ECON7002

Lecture 2
Demand, Supply, and Elasticity I

Reading: HGLO Chapters 3 & 4 (pp.94-105)

University of Queensland
Semester 1, 2021
Outline of Today’s Lecture
1. Demand and Supply
a) The demand side of the market
b) The supply side of the market
c) Market equilibrium
d) The effect of shifts in demand and supply on equilibrium

2. Elasticity: The Responsiveness of Demand and Supply – Part One

a) What is elasticity and why do we need it?
b) Computing elasticity using the midpoint formula
c) Determinants of price elasticity of demand
From last week’s lecture: The Economic
Problem that every society must solve
• All societies face problem of scarcity:
Given limited resources and unlimited wants:
• What goods and services should society produce?
• How should these goods be produced?
• Who should get the goods and services produced?

• Essentially 2 ways societies deal with these economic decisions

• Centrally Planned Economies
• Market Economies
Free Market Economies and
Perfect Competition as Benchmark
• For today’s lecture, we’ll focus on Market Economies without
Government intervention
• To serve as a benchmark to put mixed economies into context
• In later lectures, we’ll examine why Government intervention in markets
might be necessary in the face of issues such as externalities, public goods,
monopolies and asymmetric information.

• We’ll focus on one particular type of market structure: Perfectly

Competitive markets
First Big Question: How are Market Prices
determined in Perfectly Competitive Markets?
• Some commonplace complaints:
• Consumers complain that prices are too high
• Sellers complain that prices are too low
• What is an “appropriate” price level?
• Should the “correct” price be determined by
• The cost of production of the Seller?
• The value to the Buyer?
• Or both?
Demand
• We’ll start by looking at decision of the buyer:
How many units should the buyer choose to purchase.
• Quantity Demanded of a good or service is the amount that a buyer is
willing and able to purchase at a given price.
• Many factors determines the quantity demanded by a buyer
• Taste/Preferences
• Income or Budget
• But one critical factor: Price of the Good or Service
Demand Curve
• The Demand Curve describes the relationship between
• Price of the good or service
• And the Quantity Demanded

• The Demand Curve can take the form of

• An Equation
• A Table (or a Schedule)
• A Graph
Demand Curve as an Equation
• Demand Curve as an Equation (example)

𝑄𝑄𝐷𝐷 = 100 − 2𝑃𝑃

• 𝑄𝑄𝐷𝐷 refers to Quantity Demanded

• 𝑃𝑃 refers to Price
• If 𝑃𝑃 = 0, then 𝑄𝑄𝐷𝐷 = 100 − 2 ⋅ 0 = 100
• For every $1 increase in 𝑃𝑃, there will be a 2 unit decrease in 𝑄𝑄𝐷𝐷
Demand Curve as a Table
The same Demand Curve can be represented by a table.

Price Quantity Demanded

0 100
10 80
20 60
30 40
40 20
50 0
Demand Curve as a graph
P • By convention:
• The Horizontal Axis
shows
50 the Quantity (𝑄𝑄)
• The Vertical Axis shows
the Price (𝑃𝑃)
• Here is the graph of the
same Demand Curve
with equation

𝑄𝑄𝐷𝐷 = 100 − 2𝑃𝑃

Q
0 100
Demand Curve as a graph
P

50

40

30

20

10

40 80
Q
0 20 60 100
Law of Demand
• Notice that the Demand Curve is downwards sloping
• i.e. that as Prices Increase, Quantity Demanded Decreases.
• Law of Demand: Holding all other factors (besides Price) constant,
when the Price of a Good or Service Increases the Quantity
Demanded of the product Decreases
• The inverse relationship between Price and Quantity Demanded
explained by
• The Substitution Effect
• The Income Effect
The Substitution Effect
• The Substitution Effect:
• Holding all else constant,
• As the Price of a product Increases
• It becomes more expensive relative to its Substitute
• Buyers will demand a lower quantity of the original product and more of its
substitute.

• For Example: Red and White wines are substitutes

• If Red Wine increases in price, then Red wine becomes more expensive relative to
White Wine
• Since Red wine and White wine serve largely the same purpose, buyers will buy
more of the cheaper good and less of the more expensive one.
• Buyers will substitute away from Red Wine and towards White Wine
• i.e. Buy less Red Wine and more White wine.
The Income Effect
• The quantity demanded by a buyer is determined
• not only by what he/she wants buy
• but just as importantly, what s/he can afford
• Because every buyer has a limited income or budget.
• The Income Effect refers to the
• change in the quantity demanded of a product
• from the effect of that price change on the Purchasing Power of the buyer’s
income or budget
• Purchasing Power refers to the quantity of goods the buyer can afford
to buy with a given income or budget.
Shifts in Demand
• So far, we have examined the effect of changes in Prices on Quantity
Demanded
Δ𝑃𝑃 > 0 ⇒ Δ𝑄𝑄𝑄𝑄 < 0

• But many other factors influence Quantity Demanded even if Prices are
unchanged
• For example:
• News of contaminated milk might reduce Quantity Demanded of milk
at every price level – shifting the Demand curve to the Left.
• We call this a Decrease in Demand
• An advertising campaign for Vitamin supplements may Increase 𝑄𝑄𝑄𝑄 at every price
level – shifting the Demand Curve to the Right
• We call this an Increase in Demand.
Changes in Demand
Increase In Demand:
Increase in QD at every Price

50

40

30
New
20 Demand
Original
Demand
10

40 80
Q
0 20 60 100
Decrease In Demand:
Decrease in QD at every Price

50

40

30

20
New Original
Demand Demand
10

40 80
Q
0 20 60 100
Factors that Shifts Demand
• Many factors (that are not Price) can shift Demand

Some of the most Important Factors

1. Income
2. Prices of Substitutes and Complements
3. Consumer Tastes and Preferences
4. Population and Demographics
5. Expected Future Prices
1: Changes in Income Shifts Demand
• The Income that consumers have available to spend affects their
willingness and ability to buy goods and services.
• When Incomes increase, we expect that consumers will spend more
on Goods and Services
• i.e. at every given Price, Quantity Demanded should increase
• This is true for Normal Goods - Goods for which
Demand Increases as Incomes increase – e.g. laptops, cars, holidays
• But there also exists Inferior Goods – Goods for which
Demand Decreases as Incomes increase
Can you think of some examples of Inferior Goods?
Substitutes
• 2 goods are substitutes (for one another) if they are used for the same or
very similar purposes.
• For example:
• Oranges and Apples can be considered to be substitutes
• As they are both healthy and tasty fruits
• If oranges are too expensive, I’ll happily buy apples instead.
• Other examples of pairs of substitutes
• Coca Cola and Pepsi Cola
• Uber rides and Taxi rides
• Apple Music and Spotify
• Internet Explorer and Google Chrome
• MacBooks and Microsoft Surfacebook
2a: Prices of Substitutes
• When 2 goods are substitutes, when consumers buy more of one, they
tend to buy less of the other.

• Paracetamol and Ibuprofen are both analgesics (provide pain relief)

• If the Price of Paracetamol Increases – the Law of Demand suggests that consumers
will buy Less Paracetamol
• But consumers still need pain relief – so will buy more Ibuprofen – even if the price
of Ibuprofen remains unchanged.
• I.e. an increase in the price of Paracetamol will increase demand for its Substitute -
Ibuprofen

• Takeaway: Demand for a product will Increase if the Price of its Substitute
Increases.
Complements
• 2 goods are complements if they are usually used together.

• For example:
• Left shoes and Right shoes are complements.
• A left Nike sneaker is useless without a matching right sneaker.

• Other examples of complements

• Cars and Petrol
• Printers and Ink Cartridges
• Sony PlayStation and Games
2b: Prices of Complements
• When 2 goods are Complements, when consumers buy more of one,
they tend to more of the other.
• Nintendo Switch Consoles and Games are Complements

• If the Price of Nintendo Switch Console Increases – what do you think will
happen to the demand for Nintendo Switch Games?
2b: Prices of Complements
• When 2 goods are Complements, when consumers buy more of one,
they tend to more of the other.
• Nintendo Switch Consoles and Games are Complements
• If the Price of Nintendo Switch console Increases
• Consumers will buy Less Nintendo Switch consoles (Law of Demand)
• And hence will want to buy Less Nintendo Switch Games
at any price for games
• An Increase in the price of Nintendo Consoles Decreases Demand for its
Complement – games.
• Takeaway: Demand for a Product is Decreased if the Price of its
Complement is Increased.
Consumer Tastes and Preferences
• Consumers’ subjective tastes and preferences influence their
willingness to buy products.
• For example:
• Grand Seiko watches are arguably just as good as Rolex watches (if not better)
by objective measures of quality and are lower priced
• But a lot less Grand Seikos are sold every year.
• The low level of demand for Grand Seiko’s might be due to consumers’
subjective preference for Rolex as a brand.
3: Consumer Tastes and Preferences
• Consumers’ subjective tastes and preferences influence their
willingness to buy products.
• An advertising campaign (or endorsement by a celebrity) might shift
consumer preferences towards Grand Seikos
• Increasing the Quantity Demanded at each Price
• Increasing Demand for Grand Seikos
4: Population and Demographics
• An Increase in Population will
• Increase Quantity Demanded at every price
• Since more people will need to buy more stuff
• Hence increase Demand

• Changes in Demographics (i.e. the characteristics of a population) will

change demand for certain goods and services
• For example, an aging population will increase demand for Medical Services
• Another example
• An increase in birth rate will increase demand for childcare services
• As would an increase in Female labour force participation.
5: Expected Future Prices
• If you expect House Prices to Decrease substantially next year
• Will you want buy a House today or wait until next year?

• If you expect Car prices to Increase substantially next week (and you
want to buy a car sometime this month)
• Will you want to buy the car today
• Or wait until next week?

• Takeaway: An expected increase in Future price of a product will

Increase Current Demand for the Product
Change in Demand versus
Change in Quantity Demanded
• A Change in Demand sounds
very much like a Change in Quantity Demanded
• But they refer to Different things!!!

• A Change in Demand refers to a Shift of the Demand Curve

• Due to changes in Factors other than Price

• A Change in Quantity Demanded refers to changes in how much Buyers

wish to purchase
• Typically refers to a Movement along the Demand curve
• I.e. How Quantity Demanded changes as Price changes.
Change in Demand versus
Change in Quantity Demanded
Supply
• We next look at the decision of sellers
• The quantity of the product to supply to the market

• Quantity Supplied (𝑄𝑄𝑆𝑆 , 𝑄𝑄𝑄𝑄): The amount of the good or service that a
firm is willing and able to supply to a market at a give price.

• Law of Supply: Holding all else constant, an increase in price results

in an increase in the quantity supplied.
𝑃𝑃 ↑ ⇒ 𝑄𝑄𝑆𝑆 ↑
Supply Curve
• The Supply Curve for a Product describes the relationship between
Price and Quantity Supplied

• The Supply Curve can be represented by

• An equation (e.g. 𝑄𝑄𝑆𝑆 = 10000𝑃𝑃)
• The equation implies that a $1 increase in price increases Quantity Supplied by 10,000
units.
• A Table (Supply Schedule)
• A Graph of the Equation
Supply Curve
Why the Law of Supply holds
• Notice that the Law of Supply implies that the higher the price, the
more firms would like to produce and sell.
• i.e. that there is a positive relationship between Price and Quantity Supplied
• Intuitively, this make sense
• Holding all else constant (e.g. production costs)
• Increase in price increases the profit of each additional unit sold
• Hence Firms will want to increase the number of units supplied
• Since Firms are profit maximizers.
• A more in-depth explanation (with Marginal Costs of Production) will be
provided in future lectures.
Shifts in Supply
• Many factors other than Price influence Firms’ willingness to supply
goods and services to markets

• An Increase in Supply
• Is a Rightward Shift of the Supply Curve
• When Firms are willing to Increase Quantity Supplied at every price
• A Decrease in Supply
• Is a Leftward Shift of the Supply Curve
• When Firms Reduce the Quantity Supplied at every price
Shifts in Supply
Important Factors that Shifts Supply
1. Prices of Production Inputs
2. Technological Change
3. Prices of Substitutes in Production
4. Number of Firms in the Market
5. Expected Future Prices

• Factors 1 and 2 changes the cost of production

• Factor 3 influences the opportunity cost of production
1: Price of Production Inputs
• If Price of Production Inputs for a Good increases
• The cost of production increases
• Hence the profitability of each unit produced is reduced.
• Firms will want to supply less units if the price of the Good remains the same.

• For Example: How will an Decrease in the Price of Flour affect Supply of Bread?
• Decrease in Price of Flour will decrease the (Marginal) cost of Bread production
• Baking Bread becomes More profitable
• Sellers will want to increase Quantity Supplied if the Price of Bread remains unchanged.
• Supply of Bread increases (Shifts Right)

• Takeaway: An increase in the price of an Production Input results in a Decrease

in Supply.
2: Technological Change
• Technological Change refers to a change in the way a Good or Service is
produced.
• Technological Change often results in greater production efficiency – such
that the same level of output can be produced with less production inputs.
• Example: The introduction of computer word processing has reduced the number of
hours required to prepare lecture slides, essays etc.
• Hence Technological Change lowers costs of production
• Increasing the profits from each unit produced
• Firms will want to Supply more units of output.
• Takeaway: Technological Change that increases production efficiency will
increase Supply.
3: Prices of Substitutes in Production
• 2 goods are substitutes in production if the same firm can produce the 2
goods using (largely) the same production inputs.
• For example: Bread and Cake are Substitutes in Production for a bakery –
as baking Bread and Cake require the same machinery and many of the
same ingredients.
• Other examples: Tablets and Smart Phones; Computer Monitors and TVs.
• If the Price of a Substitute in Production (e.g. Cake) increases for a Good
(e.g. Bread)
• The opportunity cost of the Good (Bread in this case) increases
• Lowering the economic surplus from supplying Bread
• We’ll expect the Firm to Decrease Supply of the Good in favour of its Substitute in
Production.
4: Number of Firms in the Market
• If new firms enter the market, the supply curve shifts to the right
• If firms exit a market, the supply curve shifts to the left

• Takeaway: An increase in the number of Firms in a market increases

Supply.
5: Expected Future Prices
• If a Firm expects higher Prices in the Future compared to today
• The Firm can increase its profits over time by reducing quantity supplied into
market today
• Store “extra” produced goods to build up inventory
• To increase Supply in the future when prices are higher

• Takeaway: Expected higher prices in the future will decrease Supply

today.
Shifts in Supply Summarized
Shifts in Supply Summarized
Change in Supply versus Change in Quantity
Supplied
(Perfect Competition) Market Equilibrium
• Suppose an economist knows the Supply and Demand curves in this
market and wishes to predict the market outcome:
• For example
• How many units of the product will be traded?
• At what price?
• Who will produce the goods?
• Who will receive the goods?
• The economist will employ the concept of a Market Equilibrium
(Perfect Competition) Market Equilibrium
• Consider a Perfectly Competitive Market in which there are
• Many Buyers
• All of whom wants to maximize value for money
• Will choose to buy from the lowest priced seller who is able to supply the good
• Many Sellers
• All of which are profit-maximizing firms
• Each of which sells the same exact product
• Every Seller needs to compete with its numerous rivals for customers
• Sidenote: This is a very simplistic description of Perfect Competition
• We’ll examine Perfectly Competitive markets in greater detail in a later lecture
Equilibrium
• Intuitively speaking, a system is in Equilibrium
• If it is Stable, Balanced, Unchanging
• The concept of an Equilibrium is commonplace in Physical & Social
Sciences
• For example in Physics, a Boat floating on water is in Equilibrium
• Because the downwards force of gravity is perfectly balanced by the upwards force of
buoyancy
• Such that the Boat is neither moving up higher nor sinking deeper into the water
• Another Example:
• A ball on a side of a slope is not in equilibrium – because it will quickly roll downhill
• A ball at the bottom of a bowl is in equilibrium – because it is in a stable position.
If left alone – it will stay where it is forever.
Market Equilibrium
• Similarly, we say that a market is in equilibrium if
• No individual buyer or seller has an incentive to change their behaviour
• e.g. change how much they want to buy or sell
• Or change the price they charge or offers
• Eq. if the market price is stable and doesn’t change on its own

• In other words, at market equilibrium

• the quantity traded and the price will remain unchanged if market demand
and supply remains unchanged.
• the forces of Demand and Supply are Balanced.
• A Market in Equilibrium stays at Equilibrium
Competitive Market Equilibrium
• In a Perfectly Competitive Market
• The Market Equilibrium occurs when Demand meets Supply
(i.e. where the Demand and Supply curves intersect)
• Equivalent, occurs at the Price at which the
Quantity Demanded = Quantity Supplied

• The Equilibrium Price is the price at market equilibrium

• The Equilibrium Quantity is the quantity traded at market equilibrium
• Equals the Quantities Demanded and Supplied at Equilibrium
Competitive Market Equilibrium
Why is Equilibrium where Demand Meets
Supply?
• Suppose that the Market Price (the price that every seller is charging) is
above Market Equilibrium Price
• Then Quantity Supplied by Sellers is greater than Quantity Demanded by
Buyers
𝑄𝑄𝑆𝑆 > 𝑄𝑄𝐷𝐷
• Sellers wish to sell more than Buyers want to buy – A surplus has occurred
• What would a Seller do in this case?
• Every seller has an incentive to steal all the customers by charging a little bit under
the market price that his rivals are charging.
• If every seller is cutting prices, the market price will drift downwards – not stable
• Hence, a Price at which 𝑄𝑄𝑆𝑆 > 𝑄𝑄𝐷𝐷 cannot be an Equilibrium Price
Shortage and Surplus
Why is Equilibrium where Demand Meets
Supply?
• Suppose that the Market Price (the price that every seller is charging) is
below Market Equilibrium Price
• Then Quantity Supplied by Sellers is less than Quantity Demanded by
Buyers
𝑄𝑄𝑆𝑆 < 𝑄𝑄𝐷𝐷
• Buyers wish to buy more than Sellers want to supply – A Shortage has
occurred
• What would a Buyer do in this case?
• Every Buyer has an incentive to offer a price to sellers that is just above the market
price – in order to get the sellers to sell to him
• But if every buyer is doing the same, the market price will drift Upwards – not stable
• Hence, a Price at which 𝑄𝑄𝑆𝑆 < 𝑄𝑄𝐷𝐷 cannot be an Equilibrium Price
Why is Equilibrium where Demand Meets
Supply?
• When Quantity Demanded equals Quantity Supplied
• i.e. at the Market Equilibrium Price
• Every Seller is able to sell as much as they wish to sell at the market
equilibrium price
• Every Buyer is able to buy as much as they wish to buy at the market
equilibrium price
• No-one has any incentive to try to change prices
• The market price will remain at equilibrium unless demand or supply
curves shift.
Effect of Shifts in Demand and/or Supply on
the Market Equilibrium
• Market Demand and Supply Curves seldom stay the same for long.
• The world is constantly evolving
• Consumer preferences change over time
• Technological change occurs as science and technology progresses
• Some natural resources run out and other new natural resources are
discovered
• Some Countries grow richer while others grow older
• All of these will shift demand and supply curves
• Question: How will Changes in Demand and Supply curves change the
market equilibrium price and quantity?
Effect of Shifts in Demand on the Market
Equilibrium
• Consider the impact of China’s rapid economic development on the price of
oil.
• Over the last 3 decades, China’s Real GDP per capita has grown from USD317.88 in
1990 to USD8826.99 in 2017
• This is a 27-fold increase in average income per Chinese citizen.
• As China’s residents’ incomes increase, they purchased more cars which in turn
increased demand for oil (complementary good to cars).
• The market for oil is global in nature, an increase in Demand for oil from China also
implies an increase in Demand in global oil markets.
• Since development of oil fields and oil refineries is slow, assume that the Supply of
oil in global markets remains unchanged.
• What impact did the increased Demand for oil have on the Equilibrium
Price and Quantity in the Global Market for oil?
 Impact of Increased Demand on Equilibrium
P 𝑄𝑄 • Demand increases from 𝑄𝑄0 to 𝑄𝑄1

• Market Equilibrium shifts from

𝐸𝐸0 to 𝐸𝐸1
𝑃𝑃1∗ 𝐸𝐸1
• Equilibrium Price increases from
𝑃𝑃0∗ 𝑃𝑃0∗ to 𝑃𝑃1∗
𝐸𝐸0
𝑄𝑄1
• Equilibrium Quantity increases
from 𝑄𝑄0∗ to 𝑄𝑄1∗
𝑄𝑄0
Q
0 𝑄𝑄0∗ 𝑄𝑄1∗
Effect of Shifts in Supply on Market
Equilibrium
• The increase in the price of oil and consequent profitability of oil
production has spurred research and development into new
technologies associated with Oil extraction, such as horizontal drilling
and extraction of oil from Tar sands.
• Increased production efficiency has lowered costs of production –
which in turn has increased supply of oil.
• Holding Demand for oil unchanged, predict the change in equilibrium
price and quantity in the market for oil.
Impact of Increased Supply on Equilibrium
P 𝑄𝑄0
• Supply increases from 𝑄𝑄0 to 𝑄𝑄1
𝑄𝑄1

• Market Equilibrium shifts from

𝑃𝑃0∗ 𝐸𝐸0 𝐸𝐸0 to 𝐸𝐸1

• Equilibrium Price decreases from

𝑃𝑃1∗ 𝐸𝐸1 𝑃𝑃0∗ to 𝑃𝑃1∗

• Equilibrium Quantity increases

𝑄𝑄 from 𝑄𝑄0∗ to 𝑄𝑄1∗
Q
0 𝑄𝑄0∗ 𝑄𝑄1∗
Simultaneous Shifts in Demand and Supply
• The rapid increase in Chinese residents’ incomes has resulted in
• Higher oil Prices
• A larger number of Chinese residents who want to go on overseas holidays
• Higher Oil Prices means higher fuel costs (higher input costs) for
Airlines – Decreasing Supply of Passenger Air Travel Services
• More Chinese residents who want to go on holidays abroad means an
Increase in Demand for Passenger Air Travel Services
• What impact has this increased demand and decreased supply had on
the market equilibrium for Air Travel?
Simultaneous Shifts in Demand and Supply
P 𝑄𝑄1 • Supply decreases from 𝑄𝑄0 to 𝑄𝑄1
Small Increase in Demand
Big Decrease in Supply • Demand increases from 𝑄𝑄0 to 𝑄𝑄1
𝑄𝑄0
• Market Equilibrium shifts from 𝐸𝐸0 to 𝐸𝐸1

• Equilibrium Price decreases from 𝑃𝑃0∗ to 𝑃𝑃1∗

𝑃𝑃1∗ 𝐸𝐸1
• Equilibrium Quantity
• Decreases from 𝑄𝑄0∗ to 𝑄𝑄1∗ in this case
• But Equilibrium Quantity can either
increase or decrease
𝑃𝑃0∗ 𝐸𝐸0 • Depends on the size of the increase in
𝑄𝑄1
Demand relative to the decrease in
𝑄𝑄0 Supply
Q
0 𝑄𝑄1∗ 𝑄𝑄0∗
Simultaneous Shifts in Demand and Supply
P Big Increase in Demand • Supply decreases from 𝑄𝑄0 to 𝑄𝑄1
𝑄𝑄1
Small Decrease in Supply • Demand increases from 𝑄𝑄0 to 𝑄𝑄1
𝑄𝑄0
• Market Equilibrium shifts from 𝐸𝐸0 to 𝐸𝐸1
𝐸𝐸1
• Equilibrium Price decreases from 𝑃𝑃0∗ to 𝑃𝑃1∗
𝑃𝑃1∗
• Equilibrium Quantity
• Increases from 𝑄𝑄0∗ to 𝑄𝑄1∗ in this case
• But Equilibrium Quantity can either
increase or decrease
𝑃𝑃0∗ 𝐸𝐸0 • Depends on the size of the increase in
𝑄𝑄1
Demand relative to the decrease in
𝑄𝑄0 Supply
Q
0 𝑄𝑄0∗ 𝑄𝑄1∗
All Possible Combinations of Shifts in Demand
and Supply
Outline of Today’s Lecture
1. Demand and Supply
a) The demand side of the market
b) The supply side of the market
c) Market equilibrium
d) The effect of shifts in demand and supply on equilibrium

2. Elasticity: The Responsiveness of Demand and Supply – Part One

a) What is elasticity and why do we need it?
b) Computing elasticity using the midpoint formula
c) Determinants of price elasticity of demand
Elasticity
• Economists use the concept of Elasticity to measure how sensitive buyers and
sellers are to changes in prices.
• For example, the Price Elasticity of Demand is defined as

%Δ𝑄𝑄𝐷𝐷
𝜀𝜀 =
%Δ𝑃𝑃
Where
Δ𝑄𝑄
• %Δ𝑄𝑄𝐷𝐷 ≔ × 100% is the Percentage Change in Quantity Demanded
𝑄𝑄
Δ𝑃𝑃
• %Δ𝑃𝑃 ≔ × 100% is the Percentage Change in Price
𝑃𝑃
• Since an increase in Price (%Δ𝑃𝑃>0) always results in a fall in the Quantity
Demanded (%Δ𝑄𝑄𝐷𝐷 < 0), and vice-versa:
The Price Elasticity of Demand is always a negative number (𝜀𝜀 < 0)
Price Elasticity of Demand
• The Price Elasticity of Demand is used to measure how sensitive Buyers are
to changes in Prices
%Δ𝑄𝑄𝐷𝐷
• Rearranging 𝜀𝜀 = , we get
%Δ𝑃𝑃

%ΔQ D = 𝜀𝜀 ⋅ %ΔP

• Intuitively, we can interpret the value of 𝜀𝜀 as the percentage change in Quantity

Demanded for a 1% increase in Price.

• For Example, if the Elasticity of Demand is 𝜀𝜀 = −10, that means that 1% increase in
price (%ΔP = 1%) will result in %ΔQ D = −10 ⋅ 1% = −10% or a 10% decrease in
quantity demanded.
Price Elasticity of Demand
• Suppose you are told that
• Price Elasticity of Demand for Bananas is 𝜀𝜀𝐵𝐵 = −5
• Price Elasticity of Demand for Oranges is 𝜀𝜀𝑂𝑂 = −3
• Are buyers of Bananas more price sensitive or buyer of Oranges?
• For a 1% increase in Price
• Quantity Demanded of Bananas will fall by 5%
• Quantity Demanded of Oranges will fall by 3%
• Banana buyers are more price sensitive.
• Takeaway: The greater the absolute value of the Elasticity of Demand (|𝜀𝜀|), the
greater the degree of price sensitivity.
• E.g. Absolute Value of Price Elasticity of Demand for Bananas is 𝜀𝜀𝐵𝐵 = 5
while it is 𝜀𝜀𝑂𝑂 = 3 for Oranges.
Why do we need to use Elasticity?
Δ𝑄𝑄𝐷𝐷
• The inverse of the Slope of the Demand Curve is
Δ𝑃𝑃
• Also, gives me information on how quantity demanded changes with prices
• Also, tells me something about how sensitive buyers are to prices, doesn’t it?

• Suppose I told you that:

• In the market for Ferraris: 𝐹𝐹
Increase in Price of $1 (Δ𝑃𝑃 = $1) will result
𝐹𝐹
in
Decrease in Quantity Demanded of 1 (Δ𝑄𝑄𝐷𝐷 = −1)

• In the market for Apples: 𝐴𝐴

Increase in Price of $1 (Δ𝑃𝑃 = $1) will also
𝐴𝐴
result in
Decrease in Quantity Demanded of 1 (Δ𝑄𝑄𝐷𝐷 = −1)

• Does that mean that buyers of Ferraris are just as price sensitive as buyers of
Apples if we simply use the slopes of the respective Demand Curves?
Why do we need to use Elasticity?
• Suppose I then give you more information

• In the Market for Ferraris

• Δ𝑃𝑃𝐹𝐹 = $1 results in Δ𝑄𝑄𝐷𝐷𝐹𝐹 = −1
• At current price of 𝑃𝑃𝐹𝐹 = $1 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀, quantity demanded is 𝑄𝑄𝐷𝐷𝐹𝐹 = 2

• In the Market for Apples

• Δ𝑃𝑃 𝐴𝐴 = $1 results in Δ𝑄𝑄𝐷𝐷𝐴𝐴 = −1
• At current price of 𝑃𝑃 𝐴𝐴 = $1, quantity demanded is 𝑄𝑄𝐷𝐷𝐴𝐴 = 1 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
 Why do we need to use Elasticity?
In the Market for Ferraris In the Market for Apples
• If Price increases by Δ𝑃𝑃𝐹𝐹 = $1, the • If Price increases by Δ𝑃𝑃 𝐴𝐴 = $1, the percentage
percentage increase in Price is increase in Price is
Δ𝑃𝑃𝐹𝐹 $1 Δ𝑃𝑃 𝐴𝐴 $1
%Δ𝑃𝑃𝐹𝐹= 𝐹𝐹 × 100% = × 100% %Δ𝑃𝑃 𝐴𝐴 = 𝐴𝐴 × 100% = × 100% = 100%
𝑃𝑃 $1Million 𝑃𝑃 $1
= 0.0001%
• The resulting percentage change in Quantity
• The resulting percentage change in Quantity Demanded is
Demanded is Δ𝑄𝑄𝐷𝐷𝐴𝐴 −1
Δ𝑄𝑄𝐷𝐷𝐹𝐹 −1 %Δ𝑄𝑄𝐷𝐷𝐴𝐴
= 𝐴𝐴 × 100% = × 100%
%Δ𝑄𝑄𝐷𝐷𝐹𝐹 = 𝐹𝐹 × 100% = × 100% = −50% 𝑄𝑄𝐷𝐷 1Million
𝑄𝑄𝐷𝐷 2 = 0.0001%

• 0.0001% increase in price of Ferraris will • 100% increase in price of Apples will cause a
cause a 50% decrease in Quantity Demanded 0.0001% decrease in Quantity Demanded

• Based on this information: Do you still think buyers of Ferraris are just as price sensitive as buyers
of Apples?
• No… Apple buyers less price sensitive compared to Ferrari buyers.
Why do we need to use Elasticity?
• We have established that Ferrari Buyers are more Price Sensitive.
• Consistent with Price Elasticity of Demand for each Good.

%ΔQFD −50%
𝜀𝜀𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = = = 500,000
%ΔPF 0.0001%

%ΔQAD 0.0001%
𝜀𝜀𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐹𝐹𝐴𝐴 = = = 0.000001
%ΔP A 100%

Terminology
• Demand for Ferraris is more elastic than for Apples, since 𝜀𝜀𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 > |𝜀𝜀𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐹𝐹𝐴𝐴 |
• Equivalently, Demand for Apples is more inelastic than for Ferraris, since 𝜀𝜀𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐹𝐹𝐴𝐴 < 𝜀𝜀𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
 Elastic Demand 𝜀𝜀 > 1
|%Δ𝑄𝑄𝐷𝐷 | > |%Δ𝑃𝑃|

Inelastic Demand 𝜀𝜀 < 1

%Δ𝑄𝑄𝐷𝐷 < |%Δ𝑃𝑃|

Unit Elastic Demand 𝜀𝜀 = 1

%Δ𝑄𝑄𝐷𝐷 = |%Δ𝑃𝑃|
Perfectly Inelastic Demand
• Demand is Perfectly Inelastic if
• For any price (i.e. for any −∞ < Δ𝑃𝑃 < ∞)
• The Quantity Demanded always remains the same (Δ𝑄𝑄𝐷𝐷 = 0)
• i.e. %Δ𝑄𝑄𝐷𝐷 = 0 no matter the value of %Δ𝑃𝑃

%Δ𝑄𝑄𝐷𝐷 0
𝜀𝜀 = = =0
%Δ𝑃𝑃 %ΔP

• A Buyer with Perfectly Inelastic Demand is completely insensitive to Prices

• i.e. doesn’t care about Prices at all when choosing how much to buy.
• A Perfectly Inelastic Demand Curve is a Vertical Line.
 Perfectly Elastic 𝜀𝜀 = ∞;
Demand %Δ𝑄𝑄𝐷𝐷 = ∞
for any %ΔP ≠ 0

Perfectly Inelastic 𝜀𝜀 = 0;
Demand %Δ𝑄𝑄𝐷𝐷 = 0
for any %ΔP
Perfectly Elastic Demand
• Perfectly Elastic Demand occurs when

%Δ𝑄𝑄𝐷𝐷
𝜀𝜀 = = −∞
%Δ𝑃𝑃
• Such that for any change in prices %Δ𝑃𝑃 ≠ 0
• The change in Quantity Demanded is Infinite

%Δ𝑄𝑄𝐷𝐷 = 𝜀𝜀 ⋅ %Δ𝑃𝑃 = −∞
• A Perfectly Elastic Demand Curve is a Horizontal Line.
Computing Elasticity using the Mid-Point
Formula
• Sometimes you’ll need to calculate the Elasticity of Demand between 2 points.
• Point A: 𝑃𝑃0 and 𝑄𝑄0
• Point B: 𝑃𝑃1 and 𝑄𝑄1
• You can use the Mid-Point Formula to calculate Elasticity of Demand.
Δ𝑄𝑄𝐷𝐷
𝐴𝐴𝐴𝐴𝐴𝐴. 𝑄𝑄𝐷𝐷
𝜀𝜀𝑀𝑀𝐹𝐹𝑀𝑀𝑃𝑃𝑀𝑀 =
Δ𝑃𝑃
𝐴𝐴𝐴𝐴𝐴𝐴. 𝑃𝑃
Where
𝑄𝑄 +𝑄𝑄
• 𝐴𝐴𝐴𝐴𝐴𝐴. 𝑄𝑄𝐷𝐷 = 1 0 is the average of the Quantities Demanded
2
𝑃𝑃1 +𝑃𝑃0
• 𝐴𝐴𝐴𝐴𝐴𝐴. 𝑃𝑃 = is the average of the Prices
2
Mid-Point Formula: Example
• Suppose you are an analyst doing market research for an
Automotive Manufacturer
• The Firm wants to know the elasticity of demand in the market for
cars in Brisbane.
• You collected market data for 2 years
• In 2017: 𝑃𝑃2017 = $10000 and 𝑄𝑄2017 = 1500
• In 2018: 𝑃𝑃2018 = $14000 and 𝑄𝑄2018 = 1000
• Calculate the Price Elasticity of Demand using the Mid-Point Formula
Mid-Point Formula: Example
• In 2017: 𝑃𝑃2017 = $10000 and 𝑄𝑄2017 = 1500
• In 2018: 𝑃𝑃2018 = $14000 and 𝑄𝑄2018 = 1000

• Calculate the Price Elasticity of Demand using the Mid-Point Formula

1500+1000
• 𝐴𝐴𝐴𝐴𝐴𝐴. 𝑄𝑄𝐷𝐷 = = 1250; ΔQ D = 1000 − 1500 = −500
2
10000+14000
• 𝐴𝐴𝐴𝐴𝐴𝐴. 𝑃𝑃 = = 12000; Δ𝑃𝑃 = 14000 − 10000 = 4000
2

−500
1250
𝜀𝜀𝑀𝑀𝐹𝐹𝑀𝑀𝑃𝑃𝑀𝑀 = = −1.2
4000
12000
Determinants of Elasticity of Demand
• Demand for some goods and services may be Elastic
while Demand for other products may be Inelastic.

Some Key Determinants of Price Elasticity of Demand

1. Availability of Close Substitutes
2. Time Frame of Analysis
(i.e. Period over which Change in Quantity Demanded is examined)
3. Luxury vs Necessity
4. Definition of Market
5. Share of expenditure of the good in the consumer’s budget
Availability of Close Substitutes
• If a Good has a large number of close substitutes, then consumers can
easily switch over to the substitutes if price of the Good increases.
• A Small increase in price will result in a large decrease in Quantity Demanded
• On the other hand, if a Good has no close substitutes (e.g. Petrol),
then consumers have no choice but to continue buying the Good,
even if the price increases substantially.
• A Large increase in price will result in a small decrease in Quantity Demanded
• Takeaway: If a product has more substitutes available, it will have
more elastic demand.
Time Frame of Analysis
• It takes time for consumers to make changes to their buying habits when
changes to prices occur.
• For example: If the price of petrol goes from $1/litre to $2.20/litre
• In the very short run (i.e. in the weeks following the price increase) – consumers will
find it hard to reduce petrol consumption
• But over the longer term, consumers can change their travel options, e.g.
• Move closer to school or work place
• Buy more economical cars
• Take public transport or start riding bicycles to work
• So changes in Quantity Demanded will probably be greater over the longer term
compared to the very short run.
• Takeaway: The more time that passes after the price change, the more
elastic demand for a product becomes.
Luxury vs Necessities
• Should be pretty obvious right?

• Demand for Luxuries (iPhone, Jewelry, Fashion) should be

more elastic than demand for Necessities (Food, Housing, Water).
Definition of Market
• In a Narrowly Defined market, consumers will have more substitutes compared to
be more Broadly Defined Market.

For example:
• Buyers in the Market for Oranges have a large number of substitutes for Oranges.
• Substitutes for Oranges – Apples, Pears, Mandarins, Cherries etc…
• An increase in price of Oranges will results in a big decrease in the Quantity Demanded of
Oranges as buyers choose to buy more Apples, Pears etc.
• But if we define the Market more broadly as the Market for Fruits
• There are no close substitutes for Fruits
• An increase in price of Fruits in general is unlikely to be met with a big decrease in Quantity
Demanded.

• Takeaway: The more narrowly a market is defined, the greater the elasticity.
Share of Consumer Budget
• Products that take up a small proportion of the typical consumer’s
budget tend to have more inelastic demand.

• For example: I spend around $5 per year on Salt.

• If the price of Salt triples from $2/100g to $6/100g
• will I care
• Or even notice the price increase?