Topic 3:

Elasticity
Elasticity

• Concept of Elasticity
• Elasticity of Demand
• Elasticity of Demand – The Application
• Price Elasticity of Supply
• Key Terms

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Concept of Elasticity
Concept of Elasticity

What is Elasticity?
Elasticity = Responsiveness
therefore,
- Elastic = Responsive
- Inelastic = Unresponsive

Analogy
- Rubber band

Elasticity is a measure of how much buyers and sellers

respond to changes in market conditions

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Concept of Elasticity

• Elasticity is a measure of how much buyers and sellers

respond to changes in market conditions

• Allows us to analyze supply and demand with greater

precision.

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Concept of Elasticity

• 3 degrees of elasticity:
– Perfectly Inelastic
– Unit Elastic
– Perfectly Elastic

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Perfectly Inelastic

Price
D1

Elasticity = 0

Quantity

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Unit Elastic

Price

Elasticity = 1

Quantity

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Perfectly Elastic

Price

Elasticity = Infinity

Quantity

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Elasticity of Demand
Elasticity of Demand

• 3 types of demand elasticity:

– Price Elasticity of Demand
– Cross Elasticity of Demand
– Income Elasticity of Demand

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PRICE ELASTICITY OF DEMAND
Price Elasticity of Demand

• Definition
• Formula
• Determinants
• How do we interpret the Price Elasticity of Demand?
• Total Revenue and Elasticity

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Price Elasticity of Demand

Definition
• It measures the rate of response quantity demanded of a
good due to a change of its price, other things remaining
the same.

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Price Elasticity of Demand
Price Elasticity of Demand (Ed)
• = % change in quantity demanded / % change in price
Step (1)
• % Q = Q1 – Q0 x 100
Q0
Step (2)
• % P = P1 – P0 X 100
P0
Step (3)
• Ed = % Q
%P
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Price Elasticity of Demand

• Where,
– Q0 – old quantity demanded
– Q1 – new quantity demanded
– P0 – old price
– P1 – new price

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Example

– Q0 – 25 Step (1)
% Q = Q1 – Q0 x 100
– Q1 – 20 Q0
– P0 – RM5 = 20 – 25 x 100 = -0.2
25
– P1 – RM10
Step (2)
% P = P1 – P0 X 100
P0
= 10 – 5 X 100 = 1
5
Step (3)
Ed = % Q = -0.2 = -0.2
%P 1

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Price Elasticity of Demand

Determinants:
• 1. The availability of substitutes
• 2. Amount of income available to spend on the good
• 3. The time elapsed since a price change

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Price Elasticity of Demand

• The availability of substitutes

– The more available of the substitutes for a goods and
services, the more elastic is the demand for it.
– E.g.: Laundry detergents
– Cars
– Creamer
– How about tobacco?
– How about water?

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Price Elasticity of Demand

• Amount of income available to spend on the goods/services

– The greater amount of income spent on a good, the more
elastic is the demand for it.
– E.g.: Chewing gum vs Housing
Eraser vs Car

The time elapsed since a price change

The longer the time that has elapsed since a price change
(more time to react to price change to find other
substitutes), the more elastic is demand.
- E.g.: sugar

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Price Elasticity of Demand

• How do we interpret Price Elasticity of Demand?

ɛp > 1 Demand is price elastic

ɛp = 1 Demand is unit elastic

ɛp < 1 Demand is price inelastic

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Elasticity of Demand: The Application
Elasticity, Total Revenue, and Demand

• The elasticity of demand tells suppliers how their total

revenue will change if their price changes.
• Total revenue equals total quantity sold multiplied by price
of good.
• TR = P x Q

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Elasticity and Total Revenue

• Total revenue is the amount paid by buyers and received by

sellers of a good.
• Computed as the price of the good times the quantity sold.

• TR = P x Q

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 Elasticity and Total Revenue
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q

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 How Total Revenue Changes When
Price Changes: Inelastic Demand
Price Price
An Increase in price … leads to an Increase in
from $1 to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand
0 100 Quantity 0 80 Quantity

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 How Total Revenue Changes When
Price Changes: Elastic Demand
Price Price
An Increase in price … leads to a decrease in
from $4 to $5 … total revenue from $200 to
$100
$5
$4

Demand Demand

Revenue = $200 Revenue = $100

0 50 0 20
Quantity Quantity

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Relationship Between Elasticity
and Total Revenue

Price Rise Price Decline

Elastic (ED > 1) TR decreases TR increases

Unit Elastic (ED = 1) TR constant TR constant

Inelastic (ED < 1) TR increases TR decreases

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CROSS ELASTICITY OF DEMAND
Cross Elasticity of Demand

• Definition
• Substitutes and Complements Goods
• Formula
• How do we interpret Cross Elasticity of Demand?

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Cross Elasticity of Demand

Definition
• It measures the rate of response of quantity demanded of a
good due to a change of a substitute or complement good,
other things remaining the same

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Cross Elasticity of Demand

Types of goods:
a) Substitutes Goods
• Goods that serve a purpose similar to that of a given item
b) Complementary Goods
• Two or more goods whose use together enhances the
satisfaction a consumer obtains from each of them

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Cross Elasticity of Demand

Formula
• Cross Elasticity of Demand
= % change in quantity demanded of a good / % change in
price of substitute or complement good
= % Q/ Q
% P / P
* P average of a substitute or complement good

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Cross Elasticity of Demand
• Cross Elasticity of Demand (Ex)
= % change in quantity demanded for good A /
% change in price for good B

• Step (1)
%  QA = Q1A – Q0A x 100
Q0A
• Step (2)
%  PB = P1B – P0B x 100
P0B
• Step (3)
Ex = % QA
%  PB

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Cross Elasticity of Demand

• Where,
– Q0A – old quantity demanded for good A
– Q1A – new quantity demanded for good A
– P0B – old price for good B
– P1B – new price for good B

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Cross Elasticity of Demand

• How do we interpret Cross Elasticity of Demand?

ɛx > 0 The two goods are substitutes

(+ ve)
ɛx = 0 The two goods are
independent
ɛx < 0 The two goods are
( - ve) complements

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INCOME ELASTICITY OF DEMAND
Income Elasticity of Demand

• Definition
• Formula
• How do we interpret Income Elasticity of Demand?

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Income Elasticity of Demand

Definition
• The Income Elasticity of Demand measures the rate of
response of quantity demand due to a raise (or lowering) in
a consumer’s income, other things remaining the same.

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Income Elasticity of Demand

Formula
• Income Elasticity of Demand
• = % change in quantity demanded /% change in income
= % Q / Q
% Y / Y

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Income Elasticity of Demand

• Income Elasticity of Demand (Ey)

= % change in quantity demanded/% change in income

• Step (1)
%  Q = Q1 – Q0 x 100
Q0
• Step (2)
%  Y = Y1 – Y0 x 100
Y0
• Step (3)
Ex = % Q
% Y
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Income Elasticity of Demand

• Where,
– Q0 – old quantity demanded
– Q1 – new quantity demanded
– Y0 – old income
– Y1 – new income

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Income Elasticity of Demand

• How do we interpret Income Elasticity of Demand?

ɛy > 1 The good is a luxury good and

(+ ve) income elastic

0 <ɛy <1 The good is a normal good and

+ve but less income inelastic
than 1
ɛy < 0 The good is an inferior good and
(- ve) income inelastic

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Price Elasticity of Supply
Elasticity of Supply

• Price Elasticity of Supply

• Definition
• Formula
• How do we interpret Elasticity of
• Supply?
• Determinants

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Elasticity of Supply

Definition
• The Price Elasticity of Supply measures the rate of response
of quantity supplied due to a price change, ceteris paribus.

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Elasticity of Supply

Formula
• Price Elasticity of Supply (Es)
= % change in quantity supplied / % change in price
= % Q / Q
% P / P

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Elasticity of Supply

• How do we interpret Elasticity of Supply?

ɛs >1 Supply is price elastic

ɛs =1 Supply is unit elastic

ɛs <1 Supply is price inelastic

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Differences in Price Elasticity
of Supply
Price Price
Perfectly elastic supply An elastic supply curve

Quantity Quantity

Price Perfectly inelastic supply Price Inelastic

Supply Curve

Quantity Quantity
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Values for price elasticity
of Supply

• When supply is perfectly inelastic a change in price has no

effect on the quantity supplied onto the market
• When supply is perfectly elastic a firm can supply any
quantity at the same market price. This occurs when the
firm can produce output at a constant cost per unit and it
has no capacity limits to its production
• When supply is relatively inelastic a change in demand
affects price more than quantity supplied
• When supply is relatively elastic. A change in demand can
be met without a change in market price

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End of Slides