Price Elasticity of Demand and Supply

Price Elasticity of Demand and Supply — The Sensitivity Metric That Runs Real Markets

Price moves. Quantity reacts. Elasticity tells you how much it reacts. Learn this once and you’ll read pricing charts, promo calendars, vendor quotes, tax proposals, and “surge” screens like an operator. Elasticity is the sensitivity dial built into every demand curve and every supply curve. Flip it from theory to practice and you gain a repeatable method for pricing, forecasting, stocking, and negotiating.

Elasticity lives at the center of microeconomics, but it behaves like a simple KPI. It is a ratio of percentage changes. That’s it. The math is friendly. The value lies in interpretation and in clean data. By the end of this chapter you should be able to calculate elasticities with a spreadsheet, classify markets by sensitivity, predict revenue responses to price changes, and explain who bears a tax or a subsidy in plain English. You will also see how time, substitutes, capacity, and market structure tilt the numbers.

The core idea in one line

Elasticity = percentage change in quantity divided by percentage change in price.
Demand elasticity uses quantity demanded. Supply elasticity uses quantity supplied. Economists write it with a negative sign on demand because the curve slopes down. In business talk, we usually drop the sign and talk about sensitivity in absolute value.

If the value is greater than one, quantity reacts strongly. If the value is less than one, quantity barely moves. Around one, the response is proportional.

Why percentage changes, not raw changes

A drop from 20 to 18 is a bigger deal if the item started at 20 than if it started at 200. Percentages let you compare across prices and products. Using percentages also keeps the unit of measurement out of the way. You can measure soda in cans and gasoline in liters and still compare sensitivities.

To avoid weird results when moving from one price-quantity point to another, use the midpoint formula so the direction of change does not change the answer.

Midpoint elasticity of demand between two points:
Elasticity =

Same structure for supply.

Reading the scale – elastic, inelastic, unit elastic

If demand is elastic at a price range, a small price cut raises quantity a lot. Revenue rises because the volume effect wins. If demand is inelastic, a price cut barely moves quantity. Revenue falls because you gave up price without getting enough volume. Unit elastic is the tipping point where the percentage gains in quantity match the percentage loss in price.

Supply reads the same way. When supply is elastic, producers ramp output quickly after a price increase. When supply is inelastic, capacity and inputs are tight, so quantity barely budges in the short run.

Quick numerical check that always works

Suppose a store sells 100 units at 20 last week. This week it sells 130 units at 18. Using midpoints:

Average quantity is (100 + 130) divided by 2 which is 115. Quantity change is 30, so percentage change in quantity is 30 divided by 115 which is roughly 0.2609 or 26.09 percent.

Average price is (20 + 18) divided by 2 which is 19. Price change is minus 2. Percentage change in price is minus 2 divided by 19 which is about minus 0.1053 or minus 10.53 percent.

Elasticity is 0.2609 divided by 0.1053 which is about 2.48 in absolute value. That is elastic demand. In that range, a discount grew revenue.

This is the kind of back-of-the-envelope math that wins quick pricing debates.

Determinants of demand elasticity – why buyers react

Number and closeness of substitutes. If buyers can switch to a similar product, demand is elastic. Think streaming platforms. If a show moves, viewers move. If the product is one-of-a-kind in buyers’ minds, demand is inelastic. Strong branding tries to pull a product out of the substitute game by changing perceived uniqueness.

Share of budget. Items that take a tiny slice of spending, like salt, usually have inelastic demand. Items that hit the wallet hard, like airline tickets, tend to be elastic.

Time horizon. Short run, buyers are stuck with habits. Long run, they adjust. Home coffee gear replaces daily café visits after months, not days. Elasticity rises with time.

Definition of the market. “Soft drinks” has more substitutes than “brand X cola in a 330 ml can,” so elasticity tends to be larger the broader you define the category.

Necessity versus “nice to have.” Essential medicine is often inelastic. Premium add-ons are often elastic. The labels depend on the buyer’s situation, so treat them as context, not dogma.

Expectations. If buyers expect prices to rise next month, current demand grows and looks less sensitive today.

Determinants of supply elasticity – why sellers react

Flexibility of inputs. If a factory can switch lines or add overtime, supply is elastic. If it needs months to install equipment or secure permits, supply is inelastic in the short run.

Inventory and storage. Goods that store well, like canned food, respond faster than fresh items or bespoke services. Inventory is a shock absorber that raises short run elasticity.

Spare capacity. Idle machines or available drivers make supply elastic. You can ramp from Monday to Wednesday. Tight capacity steepens the supply curve.

Time horizon. Over months and years, firms can add plants and workers, redesign processes, or find new suppliers. Long run supply is usually more elastic than short run supply.

Market entry and exit. If new firms can enter easily, industry supply expands and looks elastic. If licenses, patents, or scale effects block entry, supply holds tight.

The “total revenue test” for demand

Revenue equals price times quantity. If a small price cut raises revenue, demand is elastic in that range. If a small price rise raises revenue, demand is inelastic. This is a quick dashboard for managers. You still want elasticity estimates for precision, but the revenue test is fast and directional.

One trap to avoid: effective price includes coupons, bundles, student plans, and fees. If you look only at list price, your test may lie. Always use the price buyers actually pay.

Cross-price elasticity and income elasticity — the spillover channels

Cross-price elasticity of demand measures how the quantity of one good responds to a price change in another good. Positive means substitutes. Negative means complements.

If the price of ride-hailing rises and e-scooter usage jumps, that positive number tells planners the products are substitutes at the margin. Bundle design, partnerships, and promo calendars should respect those links. Console makers discount the device because games are complements. The policy sits on negative cross-price elasticities.

Income elasticity of demand tracks how quantity moves with income. Positive for normal goods. Negative for inferior goods. Large positive values flag categories that surge in expansions and get hammered in recessions. Retailers manage exposure across categories using these patterns. For a high school reader, think of the difference between basic staples and premium apparel during a local downturn.

Elasticity along a single curve is not constant

Demand can be elastic at high prices and inelastic at low prices on the same curve. Why. At high prices, a small percentage change in price is a big chunk of money, so buyers react strongly. At low prices, the same absolute change is a tiny percentage, so buyers barely notice. Do not assume one number rules the whole range. Estimate elasticity where you operate most of the time and re-estimate after you shift price tiers.

Supply also changes shape across ranges. Below capacity, a small price increase can bring a big quantity jump because idle resources switch on. At capacity, the curve steepens. Quantity barely moves without large price changes or long lead times.

From elasticity to tax incidence – who actually pays

A per-unit tax wedges the price buyers pay above the price sellers receive. Quantity falls. Who bears the burden. The side that is less elastic carries more of it. If buyers have few substitutes, the buyer price jumps. If supply is tight and sellers cannot ramp, seller revenue per unit falls more. Laws about who writes the check do not decide the split. Elasticities do.

This logic runs through real policies. A city fee on rides at the airport falls mostly on travelers if their demand is inelastic at that location and time. A farm subsidy flows mostly to landowners if the supply of prime land is very inelastic. The diagram is simple, but the conclusion is powerful: options determine burden.

Minimum wage, floors, ceilings, and elasticity

With a price floor above the equilibrium, a surplus appears. The size of the surplus depends on elasticities. If demand is very inelastic and supply is elastic, quantity barely changes and the price floor has smaller side effects on traded volume. Reverse the elasticities and you get a bigger contraction. With a price ceiling below equilibrium, the shortage size depends on elasticities. Inelastic supply and elastic demand make the shortage large. Managers plan around these pressures, especially in housing and labor markets.

Why this matters for pricing strategy and promotions

Say your elasticity estimate for a snack is 1.6 around the current price. A five percent discount is expected to lift quantity by about eight percent. Revenue rises roughly three percent in the short run. That is the case for a promo. If the same product reads 0.5, a five percent discount is expected to raise quantity by only two and a half percent. Revenue drops. That is the case for holding price and improving shelf placement instead.

For subscriptions, elasticity can differ by cohort. Early adopters who love the product are inelastic. New sign-ups acquired by discounts are elastic. Treat cohorts differently. That is smart pricing, not trickery.

Estimating elasticity with real store data

You do not need a statistics degree to get a working number.

Collect weekly data: price paid after promotions, units sold, stockout flags, and a simple competitor price index. Use the midpoint formula between adjacent weeks to compute elasticities and average the values for similar weeks. Segment out holidays or big events. If a rival ran a massive promo, mark that week and keep it out of the base estimate.

To level up, run a simple regression in a spreadsheet. Put units on the left side. Put price, promo flag, holiday flag, and competitor price on the right side. The price coefficient gives you the slope. Convert that into an elasticity at the average price and quantity by multiplying the coefficient by price divided by quantity with a negative sign for demand. You now have a point elasticity at the mean. It is not perfect. It is often good enough for better decisions on Monday morning.

For supply, look at how your own shipped quantity responds to changes in the price you receive, controlling for input costs and capacity. Vendor lead times and fill rates act like early warnings for shifting supply elasticity.

Segment elasticity — different audiences, different reactions

Averages hide the game. Students, families, and business buyers react differently to the same price. New customers and long-time users do too. Geography matters. A city with many close substitutes shows higher elasticity than a town with one store.

Smart teams estimate elasticities by segment or channel. Example. Online buyers of laptop sleeves may be more price sensitive than in-store buyers who need the item today. Keep prices a bit lower online and a bit higher in-store to match sensitivity and convenience value. This is textbook third-degree price differentiation without the jargon. You match price to sensitivity across groups in a fair and transparent way.

Price endings, reference prices, and behavioral angles

Elasticity is not only about economic substitutes. Psychology shifts sensitivity. Reference price is the number buyers expect to see. If the common price for a paperback is 9.99, moving to 12.49 can trigger a stronger response than the percentage change suggests because it breaks the mental anchor. Price endings like .99 or round numbers can change reactions at the margin. Framing a discount as a limited-time offer can shift perceived urgency and short-run elasticity. Treat these as small nudges layered on top of the core economic picture. They matter most near thresholds.

Extreme cases to remember

Perfectly inelastic demand is a vertical line. Quantity does not respond to price at all. Rare in practice, but some life-saving medications look close in the short run.

Perfectly elastic demand is a horizontal line. Buyers are willing to buy any amount at one price but nothing at a higher price. Think commodity resellers facing a posted market price.

Perfectly inelastic supply is a vertical line. Quantity is fixed. Stadium seats tonight behave like this. Perfectly elastic supply is a horizontal line. Producers supply any amount at one price. Some digital goods look like this over a range when capacity is not a constraint.

These extremes are teaching devices. Real markets sit between them, but the extremes anchor your intuition.

Putting it to work – four concrete cases

1. Ride-hailing on a rainy Friday at 18:00. Demand spikes as commuters avoid the rain. In the first ten minutes, supply is inelastic because only logged-in drivers are nearby. Price jumps and quantity moves little. After thirty minutes, more drivers log in and supply becomes more elastic. The surge eases. Same market, different elasticities over time.
2. Seasonal apparel after the holiday rush. Demand softens. The retailer faces elastic demand among bargain hunters, so markdowns move units. Supply is relatively elastic because the warehouse can ship as long as sizes exist. This is why clearance works until size availability collapses, at which point the effective supply curve steepens and extra discounts produce smaller gains.
3. Smartphone launch and accessory planning. Device price cuts late in the cycle shift case demand left next quarter because fewer new devices enter pockets. Accessory sellers misread this if they look only at last year’s average. Correct planning uses cross-price links and sets orders with the supply curve in mind. If the case factory can switch molds quickly, supply is elastic and the seller can wait to order. If molds are slow and minimum order quantities are high, supply is inelastic and early orders lock risk.
4. Cafe and a city wage rule change. Labor cost per drink rises. The cafe’s supply curve shifts left. If customer demand for morning coffee near that station is inelastic, a small price increase keeps revenue intact and quantity barely falls. If demand is elastic because multiple cafes and kiosks sit within twenty meters, quantity drops sharply, so the cafe focuses on process changes that shift supply back right over months. Mobile order pick-up and batch prep reduce labor minutes per drink, making supply more elastic in the next quarter.

Elasticity and revenue forecasting that your boss will sign off

Build a small table with three price points near the current price. For each, apply your demand elasticity estimate to project quantity. Multiply by price to get revenue. If your estimate says demand is elastic where you operate, the revenue peak will appear at a lower price than today. If it is inelastic, the peak will sit above today’s price. Sanity check with competitor prices and with past promos. Then pick the point that balances revenue, margin, and brand position.

Always track what actually happens. Recompute elasticity monthly. If your number drifts, ask why. Substitutes change. New channels appear. Macro conditions move income elasticity. A simple dashboard with price, quantity, promo type, and competitor index keeps you honest.

Elasticity and cost pass-through

Suppliers often raise their prices after input costs jump. Pass-through depends on demand elasticity on the buyer side and supply elasticity upstream. If your customers are inelastic and your competition faces the same cost shock, you can pass through more without losing much volume. If customers are elastic and your rivals have locked cheaper input contracts, pass-through fails. In those cases you either accept lower margin temporarily or switch inputs to shift your own supply back right.

This is where procurement and pricing teams must talk to each other. Elasticities are shared truths across departments. When they disagree, the company loses money through misaligned moves.

Elasticity in digital markets

Digital goods with near-zero marginal cost create interesting shapes. Supply can look flat over a range because once the platform is up, serving another user costs little. Demand can be very elastic when there are many alternatives. Small price cuts can move large volume. At the same time, congestion, bandwidth, or attention can create capacity limits that steepen supply for short windows. A viral event can make the effective supply curve vertical for an hour if servers throttle. Elasticity is still the right language. It just shifts fast with traffic and constraints.

How to keep the math honest

Always measure effective price. Include coupons, taxes that buyers pay at checkout, shipping, and mandatory fees. Log stockouts. A week with a stockout is not a measure of weak demand. It is a measure of missing inventory. Use consistent time windows. Weekly is fine for retail. Hourly might be right for ride-hailing. Watch for simultaneity where price responds to demand shocks in the same period. If you raise price on busy days, a naive regression can claim that higher price causes higher quantity. Use promo flags, weather, or external instruments to control for that effect, or use planned experiments where you set price ex ante.

Elasticity and ethics – price during emergencies

During natural disasters or blackouts, demand becomes inelastic for essentials and supply becomes tight. Some regions enforce rules against large price jumps in these periods. From a model standpoint, ceilings create shortages. From a civic standpoint, many communities prefer rationing to extreme prices for life necessities during a crisis. You do not need to agree with every policy to predict outcomes. Elasticity clarifies the tradeoffs and helps stores plan fair limits, early restocking, and clear communication.

Linking to other core ideas

Elasticity connects to consumer surplus and producer surplus. When a tax reduces quantity, the triangle of lost trades is deadweight loss. The size of that triangle depends on elasticities. Flatter curves create larger gaps for a given wedge. Elasticity also links to marginal revenue in advanced classes, where the slope of the demand curve influences optimal pricing under limited competition. For our purpose, remember this: sensitivity shapes how price changes map into revenue, margin, and quantity. That is enough to run better playbooks in most real settings.

A student-ready workflow for Hozaki learners

Take a product category you know: hoodies, phone cases, coffee drinks, or digital subscriptions with a student plan. Collect eight weeks of prices paid and units sold. Compute midpoint elasticities between adjacent weeks. Flag holidays, stockouts, and competitor promos. Remove the outliers. Average the rest. Now you have a workable number. Write one paragraph that explains what a five percent price change would do to quantity and to revenue. That paragraph is your internal memo. If you can write it, you can make a case to a manager.

Frequently asked questions, answered quickly

• Is elasticity the same as slope? No. Slope uses unit changes and depends on the scale of the axes. Elasticity uses percentage changes and is unit free. Same curve, different measures.
• Can elasticity be different at morning and evening for the same product? Yes. Time changes substitutes and urgency. A commute-hour ride has more inelastic demand than a Sunday afternoon ride.
• Why do airlines change prices so often? Seats for a specific flight have inelastic supply in the short run. Demand segments vary by time and date. The system estimates elasticities by segment and adjusts fares to fill the plane while maximizing revenue.
• Why are on-campus cafes more expensive? Fewer substitutes nearby and high convenience value make demand less elastic. Students pay for time saved between classes.
• Do free trials change elasticity? They shift perceived value and lower switching costs, which can make demand more elastic after the trial if rivals offer similar trials. Companies counter with features or communities that reduce substitutability.

Two extended worked examples with step-by-step numbers

Example A: A streaming service sets student pricing.
Base monthly price is 12. Ninety-day test data with student email verification show that a move from 12 to 10 increases student sign-ups from 50 thousand to 70 thousand per month. Use midpoints.

Average quantity is (50k + 70k) divided by 2 which is 60k. Quantity change is 20k. Percentage change in quantity is 20k divided by 60k which is 0.3333 or 33.33 percent.

Average price is (12 + 10) divided by 2 which is 11. Price change is minus 2. Percentage change in price is minus 2 divided by 11 which is about minus 0.1818 or minus 18.18 percent.

Elasticity is 0.3333 divided by 0.1818 which is about 1.83 in absolute value. That is elastic. Revenue per student fell from 12 to 10, but total revenue from students rose from 600k to 700k per month because quantity rose more than price fell. The company also tracks churn and cross-sells. If bundled services raise average revenue per user by 1 at the new tier, the price move looks even better.

Example B: A bakery faces a flour price shock.
Flour costs jump by 20 percent due to a supply disruption. The bakery’s short run supply is inelastic because ovens and staff are fixed this month. It estimates the price elasticity of demand for its best-selling loaf at 0.4 in absolute value around today’s price. If the bakery passes the entire cost increase to consumers, the price per loaf rises by, say, 10 percent. Quantity falls by about 4 percent based on elasticity. Revenue per loaf rises. The bakery keeps quantity close to target while protecting margin. Over the next quarter, the bakery invests in mixing process improvements that reduce wasted dough and shift its supply curve right. Supply becomes more elastic because output per hour improves. When flour prices normalize, the bakery can lower price faster than rivals and gain share.

The math is simple. The discipline is in getting the elasticity right and updating it as conditions change.

A clean mental model you can carry into any meeting

1. Step one. Identify whether the market move is a change in price or in other conditions. If it is a price change with everything else stable, you have a movement along a curve. If it is a cost shock, a promo, a viral post, or a change in competitors, you have a shift of demand or supply.
2. Step two. Classify elasticity on the relevant side. Elastic, inelastic, or around one. Use your estimate.
3. Step three. Infer what happens to revenue, margin, and quantity in the short run. Then add the long run view. Do buyers gain options over months. Can you unlock capacity.
4. Step four. Decide. Adjust price, timing, or capacity with the numbers in hand. Then monitor and update.

That is the playbook. No mystique. Just a repeatable loop.

A Final Note

People who master elasticity early will walk into their first roles with a rare advantage. You will know how to read a pricing table, argue for or against a markdown, forecast the hit from a fee, and call out bad metrics that ignore effective price or stockouts. You will see why a city rule changes who pays for a service. You will understand why a promo flopped even though the creative looked great. You will be able to use basic spreadsheet skills to estimate the numbers your team needs.

Elasticity is small math with big decisions attached. Give it the respect you give the times table. Keep a simple sheet for midpoint calculations. Tag weeks with meaningful events. Update the number as markets shift. That is old-school rigor with modern data. That is how you turn theory into outcomes.