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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 goods price.

2. Measurement :
Ed =
percentage change in demand percentage change in price

Ed =
Q1 = Current quantity Qo = base year quantity

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

P1 = Current Price Po = Price base year

Computing the Price Elasticity of Demand


Price elasticity of demand
Percentage changein quatity demanded Percentage changein 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 20% 10 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 1. A 25% increase in price . . . Demand

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% increase in price . . . Demand

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 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. Demand

Elasticity, Ed =

0 3. At a price below $4, quantity demanded is infinite.

Quantity

Figure 9: Degree of Elasticity (Perfectly Inelastic)

(d) Perfectly Inelastic Demand: Elasticity Equals 0, Ed = 0 Price Demand $5

Elasticity, Ed = 0 %P, %Q = 0

4
1. Any increase in price . . .

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% increase in price . . . Demand

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. 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 dont 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 consumers expenditure Demand tends to be more elastic when a consumers expenditure on the product is large and vice versa. E.g.: Demand is more elastic for products such as cars as consumers 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 (revenue)

Demand

0 Q

100

Quantity

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 An Increase in price from $1 to $3

Price leads to an Increase in total revenue from $100 to $240

$3

Revenue = $240 $1 Revenue = $100 0 100 Demand Quantity 0 80 Demand 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
An Increase in price from $4 to $5

Price
leads to an decrease in total revenue from $200 to $100

$5
$4 Demand Revenue = $200 Revenue = $100 Demand

50

Quantity

20

Quantity

Cross Price Elasticity of Demand


Ec Ec
= =

% change in demand Qx % change in price of Qy


[(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 % change in price of Good Y x 100 [(Qdy 1-Qdy 0/Qdy 0)]x 100 [(Px1-Px 0/Px 0)] Price of Good X (RM) 10 12 Qd for Good Y (Unit) 100 110 Qd for Good Z (Unit) 100 70

Ec =

x 100

The Cross Price elasticity of demand for good X if price of Good X increase from RM10 to RM12:
Good X and Good Y:

Ec =

(110 -100 / 100)x 100 ( 12-10/10) x 100 = [10/ 20] = 0.5 (Substitutes good) :. Positive value indicates that good X and Good Y is a substitutes goods

(70 -100 / 100) x 100 (12-10/10) x 100 = [-30/ 20] = - 1.5 (Complement good) :. Negative value indicates that Good X and Good Z is a complement goods Ec =

Good X and Good Z:

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 % change in Income x 100 Income (RM)

Ey = [(Q1-Q0/Q0)]
[(Y1-Y0/Y0)]

x 100 x 100

Qd for Good X (Unit)

Qd for Good Y (Unit)

100
150

100
110

100
70

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

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

[(110 -100) / 100] x 100 [ (150-100)/100]x 100 = [10/ 50] = 0.2 (Normal good) :. Positive value of Ey indicates that good X is a normal goods. :. If income increases by 1%, quantity of good X demanded will increase by 0.2%

Ey =

[(70 -100) / 100] x 100 [(150-100)/100] x 100 = (-30/50 ) = - 0.6 (Inferior good) :. Negative value of Ey indicates that good Y is a inferior goods. :. If income increases by 1%, quantity of good Y demanded will decrease by 0.6%

Ey =

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.

Es =

Percentage change in quantity supplied Percentage change in price


x 100 x 100

Es =
Q1 = Current quantity Qo = base year quantity

[(Q1-Q0/Q0)] [(P1-P0/P0)]

P1 = Current Price 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% increase in price . . .

%P < %Q

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 . . .

100

110

Quantity

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

Copyright2003 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 2. At exactly $4, producers will supply any quantity.

Supply

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

Quantity

Copyright2003 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 . . .

100

Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright2003 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 . . .

100

125

Quantity

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

Copyright2003 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)

Thats all for chapter 3!!!


Domo Arigato!