Supply and Demand: Elasticity and Applications
Supply and Demand: Elasticity and Applications

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1. Study Guide (Course-wide Content)

A. Price Elasticity of Demand and Supply
1. Price elasticity of demand measures the quantitative response of demand to a change in price. Price elasticity of demand (ED) is defined as the percentage change in quantity demanded divided by the percentage change in price. That is,

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In this calculation, the sign is taken to be positive, and P and Q are averages of old and new values.

2. We divide price elasticities into three categories: (a) Demand is elastic when the percentage change in quantity demanded exceeds the percentage change in price; that is, ED > 1. (b) Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price; here, ED < 1. (c) When the percentage change in quantity demanded exactly equals the percentage change in price, we have the borderline case of unit-elastic demand, where ED = 1.

3. Price elasticity is a pure number, involving percentages; it should not be confused with slope.

4. The demand elasticity tells us about the impact of a price change on total revenue. A price reduction increases total revenue if demand is elastic; a price reduction decreases total revenue if demand is inelastic; in the unit-elastic case, a price change has no effect on total revenue.

5. Price elasticity of demand tends to be low for necessities like food and shelter and high for luxuries like snowmobiles and vacation air travel. Other factors affecting price elasticity are the extent to which a good has ready substitutes and the length of time that consumers have to adjust to price changes.

6. Price elasticity of supply measures the percentage change of output supplied by producers when the market price changes by a given percentage.
B. Applications to Major Economic Issues
1. One of the most fruitful arenas for application of supply-and-demand analysis is agriculture. Improvements in agricultural technology mean that supply increases greatly, while demand for food rises less than proportionately with income. Hence free-market prices for foodstuffs tend to fall. No wonder governments have adopted a variety of programs, like crop restrictions, to prop up farm incomes.

2. A commodity tax shifts the supply-and-demand equilibrium. The tax's incidence (or impact on incomes) will fall more heavily on consumers than on producers to the degree that the demand is inelastic relative to supply.

3. Governments occasionally interfere with the workings of competitive markets by setting maximum ceilings or minimum floors on prices. In such situations, quantity supplied need no longer equal quantity demanded; ceilings lead to excess demand, while floors lead to excess supply. Sometimes, the interference may raise the incomes of a particular group, as in the case of farmers or low-skilled workers. Often, distortions and inefficiencies result.