Chapter 3:

Elasticity and Its Application

Chapter 3:
▪ Price Elasticity of Demand
* Measurement and interpretation (calculation mid-point formula)
* Degree of elasticity of demand
* Determinants of price elasticity of demand
▪ Cross Elasticity of Demand
* Measurement and interpretation (calculation mid-point formula)
• Income elasticity of demand
• Price elasticity of supply
DEFINITION
• The word elasticity has the same meaning as sensitivity or
responsiveness.
• Therefore elasticity of demand means the responsiveness of
demand due to same changes to the factors which influence
demand.

TYPES OF ELASCITY OF DEMAND(E ) D

There are three types of elasticity of demand:

1. Price Elasticity of Demand(E ) p

2. Income Elasticity of Demand(E ) y

3. Cross Elasticity of Demand(E ) c

A. Price Elasticity of Demand(E ) p

• It measure the responsiveness of the quantity demanded due to a

change in its price.

• As mentioned in the Law of demand, when price increases,quantity

demanded will decrease as in the diagram below.
Degrees of Elasticity
 After we know the definition Price Elasticity’s of demand
now we are going to look at the 5 degree’s of price
elasticity of demand:
1. Demand is Elasticity(Ep>1)
2. Demand is inelastic(Ep<1)
3. Demand is unitary elastic(Ep=1)
4. Demand is perfectly inelastic(Ep=0)
5. Demand is perfectly elastic(Ep=∞)
1. Demand is elastic(Ep>1)
• Demand is elastic if given percentages changes in price results in a
larger percentages change in quantity demanded.

• Example, if a 5 percent decline in price results in a 20 percent

increase in quantity demand, demand is elastic.

• The coefficient of an elasticity is greater than 1. Goods which have

many substitute has an elastic demand. Example: toothpaste,
syampoo..

• This can show as below:

2. Demand is inelastic(Ep<1)
• Demand is inelastic when the percentage change in quantity
demanded is less than the percentage change in price. If a
demanded is less than the percentage change in price. If a 5%
increase in price leads to only 1% decrease in the quantity
demanded, so demand is ineslastic.

• Normally ,goods that have less substitute such as rice, petrol - have
an inelastic demand as below
3. Demand is unitary elastic(Ep=1)
• A demand relationship in which the percentage
change in quantity is the same as the percentage
change in price.
• The coefficient of a unitary elastic demand is always
equals to 1.
• The demand curve is illustrated as below
4. Demand is perfectly inelastic(Ep=0)
• This is an extreme situation where a price change result in no change to the quantity
demanded. Its numerical value is zero.

• An example of a perfectly inelastic demand is the demand for insulin by a serious

diabetic patient or addict’s demand for heroin.

• The demand curve is parallel to the vertical axis such as in the diagram.
5.Demand is perfectly elastic(Ep=∞)
• A perfectly elastic demand curve is a horizontal straight –
line such as below.
• In this case a small increase in the price of a product
causes the quantity demanded for a product to drop to
zero.
DETERMINANTS OF PRICE ELASTICITY OF
DEMAND

 The determinants of the price elasticity of demand for good are:

1. The availability of substitutes
2. The relative importance of the good in the budget
3. Nature of goods (necessity or luxury).
4. Time dimension
5. Income level
6. Habits
1. SUBSTITUTABILITY

• Generally , the larger the number of substitutes available, the

greater the elasticity of demand is.
• When substitutes are not readily available (especially close
substitute),demand is likely to less elastic.
• An example of good that has many substitutes is soft drinks
like Pepsi –Cola and Cola-Cola, where the demand is elastic.
• Whereas, necessity good such as rice which has less
substitutes, has an inelastic demand.
 2. THE RELATIVE IMPORTANCE OF THE GOOD
IN THE BUDGET (Propotion of the expenditure on a product.)

• If the demand for the good takes a large amount of our income,
demand is elastic.
• Example: Refrigerators the purchase of a refrigerators takes a large
amount of our income ; therefore a small increase in the price of
refrigerators will have a very large effect on the demand for
refrigerators .
• On the other hand, the demand for some goods that take a small
fraction of the income, such as cigarettes, pencil or salt is inelastic.
3. NATURE OF GOODS
Necessities vs luxuries

• The demand for necessity goods is inelastic.

• Example the demand for rice, water and electricity is inelastic because
it is important to us, so if there is a great increase in price the demand
will not change very much.
• On the other hand , the demand for good that is not important and
luxuries are elastic
4.TIME DIMENSION

• Normally ,we divide the time dimension into 2 time period i.e. short –
run and long –run.
• The elasticity of demand in the short –run is inelastic.
• In the long- run demand is likely to become more elastic or more
responsive, simply because consumers can make adjustment to their
demand and have time to find other substitutes.
5.INCOME LEVEL

• Those with higher income tend to have inelastic demand because being
richer they are less sensitive to price changes.
• A 10% rise in the price of a commodity may not have any impact on the
rich consumers’ expenditure on that good , compared to those with
lower income.
6. HABITS

• Habitual smokes and drinkers tend to have

inelastic demand for cigarettes and liquor
respectively.
• They disregard changes in the price of the
goods because these goods are necessities to
them. Smokers will have to smoke no matter
how expensive cigarettes are.
 PRICE ELASTICITY OF DEMAND AND ITS
RELATION TO TOTAL REVENUE
• Total revenue(TR) is Price × Quantity.
• Whether TR increase or decreases when price increase
depends on the elasticity of demand.
• If demand is elastic, a decrease in price will result in an
increase in the total revenue. This is because the
percentages change in quantity demanded is greater
than the percentage change in price.
• On the other hand a price increase will cause total
revenue to decrease.
• If demand is elastic, price change will cause total
revenue to change in the opposite direction.
• If demand is inelastic, a decrease in price will
increase the total revenue while an increase in
price will increase the total revenue
• so, we can say that , if demand is inelastic, a
price change will cause that total revenue to
change in the same direction.

❖In the special case of unitary elasticity, an increase or

decrease in price will leave total revenue unchanged.
PRICE ELASTICITY OF DEMAND
OTHER ELASTICITY OF DEMAND

• Consumers demand on a particular product is not only influence by the

product’s own price,but also on consumer income, the price of related
goods(the price of substitutes and complements), and on consumer
preferences.
• The elasticity concept also applied to the other factors affecting
demand.
B. INCOME ELASTICITY OF DEMAND (Ey)
• Income Elasticity of demand is a measure of the
responsiveness of demand for a product(∆DD) to a
change in income (∆Y).
• A rise or fall in consumers income will affect the
demand for different products. As consumer income
rises, the demand for most products increase but not
always. The exception is inferior goods, whose
demands decreases as income increases.
1. If the income elasticity of demand is positive, each 1
percent increase in income will lead to an increase in
demand for the good. We refer this to normal good. If
the value of income elasticity of demand is between 0 <
Ey <1,we can conclude that is a normal good.
Example of normal goods is clothing and shoes.

2. If the income elasticity of demand is greater than 1,people

will spend a larger fraction of their income on the good as
income increases. W refers this to luxuries goods.
Example of luxuries’ goods are antique furniture and
recreational vehicles.
3. If the income elasticity of demand negative, people
will reduce their demand on the good as income
increases.
We refer this to inferior goods.
Examples of inferior goods are black and white TV
sets, secondhand cloth and low grade rice.
4. If income elasticity of demand equals to 0,this means
that an increase in income has no effect on the
demand for the good.
We refer this to Necessity goods.
Examples of necessity goods are food item such rice ,
vegetables and fish.
 Formula
MIDPOINT
FORMULA

SYMBOL
EY OR EI =
INCOME
ELASTICITY
 EXAMPLE:
• For the following, calculate the income elasticity of demand when
income increase from RM120 to RM 150; and identify the type of
good X,Y and Z.

Income Quantity Quantity Quantity

demand demand demand
Good X Good Y Good Z

100 10 20 20

120 15 20 18

150 17 20 14

160 20 20 8
Solution:
i. Good X
ii. Good Y
iii. Good Z
 C. CROSS ELASTICITY OF DEMAND(Ec)

• Cross Elasticity of Demand is a measure of the responsiveness of demand for

one product (∆DDx) to a change in the price of related product (∆Py )
▪ A positive cross-price elasticity of demand means that an increase in the price
of one product will cause an increase in demand for the other product and
vice versa.
❖ The relationship between these two products are substitute.
❖ Example, as the price of Honda increase, the quantity demand of Honda
decrease, in part because substitutes have been purchased in place of Honda.
Proton – Waja is substitute for Honda ; therefore, an increase in the price of
Honda car causes an increase in the demand for Proton – Waja.
 ▪ A negative cross-price elasticity of demand means
that an increase in the price of one product will
cause a decrease in demand for the other and vice
versa.
The relationship between these two products are
complements.
▪ Example: As he price of a car increase, the quantity
demand of petrol decreases.
▪ If the cross – price elasticity of demand is zero, the
products have no relationship.
FORMULA
Example:
• The table below shows the demand for two good, A and B;
when there is a change in price for good A.
Price of Good A Quantity Quantity
demanded for A demanded for B
RM 10 60 15
RM 18 40 25
RM 25 20 30
RM 32 10 35

Based on the table given,

i. Calculate the cross elasticity for good B when the price
of A increase from RM 18 to RM25.
ii. From the above calculation ,determine the relationship
between good A and B.
PRICE ELASTICITY OF SUPPLY

• Price elasticity of supply measure the responsiveness of quantity

supplied to change in the price of a goods and services.
• Price elasticity of supply can be determined by comparing the %
change in quantity supplied with the % change in the price of the
product.
Formula
DEGREES OF PRICE ELASTICITY OF SUPPLY

1. Supply is elastic , Es > 1.

• % change in quantity supplied is greater than % change in

price.
2. Supply is inelastic , Es<1
• % change in quantity supplied is less than % change in
price.
3. Supply is unitary elastic, Es=1
• % change in quantity supplied is equal to the % change in
prince.
4. Supply is perfectly inelastic , Es=0

• % change in quantity supplied is zero despite the

change in the price.
5. Supply is perfectly elastic, Es=∞
• % change in quantity supplied is infinitely large compared
to the % change in price.
 Determinants of Price ELASTICITY OF SUPPLY
1. Time period.
In the short run, the supply is inelastic. It is not possible to
increase supply immediate in response to change in price. example agricultural
products.
However , in the long run, supply would be more
responsive to price changes, it is more elastic. Example manufacturing products.
2. Nature of the Goods.
If it takes too long to produce a product, the supply is
An inelastic. Otherwise ,the supply will be elastic.
For example, the supply of agricultural product is an
inelastic whereas the supply of manufactured goods is elastic.
3. Technology improvement
• Modern methods production expand output and hence
supply tends to be elastic.
• Number of outputs produced in a given periood of time is
lower when old methods of production are used
4. Substitutability of Factors or Inputs Used
•When factors of production such as land, labour and capital
are available and can easily move from one occupation to
another, supply tend to be more elastic.
•But if the production of its output requires very specialized
inputs , supply tend to be inelastic.
5. Perishability .
• Perishability products like agricultural products supply is inelastic.
Changes in price do not affect supply much because the sellers
cannot store perishable products for long period of time. Example,
fruits and vegetables.
• Less perishable products, like manufacturing products, the supply
more elastic. If the seller expects a price increase in another two
months, the seller may store these products for future sale.
Example cars, shoes and canned food.
Summary of the Four Elasticity Concepts
THANK YOU ☺