Elasticity

CHAPTER 4

ELASTICITY

Learning Objectives:

At the end of this chapter, students will be able to:

i) define the elasticity of demand and supply

ii) understand the uses of elasticity and explain the concept of elasticity
iii) enable to calculate the elasticity of demand and supply
iv) enable to interpret the coefficient of elasticity of demand and supply

CHAPTER OVERVIEW

Elasticity

Elasticity of Demand Elasticity of Supply

Price Elasticity of Demand

Price Elasticity of Supply
Measurement and
Interpretation
Measurement
Determinants of Price
Elasticity of Demand Determinants of
elasticity of supply

Relationship between Price

Elasticity of Demand and Total
Revenue

Income Elasticity of
Demand

Measurement and
Interpretation

Cross Elasticity of Demand

Measurement and
Interpretation

52 Principles of Economics
 Elasticity

Introduction

Elasticity is a ratio of change or the measurement of the magnitude responsiveness of variable

(quantity demand or quantity supply) to the change in one of the determinants factor for
example price or income.

The general formula to calculate elasticity:

% Q 
 = 
 % P 
There are two types of elasticity. Three of it will be under elasticity of demand and one under the
elasticity of supply. The types of elasticity can be show as below:

Figure 4.1: Types of Elasticity

Elasticity (ε)

Elasticity of Elasticity of Supply

Demand

Price Elasticity of Income Elasticity Cross Elasticity of Price Elasticity of

Demand (εP) of Demand (εY) Demand (εX) Supply (εS)

4.1 Elasticity of Demand

Under the elasticity of demand, there are three types of elasticity. First the price elasticity of
demand that measure the responsiveness the quantity demand when there is changes in price.
Second, income elasticity of demand, which measure that responsiveness of changes in
quantity demand because of changes in income and the last one, will be cross elasticity of
demand. Cross elasticity of demand is a measurement of the responsiveness in quantity
demand for one good or product due to a change in the price of other product.

4.1.1 Price Elasticity of Demand

4.1.1.1 Definition

Price elasticity of demand is measure the percentage of change in quantity demand with the
percentage change in price level of that particular good. It measures the degree of

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Elasticity

responsiveness in quantity demand due to the change in price level. The coefficient of the price
elasticity of demand can be calculated using the formula below.

 % Qd 
p = − 
 % P 
 Qd P 
p = −  X 0 
 P Qd 0 
Qd − Qd 0 P0 
p = −  1 X 
 Qd 0 P1 − P 0 

With,

Qd0 = original quantity demanded

Qd1 = new quantity demanded
P0 = original price level
P1 = new price level
p = coefficient of price elasticity of demand
Qd = change in quantity demanded
P = change in price
A negative sign indicates the negative (inverse) relationship between price level and
quantity demanded of the goods.

Example

Given the price of Good A increase from RM 6 with quantity demanded 250 units to RM 8 with
quantity demanded 150 units.

Qd − Qd 0 P0 
p = −  1 X 
 Qd 0 P1 − P 0 
100 − 250 6 
p = −  X
 250 8 − 6 
 − 150 6 
p = −  X 
 250 2
p = −− 0. 6 X 3
p = 1. 8

54 Principles of Economics
 Elasticity

4.1.1.2 Measurement and Interpretation

i. Elastic Demand (  p  1 )

When demand has elasticity more than one is called elastic. Demand is elastic when a change
in quantity demanded is more than the percentage changes in price. The demand curve is steep
as figure 4.2. For example, when there is the change in price by 10 percent, the percentage
changes in demand will fall by 20 percent. The products that have a close substitute tend to
have an elastic demand such as soap, body foam, cloth and shoe.

Figure 4.2: Demand Elastic

Price (RM)

(% Qd  % P )

P1

10%
P0

20%
D
Quantity
0 Q1 Q0 (Units)

ii. 0 Demand (  p  1)
Inelastic

Demand is inelastic when a percentage changes in quantity demanded is less than one but
more than zero. Inelastic demand means percentage change in quantity demanded less than
the percentage change in price. The demand curve is steeper as shown by figure 4.3 below. For
example, 10 percent increase in price will only lead to small percentage change in quantity
demanded, here by 5 percent. For example, less substitution goods as petrol and cigarettes.

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Elasticity

Figure 4.3: Inelastic Demand

Price (RM)

(% Qd  % P )
P1

10%
P0

5% D
Quantity (Units)
0 Q1 Q0

iii. 0
Unitary Elastic Demand ( p =1 )

The value of coefficient is equal to one or unity. It happens when percentage changes in
quantity demanded is equal the percentage changes in price. The demand curve is shaped like
hyperbola, as it will convex to origin. Referring to the figure below, as price increase by 5
percent, the quantity demanded will decrease equally by 5 percent.

Figure 4.4: Unitary Elastic Demand

Price (RM)

P1
(%Qd = %P)
5%
P0

5% D

Quantity (Units)
0 Q1 Q0

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 Elasticity

iv. Perfectly Inelastic Demand (  p = 0 )

The coefficient is equal to zero. It happens when changes in the price will not affect the changes
in quantity. The quantity demanded is same as the price change. The demand curve is vertical
line as it is parallel to the price axis as figure 4.5 below. For example, consumer will pay any
price for air or prescription drugs needed to most people and they will pay any amount to save
their life.
Figure 4.5: Perfectly Inelastic Demand

D
Price (RM)

% P ;% Qd = 0
P1

10%
P0

0 Q0=Q1 Quantity (Units)

v. Perfectly Elastic0Demand (  p =  )

The coefficient is equal to infinity. The demand for infinity happens when there is slightly decline
in the price will make a very huge or unlimited change in quantity demanded. But when price
increase the quantity demanded will become zero. The demand curve is straight line parallel
with the horizontal axis. Figure 4.6 below show the perfectly elastic demand.

Figure 4.6: Perfectly Elastic Demand

Price (RM)

% P = 0;% Qd
P0
D

Quantity (Units)
0 Q0 Q1

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0
 Elasticity

4.1.1.3 Determinants of Price Elasticity of Demand

i. Availability of Substitutes or Substitutability

The more one commodity or good has the substitute, the demand become more elastic. The
slightly change in the price will affect the big changes in the quantity demanded. When the price
increases, people tend to buy the substitute good which the price unchanged. But if the price
decreases, buyer will see the price is cheaper and buy that good and yet the demand of that
good will increase. For example, if the price of Gardenia Bread increases, more people will
change their consumption to Hi-5 bread. Here the demand becomes elastic.

On the other hand, if the good has less substitution, the elasticity is inelastic. This mean when
the price of the goods increases consumer facing difficulties to find the other substitution and
will still buy those goods. For example, if the price of pewter increases, the demand for pewter
will become inelastic due to the less substitutability of the goods.

ii. Proportion of Consumer’s Income Spent on a Good

As a proportion of income spent on good increase, the elasticity will increase. For example,
average household spends 35% of their income on housing and only small percentage in buying
shoe. Both goods will give a different impact because those items have the different elasticity.
Households are very sensitive to small changes in housing price will tow to purchase the house
compare if the price of shoe change.

iii. Nature of goods

Commodities such as essential goods are inelastic and not too influence by price. These
commodities are still required by consumer (quantity demanded will slightly decrease) although
the price increases. On the other hand, the less important goods have an elastic demand.

iv. Time Dimensions

In the short period, demand tends to be inelastic. This is because in the short period demand is
difficult to change due to difficulty to find other substitute goods even the price increases. On the
other hand, demand is elastic in long period due to consumer able to find other substitute goods
if price of good increases.

v. Income Level

Those who in higher income group have inelastic demand compare to middle and lower
income group. People which have higher income are less sensitive towards price changes and
yet will not affect the quantity demanded. However when price increases it will affect the
middle and lower income group.

vi. Habits

Coffee lover tend to have an inelastic demand for coffee. These people will disregard when
there is a change in price because these goods are necessity to them. They will demand it no
matter how expensive these goods are.

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 Elasticity

4.1.1.4 Relationship between Price Elasticity of Demand and Total Revenue

Total revenue is the income that received by seller from payment on goods that been bought by
consumer. Total revenue is defined as price multiplied with quantity purchase.

Total Revenue = Price (P) x Quantity Purchase (Q)

In these matters society will assume when the price of goods increase sales revenue will also
increase. But the statement shows that the rise or reduction on the total revenue is linked to the
elasticity of demand for the goods. There are three difference relationships between price
elasticity of demand and the total revenue as follows.

a. For those goods that the elasticity is equal to one, the changes in price will not change the
revenue

i. Total Revenue when Demand is Inelastic

When the price elasticity of demand is inelastic, increase in price of the goods will increase the
sales revenue and decreases in price will reduce the revenue. Figure 4.7 below show the price
of goods is increase from RM6.00 to RM8.00 and the quantity demanded is fall from 125 units to
100 units. Total revenue when the price increase is RM800 or as at 0P1AQ1. Compare to the
total revenue before the price increase, the revenue is RM750 as at 0P0BQ0. The total revenue
is increase when the price increase but it will fall when the price is decrease.

Figure 4.7: Total Revenue when Demand is Inelastic

Price (RM)

P increase -> TR increase

P decrease -> TR decrease
P1=8 A

P0=6 B

0 Q1=100 Q0=125 Quantity (Units)

0

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Elasticity

ii. Total Revenue when Demand is Elastic

When the price elasticity of demand is elastic, increases in price of goods will cause reduction in
the total revenue and vice versa. Based on the figure 4.8 below the increase in the price from
P0 to P1 will decrease the total revenue as much as Q1CBQ0. But when the price is decrease
from P1 to P0, the revenue will increase as much as at Q1CBQ0.

Figure 4.8: Total Revenue when Demand is Elastic

Price (RM)

A
P1=8 P increase -> TR decrease
P decrease -> TR increase

C B
P0=4

0 Q1=100 Q0=250 Quantity (Units)

iii. Total Revenue when Demand is Unitary Elastic

0
If demand for a goods is unitary elastic, increasing or decreasing in the price will not affect the
revenue. From the figure 4.9 below, increasing in price from P0 to P1 will also affect the
percentage change in quantity demanded. The total revenue remains unchanged.

Figure 4.9: Total Revenue when Demand is Unitary Elastic

Price (RM)
P increase -> TR not change
P decrease -> TR not change

P1=8 A

P0=4 B
C

Quantity (Units)
0 Q1=50 Q0=100

60 Principles of Economics
0
 Elasticity

4.1.2 Income Elasticity of Demand

4.1.2.1 Definition

The coefficient which shows the changes in quantity demand for goods as a result of changes in
income is known as income elasticity of demand. Income elasticity of demand is the share of
income that is used to indicate the use of goods responsiveness to the changes in income. The
coefficient or value of the elasticity can be obtained to distinguish whether these types of goods
included in the category of a luxury goods, normal or inferior goods.

4.1.2.2 Measurement and Interpretation

The formula to calculate income elasticity of demand is shown as below.

 % Qd 
y = 
 % Y 
Qd − Qd 0 Y0 
y =  1 X 
 Qd 0 Y 1 −Y 0 
 Q Y 
y =  X 0 
 Y Qd 0 

With,

Qd0 = original quantity demanded

Qd1 = new quantity demanded
Y0 = original income level
Y1 = new income level
y = coefficient of income elasticity of demand
Qd = change in quantity demanded
Y = change in income

The categories of goods are as follows.

Table 4.1: Interpretation and Example of Income Elasticity of Demand

Coefficient Type of Goods Example

i. εy > 1 Luxury or superior - When income increases,
goods (cars, jewellery, demand for these goods will
antiques) Normal increase.
Goods
ii. 0 ≤ εy ≤ 1 Necessity goods (salt,
sugar, rice etc.)

iii. εy < 1 Inferior / Giffen Goods ( broken rice, salted - When income increases,
fish, bundle clothes) demand for these goods will
decrease.

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Elasticity

4.1.3 Cross Elasticity of Demand

4.1.3.1 Definition

Cross elasticity of demand measure how much changes in the quantity demanded of one goods
when there is a change in the prices of other goods. It is used to measure the strength of the
relationship between various complement, substitution or unrelated goods. The coefficient
values for cross elasticity of demand are from positive or infinity through negative or infinity.

4.1.3.2 Measurement and Interpretation

The formula to calculate income elasticity of demand is shown as below.

 % Qdx 
x =  
 % Py 
Qdx 1 − Qdx 0 Py 0 
x =  X 
 Qdx 0 Py 1 − Py 0 
 Qx Py 0 
x =  X 
 Py Qdx 0 

With,

x = coefficient of income elasticity of demand

Qdx0 = original quantity demanded for good X
Qdx1 = new quantity demanded for good X
Py0 = original price level for good Y
Py1 = new price level for good Y
Qdx = change in quantity demanded for good X
Py = change in price of good Y

The sign of the cross elasticity of demand depends on the relationship of both goods. For the
substitution goods, the coefficient value of the cross elasticity of demand is positive. This means
that the quantity demand of goods X will change at the same direction as the price of goods Y
changes. For example, when the price of Y increases, quantity demanded for goods X will also
increase and the demand for goods Y will fall. The examples for substitute goods are tea and
coffee or BMW and Mercedes.

For the complementary goods, the coefficient value of the cross elasticity of demand is
negative. This shows that the demand for goods change as at the inverse direction with the
changes in the complementary goods. For example when price of Y increase, the quantity
demanded for goods X will decrease because the demand for goods Y in decreasing. Examples
of complementary goods are tennis racket and tennis ball or petrol and motorcycle.

When the cross elasticity of demand is equal to zero, this means both goods X and goods Y is
unrelated goods. Whenever there is a change in price of goods Y, it will not affect the quantity
demanded for goods X (quantity demanded for goods X are constant). Examples of unrelated
goods are motorcycle and tea or oil and house.
62 Principles of Economics
 Elasticity

Table 4.2: Interpretation and Example of Cross Elasticity of Demand

Sign/Coefficient Implication Example

Positive sign Demand for one good will increase if
the price of the other goods increases
Negative sign Demand for one good will increase if
the price of the other good decreases
Demand for one good is not affected
x = 0 when there is a changes in the price of
other goods
Substitute goods (orange
juice & apple juice; beef &
lamb)
Complementary goods
(coffee & skimmed milk;
entertainment & food)
Two goods are not related
(Cloths & Bicycle; Cutlery &
Air conditioner)

4.2 Elasticity of Supply

4.2.1 Definition

Price elasticity of supply is measure the responsiveness in percentage changes in quantity

supplied due to the percentage changes in the price of the goods. It can be determine by
comparing the percentage changes in quantity supply with the percentage change in the price of
the goods.

4.2.2 Measurement and Interpretation

The formula to calculate the price elasticity of supply is shown as below.

 % Qs 
s = 
 % P 
Qs − Qs 0 P0 
s =  1 X 
 Qs 0 P1 − P 0 
 Q P 
s =  X 0 
 P Qs 0 

With,

Qs0 = original quantity supplied

Qs1 = new quantity supplied
P0 = original price level
P1 = new price level
s = coefficient of price elasticity of demand
Qs = change in quantity supplied
P = change in price

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Elasticity

i. Elastic Supply ( s  1 )

Supply is elastic when the change in quantity supplied is more than percentage changes in the
price. The value of coefficient is more than one but less than infinity. The supply curve is
steeper as the Figure 4.10 below. The figure shows the small percentage changes in price will
lead to a large percentage change in quantity supplied.

Figure 4.10: Supply is Elastic

Price
(RM)

(%Qs  %P) S
P1

P0

0 Q0 Q1 Quantity
(Units)

ii. 0
Inelastic Supply ( s  1 )

Supply is inelastic when percentage change in quantity supplied is less then percentage change
in the price of the goods. The coefficient is larger than zero but less than one. The supply curve
is steeper compared to the elastic supply. Refer to figure 4.11 below, the supply curve is
inelastic because when price increase by 10 percent the quantity supplied will also increase by
less than 10 percent. The larger percentage change in price only affects a small percentage
change in quantity supply.

64 Principles of Economics
 Elasticity

Figure 4.11: Supply is Inelastic

Price (RM)
S

P1 (%Qs  %P)

10%

P0

5%

Quantity (Units)
0 Q0 Q1

iii. Unitary Elastic Supply ( s = 1 )

0
This elasticity happens when a percentage change in quantity supply is equal with percentage
changes in price. The coefficient value is equal to one. Here the supply curve will start from
origin. Refer to figure 4.12 below.

Figure 4.12: Supply is Unitary Elastic

Price(RM) S

P1

5%
(%Qs = %P)
P0

5%

Quantity
0 Q0 Q1 (Units)

Principles of Economics 65
Elasticity

iv. Perfectly Inelastic Supply ( s = 0 )

Elasticity zero happens when changes in price not affect the changes in quantity supply. The
shaped of supply curve is vertical line that parallel as the price axis such as the figure below.
The quantity supply is constant as the price increase or decrease.

Figure 4.13: Supply is Perfectly Inelastic

Price (RM)
S

P1

10%

P0

0 Q0 Quantity (Units)

v. Perfectly Elastic Supply ( s =  )

0
Perfectly elastic supply happens when there is a small change in price affect the changes in
quantity supplied is unlimited. The supply curve shaped like a straight horizontal line as the
figure 4.14 below.
Figure 4.14: Supply is Perfectly Elastic

Price (RM)

P0 S

Quantity (Units)
0 Q0 Q1

66 0
Principles of Economics
 Elasticity

4.2.3 Determinants of Price Elasticity of Supply

i. The time factor involved in making adjustment to supply

In a very short run, supplier cannot increase the supply thus the supply curve is perfectly
inelastic due to insufficient of time to make an adjustment. However in the short run, the
capacity to increase the capital (equipments) to produce could not be added. But producer can
increase the production using the present capacity of factor of production more intensively. In
the long run, production and quantity supplied can be increase easily. So in the long run supply
is more elastic. Sellers can adjust their supply or production.

ii. Change in the cost of factor of production

Supply is inelastic if there is an increase in the quantity supply need in the additional cost of
production. On the other hand, expansion in supply which requires a small additional cost, the
supply is elastic.

iii. Pattern usage for factor of production

If production of goods needs the specific usage of factor of production, the supply is inelastic
because the factor is not easily added. However, the production which required the normal
factor of production may be added easily.

iv. Technology

Advancement in technology will increase the production. In this case supply is more elastic. It
can happen when there is small increment in price; the quantity supply can be increase largely.

v. Perishability

The perishable products like agricultural products have an inelastic supply. Supplier cannot
store these perishable products for a long period of time due to perishable characteristics. In
other case, the products that are not perishable tend to have an elastic supply due to supplier
can store these products for the long period time. For example, fruits and vegetables
(agriculture products), brownies, cakes and cheese.

Principles of Economics 67
Elasticity

Topic Summary

Concepts Category Explanations

1) Elasticity of 1) Price Elasticity of demand a. Definition: It measures the degree of
Demand (PED) responsiveness in quantity demand
due to the change in the price level.

b. Measurement & Interpretation:-

i.  p  1 – Percentage change in
quantity demanded is more than
percentage changes in price.

ii.  p  1 – Percentage change in

quantity demanded is less than
percentage changes in price.

iii.  p = 1 - Percentage change in

quantity demanded is equal to the
percentage changes in price.

iv.  p = 0 – No changes in quantity

demanded as there is changes in
price

v.  p =  – unlimited changes in
quantity demanded as there is no
changes in price

c. Determinants of PED:-
i. Availability of substitutes or
substitutability
ii. Proportion of consumer’s income
spent on a good
iii. Nature of goods
iv. Time dimensions
v. Income level
vi. Habits

➢ Relationship between i. When demand is elastic, price

price elasticity of increase will affect the TR
demand and Total decrease and price decrease the
Revenue (TR) TR will increase.
ii. When demand is inelastic, price
increase will affect the TR
increases and price decrease the
TR will decreases.
iii. When demand is unitary elastic,
price increase or decrease will not
affect the TR.

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 Elasticity

2) Income Elasticity of a. Definition: It measures the degree of

demand responsiveness in quantity demand
due to the change in the income level.

b. Measurement & Interpretation:-

Coefficient Type of Goods
i. εy > 1 Luxury or
superior
goods Normal
(cars, Goods
jewellery,
antiques)

ii. 0 ≤ εy ≥ 1 Necessity
goods
(salt,
sugar, rice
etc.)

iii. εy < nferior / Giffen Goods

( broken rice, salted
fish, bundle clothes)

3) Cross Elasticity of a. Definition: It measures the

demand responsiveness in changes in quantity
demanded of one goods when there is
a change in the price of other goods.

b. Measurement & Interpretation:-

Sign/Coeffici Relationship between
ent goods
Positive
Substitute goods

Negative
Complementary goods

x = 0 Not related to each

other

2) Elasticity of 1) Price Elasticity of Supply a. Definition: It measures the degree of

Supply (PES) responsiveness in quantity supply due
to the change in the price level.

b. Measurement & Interpretation:-

i.  s  1 – Percentage change in
quantity supplied is more than
percentage changes in price.
Principles of Economics 69
Elasticity

ii.  S  1 – Percentage change in

quantity supplied is less than
percentage changes in price.
iii.  s = 1 - Percentage change in
quantity supplied is equal to the
percentage changes in price.
iv.  s = 0 – Changes in the price not
affect the changes in quantity
supplied

v. s =  – Small change in price will
affect the unlimited changes in
quantity supplied.

c. Determinants of PED:-
i. The time factor involved in making
adjustment to supply
ii. Change in the cost of factor of
production
iii. Pattern usage for factor of
production
iv. Technology
v. Perishability

70 Principles of Economics