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MICROECONOMICS

ECO162
ELASTICITY
Ms. Tai Nyuk Chin
LEARNING OUTCOMES
• At the end of this lesson, the students
should be able to:
i. Explain the concept of elasticity.
ii. Identify the types of elasticity.
iii. Identify the determinants of elasticity of
demand and supply.
iv. Define and calculate elasticity of demand
(price, income, cross) and supply.
ELASTICITY
 Four types of Elasticity:
i. Price Elasticity of Demand
ii. Income Elasticity of Demand
iii. Cross-Price Elasticity of Demand
iv. Price Elasticity of Supply
PRICE ELASTICITY OF DEMAND
1. Definition
• It is a measure of how much the quantity
demanded of a good responds to a change in
the price of that good.
• The percentage change in quantity demanded divided by
the percentage change in a good’s price.
2. Measurement :
percentage change in demand
Ed =
percentage change in price

[(Q1-QO)/QO] x 100
Ed =
[(P1-PO) /PO] x 100

 Q1 = Current quantity P1 = Current Price


 Qo = base year quantity Po = Price base year
Computing the Price Elasticity of
Demand

Price elasticity of demand  Percentagechange in quatitydemanded


Percentagechange in price

Example: If the price of an ice cream cone increases from


$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones then your elasticity of demand would be calculated as:

(8  10 )
 100
10 20 %
  2
( 2.20  2.00 ) 10 %
 100
2.00
2

:. Negative sign is ignored since its only indicates the ‘law of


demand’( P increase, Qd decrease and vice versa)
PRICE ELASTICITY OF DEMAND
• How responsive is quantity demanded to price
changes?
• Does quantity demanded change a lot, little, not
at all?
• There is five degree of elasticity to describe
how responsive demand is;
i. Elastic
ii. Inelastic
iii. Perfectly Elastic
iv. Perfectly Inelastic
v. Unit Elastic
6
Figure 6: Degree of Elasticity (Elastic demand)

(a) Elastic Demand: Elasticity Is Greater Than 1, Ed > 1


Price
 % ∆ Qd > %∆P
Elasticity, Ed>1

$5

4 Demand
1. A 25%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 50% decrease in quantity demanded.


Figure 7: Degree of Elasticity (Inelastic Demand)

(b) Inelastic Demand: Elasticity Is Less Than 1, Ed < 1

Price % ∆ Qd < %∆P


Elasticity, Ed<1

$5

4
1. A 25% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 10% decrease in quantity demanded.


Figure 8: Degree of Elasticity (Perfectly Elastic)

(c) Perfectly Elastic Demand: Elasticity Equals Infinity


Price
Elasticity, Ed = ∞
1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
Figure 9: Degree of Elasticity (Perfectly Inelastic)

(d) Perfectly Inelastic Demand: Elasticity Equals 0, Ed = 0

Price Elasticity, Ed = 0
Demand %∆P, %∆Q = 0

$5

4
1. Any
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.


Figure 10: Degree of Elasticity (Unit Elastic)

(e) Unit Elastic Demand: Elasticity Equals 1


Price Elasticity, Ed = 1
%∆P = %∆Q

$5

4
1. A 25% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 25% decrease in quantity demanded.


Determinants of
Price Elasticity of Demand
i. The existence of substitutes
• Goods with close substitutes tend to have more
elastic demand because it is easier for consumer to
change from those goods to others.
• If there are no substitutes exist, the price elasticity of
demand tends to be inelastic.
• E.g.: Coca cola and Pepsi can easily substitute each
other. Thus, a small increase in the price of Coca cola,
assuming price of Pepsi remain constant, will cause the
quantity of Coca cola sold to decrease by a large
amount. This is because, consumer will purchase Pepsi
rather than Coca cola.
Determinants of
Price Elasticity of Demand
ii. Types of Goods (Necessities vs. Luxuries)
• Necessities goods tend to have inelastic demands,
whereas luxuries goods tend to have elastic demands.
• E.g.: Price elasticity of demand for Rolex watch is
elastic as Rolex watch is considered as a luxury goods.
On the other hand, rice which is a necessities good tend
to have more inelastic demand.
• When price of Rolex increase, there will be a large
decrease in quantity demanded but if price of rice
increase, people don’t dramatically alter the
consumption of rice since rice is necessities goods.
Determinants of
Price Elasticity of Demand
iii. Time horizon.
• Goods tend to have more elastic demand over a longer
period of time horizons.
• The shorter the time period, the more inelastic demand
will become.
• This is because you will have more time to find
substitutes.
• E.g.: When the price of fuel increase, the quantity
demanded for fuel falls slightly in the first few months.
Thus the demand in short run is inelastic. However, in
longer period, people will find alternative for fuel such
as fuel-efficient cars. Thus, demand tend to be more
elastic.
Determinants of
Price Elasticity of Demand
iv. Proportion of consumer’s expenditure
• Demand tends to be more elastic when a
consumer’s expenditure on the product is large
and vice versa.
• E.g.: Demand is more elastic for products such
as cars as consumer’s proportion for cars is
large while demand for grocery items tend to
be inelastic as the proportion for this items is
smaller.
Price Elasticity of Demand and
Total Revenue (TR)
• 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.

Total Revenue (TR) = Price (P) x Quantity (Q)


TR = P x Q
Figure 11: Total Revenue

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
Elasticity and Total Revenue along a
Linear Demand Curve
• With an inelastic demand curve, an
increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.
Figure 12 How Total Revenue Changes When Price
Changes: Inelastic Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity


Elasticity and Total Revenue along a
Linear Demand Curve
• With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
Figure 13 How Total Revenue Changes When Price
Changes: Elastic Demand

Price Price

An Increase in price from $4 … leads to an decrease in


to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity
Cross Price Elasticity of Demand

Ec = % change in demand Qx
% change in price of Qy
Ec = [(Q1x-Q0x/Q0x)]
[(P1y-P0y/P0y)]

• Elasticity measure that looks at the impact of a change in


the price of one good has on the demand of another
good.
 Positive: P of Good A increase, Qdd of Good B
increase (Substitutes goods)
 Negative: P of Good A increase, Qdd of Good B
decrease (Complement goods)
Cross Price Elasticity of Demand
Ec = % change in Qd Good X x 100 Price of Qd for Qd for
% change in price of Good Y x 100 Good X Good Y Good Z
(RM) (Unit) (Unit)
[(Qdy 1-Qdy 0/Qdy 0)]x 100
Ec = 10 100 100
[(Px1-Px 0/Px 0)] x 100 12 110 70

 The Cross Price elasticity of demand for good X if price of Good X


increase from RM10 to RM12:
Good X and Good Y: Good X and Good Z:
Ec = (110 -100 / 100)x 100 Ec = (70 -100 / 100) x 100
( 12-10/10) x 100 (12-10/10) x 100
= [10/ 20] = [-30/ 20]
= 0.5 (Substitutes good) = - 1.5 (Complement good)
:. Positive value indicates that :. Negative value indicates that
good X and Good Y is a Good X and Good Z is a
substitutes goods complement goods
Income Elasticity of Demand

Ey = % change in demand Q
% change in Income
Ey =
[(Q1-Q0/Q0)]
[(Y1-Y0/Y0)]

• Income elasticity of demand measures how


much the quantity demanded of a good responds
to a change in consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
Income Elasticity of Demand
• Types of Goods
i. Normal Goods
Income Elasticity is positive.
ii. Inferior Goods
Income Elasticity is negative.
• Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded
for inferior goods.
Income Elasticity of Demand
Ey = % change in demand Q x 100 Income Qd for Qd for
% change in Income x 100 (RM) Good X Good Y
(Unit) (Unit)
Ey = [(Q1-Q0/Q0)] x 100 100 100 100
x 100 150 110 70
[(Y1-Y0/Y0)]

The income elasticity of demand for good X if The income elasticity of demand for good Y if
income increase from RM100 to RM150: income increase from RM100 to RM150:

Ey = [(110 -100) / 100] x 100 Ey = [(70 -100) / 100] x 100


[ (150-100)/100]x 100 [(150-100)/100] x 100
= [10/ 50] = (-30/50 )
= 0.2 (Normal good) = - 0.6 (Inferior good)
:. Positive value of Ey indicates :. Negative value of Ey indicates
that good X is a normal goods. that good Y is a inferior goods.
:. If income increases by 1%, :. If income increases by 1%,
quantity of good X demanded quantity of good Y demanded
will increase by 0.2% will decrease by 0.6%
THE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of how much the
quantity supplied of a good responds to a change in the price
of that good.
• Price elasticity of supply is the percentage change in quantity
supplied resulting from a percent change in price.

Percentage change in quantity supplied


Es =
Percentage change in price

[(Q1-Q0/Q0)] x 100
Es = x 100
[(P1-P0/P0)]
 Q1 = Current quantity P1 = Current Price
 Qo = base year quantity Po = Price base year
Figure 14 The Price Elasticity of Supply (Elastic Supply)

(a) Elastic Supply: Elasticity Is Greater Than 1 (Es > 1)


Price

Supply

$5

4
1. A 25%
%∆P <
increase
%∆Q
in price . . .

0 100 200 Quantity

2. . . . leads to a 50% increase in quantity supplied.


Figure 15 The Price Elasticity of Supply: Inelastic Supply

(b) Inelastic Supply: Elasticity Is Less Than 1 (Es <1)

Price

Supply
$5

4
1. A 25%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning


Figure 16 The Price Elasticity of Supply: Perfectly Elastic Supply

(c) Perfectly Elastic Supply: Elasticity Equals Infinity (Es = ∞)


Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.

Copyright©2003 Southwestern/Thomson Learning


Figure 17 The Price Elasticity of Supply: Perfectly Inelastic Supply

(d) Perfectly Inelastic Supply: Elasticity Equals 0 (Es = 0)


Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright©2003 Southwestern/Thomson Learning


Figure 18 The Price Elasticity of Supply: Unit Elastic Supply

(e) Unit Elastic Supply: Elasticity Equals 1 (Es = 1)


Price

Supply
$5

4
1. A 25%
increase
in price . . .

0 100 125 Quantity


2. . . . leads to a 25% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning


Determinants of
Price Elasticity of Supply
i. Flexibility of sellers to produce
 Depends on the flexibility on the amount of
goods the producer produces.
 Eg : Hilly land has an inelastic supply because
it is almost impossible to produce anymore
goods. (Producers are insensitive of price
changes as they cannot produce more to
response to a higher price). Other producers,
such as cars have elastic supplies as they can
response better to a changes in price.
Determinants of
Price Elasticity of Supply
ii. Time period
 In long term, elasticity of supply is usually more
elastic than in short term.
 In short term, firm cannot easily change the
quantity of goods they wanted to produce and
this makes them less responsive to price
changes.
 In long term, producers can change the quantity
supplied as they possess more time to response
to price changes.
Determinants of
Price Elasticity of Supply
iii.Availability and mobility of factors of
production
 An increase in quantity supplied requires using
more of factors of production.
 When factors of production such as capital, labor
are more mobile and easily obtained, supply
tend to be more elastic.
 However, when firms face obstacle to obtain
extra raw material to produce additional output,
they have inelastic supply.
Determinants of
Price Elasticity of Supply
iv. Technology Improvement
 Technology advancement help producer to
reduce cost and increase supply. Therefore,
supply tend to be more elastic.
 Eg: Producer of cars can increase cars
production with help from advanced
technology, therefore the producer can response
better when price change and this make cars
supply elastic.
Determinants of
Price Elasticity of Supply
v. Perishability
 The supply of good is inelastic if the good is
easily perishable.
 Goods, which are easily perishable, are not
sensitive to price changes.
 E.g: Agricultural products cannot be stored in
long period, therefore sellers cannot response
much in changes in price (Inelastic)
That’s all for chapter 3!!!
Domo Arigato!