Principle of Economics

LU3: Elasticity
 Learning Objectives
At the end of the lecture class, students will be
able to:

1. Define the meaning of elasticity

2. Identify the determinants of elasticity
demand and supply
3. Illustrate the elasticity demand and supply
curve based on different scenarios
 Elasticity

 Elasticity is a general concept that can be used to

quantify the response in one variable when
another variable changes.

 Allows one to analyze supply and demand with

greater precision and it is a measure of how much
buyers and sellers respond to changes in market
conditions.

 -RESPONSIVENESS-
 Price Elasticity of Demand
• Measure the responsiveness of Qd to changes in Price.

• E.g., If Price changes by 10%, Qd will also changes by how

much? (more, less or equal to 10%)

 Price elasticity of demand is the percentage change in

quantity demanded given a percent change in the price.

 The value of demand elasticity is always negative, but it is

stated in absolute terms.
• Measuring the elasticity:
 Calculating Elasticities
PED = ∆Q/Q ÷∆P/P
= ∆Q/Q × P/ ∆P
OR
Q2  Q
% c h a n g e in q u a n tity d e m a n d e d  1
x 100%
Q1

P2  P1
% c h a n g e in p ric e  x 100%
P1

% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d 
% c h a n g e in p ric e
  Q  P
Elasticity  
Q P P

10 1
 
60 5
10 5 P1 = 5
 
60 1
5
 P2 = 4
6
 0 . 83 ( inelastic )
OR
D1
10
%  Q   100 %  17 %
60
1
%  P   100  20 % O Q1 = 60 Q2 = 70 Q
5
17
  0 . 825 ( inelastic )
20
 p  0 . 825
Product A currently sold at
RM5/unit. The Qd at this price
is 1,700 units. If the price fall to
RM4.60, the Qd is expected to
increase to 2,000 units. Calculate
its PED?
 Calculating Elasticities
Midpoint Formula
Q2  Q1
% changes in quantity demanded   100%
 Q1  Q2 
2

P2  P1
% changes in price  100%
 P1  P2 
2
% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d 
% c h a n g e in p ric e
 Calculating Elasticities
Midpoint Formula
P

P1 = 3
Q2  5 ; Q1  10 P2  $3 ; P1  $2
P2 = 2

D1

O Q1 = 5 Q2 = 10 Q

5  10  5
%  Q   100 %   100 %   66 . 7 %
10  5  7 .5
2

3  2 1
%  P   100 %   100 %  40 . 0 %
2  3  2 .5
2
 66 . 7 %
 p    1 . 67
40 . 0 %
 Types of Demand Elasticity
 Perfectly Inelastic - Quantity demanded does not respond
to price changes.

 Perfectly Elastic - Quantity demanded changes infinitely

with any change in price.

 Unit Elastic - Quantity demanded changes by the same

percentage as the price.

 Inelastic Demand
– Quantity demanded does not respond strongly to price
changes.
– Price elasticity of demand is less than one.

 Elastic Demand
– Quantity demanded responds strongly to changes in
price.
– Price elasticity of demand is greater than one
 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand:Elasticity Equals 0

Price Demand

RM5

RM4

1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright©2003 Southwestern/Thomson Learning

 The Price Elasticity of Demand
(b) Inelastic Demand
Price

RM5

RM4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity
2. . . . leads to an 11% decrease in quantity demanded.
 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price

RM5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Copyright©2003 Southwestern/Thomson Learning

 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price

RM5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals
Infinity
Price

1. At any price
above RM4, quantity
demanded is zero.
RM4 Demand

2. At exactly RM4,
consumers will
buy any quantity.

0 Quantity
3. At a price below RM4,
quantity demanded is infinite.
 Elasticity Changes along a
Straight-Line Demand Curve
 Price elasticity
of demand
decreases as we
move downward
along a straight
line demand
curve.

 Demand is
elastic in the
upper range and
inelastic in the
lower range of
the line.
 Elasticity of Demand
Demand tends to be more elastic :

1.the larger the number of close substitutes

 
 The more substitute goods there are for a
good, especially close substitutes, the more
elastic will be the price elasticity of demand
for the good.

 For example, in a grocery shop, a rise in the

price of one vegetable such as carrots or
cucumbers is likely to result in a switch of
customer demand to other vegetables, many
vegetables being fairly close substitutes for
each other.
 Elasticity of Demand
Demand tends to be more elastic :

2.good is a luxury

3.the longer the time period

- The time horizon influence elasticity largely
because the longer the period of time which
we consider, the greater the knowledge of
substitution possibilities by consumers and
the provision of substitutes by producers.
 Price Elasticity of Demand and
Total Consumer Expenditure
 Defining total consumer expenditure

 TR = P × Q

Profit = TR – TC
 Illustrating TR graphically
4 Consumer’s Total Expenditure
P($) = Firms’ Total Revenue
3
= RM( 2m x 3m) = RM6m

1 D

0 Q
0 1 2 3 4 5
Elastic demand between two points
P($)
P($)
Expenditure falls Expenditure rises
as price rises as price falls

b b
5 5
a a
4 D 4 D

0 10 20 Q 0 10 20 Q

P rises: TE falls P falls: TE rises

Summary effects of a price change:

Elastic Demand
Inelastic demand between two points
P($)
P($)
Expenditure rises
as price rises Expenditure falls
as price falls

c
c 8
8

a a
4 4

D D

0 15 20 Q 0 15 20 Q

P rises: TE rises P falls: TE falls

Effects of a price change:

Inelastic Demand
 Applications to Pricing Decisions
Because price elasticity is significant for revenues,
obviously businessman need to know how consumers will
react to pricing decisions, not least because of the
effect of this on profits.

 Government policy-makers need to have information

about elasticity when making decisions about indirect
taxation.

Items with low price elasticity of demand such as

cigarettes and alcohol tend to useful target for taxation
since by increasing taxes on these, total revenue can be
increased. If cigarettes were price elastic, then increase
in taxation would be counter-productive as they would
result in lower government revenue.
 Income Elasticity of Demand

 Income elasticity of demand measures how much the

quantity demanded of a good responds to a change
in consumers’ income.

 It is computed as the percentage change in the

quantity demanded divided by the percentage change in
income.

 A good is income elastic if income elasticity is greater

than 1 so that quantity demanded rises by a larger
percentage than the rise in income. For example, if
household income rises by 7% and the demand for
compact discs will rise by 10% we would say that
compact discs are income elastic.
 Income Elasticity of Demand
 A good is income inelastic if income elasticity is between
0 and 1 and the quantity demanded rises less than the
proportionate increase in income. For example, the
demand for books will rise by 6% if household income
rises by 10%, we would say that books are income
inelastic.

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
 Income Elasticity of Demand
 Types of Goods

Normal Goods
– Goods which are income elastic are said to be normal
goods, which means that demand for them will rise
when household income rises, and so they have a
positive income elasticity of demand.

Inferior Goods   
– If income elasticity is less than 0, income elasticity is
negative and the commodity is said to be an inferior
good since demand for it falls as income rises.
Positive Sign
Goods are Normal or Superior

Negative Sign
Goods are Inferior
 Income Elasticity of Demand
 Goods consumers that regard as necessities
tend to be income inelastic
– Examples include food, fuel, clothing,
utilities, and medical services.

 Goods consumers that regard as luxuries tend

to be income elastic.
– Examples include sports cars, furs, and
expensive foods.
• At RM40 per week, Mr.x consumption on
chicken is 14 Kg per week. As Mr.X
weekly household earnings increases to
RM50 per week, his consumption on
chicken increases to 16 Kg per week.
Calculate Mr.X income elasticity for the
chicken and state whether the chicken is a
necessity, luxury or inferior goods to him
and why?
 Cross Elasticity of Demand
 Refers to the responsiveness of demand for one good
to changes in the price of other good.
  Measure the responsiveness of Qd of Good X to changes in
Price of Good Y.

 If the two goods are substitutes, cross elasticity will be

greater than 0.

 If the goods are complements, cross elasticity will be

negative.
 Cross Elasticity of Demand
Cross elasticity is potentially significant where two
goods are close substitutes for each other, so that a rise
in the price B, say, is likely to result in an increase in the
demand for A.
Cross elasticity of demand between two complementary
products can also be significant because a rise in the
price of B would result in some fall in demand for A
because of the fall in the demand for B.

Positive Sign
Goods are Substitutes

Negative Sign
Goods are Complementary

Zero or Near-Zero Value

Goods are Independent
Price of Good Y increases from RM9
to RM10. As a result, Qd for
Good X increases from 100 to
127 units. Calculate the cross
elasticity of demand, and state
whether Good Y and X are
substitute or complimentary?
 The Elasticity of Supply
 Price elasticity of supply is a measure of how much
the quantity supplied of a good responds to a
change in the price of that good.

 Price elasticity of supply is the percentage change in

quantity supplied resulting from a percent change in
price.

 The price elasticity of supply is computed as the

percentage change in the quantity supplied divided by
the percentage change in price.

P e rc e n ta g e c h a n g e
in q u a n tity s u p p lie d
P ric e e la s tic ity o f s u p p ly =
P e rc e n ta g e c h a n g e in p ric e
 Types of Supply Elasticity
(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

RM5

1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

 Types of Supply Elasticity
(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
RM5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

 Types of Supply Elasticity
(c) Unit Elastic Supply: Elasticity Equals 1
Price

Supply
RM5

4
1. A 22%
increase
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

 Types of Supply Elasticity
(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply
RM5

1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

 Types of Supply Elasticity
(e) Perfectly Elastic Supply: Elasticity Equals
Infinity

Price

1. At any price
above RM4, quantity
supplied is infinite.
RM4 Supply

2. At exactly RM4,
producers will
supply any quantity.

0 Quantity
3. At a price below RM4,
quantity supplied is zero.
Determinants of Elasticity of Supply
 Ability of sellers to change the amount of
the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.

 Time period
– Supply is more elastic in the long run.This
is because in long run there will be
sufficient time for all inputs to be
increased and for new firm to enter the
industry.
 Markets Where Prices are
Controlled
1. Price Ceiling
– A legal maximum on the price at which a
good can be sold.
– Price is disallowed to rise above this
level (although it is allowed to fall below
it)

2. Price Floor
– A legal minimum on the price at which a
good can be sold.
– Price is disallowed to fall below this
level (although it is allowed to rise above
it)
PRICE PEGGING: The Market for Ice cream
surplus
Price of P S
ice cream Min price( floor)
$4.00

$3.00
Max price (ceiling)
$2.00

shortage
D
Q
100
Quantity of
ice creams
39
 Effects of Price Ceilings
 Shortages because QD > QS.
 Government will not allow price to rise as to
eliminate the shortage for fairness reason
 Example: Gasoline shortage of the 1970s
 Wartime so that poor people can afford to
buy them
 Consequences:
 Allocation on ‘first come first serve’ basis
 Firm deciding which customers should be
allowed to buy – preference
 Black markets activities
 Solution: Rationing
 Effects of Price Floor
 Surplus because QS > QD.

 Government will not allow price to fall as to

eliminate the surplus for following reason:
 To protect producer’s income [crops due to
weather; demand is price inelastic]

 To create surplus – store in preparation for

possible future shortages

 Minimum rates of pay to prevent workers’

wages from falling below a certain level
 Effects of Price Floor
 Consequences:
 Firms with surplus may try to evade the
price control and cut their prices

 High prices may cushion inefficiency – firms

feel less to find more efficient methods of
production and cut their costs if their profits
are being protected by the high price

Discourage firms from producing alternative

goods which they could produce more
efficiently or higher demand
 Effects of Price Floor
 Solutions:
 Government could buy the surplus

 Restricting producers to particular quotas

 Demand could be raised by advertising,

finding alternative uses for good or reducing
consumption of substitutes goods ( by
imposing taxes or quotas on substitutes)
 Summary
 Price elasticity of demand measures how
much the quantity demanded responds to
changes in the price.

 Price elasticity of demand is calculated as

the percentage change in quantity demanded
divided by the percentage change in price.

 If a demand curve is elastic, total revenue

falls when the price rises.

 If it is inelastic, total revenue rises as the

price rises.
 Summary
 The income elasticity of demand measures
how much the quantity demanded responds
to changes in consumers’ income.

 The cross-price elasticity of demand

measures how much the quantity demanded
of one good responds to the price of
another good.

 The price elasticity of supply measures how

much the quantity supplied responds to
changes in the price. .
 Summary
 Price controls include price ceilings and price
floors.
 A price ceiling is a legal maximum on the price
of a good or service. An example is rent
control.
 A price floor is a legal minimum on the price of
a good or a service. An example is the
minimum wage.
The End