Elasticity of Demand and Supply
This section covers price, income and cross elasticity, which the exam tests through calculations, interpretation and links to total revenue. You must be able to classify elasticities and apply them to business and tax decisions.
Core rules
- Price elasticity of demand (PED) = percentage change in quantity demanded ÷ percentage change in price. Usually negative; exam answers often use the absolute value.
- PED > 1 is elastic; PED < 1 is inelastic; PED = 1 is unit elastic; PED = 0 is perfectly inelastic; PED = infinity is perfectly elastic.
- Determinants include substitutes, necessity versus luxury, share of income, time period and habit.
- If demand is elastic, a price cut raises total revenue. If demand is inelastic, a price rise raises total revenue. Unit elastic demand leaves revenue unchanged.
- Price elasticity of supply (PES) measures responsiveness of quantity supplied to price. Supply is more elastic in the long run.
- Income elasticity: positive for normal goods, negative for inferior goods. Cross elasticity: positive for substitutes, negative for complements.
Worked example
Price rises from 10 to 12, and quantity demanded falls from 100 to 80. Percentage change in price = 2/10 × 100 = 20%. Percentage change in quantity = -20/100 × 100 = -20%. PED = -20 ÷ 20 = -1, so demand is unit elastic. Total revenue initially is 10 × 100 = 1,000; finally 12 × 80 = 960. The small fall occurs because the simple percentage method gives -1, while the midpoint method gives approximately -1.22, which is elastic. State your method.
Traps
Do not drop the sign unless the question asks for magnitude; do not confuse elastic with luxury only; do not use quantity changes without dividing by the original; do not assume a price rise always raises revenue.