Elasticity

CHAPTER 3
 Elasticity?
 Elasticity = Responsiveness = Sensitivity
 Elasticity of demand?
 Responsiveness of demand due to some
changes to the factor which influence demand
i.e:
 Price of the good itself.
 Consumers’ income.

 Price of related goods.

 Types of
Elasticity of Demand:

 Price elasticity of demand

 Cross elasticity of demand
 Income elasticity of demand
 i. Price Elasticity of Demand (Ep)

 measures the responsiveness of the

quantity demanded due to the change in
its price.

 It is a ratio of the percentage change in the

quantity demanded of a product to a
percentage change in its price.
 Formula Ep
 Calculating price elasticity of demand;
Formula:
Ep = % ∆ in Qd for product X
% ∆ in P of product X
= % ∆ in Q
% ∆ in P
= ∆ Q x P0
∆P Q0
= (Q1 – Q0) x P0
(P1 – P0) Q0
 Example:
Price(RM) Quantity Demanded
2.00 10
3.00 5

Calculate the price elasticity of demand

when price increases from RM2.00 to
RM3.00.
 Working:
 Identify the value of P0,P1,Q0 and Q1
 Formula:
Ep = ∆ Q x P0 Use the modulus
sign ([xx]) to
∆P Q0 remove the (–ve)
= (Q1 – Q0) x P0 sign if the answer
is (-ve)
(P1 – P0) Q0
= (5 – 10) x 2
(3 – 2) 10
= 1
 Degrees of Price Elasticity
of Demand

1. Elastic Demand (Ep >1)

2. Inelastic Demand (Ep <1)
3. Unitary Elastic Demand (Ep=1)
4. Perfectly Elastic Demand (Ep = ∞)
5. Perfectly Inelastic Demand (Ep=0)
 1. Elastic demand (Ep > 1)
 Percentage change in quantity demanded is
greater then the percentage change in price.

Eg of good:
 %Δ Q > %Δ P 1. Good with close
P
substitute such as tooth
paste (Darlie & Colgate).
P2
+5%Δ P 2. Luxury good (as it is less
P1
important)
D
-10%Δ Q

Q2 Q1
Q
 2. Inelastic Demand (Ep < 1)
 Percentage change in quantity demanded is less
than the percentage change in price.

Eg of good:
 %Δ Q < %Δ P 1.Less substitute good such as
petrol.
P 2.Important good (necessity) such
as rice.
P2
3.Cheaper good such as salt (as it
+10%Δ P take a small fraction from
consumers’ income)
P1 4.Cigarettes as the good become
-5%Δ Q D necessity for the smokers.

Q2 Q1 Q
 3. Unitary elastic (Ep = 1)
 Percentage change in quantity demanded is
equal to the percentage change in price.

 %Δ Q = %Δ P
P

P2
+5%Δ P
P1
-5%Δ Q D

Q2 Q1
Q
 4. Perfectly Elastic (Ep = ∞)
 A small increase in the price of a product causes
the qty demanded for a product to drop to zero
 Very rare in real life
P

P0 D

Q
 5. Perfectly Inelastic (Ep = 0 )

 Quantity demanded does not change as

the price changes. Eg of good:
P D
1. Insulin by a
serious diabetic
P2 patient.
2. Heroin from a
+5%Δ P drug addict.
P1

Q0 Q
 Determinants of Price Elasticity of
Demand
1. Availability of substitutes
 The larger the number of substitutes available,
demand for a product will be elastic, Eg: shoes.
 When substitutes are not readily available, demand
for a product will be inelastic Eg: petroleum.

2. Relative importance of the goods in the budget

 If the goods take a large portion of an individuals

budget, the demand tends to be elastic. Eg are
cars, electrical appliances and other luxury goods.
 If the goods take a small portion of an individual
budget, the demand will be inelastic. Eg: salt.
Cont…
3. The amount of time available to adjust to the price
change (Time dimension)

 In the long run demand is likely to be more elastic

simply because consumers can make adjustment and
fine other substitutes.
 In the short run, demand is inelastic.

4. The importance of goods – necessity or luxury

 The demand for luxury goods or less important

goods are elastic.
 The demand for necessity such as rice is inelastic,
great increase in price will not reduce the demand for
rice very much.
Cont…
5. Income level

 The lower income group are sensitive to price

changes and their demand is more elastic.
 Those with higher income are less sensitive to price
changes, therefore their demand is inelastic.

6. Habits

 If goods consume becomes habits, the demand for

the particular goods are inelastic. Example is
demand for cigarette by smokers.
Relationship between price elasticity of
demand and total revenue (TR)
 TR = total income received by any firm that sells
goods and services at any market prices.

 Formula of TR:
TR = price x quantity

Example:
Price of ice-cream = RM2.50
Quantity sold = 500 units

Thus TR = RM2.50 x 500 units

= RM1250.00
 CONT…
TR increases or decreases when there is price
changes depend on the price elasticity of demand.

i. If demand is elastic, to increase TR, price

should be decreased because the % change in
Qd >% in price.

ii. If demand is inelastic, to increase TR, price

should be increased because the % change in
Qd<% change in price.

iii. If demand is unitary elastic, change in price

would not affect and change in TR.
Tutorial Question
 ii. Cross Elasticity of Demand (Ec)
 measures the responsiveness of quantity demanded for one
product to a change in the price of another product.
Qx = f(Py)

 Three possibilities:
i. Ec = +ve
an increase in Py would increase the demand
for good x, goods x and y are substitutes.

ii. Ec = -ve
an increae in Py would reduce the demand for
good x, goods x and y are complementary
goods.

iii. Ec =0
An increase in Py would not affect the demand
for good x, good x and y have no relatioship.
 Formula Ec
Ec = % ∆ in Qx
% ∆ in Py
= ∆ Qx x Py0
∆ Py Qx0
= (Qx1 – Qx0) x Py0
(Py1 – Py0) Qx0
 Example:
 Example:
Price of Y Quantity x Quantity Y
RM10 60 15
RM18 40 25
RM25 20 30

 Calculate the cross elasticity of demand for good

x when the price of y increases from RM18 to
RM25
 Working:
 Identify the value of Py0,Py1,Qx0 and Qx1

 Formula :

= ∆ Qx x Py0
∆ Py Qx0
= (Qx1 – Qx0) x Py0
(Py1 – Py0) Qx0
= 30 - 25 x 18
25 - 18 25
= 0.51

 Conclusion;
If Ec is positive, goods x and y are substitutes
iii.Income Elasticity of Demand (Ey)

 measures the responsiveness of quantity

demanded to a change in income.

 Three possibilities:
i. If Ey is positive = normal goods :
Ey >1 - luxury
Ey ≤ 1 – necessity
ii. If Ey is negative = inferior goods
iii. If Ey is zero = essential goods
 Formula Ey
 Formula:
Ey = % ∆ in Q
% ∆ in Y
= ∆Q x Y
∆Y Q
= (Q1 – Q0) x Y0
(Y1 – Y0) Q0
 Example:
 Example:
Income Qty A Qty B Qty C
100 10 20 20
120 15 20 18
150 17 20 14

Calculate the income elasticity of demand for

goods A, B and C when income increases from
RM120 to RM150.
 Working:
 Good A:
Ey = (QA1 – QA0) x Y0
(Y1 – Y0) QA0

= (17 – 15) x 120

(150 – 120) 15

= 0.53

 Since Ey is positive and < 1, good A is a necessity

 Working:
 Good B:
Ey = (QB1 – QB0) x Y0
(Y1 – Y0) QB0

= (20 – 20) x 120

(150 – 120) 20

= 0 (Good B is inferior good)

 Working:
 Good C:
Ey = (QC1 – QC0) x Y0
(Y1 – Y0) QC0

= (14 – 15) x 120

(150 – 120) 15

= - 0.27

 Good C is an inferior good

 Price Elasticity of Supply

 Measure “The responsiveness of quantity

supplied to a change in price.“

 Elasticity of supply can be determined by

comparing the % change in quantity
supplied with the % change in the price of
the product.
Types of Price Elasticity of Supply
P
 Elastic Supply ( fairly
S
elastic)
 % change in
quantity supplied is
greater than %
change in price.

 Es =% Δ QS > % Δ P Q
 P
S
 2. Inelastic Supply
(fairly inelastic)

 % change in quantity
supplied is less than
% change in price.

 Es =% Δ QS > % Δ P Q
 S1
S2
 Unitary Elastic

 % change in
quantity supplied
is equal to the %
change in price

Es =% Δ QS > % Δ P
Q
 Perfectly Inelastic
% change in quantity supplied is zero
despite the change in the price.
P
S
 Perfectly Elastic

% change in quantity supplied is

infinitely large compared to the %
change in price.
P

P0 S

Q
 Formula
 Es = % change in quantity supplied
% change in price

= % Δ QS
%ΔP
= Δ QS x P0
ΔP Q0

= Q1 - Q0 x P0
P1 - P0 Q0
 Working:
 When the price of cars is RM 20,000 each, the supply is 1000 units
per month. When price increase to RM 30,000 each, the supply is
1200 units per month.
Therefore, the elasticity of supply of cars is :-

= % Δ QS
%ΔP
= Δ QS x P0
ΔP Q0

= Q1 - Q0 x P0
P1 - P0 Q0

= 0.4
Determinants of Price Elasticity
of Supply
1. TIME
 In the short run, supply would be inelastic, it is not
possible to increase supply immediately in response
to change in price.
 In the long run, supply would be more responsive to
price changes, i.e. is more elastic.In the long run
sellers or producers can fully adjust their supply to
the change in prices.

2. NATURE OF THE GOOD

 If it takes too long to produce a product, supply is
fairly inelastic. Otherwise supply will be elastic. For
example, the supply of agricultural product (primary
products) is fairly inelastic
 Whereas the supply of manufactured goods
(secondary products) is fairly elastic.
Cont...
3. COST AND FEASIBILITY OF STORAGE
 If the change in supply requires only a small change
in production costs, most likely supply will be elastic.
 However if the change in supply involves a major
change in costs supply tends to be inelastic.
 Goods that are too costly to be stored will have a low
elasticity of supply.

4. SUBSTITUTABILITY OF FACTORS OR INPUTS USED

 If land, labor and capital can produce one commodity
and these factors can be readily switched to produce
another good, then supply of the factors is elastic.
 But if the production of its output require very
specialized inputs, supply tends to be more elastic.
Cont..

5.PERISHABILITY
 If the product is a easily perishable,
especially agricultural product, then the supply
would be inelastic. Such products would not be
sensitive to price changes, for example,
vegetables. Hence, an increase in price will not
bring about a distinctive change or rise in the
quantity supplied.