2017 Topic 3 Elasticities H1

Elasticity Concepts and their
Applications
Price Price
In Demand & Supply topic, you learnt that
• Price and
Inquantity
this and demanded are inversely
following lectures, you related.
When P↑
When P↓
willlearn
• What
Quantity demanded↓
are the
Quantity
EXTENT
concepts used to
demanded↑
measure this ‘extent’?
• What are the determinants of
• Price and quantity supplied are directly related.
these extent of change?
When P↑ • What’s
Quantity
thesupplied↑
point of knowing the
When P↓  Quantity
extent supplied↓
of change?
What are the concepts used to measure
the ‘extent’ of change?
• Price and quantity demanded are

inversely related.
Price elasticity of
When P↑  Quantity demanded↓ demand (PED)
When P↓  Quantity demanded↑
• Price and quantity supplied are directly

related.
Price elasticity of
When P↑  Quantity supplied↑ supply (PES)
When P↓  Quantity supplied↓
If the price of the following items increase by 20%, what
will be the extent of fall in the quantity demanded of it by
you?
Elasticity concepts
PED PES
Definition and Formula
Sign
Magnitude/Degrees
Determinants
Applications
Price Elasticity of Demand
The price elasticity of demand (PED)

measures the degree of responsiveness of
the quantity demanded for a good to a
change in its own price, ceteris paribus
It is calculated by the formula




• The sign for PED is typically negative for all

goods and services due to the Law of
demand
Value of PED ranges from zero to infinity
Price elastic demand (1<|PED|<)
Price inelastic demand (0<|PED|<1)

0 1 ∞
If the price of the computer rises by 20%, and

quantity demanded decreases by 5%, its price
elasticity of demand would be:
Price
PriceElasticity
Elasticityof
ofDemand
Demand
If the price of the computer rises by 20%, and

quantity demanded decreases by 5%, its price
elasticity of demand would be:
Percentage change in Qdd 5% 1
  0.25
Percentage change in P 20% 4
SS’
P
Interpret the value (|PED |< 1) SS
Demand for the good is price

inelastic.
A change in the price of the good
itself results in a less than DDi
proportionate change in quantity
Qty of computer
demanded.
The price of a bouquet of roses from Far East Flora

this year is $79.90 as compared to $69.90 last year.
The manager expressed that they received 150
orders this year, down from 250 orders last year.
What is the PED for the bouquet of roses sold by Far
East Flora?
PED for the bouquet of roses
=
Interpret the value (|PED| > 1) SS’

P SS
 Demand for the good is said to be
price elastic.
 A change in the price of the good DDe

itself results in a more than
proportionate change in quantity
demanded. Qty of roses
How would the curve look like?

0 1 ∞
Perfectly price inelastic demand
(PED=0)
 Demand for the good is said to be perfectly price

inelastic.
 Quantity demanded is perfectly unresponsive to

price changes.
Perfectly price inelastic demand  Quantity

demanded is perfectly unresponsive to price changes.
P D Vertical demand curve

to represent perfectly price
inelastic demand
 Total unresponsiveness
Q
0 1 ∞
Perfectly price elastic demand
(PED=∞)
 Demand for the good is said to be perfectly price

elastic.
 Quantity demanded is perfectly responsive to price

changes.
Perfectly price elastic demand  Quantity

demanded is perfectly responsive to price changes
A small fall in the price of the good itself leads

to an infinite change in quantity demanded of
the good.
A small rise in the price above the market

price causes quantity demanded to fall to
zero.
Perfectly price elastic demand  Quantity

demanded is perfectly responsive to price changes
P In general, horizontal
demand curves are used to
D represent perfectly price
elastic demand.
 Total responsiveness
Q
0 1 ∞
Unitary price elastic demand
(PED= 1)
The percentage change in quantity demanded is

equal to the percentage change in price.
Unitary price elastic demand  The percentage

change in quantity demanded is equal to the
percentage change in price.
P The demand curve assumes

the shape of a rectangular
1% hyperbola.
D
Q
1%
0 1 ∞
Price Elasticity of Demand p.45
Recall:
Determinants of PED
Why do PED values for different
products differ?
-0.32 -2.27
-0.25
Determinants of PED
The larger the
number of
substitutes
available and the
more closely
substitutable the
goods are  the
higher the PED
value
Determinants of PED
BUT the number and closeness
of substitutes also depends
on:
a. Definition of the commodity
/ how you define the market
How different would be the price elasticity of demand for

i. PENS What are the substitutes of pens?
ii. PILOT PENS What are the substitutes of Pilot
pens?
Determinants of PED
BUT the number and closeness
of substitutes also depends
on:
b. habits
How different would be the price elasticity of demand for

rice in
i. Asia
ii. West
Determinants of PED
Proportion of consumers’ income spent on
the good
The smaller the proportion of income
spent on a good, the more price inelastic
the demand for the good and vice versa.
Increase in price  less than

proportionate fall in QDD
Determinants of PED
the good
The larger the proportion of income

spent on a good, the more price elastic
Determinants of PED
the good
The larger the proportion of income
spent on a good, the more price elastic
Increase in price  more than

proportionate fall in QDD
Determinants of PED
Demand tends to be much
more price elastic in the long
run than in the short run due
to:
a. Change in consumption habits
tm tm
b. Development of more
substitutes
c. Replacement of stock
Determinants of PED
p.45
Substitutability
Elasticity concepts
PED PES
Sign
Magnitude/Degrees
Determinants
Applications
Price Elasticity of Supply p.57
Price elasticity of supply (PES) measures the

degree of responsiveness of the quantity
supplied of a product to a change in its price,
ceteris paribus.
Price Elasticity of Supply

The value of PES is always positive, because

the quantity supplied of a good is directly
related to its price (Law of Supply).
Price elastic supply (1 < PES < )

A change in price results in a more than
proportionate change in quantity supplied.
Price inelastic supply (0 < PES < 1)

A change in price results in a less than
proportionate change in quantity supplied.
Determinants of PES
1.Time period
2.Availability & Mobility of FOPs
3.Level of stocks and ease of storing stocks
4.Length and Complexity of Production

Process
Determinants of PES
Short run period

At least 1 factor of production is
fixed. Producers can vary output
only by changing the variable
factors.
Supply is price inelastic
 0 < PES <1
Determinants of PES
Long run period

All factors of production are
variable. There is sufficient
time for producers to vary all
inputs.
 Supply is price elastic
 1 < PES < ∞
Determinants of PES
Availability & Mobility of FOPs
Spare capacity
With spare capacity (e.g. idle machines, extra
raw materials), production can be increased
quickly  More price elastic supply
Mobility of resources
- Flow of input (e.g. migrant worker)
- The ease in which raw material, labour can
be employed in different industries
Determinants of PES
Stocks or inventories
If a firm has a high level of

stocks (i.e. unsold goods), it
can quickly increase
quantity supplied in the
market when DD rises.
Determinants of PES
Length & Complexity of the Production
Process
Elasticity concepts
PED PES
Sign
Magnitude/Degrees
Determinants
Applications
a. Analyse market outcomes
b. Influence in decision-making by economic
agents
c. Analyse relative impact of changes in COP on
consumers and producers
PED
Event: Fall in SS of rice due to drought
Impact: Eqm P ↑, Eqm Q ↓, TR ?
P P
S2 S2
S1 S1
P2
P2
P1 P1
D
D
Q2 Q1 Qty of rice Q2 Q1 Qty of rice
↑Eqm P > ↓Eqm Q, ↑Eqm P < ↓Eqm Q,

TR ↑ TR ↓
PES
Event: Fall in DD for pte property due to
expected fall in income
Impact: Eqm P ↓, Eqm Q ↓, TR↓
What is the relative extent of impact between Eqm P & Eqm Qty?
agents
Influence Decision-Making
Consumers
• Make decision on WHEN to consume a good
Producers
• Make price and non-price decisions to
maximise profits
Government
• Make decisions to perform its stabilisation,
allocation, distribution and growth function
b. Decision-making by Consumers
PED; Mkt: Alcohol

Steps Explanation
1. Identify expected Impending ↑ in taxes on alcohol ->
impact of event on SS COP likely ↑ -> SS expected to ↓
2. State likely PED value |PED|<1 as few substitutes due to
and Justify addictive nature
3. Consequent expected Future Px of alcohol expected to
impact on prices increase significantly
4. Link to current & future Future MC of consumption likely to
MC be > than current MC
5. Arrive at decision Increase current consumption
b. Decision-making by Consumers
PES; Mkt: Air purifier

Steps Explanation
1. Identify expected Expect haze situation to worsen ->
impact of event on DD DD expected to ↑
2. State likely PES value PES<1 in the very SR
and Justify
3. Consequent expected Future P expected to increase
impact on prices significantly
4. Link to current & future Future MC of consumption likely to
MC be > than current MC
5. Arrive at decision Increase current consumption
Consumers
Producers
maximise profits
Government
c. Decision-making by Producers
Assume objective is to maximise profits; Profits = TR - TC
Make Pricing decisions Make Non-Price decisions

• Whether to charge higher • Make products less
or lower prices substitutable through Use PED
• Whether to charge different – Product differentiation
Use prices for the same product – Advertising
PED
ie price discrimination • On when/whether to
Use PES
replenish raw materials
c. Decision-making by Producersp.53
PED & Pricing Strategies

Price Inelastic Demand
If the producer assesses that the demand for the good is
price inelastic, he should increase the price of the good.
Pricing Strategies & PED

Price Elastic Demand
If the producer assesses that the demand for the good is
price elastic, he should lower the price of the good.
Pricing Strategies & PED
An understanding of the PED concept allows for

price discrimination
Price Discrimination: Charging different prices for the
same good despite there being no differences in cost
of production of the good.
For grp of consumers with Pricing decision
|PED| < 1 Charge a higher price

|PED| > 1 Charge a lower price
Price Discrimination eg: movie ticket prices
Consumers Determinant Increase or

of PED Reduce Price
|PED| > 1 Weekday Larger Reduce
(students) proportion of price to
income increase TR
|PED| < 1 Weekend Smaller Increase
(working proportion of price to
adults) income increase TR
* Price discrimination
Assume objective is to maximise profits; Profits = TR - TC
Make Pricing decisions Make Non-Price decisions

• Whether to charge higher • Make products less
or lower prices substitutable through Use PED
• Whether to charge different – Product differentiation
Use prices for the same product – Advertising
PED
ie price discrimination • On when/whether to
Use PES
replenish raw materials
p.54
2. Non-price decisions - Marketing strategies
Reducing the price indefinitely CANNOT
be the strategy for firms
Non-pricing decisions to reduce the substitutability of

their goods by product differentiation and advertising
Marketing and sales strategies
 through advertising or product differentiation

With the marketing strategies…
PED Application:
Make demand for the good price inelastic  producer able to
increase prices  ↑ P of his good results in a less than
proportionate ↓ in the qty dded for the gd ↑ total revenue.
if a firm finds that its supply is becoming less

price elastic but DD is expected to remain strong
or increase
 replenish its stocks of raw materials and finished
products or employ more capital /labour
Consumers
Producers
maximise profits
Government
d. Decision-making by Government
Stabilisation function
1. PED helps govt determine the extent to which a

change in supply will affect the price and/or
quantity of the good in the market
If demand of a particular good is price

inelastic, a change in supply is likely to lead
to price volatility in the market.
 Needs government intervention to stabilise prices

Few substitutes -> PED < 1
Fall in SS
Demand for agricultural products is price inelastic
P
S1
P1
Di
0 Q1 Q Qty of onions
Distribution function
2. PED allows a government to predict the

effectiveness of imposing taxes to raise tax
revenue, which could be used to redistribute
income to the needy
To raise tax revenue, the indirect tax should be

imposed on goods with price inelastic demand (e.g.
cigarettes, beer and petrol).
Demand for cigarettes/alcohol is price inelastic
P
S + tax
S
B
De
Di
0 Q
3. PED allows a government to predict the effectiveness of

policies to decrease the consumption of demerit goods
Impose tax on these goods to reduce over-allocation

of resources to these goods
But since the demand for a demerit good such as alcohol

or tobacco is price inelastic, an indirect tax which leads to
an increase in price will cause the quantity demanded for
such goods to fall by less than proportionate
Demand for cigarettes/alcohol is price inelastic
Since the dd for
P demerit good such
S + tax as alcohol or
S tobacco is price
inelastic, an indirect
tax which leads to
P1
an increase in P will
cause the quantity
demanded for such
P goods to fall by less
than proportionate.
 therefore to be
Di effective  need
larger tax
0 Q1 Q Q
Growth function
4. Predict the effect of changes in the exchange rate on

the trade balance of the country
(Trade balance: X revenue – M expenditure)
Exchange Rate:
Malaysian currency 3 RM -- 1 US$
depreciates against 4 RM -- 1 US$
US currency
OUTCOME OF DEPRECIATION PRICE CHANGE ASSUMING |PED|>1
M’sian exports to US is cheaper ↓ Price of exports ↑X

(in US$) (to US)
↓P ˣ ↑Q = TR ↑ revenue
M’sian imports from US is more ↑ Price of imports ↓M
expensive (in M’sian RM) (to M’sia)
↑P ˣ ↓Q = TR ↓ expenditure
Relevant concept: PES
p.65
Stabilisation function
1. PES allows govt to determine the extent of impact

on a market when there is a change in demand
If supply of a particular good is price inelastic, a

change in demand is likely to lead to price
volatility in the market.
Governments often intervene to stabilise the

prices.
agents
e. Analyse relative impact of changes in
COP on Consumers and Producers
• Technological Who is
advancement affected
• Changes in price of more by
Impact Cost of the change
factors of production
Production in COP –
• Government policies Consumers
• Taxes or
• Subsidies Producers?
e. Analyse relative impact of increase in
Imposition of tax  COP ↑ SS ↓
P S + tax
Impact on
consumers S
P1
Pe Tax
P1-t
Impact on D
producers
Q
Q1 Qe
Relative impact
P S + tax
Impact on depends on PED
consumers relative to PES
P1 S
Consider
Tax |PED|<PES
Pe
P1-t Impact on
consumer is
Impact on larger
producers D
Q
Q1 Qe
P S + tax
Impact on S Consider
consumers PED>PES
P1
Pe Impact on
Tax producer is
D
larger
P1-t
Impact on
producers
Q
Q1 Qe
e. Analyse relative impact of fall in COP on
Consumers and Producers
Govt grant subsidy  COP ↓  SS ↑
P
S
Impact on
producers P3 S + subsidy
P1 Subsidy
P2
Impact on
consumers D
Q
Q1 Q2
P
Relative impact
S depends on PED
Impact on
producers S + subsidy and PES
P3
Consider
P1
|PED|<PES
Subsidy
P2
Impact on
consumer is
Impact on larger
consumers
D
Q
Q1 Q2
P
S
Impact on
P3 S + subsidy
producers
Consider
P1
Subsidy |PED|>PES
P2 Impact on
producer is
Impact on larger
D
consumers
Q
Q1 Q2
Limitations of Elasticity Concepts
1. Ceteris paribus assumption does not hold in reality
- can have concurrent changes that affect DD and
SS
2. Elasticity values are estimates
- values are estimated using data from surveys,
which may not be representative or reliable
3. Time lag
- data may be outdated, collected based on past
behaviour
4. Cost considerations
- in adopting non-price strategies such as
advertising, firms incur additional cost which
reduces their profits  limited in usefulness
Impact of Government Intervention
(pg. C50)
Price ceiling / maximum price:
a legal maximum price at which the good can be sold
Prevent high prices of

Price
Black Market
S especially goods/services that
Price satisfy basic needs such as
Pb
food, water and electricity
BUT
Pe
• Low quantity supplied (Qs)
Pceiling
 not all of the low income
Shortage D
grp can benefit anyway
Qs
Quantity • Black market could arise
Qe Qd
(pg. C50)
Price floor / minimum price:
a legal minimum price at which the good can be sold
Ensure a minimum level of income
E.g. pdtn of gds such as agricultural pdts
Price
Surplus S
is subject to climatic conditions. Price
Pfloor
floor protects the producers from
experiencing significant falls in income
Pe BUT
• Strain on the government’s budget,
D opp cost
Quantity of
Qd Qe Qs rice • High price  low pressure to adopt
the most cost efficient mtd of pdtn 
productive inefficiency
(pg. C50)
Quota is a legal restriction on the quantity of goods and
services that can be produced in a particular time
period:
A quota limits the no. of gds directly
- Not subjected to consumers’ and
producers’ responsiveness to price
changes (as is the case with taxes) 
outcome of the policy is more
certain.
BUT
• producers, in trying to maximise
profits, may attempt to produce
beyond the quota  black markets
may develop
Application:
Elasticities of Demand & Supply of
Labour (pg. C43)
Wage elasticity of demand for labour measures the
responsiveness of quantity demanded of labour to a change
in the wage rate, c.p.
S’
• measures the extent of

movement along the dd
curve when ss curve
shifts
Application:
Labour
Determinants of wage elasticity of demand for labour:
Ease of substitution btwn labour & other factors of production
The more substitutable labour is with other factors of production,
the more wage elastic will be the demand for labour
Application:
Labour
Wage cost as a proportion of total production cost (the larger
the proportion, the more elastic will be the demand)
Application:
Labour
Time period
With sufficient time, firms can
respond to a change in wage rates by
reorganising their production
process.
Application:
Labour
The price elasticity of demand for the final product
If the demand for a product is price elastic:

↑ in wages of workers  ↑ COP of the good  ↓ss of the gd 
↑ in the price of the good  ↓ qty dded of the gd
Result in large decrease in the
quantity of labour employed.
Application:
Labour
Wage elasticity of supply of labour measures the
responsiveness of quantity supplied of labour to a change in
the wage rate, c.p.
• measures the extent of

movement along the ss
curve when dd curve
shifts
D’
Application:
Labour
Determinants of wage elasticity of supply of labour:
Mobility of labour
The higher the Do alternative jobs require

willingness and ability of similar skills?
labour to move to another job, If alternative jobs require
the more elastic will be the different skills, is it easy to
supply of labour. learn these skills?
If there’s a similar job in
another location, are labour
willing to move?
Application:
Labour
Determinants of wage elasticity of supply of labour:
Time period
• In the long run, people have
to time to acquire new skills
 More elastic supply of
labour
• Changes can be made to the

education system to better
prepare labour for the
changing demands of the
economy / industries.
Elasticity concepts
PED PES

Sign
Magnitude/Degrees
Determinants
Applications:
• Relevance of the concepts for Limitations
consumers, producers and the govt
• Wage elasticity of dd & ss of labour
• Impact of govt intervention

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Elasticity Concepts and their

• Price and quantity demanded are

• Price and quantity supplied are directly

Definition and Formula

The price elasticity of demand (PED)

It is calculated by the formula

It is calculated by the formula

It is calculated by the formula

It is calculated by the formula

• The sign for PED is typically negative for all

Price elastic demand (1<|PED|<)

Price inelastic demand (0<|PED|<1)

If the price of the computer rises by 20%, and

If the price of the computer rises by 20%, and

Demand for the good is price

The price of a bouquet of roses from Far East Flora

Interpret the value (|PED| > 1) SS’

 A change in the price of the good DDe

How would the curve look like?

 Demand for the good is said to be perfectly price

 Quantity demanded is perfectly unresponsive to

Perfectly price inelastic demand  Quantity

P D Vertical demand curve

 Demand for the good is said to be perfectly price

 Quantity demanded is perfectly responsive to price

Perfectly price elastic demand  Quantity

A small fall in the price of the good itself leads

A small rise in the price above the market

Perfectly price elastic demand  Quantity

The percentage change in quantity demanded is

Unitary price elastic demand  The percentage

P The demand curve assumes

How different would be the price elasticity of demand for

How different would be the price elasticity of demand for

Increase in price  less than

The larger the proportion of income

Increase in price  more than

Definition and Formula

Price elasticity of supply (PES) measures the

It is calculated by the formula

The value of PES is always positive, because

Price elastic supply (1 < PES < )

Price inelastic supply (0 < PES < 1)

2.Availability & Mobility of FOPs

3.Level of stocks and ease of storing stocks

4.Length and Complexity of Production

Short run period

Long run period

If a firm has a high level of

Definition and Formula

↑Eqm P > ↓Eqm Q, ↑Eqm P < ↓Eqm Q,

PED; Mkt: Alcohol

PES; Mkt: Air purifier

Make Pricing decisions Make Non-Price decisions

PED & Pricing Strategies

Pricing Strategies & PED

Pricing Strategies & PED

An understanding of the PED concept allows for

For grp of consumers with Pricing decision

|PED| < 1 Charge a higher price

Consumers Determinant Increase or

Make Pricing decisions Make Non-Price decisions

Non-pricing decisions to reduce the substitutability of