What this lesson teaches
I can use price, income and cross elasticities to judge how large those changes will be.
Syllabus 9570, 2.1.2(g). Demand and Supply Analysis and its Applications: These outcomes can be affected by price elasticities of demand and supply, income and cross elasticities of demand
Make a guess
Demand for private homes jumps as incomes rise. New homes take years to build. In the first year, what mostly happens?
- Prices and homes sold both rise by about the same percentage.
- Many more homes are sold, and prices barely change.
- Prices rise a lot, and the number of homes sold barely changes.
Show the answer
Prices rise a lot, and the number of homes sold barely changes.
Supply is very price inelastic in the short run. Developers cannot add homes quickly, so the extra demand shows up mostly as higher prices.
When demand rises, inelastic supply means a big price rise and a small quantity rise.
Elasticity tells us how a shift in one curve is split between a change in price and a change in quantity.
When demand rises: if supply is inelastic, producers cannot raise output much, so most of the change shows up as a higher price. If supply is elastic, output rises a lot and the price barely moves.
When supply falls: if demand is inelastic, buyers keep buying, so the price rises a lot and quantity falls little. If demand is elastic, the price rises a little and quantity falls a lot.
This explains why prices of housing and fresh food can swing sharply, while prices of manufactured goods are more stable.
Farm prices are especially volatile for three reasons. Supply shifts often, because weather, disease and pests change harvests. Supply is price inelastic in the short run, because crops are planted months or years before they are sold. And demand for food is price inelastic, because people need to eat. So a poor harvest causes a large price rise, and a good harvest a large fall.
Cocoa shows this. After poor harvests in West Africa, which grows most of the world's cocoa, the world price more than tripled between early 2023 and 2024. New cocoa trees take years to bear fruit, so supply could not respond quickly.
Put these in order
A poor cocoa harvest sends the world price soaring. Put the chain in order.
- The world price has to rise a long way, and more than triples.
- Supply cannot respond quickly, so the price stays high for years.
- Chocolate makers keep buying almost as much as before.
- Bad weather and disease cut the West African cocoa harvest.
- The supply of cocoa shifts to the left.
Show the answer
- Bad weather and disease cut the West African cocoa harvest. A smaller harvest means less cocoa reaches the market at every price.
- The supply of cocoa shifts to the left. Less cocoa is for sale, but chocolate makers have no close substitute for it, so demand is price inelastic.
- Chocolate makers keep buying almost as much as before. When buyers hold on like this, only a large price rise can clear the shortage.
- The world price has to rise a long way, and more than triples. The high price gives farmers a reason to plant more, but new trees take years to bear fruit.
- Supply cannot respond quickly, so the price stays high for years.
- Demand rises, inelastic supply
- Big price rise, small quantity rise.
- Supply falls, inelastic demand
- Big price rise, small quantity fall.
- Farm prices
- Frequent supply shifts + inelastic supply and demand = volatile prices.
Worked example: Why property prices jump
Suppose demand for private housing rises sharply as incomes grow and interest rates fall.
- New homes take years to build, so supply is very price inelastic in the short run.
- The rise in demand therefore shows up mostly as higher prices, not more homes.
- Over several years, developers build more, supply becomes more elastic and price pressure eases.
- This is one reason the government uses cooling measures in the short run and land sales in the long run.
Watch out for this
The size of the price change depends only on how big the shift is.
The size of the shift matters, but so does the elasticity of the other curve. The same shift gives very different price changes.
Check your understanding
A drought cuts the supply of rice. Demand for rice is price inelastic. What is the likely result?
- Little change in price, because inelastic demand means buyers keep buying.
- A large rise in price and a small fall in quantity.
- A small rise in price and a large fall in quantity.
Show the answer
A large rise in price and a small fall in quantity.
Right. Buyers keep buying rice, so the adjustment happens mostly through the price.