable to sacrifice
consumption when the price rises. Other goods have an abundance of equivalent or
nearly equal substitutes that we gracefully shift our consumption towards when the
price of the good rises. The responsiveness of quantity demanded to a change in a
good's price is known as theelasticity of demand. In this section we will explore the
concept of elasticity as it relates to the demand and supply curves, to incomes and to
the prices of related goods.
The Price Elasticity of Demand
We begin our discussion of elasticity with the price elasticity of demand. The price
elasticity of demand measures the responsiveness of the quantity demand of a good
when the price of that same good changes. We calculate the elasticity of demand by
measuring the percentage change in the quantity demand over the percentage change
in price of that good (% change in Qd / % change in price). In general, if the quantity
demanded of a good is very responsive to a change in the good's price, the good is
considered to be elastic. In simpler terms, this implies if we raise the price of an
elastic good, there is a significant reduction in the consumption of that good, and vise
versa for a price decrease (1).
(1) Be sure to recognize that when we speak of the price elasticity of demand
for a good, we are referring to the change in the quantity demand of the good
when the price of the same good changes. Later we will look at the crossprice elasticity of demand which examines the change in the demand for a
good when the price of another good changes.

In contrast to a product where the quantity demanded of the good is very responsive to
a change in the product's price, is an inelastic good. Goods that are inelastic, show
little response in the quantity demanded to a change in price. Inelastic goods tend to
be necessities and those that have few available substitutes in the short-run. An
increase in the price of an inelastic good offers little opportunity for substitution in
consumption, resulting in a minimal change in the quantity demanded. For price
decreases, there is little additional consumption of inelastic goods. This yields the

logical conclusion that producers will have no incentive to drop prices for inelastic
goods unless market conditions dictate they do so.
So far we have discussed some general relationships between elasticity and the
response in the quantity demand when there is a change in the price of a product. Now
let us be more explicit:
A good is considered to be relatively elastic when the price elasticity of
demand exceeds an absolute value of 1. This indicates that if the price of
the good changes by 1%, the response in the quantity demand is greater
than 1%. The demand curves for elastic goods are relatively flat in slope.
A good is considered to be relatively inelastic when the price elasticity
of demand is below an absolute value of 1. This indicates that if the price
of the good changes by 1%, the response in the quantity demand is less
than 1%. The demand curves for inelastic goods are relatively steep in
slope.
A good has unitary elasticity when the price elasticity of demand exactly
equals 1.
There are two extremes:
1. A good is considered perfectly elastic when the price elasticity of
demand approaches infinity. This implies that the demand for the
product is unlimited at the market price - the demand curve is
horizontal.
2. A good is considered perfectly inelastic when the price elasticity
of demand equals zero. This implies that changes in price have no
effect on the quantity demand of a good - the demand curve is
vertical.
Let us take a graphical look at several demand curves. We begin with a relatively
elastic demand curve as shown in Figure 4-1. This graph shows the demand curve for
a good with a number of close substitutes in consumption such as soft drinks or colas.
To calculate the price elasticity of demand we examine the response when the price of
a six-pack of sodas goes from $2 to $2.20, a 10% increase in price. In this case, the
quantity demanded falls from 1,000 to 850, a 15% decrease in the quantity demanded.
Calculating the price elasticity of demand (% change in quantity demanded / %
change in price = 15%/10%) yields a price elasticity of 1.5 (2). The price elasticity of
demand of 1.5 calculated here, implies that for every 1% change in the price of sodas,

quantity demand changes by 1.5% - clearly a

relatively elastic good.
(2) For simplicity, we use absolute values
when calculating price elasticity's.

Figure 4-2 follows with an relatively inelastic

demand curve for a good such as gasoline.
There are few substitutes for purchasing
gasoline, especially in the short-run. In this
case the price of a gallon of gas rises from $1
a gallon to $1.10, a 10% increase. The
quantity demand falls very little - from 20
gallons to 19, a 5% decrease. The resulting
elasticity calculation is 0.5 (% change in
quantity demanded / % change in price = 5%/10%, in absolute terms). With a price
elasticity of 0.5, for every 1% increase (decrease) in the price of gasoline, the quantity
demanded of gasoline decreases (increases) by one-half as much.

In the graphs above, we show the two

extremes of the price elasticity of
demand. The left graph shows
a perfectly elastic demand curve,
characterizes goods with perfect
substitutes such as agricultural
commodities. If a typical producer
facing a perfectly elastic demand curve
to raise the price of the good, demand
to zero.

which

tries
falls

We will revisit this type of demand

curve
later in the course when we discuss an industry structure known as perfect
competition. The graph on the right (Figure 4-4), shows a perfectly inelasticdemand
curve that is vertical. Goods that have perfectly inelastic demand have no substitutes
and are considered an absolute necessity such as insulin used by diabetics and a few
other life-sustaining health care products. If the price of a perfect inelastic good is
increased, there is no effect on the quantity demanded. While perfectly elastic and
inelastic goods represent some goods, the majority of consumer goods have a

downward sloping demand curve, characterized by an elasticity somewhere between

the two extremes.
We now turn our attention to optimal producer behavior given the elasticity of demand
for their product. In other words, given the price elasticity of demand facing the firm
in the relevant range of production, how would a change in the price of the good affect
a firm's revenues? Remember, if a firm raises prices they reduce sales (for a typical
downward sloping demand curve) and the firm increases sales when there is a
reduction in prices.
A firm's revenues equals the total sales of a good sold times the price charged.
TR = P x Q:
Total Revenue = Price x Quantity
Assume that a firm faces a price elastic demand in the relevant range of good pricing.
If the firm lowers price quantity demanded will increase. The effect on total revenue is
a factor of the two parts:
Cutting price implies all goods will be sold at that lower price, reducing
total revenue - decrease P and hold Q constant.
But higher sales increases total revenue - hold P constant and increase Q.
Since demand is elastic, total revenue will increase because the
percentage gain in revenues due to higher quantity sales exceeds the loss
in revenues resulting from a lower price per output.
In summary, a price elastic demand implies the percentage change in quantity
demanded (output) exceeds the percentage change in price. Thus the firm that lowers
prices under these circumstances will have a net gain in total revenues due to the
increase in revenues resulting from greater sales exceeding the reduction in revenues
coming from a lower price per unit of output sold to consumers.
Since firms facing an elastic demand can increase total revenue when they cut prices,
the opposite condition exists when they try to raise prices. With many substitutes in
consumption available, a price increase leads to a significant decline in consumption the percentage change in quantity demanded (output) exceeds the percentage change
in price. Producers that raise prices when facing an elastic demand will find that total
revenues decrease as the gain from charging higher prices is more than offset by a
desertion of consumers to cheaper substitutes, with sales and output falling.

To understand the changes in revenue which occur when the firm prices in the
inelastic portion of the demand curve, we reverse our reasoning from the elastic
circumstances discussed above. When price elasticity is inelastic, the percentage
change in quantity demanded (output) is less than the percentage change in price. As a
result, the change in revenues due to the response in the quantity demanded is less
than the change in revenues as a consequence of the price change. We conclude that a
firm pricing in the inelastic range of the demand curve will have a net increase in total
revenues when they raise the price of the good they produce to the consumer. For the
most part, the consumer will have little opportunity to significantly reduce
consumption and must pay the higher price. The opposite holds true when the firm
pricing in the inelastic portion of the demand curve reduces price - total revenues
decline.
For an example of the change in revenue with different values of the
elasticity consider a firm that raises it price by 1%.
Assume:
P0 = $100, Q0 = 1,000 units and TR = $100,000 (P0 x Q0)
Also assume that the price elasticity of demand is equal to 0.5. With a
1% increase in price we have.
P1 = $101, Q1 = 995 units and TR = $100,495 (P1 x Q1)
If the elasticity is equal to 0.5, then a 1% increase in price will lead to
a 0.5% decrease in quantity demanded. In this example, we can see if
the good has an inelastic demand, total revenue will increase in
response to a price rise.
Let us modify our example to show what happens when price is
increased by 1%, but the good is elastic. For example, assume the
price elasticity of demand is equal to 2.0.
Assume:
P0 = $100, Q0 = 1,000 units and TR = $100,000 (P0 x Q0)
Also assume that the price elasticity of demand is equal to 0.5. With a
1% increase in price we have.
P1 = $101, Q1 = 980 units and TR = $98,980 (P1 x Q1)

If the elasticity equals 2.0, then a 1% increase in price will lead to a

2% decrease in quantity demanded. In this example, we can see if the
good has an elastic demand, total revenue will decrease in response
to a price rise.

Summary of Price Elasticity of Demand

Change in
Change in
Change in
Change in
Quantity
Quantity
Revenue with
Revenue with
Demanded with
Demanded with
an Increase
a Decrease in
a 1% Increase
a 1% Decrease
in Price
Price
in Price
in Price

Elasticity

Description

Zero

Perfectly
inelastic
- vertical
demand curve

Zero

Increased by
1%

Zero

Decreased by
1%

Between 0
and 1

Inelastic

Decreased by
less than 1%

Increased

Increased by less
than 1%

Decreased

Unitary
elasticity

Decreased by 1%

No change

Increased by 1%

No change

Greater
than 1

Elastic

Decreased by
more than 1%

Decreased

Increased by
more than 1%

Increased

Decreased to
zero

Decreased to
zero

No change

Increased by
1%

Perfectly elastic
Infinite
- horizontal
demand curve

Elasticity Over Time

OPEC was formed during the 1950s by emerging oil producing nations located
throughout the world. Until the 1970s, oil prices remained fairly steady at around $3
to $4 a barrel. As a result of the oil embargoes of 1973 and 1979, oil prices surged to
over $35 a barrel, and were soon expected to top $60 a barrel. Instead, by the mid1980s, prices per barrel had collapsed to well below $20. It was during the 1970s
when the combination of an inelastic good (oil or gasoline) coupled with soaring
prices had the most dramatic economic effects.
Gasoline is typical of a good that is inelastic in the short-run. When an automobile and
energy dependent country such as the United States was hit by soaring gasoline prices
during the 1970s, consumers had little short-run choice but to pay higher prices for

gas required to run their mostly gas-guzzling cars. The OPEC nations were not the
only beneficiaries of escalating oil prices. U.S. oil producers in Texas, Louisiana,
Alaska and other states as well as gasoline and petroleum distributors also enjoyed
soaring profits. In fact, due to rising pump prices, major U.S. gasoline retail firms
were required to pay a windfall profits tax.
However, over time the price elasticity of demand for gasoline increased and
consumption became more responsive to increases in prices. Substitutes develop such
as fuel-efficient automobiles and improved public transportation. As a response to the
oil shocks of the 1970s, Ford rolled out the legendary Pinto and Chevrolet the
memorable Vega; both more fuel-efficient than the typical Ford or General Motors car
produced during that period. Needless to say, given consumer choices, consumption of
foreign imports, especially fuel-efficient cars from Japan soared.
Along with reducing gasoline consumption, conservation and alternative fuels and
sources of petroleum helped to alleviate the dependency on OPEC oil sources. Natural
gas, coal, solar and other alternative fuels were increasingly substituted for oil by
consumers, industry and electric utilities. The Iran-Iraq war lead to widespread
cheating by OPEC members who exceeded their predetermined quotas and quickly
adjusted spending to higher cash flows of income. Eventually, gasoline prices fell as
oil production increased during the 1980s. Although the major gasoline companies
were reluctant to lower the prices of an inelastic good such as gasoline, an increase in
market supplies led to this outcome in the United States.
The conclusion we can draw from the wild 1970s, characterized by escalating energy
prices, lower thermostats, disco music and clothing that was often of dubious taste, is
that over time, elasticity increases. Even for goods that are very price inelastic such as
gasoline and some health care products, substitutes and alternatives in consumption
develop when prices increase. There may be little opportunity for consumer response
in the short-run, but in the long- run he or she will often find it easier to reduce
consumption of a good when its price increases by a significant amount. This idea will
be developed later in this course when we study market behavior of firms. As OPEC
has learned, while rapid price increases can lead to a blizzard of short-term profits,
such behavior can result in a long-run demise. For this reason, OPEC and other firms
that look to the long run have a market incentive not to gouge the consumer. As the
price of oil rose during the 1970s, so did the cost-effectiveness of alternative fuels
sources (e.g. ethanol and other food-based gasoline mixtures) that could displace oil
as an energy course. Likewise, a firm that is earning excessive profits attracts
competitors like dogs to a bone yard.
An excellent example of a firm showing short-run pricing restraint to ensure long-run
profitability is Intel, which has most likely supplied the processor (CPU) in the

computer that you are currently working on. Intel almost monopolizes the computer
processor market, supplying the CPU in roughly 85% of all personal computers sold
over the past decade. In the short-run, Intel could easily increase CPU prices and
company profits. But this would come at the expense of long-run market share and
profits. To discourage competition and ensure that PC manufacturers continue to ship
the majority of their units with Intel processors, Intel continuously innovates and
reduces prices for its processors. For competitors such as Cyrix and AMD, gaining
inroads into Intel's market share is extremely difficult given the price, quality and
name competition that Intel generates.
The Price Elasticity of Supply
Using similar concepts we discussed when examining the elasticity of demand, we
now turn our attention to the price elasticity of supply. Like the demand curve,
elasticity changes as we move along the supply curve. We can find supply curves for
goods such as housing, which are relatively vertical (inelastic), representing little
response in output to changes in prices in the short-run. Other goods, such as fast-food
hamburgers, have supply curves that are relatively elastic and flatter in shape. For
goods with an elastic supply, production responds quickly to changes in prices.
Many goods will have supply curves that have regions that are both very elastic and
inelastic. A manufactured good such as steel or automobiles will have ranges of
supply which illustrate regions where output can be rapidly expanded with little or no
change in price, and parts of the same supply curve where there is little response in
output, but a significant change in price. This concept is explained best using a shortrun supply curve, where the firm has fixed inputs such as total productive capacity
(factory, machinery, etc.), and variable inputs such as labor.
The changing elasticity along the supply curve is shown quite dramatically in Figure
4-5. At low levels of output, the supply curve is very elastic (the flat portion). The
elastic portion of the supply curve represents excess productive capacity including
underutilized machinery and other capital used in production.
As the firm expands output in the elastic range of the supply curve, there is little or no
increase in production costs, as the idled capacity is increasingly utilized. Constant
production costs imply there is little need or incentive for the firm to raise the market
price of the good. In this case, the firm can easily expand output with little or no
increase in the market price of the good produced.

As the firm continues to move along its

supply curve, increasing output, soon all of
the excess productive capacity or slack, is
absorbed. All capital used in producing the
good is fully utilized and the only way to
further increase output is to add extra shifts of
workers and overtime. The likely result is
higher production costs per unit of output as
wages and capital maintenance costs rise.
Increased production costs are passed on to
the consumer in the form of higher market
prices for the final good. This is shown by the
portion of the manufacturer's supply curve
that is nearly vertical - incremental increases
in output lead to a significant response in
price.
Income Elasticity
Thus far, we have dealt with the effect of a change in the price of a good on the same
good's quantity demanded or supplied. Now we turn our attention to the impact on the
demand for a good when consumer incomes change, holding prices constant. The
business cycle describes alternating periods of economic growth, when incomes
generally increase, and contraction (recession) which lead to a decrease in consumer
incomes. A firm needs to understand income elasticity to see how changes in the
macroeconomy translates into the demand for the good or service produced by the
firm. Our consumption of some goods, such as luxuries, is very sensitive to changes in
economic growth and consumer incomes. In contrast, necessities such as food and
housing tend to be less affected by economic swings and the corresponding changes in
consumer incomes.
There are three possibilities for a good's income elasticity:
1. A good is income elastic if the income elasticity of demand is greater
than 1. This implies that for a 1% change in income, demand for the
good changes by more than 1%.
2. A good is income inelastic if the income elasticity of demand is greater
than 0 but less than 1. This implies that for a 1% change in income,
demand for the good changes by less than 1%.

3. A good is considered inferior if the associated income elasticity of

demand is a negative number. In this case, if income increases,
consumers actually buy less of the good.
The first two categories above, income elastic and income inelastic, both correspond
to a normal good, where the income elasticity of demand is greater than zero. A
normal good is one that we buy more of when our income increases. If the income
elasticity of demand exceeds a value of 1.0, the good is often considered a luxury such
as a computer, cellular telephone or many types of entertainment. A necessity is a
good that we buy more of when our income increases, such as health care or gasoline,
but our consumption is not substantially affected. Finally, consider inferior goods
characterized by consumption that actually decreases with improvements in income.
For many consumers, inferior goods include items such as canned macaroni and
cheese, high fat meats, cheap seats at the ball game, and many others.
Cross-price Elasticity
The final type of elasticity we will consider in this section is known as the cross-price
elasticity and measures the responsiveness of our consumption of one good when the
price of another good changes. The cross-price elasticity of two goods, say good A
and good B, measures the percentage change in the quantity demanded of good A,
when the price of good B changes by 1%. Cross-price elasticity's are given two
categories: complements and substitutes.
Complements - Two goods that have a negative value for their crossprice elasticity are considered complementary goods such as compact
disk (CD) players and compact disks. If the price of CD players
increases then our consumption of CD's decreases, leading to a negative
relationship between the two. Conversely, if the price of CD players falls
(a negative coefficient), our consumption of CD's rises (a positive
coefficient).

Substitutes - Two goods that have a positive value for their cross-price
elasticity are considered substitutes such as gasoline prices and the
demand for public transportation. If the price of gasoline rises, so does
consumer demand for less expensive transportation alternatives such as
public transportation (buses, subways).