1.1.

4 Elasticities
Learning objectives
Learning objectives
Learning objectives
Real world context
How might consumers respond when the price of insulin increases
significantly?
Introduction
Elasticity in economics, refers to the responsiveness of a variable as a result
of a change in another variable. In this unit, we will examine the elasticity of
demand, supply, and income.
The concept of elasticity

Demand is price inelastic when a change in Price Inelastic Demand

price leads to a proportionally lower change

in quantity demanded. In this case, 𝑃2
consumers are less responsive to changes
in price.
What are some examples of
goods/services with price inelastic 𝑃1
demand?
D inelastic
0 𝑄𝑄
2 1
Quantity
The concept of elasticity

Demand is price elastic when a change in price Price Elastic Demand

leads to a proportionally greater change in
quantity demanded. In this case, consumers are
highly responsive to changes in price.
𝑃2 D elastic
What are some examples of
𝑃1
goods/services with price inelastic
demand?

0 𝑄2 𝑄1 Quantity
Price Elasticity of Demand (PED)
To quantify the responsiveness of quantity demanded to a change in price, the
price elasticity of demand (PED) of a given good/service can be calculated
using the formula:
percentagechange ∈quantity demanded %∆ 𝑄𝑑
PED= =
percentage change ∈price %∆ 𝑃

The PED value quantifies the law of demand, hence it is always negative. The
negative sign may be omitted as the value is always negative, and only the
magnitude of the PED is of concern.
Interpretations of PED
proportionally greater
Demand is price elastic if a change in price leads to a ________________________
change in quantity demanded. Furthermore, demand is price inelastic if a
proportionally lesser
change in price leads to a ________________________ change in quantity
demanded.
Therefore, mathematically, demand is price elastic if:

or

It follows that demand is price inelastic if:

or
Applications of PED – Firm Revenue
Total revenue (TR) is the amount of
money received by firms when they
sell a good or service given by TR = P
xQ

Calculate the total revenue at point a.

$10 x 80 units = $800.

Applications of PED – Revenue for firms
1. Calculate the change in total
revenue for the following movements:

a) a to b

b) f to e

2. At which point is total revenue

maximized?
Applications of PED – Revenue for firms
PED can help firms predict the effect of a price
change on total revenue.

When demand is elastic, an increase in price

causes a fall in total revenue, while a decrease
in price causes a rise in total revenue.

When demand is inelastic, an increase in price

causes an increase in total revenue, while a
decrease in price causes a fall in total
revenue.
PED along the demand curve (HL only)
The percentage change in quantity
PED along the demand
demanded is greater at higher price Price curve
A |PED|=∞
levels, despite the gradient of the
demand curve being the same.
• As price approaches zero, the
M
percentage change in price
(denominator of PED formula),
approaches infinity. Overall, the PED
D
B |PED|=0
approaches zero.
0 Quantity
• As quantity demanded approaches
zero, the percentage change in
quantity (numerator of the PED
PED along the demand curve (HL only)
At the midpoint of the demand curve,
PED along the demand
the percentage change in quantity Price curve
A |PED|=∞
demanded (numerator) is equal to the
percentage change in price |PED|>1

(denominator). Hence, PED is equal to

|PED|=1
M
1.
|PED|<1

Thus, it follows that:

D
B |PED|=0
• At price levels above the midpoint,
0 Quantity
demand is price elastic.
• At price levels below the midpoint,
 Theoretical range of values for PED
While the PED varies in downwards-sloping linear demand curves, there are
three special cases where the PED stays constant:

Perfectly price Perfectly price Unitary price

Price elastic Price inelastic Price elastic
() () ()

D D

0 Quantity 0 Quantity 0 Quantity

Determinants of PED
The determinants of PED can be remembered through the following mnemonic:

H - Habits
I - Income
N - Necessity
T - Time
S - Substitutes
Price elasticity of supply
Price elasticity of supply measures the responsiveness of quantity supplied in
a market as a result of a change in price.

Due to the law of supply, the mathematical value for PES is always greater
than or equal to zero.
Real world context
Watch from 1:42-2:50, then 3:38-5:18
Why are avocado farms struggling to respond to rising demand?
Relatively Inelastic Supply
When a change in price leads to a proportionally Relatively Inelastic Supply
lesser change in quantity supplied, supply is
Price Sinelastic
relatively price inelastic. A relatively price
elastic supply curve will intersect the Q-axis. 𝑃2

Great
er

𝑃1

Examples of products which may be

inelastic in supply include agricultural 0
𝑄1 𝑄 2 Quantity

products e.g. avocados. Lesser

Relatively Elastic Supply
When a change in price leads to a Relatively Elastic Supply
proportionally greater change in quantity
Price
supplied, supply is relatively price elastic. A
relatively price elastic supply curve will
intersect the P-axis. 𝑃2
S elastic
Lesse
r 𝑃1

Examples of price elastic supply include

fast moving consumer goods that are
0
𝑄1 Greater 𝑄 2Quantity
often mass produced.
Unitary Elastic Supply
A supply curve passing through the origin
Unitary Elastic Supply
will always have a PES of 1 i.e., unitary Price

elastic. This can be explained through the

PES formula:

As the price and the quantity supplied are

directly proportional, the percentage change
in quantity supplied will always equal the
percentage change in demand. 0 Quantity
Perfectly Elastic Supply
A horizontal supply curve is perfectly price Perfectly price elastic (horizontal
supply)
elastic. Here, producers are willing to
Price
supply any level of output at P*. This is only
the case when marginal costs are constant
and there are no limits on productive
capacity. For perfectly elastic supply: P*
S

An example of this is computer software.

The marginal costs of creating another
copy is negligible and there is no limit on 0 Quantity

the number of copies made.

Perfectly Inelastic Supply
A vertical supply curve is perfectly price Perfectly price inelastic (vertical
supply)
inelastic. Here, supply is fixed, where S
Price
producers are only willing to supply at Q*
irrespective of the price. For perfectly
inelastic supply:
% ∆ 𝑄𝑠 0
PES = = =0
%∆𝑃 %∆𝑃

An example of perfectly inelastic supply

0 Q* Quantity
are seats in a sports stadium. Irrespective
of prices, stadiums can only supply at its
Determinants of PES
The determinants of PES include:
• Time
• Inventory
• Capacity
• Factors of Production
Determinants of PES - Time
Supply tends to be inelastic in the short run as there are several types of time
lags between the increase of price and the increase in quantity supplied:
• Time is required to produce the products

• Time is required to obtain more factors of production

• Time is needed to distribute goods to consumers

Over time, supply becomes more elastic and responsive.

Determinants of PES - Time
Primary commodities vs manufactured goods

The production time for primary commodities tends to be longer than that of secondary
manufactured goods.

Primary commodities
• Agriculture must be sowed, grown, and harvested before supply can be increased
• The extraction of precious metals and crude oil is dependent on the rate of their discovery

Manufactured goods
• Fast-moving consumer goods are made with flow (mass) production, which is easy to
increase
• Manufactured goods are often not perishable, meaning higher levels of inventory can be
kept
Determinants of PES - Inventory
Inventory refers to the stocks of
unused raw materials, work-in-
progress goods, and finished goods.
Firms that are able to hold inventory
can respond quickly to an increase in
price and can hold more inventory
when price falls.
elastic
As a result, firms who are able to hold
inelastic
inventory have relatively price
__________ supply, whereas firms who
cannot hold inventory have relatively
Determinants of PES - Inventory
Primary commodities vs manufactured goods

Primary commodities such as agricultural goods

tend to be perishable and cannot be stored for
long periods of time. As such, their supply is
relatively price inelastic.

Secondary manufactured goods often do not

perish, and hence supply is more price elastic.
Determinants of PES - Spare Capacity
Spare capacity refers to the spare available
resources a firm has but does not utilise. Firms
that choose to have spare capacity can increase
production following an increase in price, or
decrease production following a fall in price.

Firms that choose to operate at or near full

capacity are less price elastic as factors of
production are immobile in the short run.
Determinants of PES - Spare Capacity
Primary commodities vs manufactured goods
The supply of land is fixed in the short run and thus
primary producers often operate at or near full
capacity, resulting in inelastic supply.

Firms in the secondary sector can increase the

number of working hours to increase output to
respond to increases in demand, hence supply is
more elastic.
Determinants of PES - Factor Mobility
Factor mobility refers to a firm’s ability to substitute
factors of production in the production process.

When it is easier to substitute factors of production,

producers are more able to adjust supply following a
change in price.

elastic
As a result, firms with mobile factors of production
have relatively price _________ supply. Meanwhile,
firms are less able to substitute factors of
inelastic
production and hence have relatively price __________
supply.
Determinants of PES - Factor Mobility
As primary commodities are often land or
labour intensive, primary sector producers
suffer a higher degree of geographical and
occupational immobility. Additionally, capital
such as oil drills, harvesters, and tractors are
more specialised and have fewer substitutes.

Secondary manufactured goods have more

flexible and adaptable capital. Land factors
such as different plastics and metals have
many substitutes.
Real world context – group research activity
Article: The global chip shortage could last until 2023

Using the article, determine the price elasticity of supply of the automobile
market.
Real world context – group research activity
The reasons behind the IC (chip) shortage can be analyzed using the
determinants of price elasticity of supply:
‘the situation may improve for some sectors in the next six months, but that there may be
T a “knock-on effect” into 2022.’

As ICs (chips) are produced using flow (mass) production, marginal costs do not increase
R significantly as production increases.

I A failure to stockpile factors with low mobility led to the shortage of ICs.

The shortage is a result of a lack of spare capacity and “the industry is putting more
C capacity in place, but it does take time (T).”

The shortage isn't the result of a genuine lack of resources, such as a shortage of the raw
S silicon, but rather a disequilibrium between demand and supply. Rebalancing will require
expanding capacity (C) —and time (T).
Income Elasticity of Demand (YED)
To quantify the responsiveness of quantity demanded to a change in the real
income of consumers, the income elasticity of demand (YED) of a given
good/service can be calculated using the formula:

percentage change∈quantity demanded % ∆ 𝑄𝑑

YED= =
percentage change∈real income %∆𝑌

The mathematical value for YED can either be positive or negative. Therefore,
the sign of the YED value is significant and should be indicated.
Real world application
Suppose you are the manager of a department store / supermarket responsible
for selecting the range of goods and services to stock. Suggest a product
portfolio for the following two scenarios:

a) An economic boom where consumer incomes are rising.

b) An economic recession where consumer incomes are falling.

Present your work on a Google Jamboard frame

Normal goods
Normal goods refer to goods with a positive PED value, where demand
increases as consumer income increases. Normal goods can be separated into
necessities and luxury goods
Interpretations of YED – Necessities
Necessities are goods and services used to satisfy
basic needs where consumer demand does not
increase or decrease significantly with changes in
income. Hence:
0 < YED < 1

Examples may include:

• Toothpaste

• Toilet paper

• Staple foods e.g. rice, bread, and pasta

Interpretations of YED – Luxury goods
Luxury goods are goods and services used to
satisfy wants and indulgences, where consumer
demand changes significantly with changes in
income. Hence:
YED > 1

Examples may include:

• Mechanical watches
• Designer clothing
• Sports cars
Interpretations of YED – Inferior goods
Inferior goods are goods and services with more
expensive and higher quality substitutes. As incomes
rise, demand for inferior goods fall as consumers are
more willing and able to purchase better alternatives.
Hence a negative relationship:
YED < 0

Similarly, as incomes fall, demand for inferior goods

rise as consumers are less able to afford the better
alternatives and resort to the cheaper substitute.
Examples include microwave meals, instant noodles,
secondhand clothes, and canned foods.
Impact of YED on the decision-making of economic
agents
YED can be used for estimating the impact of changes in the business cycle, hence
income, on different markets:

• Necessities are less affected by business cycle fluctuations; demand stay relatively
constant.
• Luxury goods are subject to the highest volatility in demand; proportionately
stronger demand during economic booms and proportionately weaker demand in
recessions.
• Inferior goods are counter-cyclical. For example, supermarkets may increase
offerings for canned foods and microwaved meals during a recession while reducing
these during a boom and increasing inventory for exotic foods such as imported
fruits and fresh produce.
Impact of YED on the decision-making of economic
agents
YED can be used for understanding sectoral changes
as a result of higher incomes. As incomes rise:

• the primary sector providing primary commodities

(0 < YED < 1), grows at a slower rate.

• the secondary sector providing manufactured

products
(YED > 1), grows at a faster rate.

• the tertiary sector providing services (YED > 1),

likely grows at an even faster rates.