Price elasticity of demand and supply
Elasticity measures how much quantity demanded or supplied responds to a change in price. It helps firms set prices and governments choose what to tax.
📌 Key points
- Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price.
- PED = % change in quantity demanded% change in price. It is usually negative, because price and quantity demanded move in opposite directions.
- Demand is price elastic if PED is greater than 1 (ignoring the sign), price inelastic if it is less than 1, and unitary if it equals 1.
- PED is perfectly inelastic when it is 0 (quantity does not change) and perfectly elastic when it is infinite.
- Demand is more elastic when there are many close substitutes, the product takes a large share of income, it is a luxury, and over a longer time period.
- If demand is price elastic, a price cut raises total revenue; if demand is price inelastic, a price rise raises total revenue.
- Governments often tax products with price inelastic demand (e.g. petrol, cigarettes), because sales fall little and tax revenue is high.
- Price elasticity of supply (PES) = % change in quantity supplied% change in price; it is positive.
- Supply is more elastic when firms have spare capacity, stocks of finished goods, a short production time and factors that are easy to move, and over a longer time period.
📖 Key terms
- Price elasticity of demand
- A measure of the responsiveness of quantity demanded to a change in price.
- Price elasticity of supply
- A measure of the responsiveness of quantity supplied to a change in price.
- Price elastic
- Quantity changes by a greater percentage than price (elasticity greater than 1, ignoring the sign).
- Price inelastic
- Quantity changes by a smaller percentage than price (elasticity less than 1, ignoring the sign).
- Unitary elasticity
- Quantity changes by the same percentage as price (elasticity equal to 1).
- Total revenue
- Price × quantity sold.
✏️ Worked example
The price of a product rises from $10 to $12 and quantity demanded falls from 500 to 450. Calculate the PED and state the effect on total revenue.
- % change in price = (12 − 10) ÷ 10 × 100 = +20%.
- % change in quantity demanded = (450 − 500) ÷ 500 × 100 = −10%.
- PED = −10 ÷ 20 = −0.5, so demand is price inelastic.
- Revenue before = $10 × 500 = $5,000. Revenue after = $12 × 450 = $5,400.
- Answer: PED = −0.5; total revenue rises by $400.
Always calculate percentage changes, not absolute changes, and put quantity on top of the fraction. Then link the size of PED to what happens to revenue.
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