Office Hours: Elasticity of Demand

Today, we'll be applying elasticity of demand in the real world. We'll do so with two examples.

First, suppose in your college town, real estate developers are building thousands of new student-friendly apartments close to campus. If you want to pay the lowest rent possible, should you hope that demand for apartments is elastic or inelastic?

As always, try to answer the question by yourself. Check out our video on Elasticity of Demand, attempt the problem, and then come back, and we can work through it together.

An easy way to approach this problem is to test it out with extreme examples. What happens when demand is very elastic, and what happens when demand is very inelastic?

First, let's imagine an apartment is, say, $600, and that demand is very elastic. These are our most price-sensitive consumers. Now, if real estate developers build more houses, the supply curve will shift out. Note that the demand curve does not change, so we move along the demand curve. Clearly, demand will increase.

But here's the thing -- if demand is very elastic, the price won't change all that much. Housing cost decreased by a bit, but you might not even notice the change. Let's see if there's a better price with very inelastic demand.

So start with the initial conditions again -- an average apartment is $600. By the way, a trick for distinguishing between inelastic and elastic is that a perfectly inelastic line looks like an "I," for inelastic. So housing increases in the area and supply shifts out. Now, what happens to demand? It barely budges!

Perhaps more surprisingly, the price falls by quite a bit. Now this is great news for college kids and any renters out there. If we compare this to the price drop from our elastic demand curve, it's much lower. So if you're a student hoping to pay the lowest rent possible, you'd hope for an inelastic demand curve in this case.

Let's try one more example to ensure you've got the hang of it. Now let's say the local government announces that thousands of apartments close to campus are uninhabitable and must be torn down next semester. If you want to pay the lowest rent possible in this case, should you hope that demand for apartments is elastic or inelastic?

We'll use the same approach we used last time. First, suppose demand is very elastic. If apartments are suddenly condemned, then in the short run this causes a rapid drop in the supply of available apartments, and the supply curve shifts back. Our new equilibrium price is slightly higher and the quantity is much lower. Once again, elastic demand means consumers are very responsive to changes in price.

But, if the demand curve were inelastic, closer to looking like an "I," even a small decrease in quantity would trigger a large increase in price. In comparison to our elastic demand, the price is much higher.

So if you're hoping to pay the lowest rent possible, you'd hope for an elastic demand curve in the case of apartment shortages, such that a large drop in supply would result in only a small increase in rental price.

Let's sum up. In both examples, elastic demand was very price-sensitive. Small changes in price, up or down, led to large changes in demand. Inelastic demand, on the other hand, was less responsive to changes in price. The price had to drop by quite a bit to get the same change in quantity demanded. So, inelastic demand works in our favor when supply increases and shifts out, but works against us when supply shrinks and shifts back.

As always, let us know what you think. And if you'd like more practice, check out our additional brain teasers at the end of this video.