Understanding Price Elasticity of Demand and Supply

Demand Elasticity Concepts

Elastic Demand: When the percentage change in the amount demanded surpasses the percentage change in price. That is, $E > 1$ (when the consumer response to a change in price is significant).

Inelastic Demand: If the percentage change in quantity demanded is less than the percentage change in price, so $E < 1$ (when the reaction of consumers to a change in the price of the good is small).

Unit Elastic Demand: When the percentage change in quantity demanded is exactly equal to the percentage change in price. This is the limiting case, $E = 1$.

Total Revenue and Elasticity

When a price changes, the change in total revenue of producers depends on the elasticity of demand.

• Elastic Demand: A reduction of 1% in price increases the quantity sold by more than 1%, and total revenue increases. (If a reduction in price increases total revenue, demand is elastic).
• Inelastic Demand: A 1% price reduction increases the amount sold by less than 1%, and total revenue lessens. (If a price reduction lessens total revenue, demand is inelastic).
• Unit Elastic Demand: A 1% reduction in price increases the quantity sold by exactly 1%, so total revenue remains unchanged. (If a price reduction does not change the total revenue, the elasticity of demand is unitary).

Factors Determining Demand Elasticity

These factors influence whether demand is elastic or inelastic:

1. Necessary Goods versus Luxury Goods: Necessary goods are inelastic; luxury goods are elastic.
2. Substitute Goods: Goods with many substitutes tend to be more elastic.
3. Definition of Market: Markets defined within a very narrow sense tend to have more elastic demand.
4. Temporal Horizon: Goods tend to have more elastic demand when time horizons are greater (e.g., gasoline demand in the short term versus the long term).
5. Consumer Income: The higher the proportion of income spent by consumers on a good, the more sensitive they are to price changes; therefore, the demand is more elastic.

Supply Elasticity

Supply elasticity depends on:

1. Substitutability of resources.
2. Time for the decision to supply.

The more insubstitutable an input or resource is, the more inelastic supply will be.

Elastic Supply

This occurs when the response of producers to a price change is significant.

Inelastic Supply

This occurs when the reaction of producers to a change in the price of the good is small.

Factors Influencing Supply Elasticity

These factors determine the price elasticity of supply:

1. Possibility of input substitution.
2. Time frame for the supply decision.

Examples:

• Goods like corn and wheat have elastic supply; goods such as works of art have inelastic supply.
• Regarding the time frame, the elasticity of supply increases over time. The supply of fruit in the short run is inelastic because production decisions were made long before producers reached the market.