SECTION 3: DEMAND AND SUPPLY

Specific Objective 9: To explain the concept of price, income and cross-price elasticities
of demand.

ELASTICITY OF DEMAND (ED)

ED tells us by how much the quantity demanded of a good will change in response to a
change in its price. Thus, the sensitiveness or responsiveness of demand to change in price is
called elasticity of demand.
There are three (3) demand elasticities:
1. Price Elasticity of Demand (PED)
2. Income Elasticity of Demand
3. Cross Elasticity of Demand

Price Elasticity of Demand (PED)

PED measures the relative responsiveness of demand to a small change in price.
It shows the degree of responsiveness of changes in quantity demanded to changes in price.
Price elasticity can be defined as the percentage change in quantity demanded resulting from
a one percent (1%) change in price.
Formula:
Price Elasticity of Demand = - Percentage Change in Quantity Demanded
Percentage Change in Price

In symbol,
PED = - % ∆ QD OR P.E.D = - ∆ q x p
%∆P ∆p q

Expanded Formula:

New QD – Old QD x 100

Old QD 1
PED = - New P – Old P x 100
Old P 1

Where QD = Quantity Demanded

P = Price
∆ QD = change in quantity demanded
∆ P = change in price

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NB. Since quantity demanded is ‘inversely’ related to price, a negative sign in the definition
of PED is introduced simply to ‘neutralize’ the negative sign and thus make it positive.

Income Elasticity of Demand (YED)

YED shows the degree of responsiveness of quantity demanded of a commodity by
consumers to changes in the incomes of the consumers.
It is measured by dividing the percentage change in the quantity demanded of the good by the
percentage change in income.
Formula:
Income Elasticity = Percentage change in quantity demanded
Percentage change in Income

YED = % ∆ QD
%∆Y

Expanded Formula:

New QD – Old QD x 100

Old QD 1
YED = New Y – Old Y x 100
Old Y 1

Where QD = Quantity Demanded

Y = Income
∆ QD = change in quantity demanded
∆ Y = change in income

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Cross Elasticity of Demand (XED)

XED measures the extent to which a proportionate change in the quantity demanded of one
good is due to a proportionate change in the price of another good ie. It is the percentage
change in the quantity demanded of good X divided by the percentage change in the price of
good Y, the price of good X remaining constant.
Formula:
Cross Elasticity = Percentage change in the quantity demanded for good X
Percentage change in price of good Y

XED = % ∆ QDx
% ∆ Py

Expanded Formula:

New QDx – Old QDx x 100

Old QDx 1
XED = New Py – Old Py x 100
Old Py 1

Where QDx = Quantity Demanded for good X

Py = Price for good Y
∆ QDx = change in quantity demanded for good x
∆ Py = change in price for good Y

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Specific Objective 10: To calculate the price, income and cross-price elasticities of
demand.

CALCULATIONS OF ELASTICITIES.
.
1. Price Elasticity of Demand (P.E.D)
P.E.D = - Percentage Change in Quantity Demanded
Percentage Change in Price
Example 1:
When the price of CD increased from $20 to $22, the quantity of CDs demanded
decreased from 100 to 87. What is the price elasticity of demand for CDs?
87 – 100 x 100
100 1
PED = - 22 – 20 x 100
20 1

- 13 x 100
= - 100 1 = - -13 = 1.3
2 x 100 10
20 1

Example 2:
P Qd
$15 100
$30 80

P.E.D = - ∆ q x p
∆p q

= - 20 x 15
-15 100
= 0.2

2. Income Elasticity of Demand (Y.E.D)

Example 1:

Y Qd
100 100

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110 130

Y.E.D = ∆Q x Y
∆Y Q
= 30 x 100
10 100
=3

Example 2:

Y Qd
100 100
110 80

Y.E.D = ∆Q x Y
∆Y Q
= - 20 x 100
10 100
= -2

Example 3:
Y Qd
1000 2000
1500 2000

Y.E.D = ∆Q x Y
∆Y Q
= 0 x 1000
500 2000
=0

3. Cross-price elasticity of demand (X.E.D)

Example 1:

Suppose that when the price of a burger falls by 10 percent, the quantity of pizza demanded
decreases by 5 percent.

XED = Percentage change in quantity demanded of a good

Percentage change in the price of one of its substitutes or complements
= – 5 percent
– 10 percent
= 0.5

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Example 2:

If there is an increase in the price of tea by 10%. and the quantity demanded for coffee
increases by 2%, then the cross elasticity of demand = 2/10 = +0.2

Specific Objective 11: To interpret the price, income and cross-price elasticities of
demand.

INTERPRETATION OF ELASTICITIES.

Price Elasticity of Demand

1. Interpretation:
Numerical Value Type of Price Elasticity Description
P.E.D = ∞ Perfectly Elastic Demand There is a greater change in demand in
response to percentage or small change in the
price. For example, the demand for a product
decreases or completely stops, with a little
change in its price and vice versa.
P.E.D > 1 Elastic Demand The percentage change in the quantity
demanded of a product is greater than the
percentage change in price. In such a case,
consumers generally switch to new brands
when the price of a particular brand increases.
However, some consumers are loyal to the
same brand.

P.E.D = 1 Unitary Elastic Demand The change in demand and the change in the
price of a product is the same.

P.E.D < 1 Inelastic Demand The change in the demand of a product is less
than that of a change in its price.

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P.E.D = 0 Perfectly Inelastic Demand Consumers do not respond to the demand for
a product with increases or decreases in price.
This implies that the demand remains the
same with change in the price.

2. Graphical Representation:

Goods which are elastic, tend to have some or all of the following characteristics.
 They are luxury goods, e.g. sports cars
 They are expensive and a big % of income e.g. sports cars and holidays
 Goods with many substitutes and a very competitive market. E.g. if Kiss Bakery
increases the price of its bread there are many alternatives, so people would be price
sensitive.
 Bought frequently

Goods which are inelastic tend to have some or all of the following features:
 They have few or no close substitutes, e.g. petrol, cigarettes.
 They are necessities, e.g. if you have a car, you need to keep buying petrol, even if
price of petrol increases
 They are addictive, e.g. cigarettes.

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 They cost a small % of income or are bought infrequently.

 In the short-term demand is usually more inelastic because it takes time to find
alternatives
 If the price of chocolate increased demand would be inelastic because there are no
alternatives, however if the price of Mars increased there are close substitutes in the
form of other chocolate therefore demand will be more elastic.

Interpretations for calculations above for P.E.D

Example 1:
In this case demand is price elastic.
Therefore, Demand is elastic. Elastic demand occurs when % change in quantity demanded is
greater than % change in price; when PED >1

Example 2:
In this case demand is price inelastic.
Therefore, Demand is inelastic. Inelastic demand occurs when % change in quantity is
smaller than the % change in price; when PED < 1

Income Elasticity of Demand

Interpretation:

Numerical Value Type of Income Description

Elasticity
Y.E.D > 1 Income Elastic Demand The percentage change in quantity is greater than
the percentage change in income.
Y.E.D = 1 Unitary Income Elastic The change in demand and the change in income
Demand is the same.
Y.E.D < 1 Income Inelastic Demand The percentage change in quantity is less than
the percentage change in income.
Y.E.D = 0 Zero Income Elastic This shows that quantity bought is constant
Demand regardless of changes in income
Y.E. D < 0 Negative Income Elastic In this case an increase in income is
Demand accompanied by a decrease in quantity
demanded.

Interpretations for calculations above for Y.E.D

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Example 1:
Y.E.D = 3, therefore, it is ‘income elastic demand’.
NB. Since YED is +ve, the good is a normal good.

Example 2:
Y.E.D = -2, therefore, it is ‘negative income elastic demand’
NB. Since YED is -ve, the good is an inferior good

Example 3:
Y.E.D = 0, therefore, it is ‘zero income elastic demand’
NB. If YED is zero (0), the good will be a basic necessity.

Cross Elasticity of Demand

Interpretation:

Numerical Value Description

0 < XED < ∞ When Good A and Good B are substitutes
XED = 0 When there is no relationship between Good A and Good B
-∞ < XED < 0 When Good A and Good B are complementary

Example 1:
Since X.E.D = 0.5 both goods are substitutes

Example 2:
Since X.E.D = 0.2 both goods are substitutes

For example, if, in response to a 10% increase in the price of fuel, the demand for new cars
that are fuel inefficient decreased by 20%, the cross elasticity of demand would be:cross body
(-20%)/10%=-2. Both goods are complementary

Elasticity Questions
Questions

1. Work out the price elasticity of demand for this product from the data provided:
(4 marks)

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Quantity Demanded Price

100 units $5.00
125 units $3.75

2. Cocoa production in Dominica (6 marks)

Year Production (metric Tonnes)
2003 220
2002 200
2001 200
2000 200

The table above shows that in 2003 production of cocoa beans in Dominica
increased. If the price was $60 per metric tonne in 2002 and in 2003 fell to $55,
calculate the price elasticity of demand and describe whether the demand for cocoa
beans is elastic or inelastic.

3. June’s income increases from $100 to $150 per week. She buys three packs of juice
now instead of two. What is her income elasticity of demand for juice and interpret its
value? (3 marks)

4. Y (Income) QD (Loaves of bread)

$1000 4
$1500 7

Calculate the income elasticity of demand and interpret its value. (3 marks)

5. The quantity demanded of product A has increased by 12% in response to a 15%

increase in price of product B. Calculate the cross elasticity of demand and tell
whether the product pair is (a) apples and oranges, or (b) cars and gas.

6.
Price of X Quantity Demanded of X Quantity Demanded of Y
30 400 250
20 700 150

Calculate the cross elasticity of demand for Y with respect to the price of X and interpret its
value. (3 marks)

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Specific Objective 12: To outline the factors affecting price, income and cross-price
elacticities of demand.
 Habit-forming goods (eg. tobacco and alcohol) – people can be addicted to certain
products. Where this is the case, demand will be inelastic

 Availability of substitutes – if a commodity has a number of close substitutes, all at

similar prices, the demand for it will be elastic. A small price increase will cause
many consumers to switch to the substitutes.
However, where a commodity has no close substitute, demand will be inelastic

Some examples of good/services with close substitutes are…

Butter margarine
Taxi services bus & train services
Hamburgers hot dogs

 Time period (ie Long-run/ short-run) – Elasticity is usually higher in the long-run.

 The percentage (%) of a consumer’s income allocated to spending on the good.

Goods and services that take up a high proportion of a household’s income will tend
to have a more elastic demand than products where large price changes makes little or
no difference to someone’s ability to purchase the product.
E.g. a box of matches vs. a new car

 Whether the good is a necessity or not. Goods and services deemed by consumers
to be necessities tend to have an inelastic demand whereas luxuries will tend to have a
more elastic demand because consumers can make do without luxuries when their
budgets are stretched.

 The degree of complementarity of a good/service

Highly complementary goods tend to have a low PED. In essence, it is often the lack
of substitutes rather than the degree of complementarity that causes the demand to be
inelastic. However, this is not always the case. Whereas a fall in the price of a good
without close substitutes will tend to increase the quantity demanded, the quantity
demanded of goods with a high degree of complementarity will not necessarily
increase if their prices fall. Take salt for example. People will not start buying more
salt just because the price of salt has decreased relative to other goods (e.g. pepper.)

Examples of goods with a high degree of complementarity include…

IPhones ITunes
Games consoles Games
Golf clubs Golf balls
Cars Car parts

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ELASTICITY OF SUPPLY

Elasticity of supply measures the degree of responsiveness of a change in quantity supplied,

to a change in price.

Formula:
Price Elasticity of Supply (PES) = Percentage change in Quantity Supplied
Percentage change in Price

OR

PES = % ∆ Qs
%∆P

PES = ∆Qs x 100

Old/ original Qs 1
∆P x 100
Old/ original P 1

INTERPRETATION:

Numerical Value Type of Elasticity Description

PES = 0 Perfectly Inelastic The percentage in quantity
supplied is zero. Quantity
supplied does not respond to
a change in price.
0 < PES < 1 Fairly Inelastic The percentage change in
quantity supplied is less than
the percentage change in
price.
PES =1 Unitary Elasticity The percentage change in
quantity supplied is equal to
the percentage change in
price.
1 < PES < ∞ Fairly Elastic The percentage change in
quantity supplied is greater
than the percentage change
in price.
PES = ∞ Perfectly Elastic Quantity supplied changes
when there is NO change in
price.

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Graphical representations:

i. Perfectly inelastic supply ii. Inelastic supply Qs

iii. Unitary Elastic Supply iv. Elastic Supply

v. Perfectly Elastic Supply

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CALCULATIONS:

Question 1: Calculate P.E.S and interpret its value.

Qs (pencil cases) Price ($)
5 10
7 12

Question 2: Calculate P.E.S and interpret its value.

Qs (Milk) Price ($)
10 50 each
15 75 each

Question 3: Calculate P.E.S and interpret its value.

Qs (cellphones) Price ($)
50 400
60 500

Question 4 (2015 Past Paper Ques # 1d):

Price ($) Quantity Demanded Quantity Supplied
1 500 100
2 400 200
3 300 300
4 200 400
5 100 500

(i) Calculate the price elasticity of supply when the price per sno-cone changes from
$2 to $4. (4 marks)

(ii) Interpret it’s value. (1 mark)

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Determinants of Elasticity of Supply

What factors affect the elasticity of supply?

1. Spare production capacity: If there is plenty of spare capacity then a business can
increase output without a rise in costs and supply will be elastic in response to a
change in demand. The supply of goods and services is most elastic during a
recession, when there is plenty of spare labour and capital resources.

2. Stocks of finished products and components: If stocks of raw materials and

finished products are at a high level then a firm is able to respond to a change in
demand - supply will be elastic. Conversely when stocks are low, dwindling supplies
force prices higher because of scarcity.

3. The ease and cost of factor substitution/mobility: If both capital and labour are
occupationally mobile then the elasticity of supply for a product is higher than if
capital and labour cannot easily be switched. E.g. a printing press which can switch
easily between printing magazines and greetings cards. Or falling prices of cocoa
encourage farmers to switch into rubber production.

4. Time period and production speed: Supply is more price elastic the longer the time
period that a firm is allowed to adjust its production levels. In some agricultural
markets the momentary supply is fixed and is determined mainly by planting
decisions made months before, and also climatic conditions, which affect the
production yield. In contrast the supply of milk is price elastic because of a short time
span from cows producing milk and products reaching the market place.

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