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
Q 2 Q1
% change in quantity dem anded x 100%
Q1
P2 P1
% ch an g e in p rice x 100%
P1
% ch an g e in q u an tity d em an d ed
p rice elasticity o f d em an d
% ch an g e in p rice
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
% ch an g e in q u an tity d em an d ed
p rice elasticity o f d em an d
% ch an g e in p rice
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
Price Demand
RM5
RM4
1. An
increase
in price . . .
0 100 Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learn
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 Learn
The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than
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
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
Defining totalConsumer Expenditure
consumer expenditure
TR = P × Q
Profit = TR – TC
Illustrating TR graphically
4 Consumer’s Total
P($) Expenditure = Firms’ Total
3
Revenue
= 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 P falls: TE rises
falls
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.
Percentage change
in quantity dem anded
Incom e elasticity of dem and =
Percentage change
in incom 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 ercentage change
in quantity supplied
P rice elasticity of supply =
P ercentage change in price
Types of Supply Elasticity
(a) Perfectly Inelastic Supply: Elasticity Equals
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 Min price( floor)
cream $4.00
$3.00
Max price
$2.00 (ceiling)
shortage
D
Q
100
Quantity
of ice
creams
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
