Price Elasticity of Demand and Supply
In one line. Price elasticity of demand (PED) is the percentage change in quantity demanded divided by the percentage change in price, always negative, with a magnitude above one meaning elastic and below one inelastic; it decides the direction of total revenue. Price elasticity of supply (PES) is the percentage change in quantity supplied divided by the percentage change in price, and shows up as the slope of the supply curve.
Exam relevance: a core A Level Economics topic, on ETG analysis of the last ten years. Taught the way an economics tutor who wrote the answer keys teaches it.
01What price elasticity of demand is
Price elasticity of demand measures how strongly quantity demanded reacts to a change in the good's own price, and it is the single most used idea on the microeconomics paper.
Price elasticity of demand (PED) is the percentage change in quantity demanded divided by the percentage change in price. By the law of demand the two move in opposite directions, so PED is always negative.
What matters for analysis is the magnitude, read while ignoring the sign. If the magnitude is greater than one, demand is elastic: quantity demanded changes more than proportionately to price. If it is less than one, demand is inelastic: quantity changes less than proportionately. A magnitude of exactly one is unitary, a value of zero is perfectly inelastic and an infinite value is perfectly elastic.
02Calculating and interpreting PED
Two distinct skills are assessed: computing PED from figures in the case, and reading a quoted value to drive a downstream argument.
- The figures. Suppose a price rise of 20 percent causes quantity demanded to fall by 24 percent.
- The calculation. PED = (minus 24 percent) divided by (plus 20 percent) = minus 1.2.
- The interpretation. The magnitude 1.2 is greater than one, so demand is price elastic over this range: quantity demanded fell more than proportionately to the price rise.
Keep the negative sign and put the quantity change on top. State the value with its sign, then translate it: a value such as minus 1.2 means a more than proportionate fall in quantity demanded, and that interpretation, not the bare number, is what powers the rest of the answer.
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03What makes demand elastic or inelastic
Whether demand is elastic depends on a short list of determinants, and a good answer applies them to the specific good rather than listing them.
- Availability and closeness of substitutes. The more close substitutes a good has, the more elastic its demand, because buyers can switch away when its price rises.
- Proportion of income spent. A good that takes up a large share of income, such as a car, tends to have more elastic demand than a low cost item such as salt.
- Necessity versus luxury. Necessities tend to have inelastic demand because they are hard to do without; luxuries tend to be more elastic.
- Time period. Demand is usually more elastic over a longer horizon, because buyers have time to find substitutes and adjust habits.
In practice no good is perfectly inelastic. The desert water case is only a theoretical extreme, and recognising that real demand always has some responsiveness is the caveat that higher mark answers build in.
04PED and total revenue
The most recurring use of PED is to predict what happens to total revenue, equivalently consumer expenditure, when price changes.
Total revenue is price multiplied by quantity, the rectangle under the demand point. The direction it moves after a price change depends entirely on PED:
If demand is inelastic, price and revenue move together: a price rise raises revenue. If demand is elastic, they move oppositely: a price rise lowers revenue. If demand is unitary, revenue is unchanged.
This is why a firm with genuinely inelastic demand can raise price to lift revenue, and why a tax on a price elastic good causes a more than proportionate fall in quantity and so lowers spending on it. Whether the net effect across a basket of goods is positive depends on the mix of inelastic necessities and elastic luxuries within it.
05Price elasticity of supply
Price elasticity of supply measures how strongly quantity supplied reacts to a change in price, and it usually shows up as the slope of the supply curve in a demand and supply diagram.
Price elasticity of supply (PES) is the percentage change in quantity supplied divided by the percentage change in price. By the law of supply the two move together, so PES is positive.
The diagram is the point of PES in most questions: with inelastic, steep supply a rise in demand drives a large price increase and only a small quantity increase, while flatter, elastic supply absorbs the same demand rise mostly as extra quantity. The Singapore residential property surge is the standard case, where inelastic housing supply amplifies the price rise against rising demand.
06What makes supply elastic or inelastic
Supply is elastic when producers can expand output quickly and cheaply in response to a higher price, and inelastic when they cannot.
- Spare capacity. Firms with idle plant and labour can raise output fast, so supply is more elastic.
- Level of stocks. Goods that can be stored let producers release inventory when price rises, raising elasticity.
- Mobility of factors of production. If labour and capital can be shifted into the industry easily, supply responds more.
- Time period. Supply is more elastic the longer the horizon, since production capacity is fixed in the short run but adjustable over time.
Do not confuse a movement along the supply curve, caused by a price change, with a shift of the curve. PES is about the responsiveness shown by the slope, not about supply shifting for some other reason.
07Test yourself
- A 10 percent rise in the price of a good causes quantity demanded to fall by 5 percent. Calculate PED, state it with its sign, and say whether demand is elastic or inelastic.
- Explain, using PED, why a price rise raises total revenue for one good but lowers it for another.
- Using a diagram, explain why a rise in demand raises price by more when supply is price inelastic.
08Questions students ask
Price elasticity of demand (PED) measures how responsive quantity demanded is to a change in the good's own price. It is the percentage change in quantity demanded divided by the percentage change in price, and by the law of demand it is always negative. Ignoring the sign, demand is elastic if the magnitude is greater than one and inelastic if it is less than one.
Divide the percentage change in quantity demanded by the percentage change in price, keeping the negative sign. If price rises 20 percent and quantity demanded falls 24 percent, PED = minus 24 divided by plus 20, which is minus 1.2. Because the magnitude exceeds one, demand is price elastic over that range, so the fall in quantity is more than proportionate to the price rise.
When demand is elastic, a magnitude greater than one, quantity demanded responds more than proportionately to a price change, so a price rise lowers total revenue. When demand is inelastic, a magnitude less than one, quantity demanded responds less than proportionately, so a price rise raises total revenue. The split decides the direction of the revenue or expenditure effect that most questions turn on.
Price elasticity of supply (PES) measures how responsive quantity supplied is to a change in price. It is the percentage change in quantity supplied divided by the percentage change in price, and by the law of supply it is positive. Supply is elastic if the magnitude is greater than one and inelastic if it is less than one; the main determinants are spare capacity, the level of stocks, the mobility of factors and the time period.