Elasticity of Demand
Elasticity of Demand
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Consider the case where there is an increase in supply in a given market.
Supply shifts “outwards” as a result of, for example, companies opening new facilities. The result is that the price falls from , and quantity supplied rises from . We can ask the question, what happens to profits in this case? It is possible that profits will either increase or decrease. In the first instance this depends on the elasticity of demand. Revenue is revenue = price × quantity Revenue (also called Sales, or Turnover) is represented in a graph by an area. [See figure 2.] When the price goes down sales (revenue) can in fact increase. This is because the rectangle representing revenue = price × quantity can be larger at the lower price than at the higher price. [See figure 3.] |
Figure 1. An increase of supply in a market.
Figure 2. Sales as an area in the price/quantity diagram.
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Figure 3. It is possible to increase revenue when price falls.
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Another way to see this is illustrated by figure 4.
Here the rectangle B is larger than A. The rectangle representing sales at the higher price is , whilst the rectangle representing sales at the lower price is . Since C is common to both sales figures, and B is larger than A, sales at the lower price are greater than sales at the higher price. In this case a fall in price has resulted in an increase in sales. In this situation we call the demand “elastic”. Demand is “elastic” when a fall in price leads to an increase in sales. In figure 4 the rectangle representing sales at the lower price is larger than the rectangle representing sales at the higher price. So a fall in price has led to an increase in sales. The increase in sales, however, does not necessarily mean an increase in profits. The increase in sales means that there is also an increase in costs, as more has to be produced. However, if the costs do not increase as much as the sales, then the fall in price will lead to an increase in profits. However, when demand is “inelastic” then a fall in price leads to a decrease in sales, and consequently, must also lead to a decrease in profits. In summary: If the demand is elastic then a fall in price results in an increase in revenue, but as costs also increase the effect on profits is uncertain. It is possible that profits increase. If demand is inelastic then a fall in price leads to a fall in revenue and as costs also increase, the effect on profits is that they decrease. 
Table 1. Effect of elastic and inelastic demand.
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Figure 4. When demand is elastic.
Figure 5. A fall in price along a demand curve leads to an increase in sales. This is a situation of elastic demand.
Figure 6. A fall in price along a demand curve has lead to a fall in Sales (or Revenue). In this case the demand is said to be inelastic.
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“Perfect” elasticity and inelasticity
A “perfectly” elastic demand curve is horizontal, a “perfectly” inelastic demand curve is vertical
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Figure 7. A perfectly elastic demand curve. The price remains the same regardless of the quantity supplied to the market.
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Figure 8. A perfectly inelastic demand curve. The quantity demanded remains the same regardless of what the price of the good is.
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Price elasticity of demand
Price elasticity of demand is a numerical measure of how the quantity demanded is affected by the price. It is defined to be:
Calculations involving elasticities
If you know the elasticity of your product then you can calculate the effect of a rise or fall in price on demand and revenue.
If you know the elasticity of your product then you can calculate the effect of a rise or fall in price on demand and revenue.
Determinants of elasticity
The following factors influence the elasticity of a demand curve.
It is important for businesses to have some knowledge of the elasticity of demand for their products, and this question of what determines the elasticity of demand for a product is taken up in greater detail in a subsequent unit.
- The more substitutes a good has, then there more elastic the demand for that good becomes.
- How the good is defined will affect its elasticity. The narrower the definition, then the more elastic the demand.
- Elasticities of demand for many goods tend to be greater the longer the time period.
It is important for businesses to have some knowledge of the elasticity of demand for their products, and this question of what determines the elasticity of demand for a product is taken up in greater detail in a subsequent unit.
Changes in elasticity along a demand curve
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Elasticity of demand usually changes along a demand curve, and this is one of the properties of a demand curve that students find difficult to grasp at the beginning.
One naturally tends to think that because the demand curve here is linear (a straight line) that its elasticity must be constant all along the demand curve. But this is not so. Revenue will increase if price falls along the top part of the demand curve and will increase with a fall in price along the bottom part of the curve. A demand curve that has a constant elasticity has the shape of a hyperbola.
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Figure 8. Changes of elasticity along a demand curve.
Figure 9. A demand curve with a unit elasticity throughout is a hyperbola.
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