Chapter Three

Elasticity and its Application

 Elasticity of Demand

• Measures the responsiveness of quantity demanded of a

product due to a change in price of product itself, price of
other goods, and income.

• Three types of elasticity of demand:

i) Price elasticity of demand;
ii) Cross elasticity of demand; and
iii) Income elasticity of demand.
i) Price elasticity of demand
• measures the responsiveness of the quantity demanded
of a product due to the change in its price.

• or a measure of the extent to which the quantity

demanded of a good changes when the price of the
good changes and all other influences on buyers’ plans
remain the same.
 Price Elasticity of Demand

• Measuring Responsiveness to Price Changes

• Relatively Elastic or Inelastic
• Price-Elasticity Coefficient and Formula

Percentage Change in Quantity

Demanded of Product X
Ed = Percentage Change in Price
of Product X
 Determinants of price elasticity of demand

i) Availability of substitutes;

ii) Relative importance of the good in the budget (Share

of budget spent on the product);

iii) Type of good;

iv) Time dimension;

v) Habits.
 Estimated Price Elasticity of Demand

_______________________________________
Item Short run Long run
Automobile 1.87 2.24
Movies 0.87 3.67
Medical care 0.31 0.92
Housing 0.30 1.88
Gasoline 0.20 0.70
Foreign travel 0.10 1.77
Air travel 0.10 2.40
________________________________________
 Degrees of Price Elasticity of Demand

Demand is elastic

Demand is inelastic

Demand is unitary elastic

Demand is perfectly elastic

Demand is perfectly inelastic

 The Total Revenue Test

TR = P x Q

Elastic Demand
P
$3

a
2

b
1
D1

0 10 20 30 40 Q
The Total Revenue Test

TR = P x Q
Inelastic Demand
P
$4 c

d
1
D2
0 10 20 Q
 The Total Revenue Test

TR = P x Q
Unit-Elastic
P
$3 e

f
1
D3

0 10 20 30 Q
 Elasticity on a Linear Demand Curve

Price Elasticity of Demand for Movie

Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1)
Total Quantity of (3) (4) (5)
Tickets Demanded (2) Elasticity Total Revenue Total-Revenue
Per Week, Thousands Price Per Ticket Coefficient (Ed) (1) X (2) Test

1 8 $8,000
2 7
] 5.00
14,000
] Elastic

3 6
] 2.60
18,000
] Elastic

4 5
] 1.57
20,000
] Elastic

5 4
] 1.00
20,000
] Unit Elastic

6 3
] 0.64
18,000
] Inelastic

7 2
] 0.38
14,000
] Inelastic

8 1
] 0.20
8,000
] Inelastic

Graphically…
 Price Elasticity and the
Total-Revenue Curve
Elastic
$8 a Ed > 1
7
b Unit Elastic
6
c
Ed = 1

Price
5
d
4
e Inelastic
3 Ed < 1
f
2 g
1 D
h
0 1 2 3 4 5 6 7 8
Quantity Demanded Elastic
Ed > 1
(Thousands of Dollars)

$20
18
Total Revenue

16
14 Unit Elastic
12 Ed = 1
10
8
6 TR Inelastic
4 Ed < 1
2
0 1 2 3 4 5 6 7 8
Quantity Demanded
ii) Income elasticity of demand
• a measure of the responsiveness of the quantity
demanded of a product due to a change in income.

• or a measure of the extent to which the demand for a

good changes when income changes, other things
remaining the same.
 Percentage Change in Quantity
Demanded
Ei =
Percentage Change in Income

• Normal Goods – Positive Sign

• Inferior Goods – Negative Sign
• Insights into the Economy
• Degrees of Income Elasticity:

Positive coefficient → Normal goods;

Positive coefficient → Luxury goods;
Negative coefficient → Inferior goods; and
Zero → Necessity goods
iii) Cross elasticity of demand
• a measure of the responsiveness of quantity
demanded for one product due to a change in the
price of a related product.
• or a measure of the extent to which the demand for a
good changes when the price of a substitute or
complement changes, other things remaining the
same.
 Percentage Change in Quantity
Demanded of Product X
Exy =
Percentage Change in Price
of Product Y

• Substitute Goods – Positive Sign

• Complementary Goods- Negative Sign
• Independent Goods – Zero or Near-Zero Value
 Value of cross elasticity of demand

• positive value; goods are substitute to one another.

• negative value; goods are complement to one another.
• zero; goods are not related to one another.
 Price Elasticity of Supply

• Measures the sensitivity/responsiveness of the quantity supplied

due to a change in its price.

• Formula :-
Price elasticity of supply = % change in Qs
% change in P

• If the price of book is RM 60 the quantity supply is 1,000 unit.

When the price of book increases to RM 90 the quantity supply is
1,100 unit. Calculate the price elasticity of supply for book.
 Percentage Change in Quantity
Supplied of Product X
Es =
Percentage Change in Price
of Product X

Unit Elastic Supply Es = 1

Market Period:
Not Enough Time to Shift Resources
P
Sm

Greatest Pm
Price
Impact P0

D1 D2
Q0 Q
 Percentage Change in Quantity
Supplied of Product X
Es =
Percentage Change in Price
of Product X

Inelastic Supply Es < 1

Short Run:
Resources Not Easily Shifted to Alternative Uses
P
Ss

Lower
Price Ps
Impact P0

D1 D2
Q0 Qs Q
 Percentage Change in Quantity
Supplied of Product X
Es =
Percentage Change in Price
of Product X

Elastic Supply Es > 1

Long Run:
Resources Easily Shifted to Alternative Uses
P

Sl
Least
Price Pl
Impact P0

D1 D2
Q0 Ql Q
 Determinants of price elasticity of supply

i) Nature of Output
Shorter production process; manufactured products → elastic.
Longer production process; agricultural products → inelastic

ii) Time frame for supply

Short time period; supply is less responsive to changes in price
→ inelastic.
Long time period; supply is more responsive to changes in price
→ elastic

iii) Perishability
Highly perishable; agricultural products → inelastic.
Low perishable; manufactured products → elastic.
iv) Substitutability of input used
Inputs are not readily switch; production requires very specialize
inputs → inelastic.
Inputs can be readily switch to produce other goods → elastic.

v) Cost and feasibility of storage

Involve major changes in cost; goods are too costly to be stored
→ inelastic.
Involve small changes in production → elastic.
 Determinants of price elasticity of supply

i) Nature of Output (Gestation Period)

Shorter production process; manufactured products → elastic.
Longer production process; agricultural products → inelastic

ii) Time frame for supply

Short time period; supply is less responsive to changes in price
→ inelastic.
Long time period; supply is more responsive to changes in price
→ elastic

iii) Perishability
Highly perishable; agricultural products → inelastic.
Low perishable; manufactured products → elastic.
iv) Substitutability of input used
Inputs are not readily switch; production requires very specialize
inputs → inelastic.
Inputs can be readily switch to produce other goods → elastic.

v) Change in cost and feasibility of storage

Involve major changes in cost; goods are too costly to be stored
→ inelastic.
Involve small changes in production → elastic.
Next Chapter

Market Equilibrium