Elasticity of demand and supply (SACE Stage 2 Economics)

What this dot point is asking

You need to define, calculate and interpret price elasticity of demand (PED) and price elasticity of supply (PES), explain what determines them, and connect elasticity to total revenue and the effect of taxes.

Price elasticity of demand

Price elasticity of demand measures how responsive the quantity demanded of a good is to a change in its price. The formula is:

Because demand curves slope downward, PED is normally negative, so economists usually refer to its size (absolute value).

• Elastic demand ($PED > 1$): quantity changes by a larger percentage than price. Buyers are very responsive.
• Inelastic demand ($PED < 1$): quantity changes by a smaller percentage than price. Buyers are not very responsive.
• Unit elastic ($PED = 1$): quantity changes by the same percentage as price.

Factors affecting PED

• Availability of substitutes. More close substitutes make demand more elastic.
• Necessity versus luxury. Necessities (insulin, basic food) tend to be inelastic; luxuries tend to be elastic.
• Proportion of income spent. Goods that take a large share of income (cars) tend to be more elastic.
• Time. Demand is usually more elastic over a longer period, as buyers find alternatives.

Elasticity and total revenue

Elasticity tells a firm what happens to total revenue when it changes price. Total revenue is price multiplied by quantity ($TR = P \times Q$).

• If demand is elastic, raising price reduces total revenue (the fall in quantity outweighs the higher price).
• If demand is inelastic, raising price increases total revenue.

Price elasticity of supply

Price elasticity of supply measures how responsive the quantity supplied is to a change in price:

Supply is elastic when $PES > 1$ and inelastic when $PES < 1$. Its main determinants are:

• Time. Supply is more elastic the longer producers have to adjust output.
• Spare capacity. Idle factories and labour make supply more elastic.
• Ability to store stock. Goods that can be stockpiled have more elastic supply.
• Factor mobility. The easier it is to shift resources into production, the more elastic supply is.

Why elasticity matters for policy

Elasticity explains who really bears a tax. When a government taxes a good with inelastic demand (such as tobacco or fuel), consumers cannot easily reduce their purchases, so they bear most of the tax burden and government revenue is reliable. When demand is elastic, producers bear more of the burden and quantity falls sharply. This is central to evaluating indirect taxes in the market failure dot point.

Income and cross elasticity

SACE Stage 2 also expects you to recognise two further measures beyond price elasticity.

• Income elasticity of demand (YED) measures how responsive demand is to a change in income: $YED = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in income}}$. Normal goods have a positive YED (demand rises as income rises), and luxuries have a YED greater than one. Inferior goods have a negative YED, because demand falls as income rises and consumers switch to better alternatives.
• Cross elasticity of demand (XED) measures how the demand for one good responds to a change in the price of another. Substitutes have a positive XED (a rise in the price of beef raises demand for chicken), while complements have a negative XED (a rise in the price of cars lowers demand for petrol).

These measures help firms and governments anticipate how demand will move as the economy grows or as related prices change, and they appear in source-based questions that describe shifting consumer behaviour.