Chapter 3 Elasticities of demand and supply

Chapter 3 ELASTICITIES OF DEMAND AND SUPPLY

Chapter 3, pp85-108 Reference: Ellie

3.1 Price elasticity of demand
 Explain the concept of PED: define and formula P85
 Calculate PED, change in price and change in P86
quantity
 Interpret the range of PED P87
 Explain that the steeper the demand curve the less P89
price elastic the demand curve P90
 Explain the nature of PED along straight line
downward sloping demand curve (HL) pp91-92
 Explain the determinants of PED pp92-95
 Explain how knowledge of PED is useful in helping a pp96-97
firm in making appropriate pricing decisions
 Why do primary products have lower PED than
manufactured goods? (HL) pp98

3.2 Income elasticity of demand (HL)

 Explain the concept of YED: Define and formula pp99
 Calculate YED, change in income and change in pp99
quantity
 Interpret YED: sign and numerical values pp100-101
 Draw a diagram to show Engel Law pp101-103
 Relevance of YED to firms and implication on
changes in the sectoral structure of the p104
economy(HL)
p104
3.3 Price elasticity of supply
 Explain the concept of PES: define and formula
pp105-106
 Calculate PES, change in price and change in
pp107
quantity
p108
 Interpret PES
 Determinants of PES
 Why do primary products have lower PES than
manufactured goods? (HL)

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Chapter 3 Elasticities of demand and supply

1. Price Elasticity of demand (PED)

Definition

Price elasticity of demand measures the degree of responsiveness of quantity

demanded of a good to a change in the price of the good itself, ceteris paribus. It involves
a movement along the demand curve in response to a price change.

Formula

Price elasticity of demand for good A = % in quantity demanded of good A

% in the price of good A

Calculation

Example 1 Price of good A rose from $100 to $102. Quantity demanded of good A falls
from 2000 units to 1900 units. What is the price elasticity of demand of good A of a price
rise from $100 to $102?

PED = - 5% = - 2.5
+2%
This means that a 1% rise in the price of good A will lead to a 2.5% fall in the quantity
demanded of good A.

Interpreting the coefficient of PED

The numerical sign of the price elasticity of demand for normal goods is necessarily negative.
This is because there is an inverse relationship between the price and quantity demanded of
the good. However, the negative sign is usually omitted and this convention is followed here.

If the numerical value is greater than 1, the demand for the good is price elastic i.e. for a given
change in the price of the good, there will be a more than proportionate change in the quantity
demanded of the good, ceteris paribus.

On the other hand, if the numerical value is less than one, it means that the demand for the
good is price inelastic. i.e. for a given change in the price of a good, there will be a less than
proportionate change in the quantity demanded of the good, ceteris paribus.

If the numerical value is one, it means that the price elasticity of demand for the good is
unitary i.e. for a given change in the price of a good, there will be a proportionate change in
the quantity demanded of the good, ceteris paribus.

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Chapter 3 Elasticities of demand and supply

The table below illustrates the different categories of elasticity of demand.

Category Value Characteristics Graphical Representation

Perfectly Ed = 0 Quantity demanded remains
inelastic constant as price changes

Inelastic 0 <Ed<1 A proportionate change in price

lead to a less than proportionate
change in quantity demanded

Unitary Ed=1 A proportionate change in price

lead to a proportionate change in
quantity demanded

Elastic 1<Ed< A proportionate change in price

lead to a more than proportionate
change in quantity demanded

Perfectly Ed=  Any amount will be bought at

elastic certain price but none at a higher
price

Why price elasticity of demand varies along the length of a straight-line demand
curve?

The elasticity of a downward-sloping straight-line demand varies from zero at the quantity axis to
infinity at the price axis as shown figure below. Notice that a straight line has a constant slope,
 P/Q. Therefore its reciprocal, Q/P must also be constant. The price elasticity at different
points on the demand curve can be inferred from the ratio P/Q. As price falls, the quantity demanded
increases; this will cause the ratio of P/Q to fall. Hence, the numerical value of price elasticity of
demand of a downward sloping straight line demand curve will decline as price of the good falls
Price
Figure
Ed
A
1<Ed<

Ed =1

0 <Ed<1

Ed =0 Quantity
0 B

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Chapter 3 Elasticities of demand and supply

Price Elasticity of demand and total revenue

The relationship of elasticity of demand and total revenue was put forward by French
mathematician and economist Antoine Augustin Cournot (1801-1877).

When demand is price elastic, a given percentage fall in the price will lead to a more than
proportionate increase in quantity demanded, thus causing an increase in total revenue as
shown in figure 1.
Figure 1
Price

P1
P2

D
0 Quantity
Q1 Q2

When demand is price inelastic, a given percentage fall in the price will lead to a less than
proportionate increase in quantity demanded, thus causing a decrease in total revenue as
shown in figure 2.

Figure 2

Price
D

P1
P2

0 Q1 Q2 Quantity

When the price elasticity of demand is unitary, a given percentage fall in price will lead
to a proportionate increase in quantity demanded, thus leaving total revenue unchanged
as shown in figure 3. The curve representing unitary elasticity of demand is called a
rectangular hyperbola. (refer to the Appendix 1 on p 15)

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Chapter 3 Elasticities of demand and supply

Figure 3
Price ($)

20

10
D
Quantity
40 80

Factors affecting price elasticity of demand

1. Availability of substitute goods

The greater the availability of substitutes for a good and the closer these substitutes are the more
price elastic the demand of the good.

The availability and closeness of substitutes depends on how the good is defined. A broadly defined
good has fewer substitutes and it will have a less price elastic demand. The demand for shoes, for
example, will be less elastic than the demand for running shoes. This is because there are few
substitutes for shoes but several substitutes for running shoes such as sneakers and tennis shoes.
The demand for sports shoes, however, will be less price elastic than the demand for Nikes because
the consumer has more substitutes for Nikes, such as Reebok and New Balance.

For some goods there are no close substitutes. When a diabetic needs insulin, nothing else will do.
The demand for such goods tends to be price inelastic.

Producers can make the demand for their products price inelastic through advertising, which aims at
establishing in the consumers’ minds the uniqueness of a particular product. Prices can then be
raised with a less than proportionate fall in sales, resulting in higher total revenue.

2. Luxuries vs. necessities

The price elasticity of demand is lower for necessities than for luxuries. Food may be viewed as a
necessity. On the other hand, a higher price for movie tickets may cause people to forgo going to
movies and opt instead to watching television at home; movies may be viewed as a luxury good.

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Chapter 3 Elasticities of demand and supply

3. Proportion of income spent on the product

The greater the proportion of income spent on the product, the greater is its price elasticity of
demand. If the price of a box of matches were to rise by 50% from 10 cents to 15 cents, it would
discourage very few buyers because such an amount is a minute proportion of their incomes. No
great effort would be made to look for substitutes when price increases. Demand for such goods
tends to be relatively price inelastic. However, if the price of a car were to rise from $80000 to
$120000, also by 50%, it would have an enormous effect upon sales. When the expenditure on a
good is fairly large, an increase in price would provide considerable incentive to find substitutes.
Demand for such goods tends to be relatively price elastic.

4. Durability
The greater the durability of a product, the greater its elasticity of demand will tend to be. If the price
of potatoes rises, it is not possible to eat the same potatoes twice. However, if the price of furniture
rises, we can make our existing tables and chairs last a little longer

5. Addiction
Some products such as cigarettes and liquor are habit forming. The demand for such goods will tend
to be price inelastic

6. Time
The longer the period of time under consideration, the greater would be the effect of a change in the
price of the good on the quantity demanded. There are several reasons why demand is more elastic
in the long term than in the short-term:
 News of price changes take time to percolate through the whole community;
 Habits take time to be broken;
 The commodity itself may be durable, so that the full reaction does not occur until all the
existing stock has been replaced;
 Full adjustments require a lot of time.

Figure 4 shows how demand becomes more price elastic over time. For instance, a large fall in the
price of imported cars will not make everyone discard their domestically- made cars immediately; but
as these cars are replaced, more buyers may switch to imported cars. The result may be small
response to price reduction over a month, quite a large response over a year and a massive
response over five years.

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Chapter 3 Elasticities of demand and supply

Price
Figure 4

P1

Pe E

D3
D1 D2
Quantity
0 Q3 Q2 Q1 Qe

7. Goods that have several uses

The more uses of a commodity has, the greater is its price elasticity of demand. This is because
when a product has many uses, there are many different markets on which price changes can exert
their effect. Hence, there is a greater possibility that in some of the markets substitutes may be
readily available. Electricity, for example has many uses- heating, lighting, cooking, etc. A rise in the
price of electricity might cause people not only to economize in all these areas but to substitute with
other fuels for some uses.

Reasons why the price elasticity of demand for primary commodities tends to be relatively low while
the price elasticity of demand for manufactured products tends to be relatively high. (HL)

Demand for food is price inelastic because food is a necessity. When price rises, we still need to eat
to survive. When price of food falls, there will be a less than proportionate increase in quantity
demanded of food because the amount we can consume is limited by biological constraints. The
change in quantity demanded is, therefore, minimal with any change in price.

Demand for raw materials is also price inelastic. I shall explain two reasons why demand for raw
materials tends to be price inelastic. First, the demand for raw materials such as steel is a derived
demand. Changes in quantity demanded of raw materials such as steel are governed more by
changes in the demand for the final goods such as cars and less by changes in their own prices.
Second, the cost of raw materials (such as tin cans) generally constitutes a low proportion of the total
cost of production of the final product (such as a can of coke). Thus, if there is an increase in the
price of tin metal, the producer of final product such as the coke producer is unlikely to bother very
much and demand for tin is unlikely to be curtailed.

Manufactured goods are secondary goods which are the result of processing primary goods. They
include goods such as smartphones, MP3 players, televisions, computers, cars, etc. Demand for
manufactured goods is price elastic. There are two reasons to explain this. First, the expenditure on
these goods constitutes a large percentage of the total expenditure of households. Second, they are
many substitutes for manufactured goods. For example, apple smartphones have several substitutes
such as LG, Motorola, Samsung, Sony Ericsson, etc.

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Chapter 3 Elasticities of demand and supply

As shown in figure 1 below, a fall in price from P1 to P2 would lead to a more than proportionate

increase in quantity demanded for manufactured goods, Q1 to Q3, whereas for primary products, the
same fall in price will lead to a less than proportionate increase in quantity demanded, Q1 to Q2.
Figure 1

Demand for food is price inelastic because food is a necessity. When price rises, we still need to eat
to survive. When price of food falls, there will be a less than proportionate increase in quantity
demanded of food because the amount we can consume is limited by biological constraints. The
change in quantity demanded is, therefore, minimal with any change in price.

Demand for raw materials is also price inelastic. I shall explain two reasons why demand for raw
materials tends to be price inelastic. First, the demand for raw materials such as steel is a derived
demand. Changes in quantity demanded of raw materials such as steel are governed more by
changes in the demand for the final goods such as cars and less by changes in their own prices.
Second, the cost of raw materials (such as tin cans) generally constitutes a low proportion of the total
cost of production of the final product (such as a can of coke). Thus, if there is an increase in the
price of tin metal, the producer of final product such as the coke producer is unlikely to bother very
much and demand for tin is unlikely to be curtailed.

Manufactured goods are secondary goods which are the result of processing primary goods. They
include goods such as smartphones, MP3 players, televisions, computers, cars, etc. Demand for
manufactured goods is price elastic. There are two reasons to explain this. First, the expenditure on
these goods constitutes a large percentage of the total expenditure of households. Second, they are
many substitutes for manufactured goods. For example, apple smartphones have several substitutes
such as LG, Motorola, Samsung, Sony Ericsson, etc.

As shown in figure 1 below, a fall in price from P1 to P2 would lead to a more than proportionate

increase in quantity demanded for manufactured goods, Q1 to Q3, whereas for primary products, the
same fall in price will lead to a less than proportionate increase in quantity demanded, Q1 to Q2.
Figure 1 (Not provided)

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Chapter 3 Elasticities of demand and supply

2. Income Elasticity of demand (YED) (HL)

Definition

Income elasticity of demand measures the degree of responsiveness of demand of a good to a

change in income, ceteris paribus. It involves a shift in the demand curve in response to changes in
income

Formula

Income elasticity of demand = % in quantity demanded of a good

% change in income

Calculation

Example Income rises from $1000 to $1100. Quantity demanded for good A rises from 50
units to 60 units. What is the income elasticity of demand of good A of an increase in income from
$1000 to $1100?

Interpreting the coefficient of YED

The numerical value of income elasticity of demand may be positive or negative.

Positive income elasticity of demand means that as income increases the demand for the good
increases. Goods with positive income elasticity of demand are called normal goods. Hence, an
increase in income will cause the demand curve for normal goods to shift to the right.

Negative income elasticity of demand means that as income increases the demand for the good falls.
Goods with negative income elasticity of demand are called inferior goods. Hence, an increase in
income will cause the demand curve for inferior goods to shift to the left.

Ernst Engel, a German statistician, divided normal goods into two types: luxury goods and
necessities. The income elasticity of demand for luxury goods, such as recreation, is greater than
one. i.e. for a given increase in income, there will be a more than proportionate increase in the
quantity demanded of the good. The demand for luxury goods is therefore described as income
elastic. The income elasticity of demand for necessities, such as food, is less than one but greater
than zero. i.e. for a given increase in income there will be a less than proportionate increase in
quantity demanded of the good . The demand for necessities is therefore said to be income inelastic.
Engel also pointed out that while the expenditure on food increases in absolute terms as income
increases, it declines as a proportion of total income. This is called the Engel Law.

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Chapter 3 Elasticities of demand and supply

Figure 5 shows the relationship between income and quantity demanded of a good

Figure 5

Quantity demanded Luxury good

Necessities

Inferior good

0 Income

Engel also noted that the numerical values and signs of income elasticity of demand for a good may
change as income changes i.e. the good can be a luxury good at low income and an inferior good at
a high income. This is illustrated in figure 6. This curve is called the Engel Curve. Consider a product
like potatoes. If an economy is very poor then as income rises, people will be pleased to eat more
potatoes; therefore, potatoes will be a normal good. As income continues to increase, people will buy
other types of food to supplement their diet; the demand for potatoes remains constant. There is
therefore zero income elasticity. As the economy becomes richer, people consume large quantities of
meat and other vegetables and they need less potatoes. The income elasticity of demand for
potatoes will become negative.

This example helps to emphasize that income elasticity of a good is related to standard of living. As
income rises in the less developed countries, one would expect the demand for such goods as
television sets, cars and refrigerators to move into the range of high positive income elasticities of
demand; while in the richer countries, the demand for these goods have become income inelastic

Figure 6
Quantity demanded

YED =0

YED>0 YED <0

Income
0 Q1 Q2

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Chapter 3 Elasticities of demand and supply

4. Uses of the PED and YED concepts to a businessman

Price Elasticity of demand

It will assist the firm in selecting an appropriate price policy. For example, if the demand for the good
is price elastic, the firm should lower the price of the good in order to increase the total revenue. This
is because a fall in the price of the good will lead to a more than proportionate increase in the
quantity demanded. Hence, firms selling luxury goods; goods for which there are many substitutes;
and goods that make up a large percentage of the total expenditure should lower its price in order to
increase its revenue. On the other hand, if the demand for the good is price inelastic, it should raise
the price of the good in order to increase the total revenue of the firm. This is because a rise in the
price of the good will lead to a less than proportionate fall in the quantity demanded. Hence, firms
selling necessities; goods for which there are few substitutes; and goods that make up a small
percentage of the total expenditure should raise its price in order to increase their revenue.

Second, it helps the firm determine exactly how much quantity demanded will change if it alters the
price of its product. For example, if the numerical value of price elasticity of demand of its mobile
phone is 2, it means that if the firm lowers the price by 10%, the quantity demanded would increase
by 20% and the firm will therefore have to expand its output by 20%.

Third, the govt may apply PED to assess the effectiveness of policies imposed on producers for
goods and services. The govt may want to impose a tax on goods to discourage consumption of
certain goods and services as the imposition of tax increases the price of the good. For example,
taxes are being imposed on cigarettes in Singapore to reduce the consumption of cigarettes.
However, the demand for cigarettes price inelastic as its habit-forming. In view of this the govt. must
impose a larger amount of tax for it to be effective in reducing consumption.

On the other hand, the govt may want to provide a subsidy for goods to encourage consumption of
certain goods and services as the provision of a subsidy decreases the price of the good. For
example, the subsidy is provided on training courses for mid-career workers (i.e workers age above
40) in Singapore to encourage them to learn new industrial skills or knowledge. However, the
demand for training courses may be price inelastic as the training courses fee may take up a large
proportion of workers’ income (e.g. approx. $8000-$10000 for a post-graduate diploma course). In
view of this the govt. must provide a larger amount of subsidy for it to be effective in encouraging
consumption

Income elasticity of demand (HL students)

It will assist the firm in selecting the types of goods it should sell as a result of a change in income.
During a boom, it should sell goods for which income elasticity of demand is positive and elastic. The
rise in income during a boom will lead to a more than proportionate increase in the demand for the
good and hence the revenue of the firm. On the other hand, in a recession, firms should sell more
inferior goods. This is because the demand for such goods increases as income falls.

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Chapter 3 Elasticities of demand and supply

It helps the firm to determine exactly how much quantity demanded of its product will change if there
is a change in income. For example, if the numerical value of income elasticity of demand of its
mobile phone is 1.5, it means that if the income rises by 10%, the quantity demanded would increase
by 15% and the firm will therefore have to expand its output by 15%.
.

Limitations

The prediction of the estimates of elasticity of data, however, may not be accurate because they are
based on the assumption of ceteris paribus which is unrealistic. In the real world, the factors affecting
demand for a good may change at the same time. This will make the estimates of price, cross and
income elasticity of demand less accurate. For e.g. when a firm lowers its price, competitors may
retaliate and cut their prices; the resulting percentage change in quantity demanded is less than what
is suggested by the numerical coefficient of estimates of price elasticity of demand. Similarly, a rise in
income may lead to an increase in quantity demanded of a normal good that is lower or higher than
that predicted by income elasticity of demand because the other factors affecting the demand for the
good may have also changed

In conclusion, while an understanding of elasticity of demand helps firms make appropriate price and
output changes so that they can maximize their total revenue and profits, firms should exercise
caution in using these values as the basis for decision-making because in the real-world factors
affecting demand may change at the same time.

HL students
Discuss the relevance of YED to firms and discuss the changes in the sectoral structure of an
economy. Ellie Tragakes Pp101-103

The differing YED will also help us to understand how the relative share of output of different sectors
of the economy changes as income grows.

Since the YED of primary products such as food is positive but less than one, as income grows over
time, the demand for primary products grows more slowly than the growth in income. On the other
hand, during a boom demand for manufactured goods such as cars, television and computers, which
has YED greater than one will grow faster than the growth in income. Since services have higher
positive YED than manufactured goods, the demand for services will grow faster than manufactured
goods during a boom.

Hence, as an economy grows over time, (i.e. increase in real GDP), the share of output of the service
sector will grow at the expense of both primary and manufacturing sectors.

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Chapter 3 Elasticities of demand and supply

B) PRICE ELASTICITY OF SUPPLY (PES)

Definition

Price elasticity of supply measures responsiveness of quantity supplied to a change in the price of
good, ceteris paribus.

Formula
Price elasticity of supply for good A = % in quantity supplied of good A
% in the price of good A

= Q/Q or Q  P
P/P P Q
Calculation
Example
Price of good A fell from $8 to $7. Quantity supplied of good A fell from 60 units to 50 units. What is
the price elasticity of supply of good A of a price fall from $8 to $7? Why is the price elasticity of
supply positive?

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Chapter 3 Elasticities of demand and supply

Interpreting the coefficient of PES

The coefficient for elasticity of supply is positive because of the direct relationship between price of
the good and the quantity supplied of the good itself. The table below illustrates the different
categories of elasticity of supply.

Category Value Characteristics Graphical Representation

Perfectly Es = 0 Quantity supplied remains constant as
inelastic price changes

Inelastic 0 <Es<1 A proportionate change in price lead to

a less than proportionate change in
quantity supplied

Unitary Es=1 A proportionate change in price lead to

a proportionate change in quantity
supplied

Elastic 1<Es< A proportionate change in price lead to

a more than proportionate change in
quantity supplied

Perfectly Es=  Any amount will be supplied at certain

elastic price but none at a lower price

Figure 1: Different elasticities of supply

Es =0
Price
Es<1

Es=1
Es>1
Es=

0 Quantity

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Chapter 3 Elasticities of demand and supply

Factors affecting elasticity of supply

1. Time
The shorter the time period, the more inelastic the supply is. During the late 1970s, when
skateboarding first become a craze. Suppliers were overwhelmed with orders. Firms were initially
unable to expand production sufficiently to cope with demand. Supply elasticity was low. In the
longer-term new firms came into the market, existing firms expanded their production facilities and
price elasticity of supply rose. Another example is the case with agricultural products which require a
long gestation period.

2. Existence of spare capacity

In the short run firms and industries with spare productive capacity will tend to have higher price
elasticity of supply. However, shortages of factor inputs (skilled workers, components, fuel) will often
lead to price inelastic supply.

3. Availability of stocks
Where a product can be stored cheaply with minimum loss of quality, supply will tend to be elastic
while stocks last. This explains why supply of processed food will tend to be more elastic than supply
of fresh food

4. Factor mobility
The higher the factor mobility, the more elastic will be the supply. When it is easy to divert resources
into the production of a good, the supply will be relatively elastic.

5. Behaviour of cost as output expands (HL)

When firms are subject to relatively small increases in average costs as output expands supply will
tend to be more elastic. On the other hand, if firms experience severe diseconomies of scale and
costs rise steeply as output expands, supply will tend to be less elastic.

6. Barriers to entry (HL)

In certain cases, it might be difficult for additional firms to enter an industry and undertake production.
These barriers might take a variety of forms. (These will be covered under monopoly and oligopoly in
Term 2). Their existence will tend to make supply less elastic than otherwise.

Reasons for low price elasticity of supply of primary products (HL students)

The supply of agricultural products is price inelastic. This means that a change in the price of the
good, will lead to a less than proportionate change in the quantity supplied of the good. The supply
for agricultural products is price inelastic because of the long gestation period for most crops. For
example, it takes seven years for rubber trees to mature. Similarly, the supply of most minerals is
also price inelastic because the sinking of new mines and the extension of the existing ones is a
lengthy procedure. 

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Chapter 3 Elasticities of demand and supply

Reasons for high price elasticity of supply of manufactured products (HL students)

The supply of manufactured products, on the other hand, is price elastic. This means that, a change
in the price of the good, will lead to a more than proportionate change in the quantity supplied of the
good. This is because output of manufactured goods can be easily increased by employing more
variable factors such as labor or introduction of overtime work.
Furthermore, manufactured goods like processed food can be stored without loss of quality or undue
expense over a longer period than fresh food. This explains why the supply of processed food tends
to be price elastic than fresh food. 

Self-Assessment Practice

Nov 2019HP1/TZ0/Q1
(a) Using real life examples, Explain two reasons why the demand for primary
commodities might be price inelastic. [10] (HL)

(b) Using real life examples, Discuss the significance of price elasticity of demand
(PED) for a government imposing an indirect tax on a good.[15]

May2019HP1/TZ1/Q1
(a) Using real life examples, Explain why price elasticity of demand varies along the
length of a straight-line demand curve. [10] (HL)

(b) Using real life examples, Examine the significance of price elasticity of demand for
the decision-making of firms and governments.[15]

(a) Using real life examples, Explain why PED for primary products is often relatively low
while PED for manufactured goods is often relatively high [10] HL
(b) Using real-life examples, discuss the importance of PED in business decision-
making.[15]

“The income elasticity of demand for primary products tends to be lower than that for
manufactured products and services.” With reference to real life examples, examine the
implications of this for producers and for the economy as a whole. [15] (HL)

16