Elasticity of Demand and Supply
Elasticity measures how responsive quantity is to a change in price (or income, or related-good price). Price elasticity of demand Ed = %ΔQd / %ΔP. Types range from perfectly elastic (Ed=∞) to perfectly inelastic (Ed=0). Income elasticity and cross elasticity classify goods as normal, inferior, substitutes, complements.
In this chapter
Meaning of Elasticity of Demand
Elasticity of demand measures the degree of responsiveness of quantity demanded to a change in its determinants — price, income, or price of related goods. According to Marshall, "the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price." Lipsey defined it as a ratio of percentage change in quantity demanded to percentage change in any of its determinants.
Price Elasticity of Demand (Ed)
Price elasticity of demand (percentage method)
Since demand curve slopes downward, ΔQ/ΔP is negative. Economists take the absolute value, so Ed is reported as a positive number. Example: if the price of restaurant momos in New Road rises by 10% and quantity demanded falls by 20%, Ed = 20/10 = 2 (elastic demand).
Five degrees of price elasticity of demand
| Type | Value of Ed | Shape of Curve | Example (Nepal) |
|---|---|---|---|
| Perfectly Elastic | Ed = ∞ | Horizontal line | Perfectly competitive firm's demand |
| Elastic | Ed > 1 | Flatter slope | Restaurant meals, luxury clothes |
| Unitary Elastic | Ed = 1 | Rectangular hyperbola | Some mid-range goods |
| Inelastic | Ed < 1 | Steeper slope | Salt, kerosene, medicine |
| Perfectly Inelastic | Ed = 0 | Vertical line | Life-saving drug, urgent surgery |
Nepal Examples — Salt vs Restaurant Meals
Salt is a necessity used in tiny amounts and has no close substitute — its demand is inelastic (Ed < 1). Even if the price of iodised salt doubles, households still buy almost the same amount. Restaurant meals are a luxury with many substitutes (home-cooked food, street food) — demand is elastic (Ed > 1). If a New Road restaurant raises momo prices by 25%, many customers eat at home instead, and quantity demanded falls sharply.
Income Elasticity of Demand (Ey)
Income elasticity of demand
Income elasticity classifies goods by how demand responds to income changes. If Ey > 0, the good is normal (income ↑ → demand ↑). If Ey < 0, the good is inferior (income ↑ → demand ↓ — people switch to better goods). Among normal goods: if Ey > 1 it is a luxury (e.g., foreign tour); if 0 < Ey < 1 it is a necessity (e.g., rice, cooking oil).
Cross Elasticity of Demand (Exy)
Cross elasticity of demand of X wrt price of Y
- Cross elasticity tells us about the relation between two goods. If Exy > 0, the goods are substitutes (P of Y ↑ → Q of X ↑). If Exy < 0, they are complements (P of Y ↑ → Q of X ↓). If Exy = 0, they are unrelated. Examples from Nepal: tea & coffee are substitutes (Exy > 0)
- mobile phone & SIM card are complements (Exy < 0)
- rice & toothpaste are unrelated (Exy = 0).
Measurement Methods (Total Outlay & Point Method)
- Total Outlay (Expenditure) Method — compare total expenditure (P × Q) before and after the price change. If total outlay rises when price falls → elastic (Ed>1); if unchanged → unitary (Ed=1); if falls → inelastic (Ed<1).
- Point Method (Geometric) — on a linear demand curve, Ed = lower segment / upper segment. At the midpoint Ed = 1; above midpoint Ed > 1; below midpoint Ed < 1; at the price axis Ed = ∞; at the quantity axis Ed = 0.
- Total outlay method does not give an exact numerical value; point method does.
Factors Affecting Price Elasticity (Key Determinants of Ed)
- Availability of substitutes — more substitutes → more elastic (e.g., Coca-Cola vs Pepsi).
- Nature of the good — necessities are inelastic (salt, medicine); luxuries are elastic (foreign tour).
- Share in income — small share (salt) → inelastic; large share (car) → elastic.
- Time period — demand is more elastic in the long run (consumers adjust habits).
- Number of uses — more uses → more elastic (electricity: lighting, cooking, heating).
- Habit goods — cigarettes, alcohol are inelastic (addiction reduces response).
Price elasticity of supply (Es)
Supply elasticity measures how responsive quantity supplied is to a price change. Since supply slopes upward, Es is positive. Five types mirror demand: perfectly elastic (Es=∞), elastic (Es>1), unitary (Es=1), inelastic (Es<1), perfectly inelastic (Es=0). Example: agricultural supply in Nepal is usually inelastic in the short run — it takes time to grow more rice once price rises.
Practice Problem
When the price of Coca-Cola in a Patna shop rises from Rs 50 to Rs 60 per bottle, the quantity demanded falls from 100 to 80 bottles per day. Calculate the price elasticity of demand and state its type.
Practice Problem
A consumer's monthly expenditure on LPG gas in Kathmandu is given below. Use the total outlay method to find the type of price elasticity of demand. Price (Rs/cylinder) | 1500 | 1600 | 1750 | 2000 Quantity (cylinders/month) | 4 | 3 | 2.4 | 2
Practice Problem
A rice mill in Biratnagar supplies 200 quintals when the wholesale price is Rs 4000/quintal, and 280 quintals when the price rises to Rs 5000/quintal. Calculate the elasticity of supply and state its type.
Quick Revision
- Elasticity = responsiveness of quantity to a determinant.
- Ed = %ΔQd / %ΔP. Ed > 1 elastic; Ed = 1 unitary; Ed < 1 inelastic.
- Income elasticity: Ey > 0 normal, Ey < 0 inferior, Ey > 1 luxury.
- Cross elasticity: Exy > 0 substitutes, Exy < 0 complements, Exy = 0 unrelated.
- Total outlay method: outlay ↓ when P ↓ → elastic.
- Es = %ΔQs / %ΔP (always positive).