CHAP T

ER 3 ECO415
 ELASTICITY & ITS
APPLICATION

3.1Price elasticity of 3.2Cross elasticity of

demand demand
 Measurement and • Measurement and
interpretation interpretation
(calculation) (calculation)
 Degree of elasticity of supply
 Determinants of price elasticity of
supply
3.3Income
elasticity of
demand
• Measurement and interpretation
(calculation)

3.4Price elasticity of
supply
 Measurement and interpretation
(calculation)
 Degree of elasticity of supply
 Determinants of price elasticity of
supply
ELASTICITY – THE CONCEPT

• The responsiveness of one variable to

changes in another.
• When price rises, what happens to demand?
• Demand falls..
• BUT!
• How much does demand fall?
ELASTICITY – THE CONCEPT

• If price rises by 10% - what

happens to demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent to
which demand will change..
 PRICE ELASTICITY OF
DEMAND

•The responsiveness of demand to

changes in price
•To measure the responsiveness
of quantity demanded to
changes in its own price.
The Formula:
% Change in Quantity Demanded_
Ped = % Change in Price
• Where % change in demand is
greater than % change in price –
elastic
• Where % change in demand is less than
%
change in price - inelastic

Note: PED has –ve sign in front of it; because as

price rises demand falls and vice-versa (inverse
relationship between price and demand – LAW
OF DEMAND)
 The demand curve
can be a range of
shapes each of
Price (RM) differe relations
Perfectly Inelastic = 0 nt pric an th
quantity

Elastic = > 1

Unitary Elastic = 1
Inelastic < 1
Degree Description Value of Slope of demand
coefficient curve
P

If the answer is between –

Elastic %  Qd  %  1  p   P 1 and infinity: the
P
Q relationship
Q
P
is elastic

P
Inelastic %  Qd  %  0  p  1 If answer is between 0
Q
P Q and -1: the relationship is
%  Qd = %  p = 1
P inelastic
Unitary P
P

Q
Q
P
The reason to
Perfectly Any increase in p =  P compute price
elastic P will cause the
Qd to be 0. Q
Q
elasticity is to find
Price is fixed
P out the sensitiveness
Perfectly Any change in p = 0  of market demand
inelastic P will not P
change the Qd.  toward changes in
Q
Qty demanded
is fixed.
Q price. The degrees of
price elasticity
 CROSS ELASTICITY OF
DEMAND
• The responsiveness of demand of one good to
changes in the price of a related good – either
a substitute or a complement.
• To measure the responsiveness of quantity
demanded to changes in the price of other
goods.

The Formula:
 % Δ Qd of good t
Xed = % Δ Price of good y
 Goods which are complements:
 Cross Elasticity will have negative sign
(inverse relationship between the two).
Goods which are substitutes:
 Cross Elasticity will have a positive sign
(positive relationship between the two).

The to comput cros

relationship between good x and good y given that
e there is a chan
s
Value of Relationship Description reason
coefficient

Positive Substitute Py  , Qy  ; Qx 

Negative Complementary Py  , Qy  ; Qx 

Zero Not related Py  , Qy  ; no

change in Qx
 INCOME ELASTICITY OF
DEMAND
 The responsiveness of demand to changes in
incomes.
 To measure the responsiveness of quantity
demanded to changes in income.

The Formula:

Yed = % Change in Quantity Demanded

% Change in Income
 A positive sign denotes a normal good.
Normal Good – demand rises as income rises
and vice versa.

A negative sign denotes an inferior good.

Inferior Good – demand falls as income rises
and vice versa.
Value of Type Description
coefficient

Positive Luxury goods I  , big  in Qd The reason to compute

i  1
Positive Normal goods I  , small  in Qd income elasticity is to
i  1 identify the type of
Zero Necessity goods I  , no change in Qd
i = 0 goods being demanded
given that there is a
Negative Inferior goods I  , Qd 
•For example:

• Yed = + 1.6: Good is a normal good and elastic

- a rise in incomes of 3% would lead to demand rising
by 4.8%
• Yed = - 2.1: Good is an inferior good and elastic
- a rise in incomes of 3% would lead to a fall in
demand of 6.3%
• Yed = + 0.4: Good is a normal good but inelastic
- a rise in incomes of 3% would lead to demand rising
by 1.2%
• Yed = - 0.6: Good is an inferior good but inelastic
- a rise in income of 3% would lead to demand falling
by 1.8%
 DETERMINANTS OF
ELASTICITY OF
DEMAND
1. Availability of substitutes
• Demand is more elastic when more substitutes for
the product are
available.
• The greater the number of substitutes, the more
elastic.

2. Relative importance of the item in the budget

• Demand is more elastic when the item
 takes a more significant portion of the
consumer’s budget.
• The smaller the proportion the more inelastic.
3. Time frame
• Demand becomes more elastic over longer time
period. More time to find information and
substitutes.
• Thelonger the time under consideration the
more elastic a
good is likely to be.

4. The degree of necessity or luxury

• Demand is less elastic when the item
is considered necessity goods - for example,
handbags vs rice, jeans vs sugar.

5. Consumption habit / Brand loyalty

• Demand is less elastic when the item is
consumed habitually or loyally - for example,
cigarettes, shampoo.
 PRICE ELASTICITY OF
SUPPLY
• The responsiveness of supply to changes in price.
• To measure the responsiveness of quantity
supplied to changes in its own price.

The Formula:

%  Qs percentage change in quantity supplied

%P =
percentage change in price
 Degree Description Value of Slope of supply curve
coefficient
P
Where % change in
supply is greater than %
Elastic %  Qs  %  P 1  s 
change in price – elastic
 Q
P

Inelastic %  Qs  %  P 0  s  1
Q Where % change in
P
supply is less than %
change in price - inelastic
Unitary %  Qs = %  P s = 1
Q
P

Perfectly At level P, Qs is s =  P
elastic 
Q
Q
P


Perfectly No change in s = 0 P
inelastic Qs although P 
changes Q
Q
 DETERMINANTS OF
ELASTICITY OF SUPPLY

1. The change in cost of production

 If change in production cost is small, supply
will be elastic (consumer goods).
 If change in production cost is big, supply will be inelastic
(agricultural products).

2. Substitutability of inputs used

 If inputs can be easily substituted, supply will be elastic.
 If inputs cannot be substituted, supply will be inelastic.
 3. Period of production process
 If production process is short, supply will be elastic
(stationary).
 If production process is long, supply will be inelastic
(rubber).

4. Time frame for supply- (tomatoes)

 Momentary time period – supply is perfectly inelastic.
 Short run time period – supply is fairly inelastic.
 Long run time period – supply is fairly elastic.

5. Degree of perishability
 If a product is highly perishable (agri. goods), supply is
 inelastic.
 If a product is non-perishable (manufactured goods),
supply is elastic.
 TUTORIAL

1. If the price of original VCD falls from RM 15 to

RM 10, the quantity supplied declines by
20%. Compute the price elasticity of supply.
State the degree of elasticity.
2. Given that the price elasticity of supply is 1.5
and quantity supplied falls by 30%. Compute
the percentage change of price.
RELATIONSHIP BETWEEN
TOTAL REVENUE AND PED
The importance of elasticity
is the information it
Price provides on the effect on
total revenue of changes in
price.
Total revenue is price x
quantity sold. In this
RM
5 example, TR = RM5 x 100
UNIT = RM5,000.

Total Revenue This value is represented

 D

100 Quantity Demanded (000s)

 Changes in TR as changed in prices

Price If the firm decides to

decrease price to (say)
RM3, the degree of price
elasticity of the demand
curve would determine the
RM
5 extent of the increase in
demand and the change
RM
therefore in total revenue.
3

Total Revenue
D
100 140
Quantity Demanded (000s)
 Producer decides to lower price to
attract sales

Price
(RM)

% Δ Price = -50%
10

% Δ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)

5 Total Revenue would ll

fa
Not a good move!
5 6 Quantity Demanded
 Producer decides to reduce price to
increase sales

Price (RM)

% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D
5 20
Quantity Demanded
 TUTORIAL – PED, XED, YED
1. The data below shows the relationship between the price of good A
and quantity demanded of good A, B, C , and the level of income.

Price GOOD GOOD GOOD Income

of A A B C
1 50 25 20 1000
2 40 30 20 750
3 30 35 20 500
4 20 40 20 250
a) Calculate the price elasticity of demand for good A when its price
decreases from RM 3 to RM 2 . What is the degree of elasticity?
b) Calculate the cross elasticity for good B when the price of A increases
from RM 2 to RM
4. What is the relationship between good A and B ?
c) The relationship between good A and good C is
d) Calculate income elasticity for good B when income rises from RM
750 to RM 1000.
What is the type of good B ?
25
2. The schedule below shows the relationship between the price of
Good X and the quantity demanded for Good X, Good Y, and Good D.

Price of X Qty of X Qty of Y Qty of Z

(RM) (unit) (unit) (unit)
4.00 18 12 30
5.00 15 16 24
6.00 11 25 17

a) Compute the price elasticity of demand for Good X when the price
of X decreases
from RM 5 to RM 4. State the degree of elasticity.
b) Compute the cross elasticity of demand for Good Y when the price of
X increases from RM 5 to RM 6. State the relationship between the
two goods.
c) The relationship between Good X and Good Z is
d) State the type of good given the followings;
e) %  of Qd when the %  of income
f) in the %  of Qd  in the %  of income
g) Given Mr. GQ’s level ofincome increased from RM 5000 to RM 6000,
monthly expenses on his hobby also rose by 40%. Compute the
income elasticity for Mr. GQ.

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 TUTORIAL - PES

1. If the price of original VCD falls from RM 15 to RM 10, the

quantity supplied declines by 20%. Compute the price
elasticity of supply. State the degree of elasticity.
2. Given that the price elasticity of supply is 1.5 and quantity
supplied falls by 30%. Compute the percentage change of
price.
27
SUMMARY – TR AND PED
When demand is elastic ; % 
Qd  %  P P , Qd  : TR 
P , Qd  : TR 

When demand is inelastic ; % P  %  Qd

P , Qd  : TR 
P , Qd  : TR 

When demand is unitary ;  %  P = %  Qd

P , Qd  : TR unchanged

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