Price Elasticity of Demand and Supply

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1Summary 重點摘要

Elasticity measures how strongly quantity responds to price changes: with demand elasticity above one (elastic), cutting the price raises total revenue; below one (inelastic), raising it does. Availability of substitutes, budget share and time all shape elasticity.

2Vocabulary cards Vocabulary

3Step by step Steps

1. Step 1: Why measure elasticityThe law of demand gives the direction only: price up, quantity down. But by how much? This matters greatly for pricing and tax policy. Elasticity is the tool for measuring the magnitude of the response. For example, two coffee chains raise prices by ten per cent at once: chain A loses only 2 per cent of sales, while chain B loses a fifth. The same rise, totally different revenue outcomes — the difference lies in demand elasticity. Without it, no shop can judge whether a discount campaign pays.
2. Step 2: Computing arc elasticityArc elasticity computes percentages from the averages of the before and after values: the percentage change in quantity = the change in quantity ÷ the average quantity; likewise for price. For example, milk tea rises from $14 to $16 and quantity demanded falls from 120 cups to 100. Percentage change in quantity = 20 ÷ 110 ≈ 18.2%; percentage change in price = 2 ÷ 15 ≈ 13.3%; elasticity = 18.2% ÷ 13.3% ≈ 1.36, quoted in absolute value, greater than one.
3. Step 3: Classifying elasticityElasticity above one is elastic, below one inelastic, equal to one unit elasticity. Compute the value first, then compare with one. In the example above, elasticity is about 1.36 — elastic: each 1 per cent price rise cuts quantity demanded by more than 1 per cent. An elasticity of 0.5 would mean a 20 per cent price rise cuts sales by only 10 per cent — inelastic. Necessities with few substitutes tend to be inelastic; luxuries with many substitutes elastic.
4. Step 4: Elasticity and total revenueTotal revenue = price × quantity sold. With elastic demand, a price cut raises total revenue and a rise lowers it; with inelastic demand the reverse holds. Verify with the numbers: 14 × 120 = $1,680, but 16 × 100 = $1,600 after the rise — revenue falls, matching elasticity above one. For example, cinema morning discounts attract price-sensitive viewers — cutting price to raise revenue. A bus fare rise still lifts revenue because commuters have few substitutes in the short run.
5. Step 5: Factors affecting demand elasticityFour main factors: availability of substitutes — the more, the more elastic; the share of income spent on the good — the larger, the more elastic; the time period — longer periods are more elastic as consumers find alternatives; necessity versus luxury — necessities are inelastic, luxuries elastic. For example, salt takes a tiny share of household spending and has no substitute, so demand is highly inelastic; an overseas trip takes a large share and can be postponed or cancelled, so demand is elastic. In answers, explain each factor in turn.
6. Step 6: Price elasticity of supply and its calculationThe price elasticity of supply = % change in quantity supplied ÷ % change in price, computed the same arc way with averages; since price and quantity supplied move together, it is positive. For example, egg tarts rise from $8 to $10 and the bakery's daily output grows from 200 to 300. Percentage change in quantity = 100 ÷ 250 = 40%; percentage change in price = 2 ÷ 9 ≈ 22.2%; elasticity ≈ 1.8 — greater than one, elastic supply: the bakery can raise output quickly.
7. Step 7: Factors affecting supply elasticityThree main factors: the time needed to adjust production — the shorter the horizon, the harder to adjust and the lower the elasticity; the level of inventories — stock on hand can be released at once, raising elasticity; spare capacity — producers with idle equipment can ramp up immediately. For example, a tea restaurant cannot add seats or staff overnight, so supply is inelastic in the short run; a factory running half its machines can work overtime as orders grow — elastic supply. Over longer periods, elasticity rises across all industries.

5Worked example Example

6Common mistakes Mistakes

7Quick check Quick check

8Recap Recap

• Ed = % change in quantity demanded ÷ % change in price; arc elasticity uses averages of before and after values
• Above one elastic, below one inelastic, equal to one unit elasticity; quote demand elasticity in absolute value
• Elastic: cutting price raises total revenue; inelastic: raising it does — the basis of pricing decisions
• Demand elasticity depends on substitutes, budget share, time, and necessity versus luxury
• Supply elasticity is computed the same way; adjustment time, inventories and spare capacity matter most