Chapter 4

Elasticity of Demand & Supply

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ELASTICITY OF DEMAND

Definition: Elasticity means responsiveness or sensitivity. Therefore elasticity of demand means the responsiveness of demand due to the changes of the factors that influence demand.

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Types of Elasticity:
Price elasticity of demand Cross elasticity of demand Income elasticity of demand Price elasticity of supply

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i.

Price Elasticity of Demand (Ep)

Ep measures the responsiveness of the quantity demanded due to the change in its price. Ep tries to measure how much does demand has decreased when price increased

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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
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Example: Price(RM) 2.00 3.00

Quantity Demanded 10 5

Calculate the price elasticity of demand when price increases from RM2.00 to RM3.00.
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Formula: Ep = - Q x P0 P Q0 = - (Q1 Q0) x P0 (P1 P0) Q0 = - (5 10) x 2 (3 2) 10 = 1

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Degrees of Price Elasticity of Demand

Elastic demand (Ep > 1)

Percentage change in quantity demanded is greater then the percentage change in price. P % Q > % P
D

D
Q
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ii.

Inelastic demand (Ep < 1)

Percentage change in quantity is less than the percentage change in price.
P D

% Q < % P

D Q

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iii.

Unitary elastic (Ep = 1)

Percentage change in quantity demanded is equal to the percentage change in price.

P

% Q = % P

D X

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iv.

Perfectly Elastic (Ep = )

Percentage change in quantity demanded is infinite in relation to the percentage change in price.
P

P0

Q
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v.

Perfectly Inelastic (Ep = 0 )

Quantity demanded does not change as the price changes.
P D

P2

P1

Q0

Q
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Determinants of Price Elasticity of Demand

Availability of substitutes

Normally, the larger the number of substitutes available, the greater the elasticity of demand for a product. When substitutes are not readily available, the elasticity of demand is likely to be less.

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. Examples are cars, electrical appliances and other luxury goods. Therefore a small increase in the price of the goods will have a very large effect on the demand for the goods.
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The amount of time available to adjust to the price change (Time dimension) In the short run, demand is less elastic. In the long run demand is likely to be more elastic simply because consumers can make adjustment and fine other substitutes.

The importance of goods necessity or luxury The demand for necessity such as rice is inelastic, great increase in price will not reduce the demand for rice very much. On the other hand the demand for luxury goods or less important goods are elastic.

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Income level

Those with higher income are less sensitive to price changes, therefore their demand is inelastic. Whereas those from lower income group are sensitive to price changes and their demand is more elastic.

Habits If goods consume becomes habits, the demand for the particular goods are inelastic. Example is demand for cigarette by smokers.

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Relationship between price elasticity of demand and total revenue (TR)

TR = price x quantity TR increases or decreases when there is price changes depend on the price elasticity of demand. i. ii. iii. If demand is elastic, to increase TR, price should be decreased. If demand is inelastic, to increase TR, price should be increased. If demand is unitary elastic, change in price would not affect and change in TR.

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Income Elasticity of Demand (Ey)

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
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Formula: Ey = = =

% in Q % in Y Q x Y Y Q (Q1 Q0) x Y0 (Y1 Y0) Q0

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Example: Income 100 120 150

Qty A 10 15 17

Qty B 20 20 20

Qty C 20 18 14

Calculate the income elasticity of demand for goods A, B and C when income increases from RM120 to RM150.

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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

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Good B: Ey =

(QB1 QB0) x Y0 (Y1 Y0) QB0

(20 20) (150 120) 0 x 120 20

= good)

(Good B is inferior

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Good C: Ey =

(QC1 QC0) x Y0 (Y1 Y0) QC0 x 120 15

= =

(14 15) (150 120) - 0.27

Good C is an inferior good

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Cross Elasticity of Demand (Ec)

Ec measures the responsiveness of quantity demanded for one product to a change in the price of another product. Qx = f(Py) Two possibilities: Ec = +ve - an increase in Py would increase the demand for good x, goods x and y are substitutes

Ec = -ve - an increae in Py would reduce the demand for good x, goods x and y are complementary goods.
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Formula: Ec = % in Qx % in Py = Qx x Py0 Py Qx0 = (Qx1 Qx0) x Py0 (Py1 Py0) Qx0

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Example: Price of Y RM10 RM18 RM25

Quantity x 60 40 20

Quantity Y 15 25 30

Calculate the cross elasticity of demand for good x when the price of y increases from RM18 to RM25

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Answer: Formula : = = = =

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

Py0 Qx0 x Py0 Qx0 18 25

Conclusion; If Ec is positive, goods x and y are substitutes

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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. I

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Types of Price Elasticity of Supply

Elastic Supply ( fairly elastic) % change in quantity supplied is greater than % change in price.
Es =% QS > % P

P S

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P S

2. Inelastic Supply (fairly inelastic) % change in quantity supplied is less than % change in price.
Es =% QS > % P
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S1

Unitary Elastic
% change in quantity supplied is equal to the % change in price

S2

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

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Perfectly Elastic
% change in quantity supplied is infinitely large compared to the % change in price.

P0

Q
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mathematical formula

Es

% change in quantity supplied % change in price

% QS %P QS P Q1 - Q0 P1 - P0

= =

P0 Q0

x P0 Q0

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When the price of cars in 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 := = % QS %P QS P Q1 - Q0 P1 - P0 0.4

P0 Q0

x P0 Q0

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Factors Influencing 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. However, 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.
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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.
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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.

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