chapter 4 - elasticity and its application-1

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ATW 107 Microeconomics

Chapter 4:Elasticity and Its Application

DR. TANG CHOR FOON

Centre for Policy Research & International StudiesUniversiti Sains Malaysia,Room: 116, Tel: 04 – 653 2044

E-mail: [email protected] / [email protected]

mailto:[email protected]






LESSON OUTLINE

• Definition of Elasticity?

• Price Elasticity of Demand

• Price Elasticity of Supply

• Cross Elasticity of Demand

• Income Elasticity of Demand

• Applications of Variety of Elasticities



WHAT IS ELASTICITY?

• … allows us to analyse supply and demand withgreater precision.

• Elasticity is a measure of how much buyers

(consumers) and sellers (producers) response tochanges in market conditions.

• Elasticity is also known as “ sensitivity”



THE PRICE ELASTICITY OF DEMAND

• The price elasticity of demand is a measure of howmuch of the quantity demanded of a goodresponds to a change in the price of that good.

• When we talk about elasticity, that responsiveness is

always measured in percentage terms.

• Specifically, the price elasticity of demand is thepercentage change in quantity demanded owing

to a percentage change in the price.

• How sensitive is consumer response to pricechange?



Computing the Price Elasticity ofDemand

• The price elasticity of demand is computed as thepercentage change in the quantity demandeddivided by the percentage change in price.

2 1

1

2 1

1

Percentage change in quantity demandedPrice elasticity of demand=

Percentage change in price

100% QPrice elasticity of demand=% P

100

Q Q

Q P P

P



Computing the Price Elasticity ofDemand

• Example: If the price of an ice-cream coneincreases from RM2.00 to RM2.20 and the amountyou buy falls from 10 to 8 cones, then your elasticityof demand would be calculated as:

% QdPrice elasticity of demand=

% P

10 8

100 20%10Price elasticity of demand= 22.2 2 10%

1002



The Mid-Point Method: A Better Way toCalculate Percentage Changes and Elasticities

• The mid-point formula is preferable whencalculating the price elasticity of demand becauseit gives the same answer regardless of the directionof the price change.

2 1 2 1

2 1 2 1

2Price elasticity of demand =

2 D

Q Q Q Q E

P P P P



The Mid-Point Method: A Better Way toCalculate Percentage Changes and Elasticities

• Example: If the price of an ice-cream coneincreases from RM2.00 to RM2.20 and the amountyou buy falls from 10 to 8 cones, then your elasticityof demand, using the mid-point formula, would be

calculated as:

2 1 2 1

2 1 2 1

2 10 8 10 8 2=

2 2.2 2 2.2 2 2

22%= 2.32

9.5%

D

D

Q Q Q Q E

P P P P

E



The Variety of Demand Curves

1. Elastic Demand• Quantity demanded responds strongly to changes in price

• %∆Q > %∆P

• Price elasticity of demand is greater than ONE (ED > 1)

2. Inelastic Demand

• Quantity demanded does not respond strongly to pricechanges

• %∆Q < %∆P

• Price elasticity of demand is less than ONE (ED < 1)

3. Unit Elastic Demand• Quantity demanded changes by the same percentage as

the price

• Price elasticity of demand is equal to ONE (ED = 1)




4. Perfectly Elastic Demand

• A price increase will cause the quantity demanded todecline from an infinite amount to zero.

• When a small percentage change in price causes anextremely large percentage change in the quantity

demanded (from buying all to buying nothing)• Price elasticity of demand is infinity(ED = )

5. Perfect Inelastic Demand

•

Quantity demanded does not respond price changes• Price elasticity of demand is equal to ZERO (ED = 0)



Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

8 Demand

2. At exactly RM8,

consumers will

buy any quantity.

1. At any price

above RM8, quantity

demanded is zero.

3. At a price below RM8,

quantity demanded is infinite (unlimited).





• As the price elasticity of demand measures howmuch of quantity demanded responds to the price,it is also closely related to the slope of the demandcurve.

•

However, it is not the same thing as the slope!!



Elasticity is Not Slope




100 50100 100

50 100 50

752 2

3.67210 12100 100

1112 10

2 2

B A

A B

D B A

A B

Q Q

Q Q

E P P

P P

10 12of axis verticalSlope 0.040 of axis horizonal 100 50

P Q

Between point A and B




150 100100 100

100 150 50

1252 2

1.8028 10100 100

98 10

2 2

B A

A B

D B A

A B

Q Q

Q Q

E P P

P P

8 10of axis verticalSlope 0.040 of axis horizonal 150 100

P Q

Between point B and C



Total Revenue & the Price Elasticity ofDemand

• Total Revenue (TR) is the amount paid byconsumers and received by the producers of agood.

• TR can be calculated as the product price (P)multiply the quantity sold (Q):

Q P TR




• When the P = 2, Q = 10and TR = $20

•

When price reduces, e.g.P = 1, Q = 40 and TR = $40

• Summary:If the ED > 1, P should ↓ togain extra revenue (R)

(yellow area < blue area.)




• When P = 4, Q = 10 and TR = $40

• When price reduces:

P = 1, Q = 20 and TR = $20

• Summary:If the ED < 1, P should ↑ togain extra revenue (R)(yellow area > blue area.)




• When P = 3, Q = 10 and TR = $30

• When price reduces:

P = 1, Q = 30 and TR = $30

• Summary:If the ED = 1, P should ↑ / ↓

earn no extra revenue (R).(yellow area = blue area.)



The Factors that Influence the Elasticityof Demand

1. The Number of Close Substitutes for the Good

2. Proportion of Income Spent on the Good

3. Necessities VS Luxuries

4. Time Horizon (The Duration of the Price Change)

5. Definition of the Market

6. Addiction / Habit

7. Low VS High Income Consumers



(1) The Number of Close Substitutes

•

Goods with close substitutes are likely to have moreelastic demand because it easier for consumers toswitch from that good to others.

• E.g. Coca-Cola & Pepsi / butter & margarine are

easily substitutable. A small increase in the price ofbutter (Coca-Cola), the quantity demanded for butter (Coca-Cola) drop tremendously.



(2) Proportion of Income Spent on theGood

• The greater the proportion of income spent on agood, the more elastic is the demand for it.

• Likewise, the smaller the percentage of income

goes to buy a good, the lower the price elasticity ofdemand will be.

• E.g. The share of income spent on salt is very low.Even if the price of salt doubles, you consume

almost the same amount or only a small decline inthe quantity demand. How about “houses”, “cars”,& “furniture”?



(3) Necessities VS Luxuries

•

Goods that are luxuries usually have more elasticdemand curve that goods that are necessities.

• E.g. 1: “Bread & Tickets to concert” - the demandfor Bread is inelastic as bread is a necessity good,

and the quantity that people buy is not verysensitive to its price. Tickets to concert are a luxury,so the demand are more elastic.

• E.g. 2: “Jewellery & Medicine” – If jewellery price ↑,

demand ↓ is easy as one can survey without jewellery. If the price of medicine ↑, demand ↓ isNOT easy. “ED for Jewellery > ED for Medicine”



(4) Time Horizon

• If the price of a good rises, consumers need some

time to adjust their buying habits or to find andexperiment with other goods to see they areacceptable. Thus, the longer the time period, themore elastic is demand curve.

• So, long-run demand for gasoline is more elastic(ED = 0.8) than the short-run demand (ED = 0.2).

• E.g. If price of gasoline ↑ by RM0.20 per litre in aweek (short-run), it is unlikely that you will buy a

hybrid-car. But, if the price ↑ RM1.00 per litre in ayear (long-run), it is likely that you will buy a hybrid-car or car-pool to reduce the consumption ofgasoline.



(5) Definition of the Market

•

The more narrowly defined the market, the demandtend to be more elastic because it is easier to findclose substitutes for narrowly defined goods.

• E.g. “Food” is a broadly defined item, has a fairly

inelastic demand as there are no good substitutesfor food. But, if the definition is more narrowed e.g.ice-cream, has a more elastic demand since it iseasy to substitute other desserts for ice-cream.



(6) Addiction / Habit

•

When consumers are addicted to certain good, thedemand for it tends to be inelastic.

• E.g. 1: An addicted smoker will continue to buy thesame quantity of cigarette even when the price of

cigarette increase.



(7) Low VS High Income Consumers

•

The higher the income of a consumer, the moreinelastic demand for a good.

• E.g. The demand for a millionaire will not changemuch with respect to the change in price.

However, the respond of low income consumer tosuch increase is very significant.



Summary

Demand tends to be more elastic:

(a)The larger the number of close substitutes

(b)The larger the portion of income spent of a good

(c)If the good is a luxury

(d)The more narrowly defined the market

(e)The longer the time period

(f) If not addicted to a specific good

(g)If the consumers’ income is low



THE PRICE ELASTICITY OF SUPPLY

• The price elasticity of supply is a measure of howmuch of the quantity supplied of a good respondsto a change in the price of that good.

• Price elasticity of supply is the percentage change

in quantity supplied resulting from a percentagechange in price.



Computing the Price Elasticity of Supply

• The price elasticity of supply is computed as thepercentage change in the quantity supplied(%∆Qs) divided by the percentage change in price(%∆P).

2 1

1

2 1

1

Percentage change in quantity suppliedPrice elasticity of supply (Es) =Percentage change in price

100%

Price elasticity of supply (Es) =%100

Q Q

Q Q

P P P P



The Variety of Supply Curves

1. Elastic Supply

• Quantity supplied responds strongly to changes in price

• %∆Q > %∆P

• Price elasticity of supply is greater than ONE (ED > 1)

2. Inelastic Supply

• Quantity supplied does not respond strongly to price changes

• %∆Q < %∆P

• Price elasticity of supply is less than ONE (ED < 1)

3. Unit Elastic Supply• Quantity supplied changes by the same percentage as the

price

• Price elasticity of supply is equal to ONE (ED = 1)




4. Perfectly Elastic Supply

• A price increase will cause the quantity supplied to declinefrom an infinite amount to zero.

• When a small percentage change in price causes anextremely large percentage change in the quantitysupplied (from buying all to buying nothing)

• Price elasticity of supply is infinity(ED = )

5. Perfect Inelastic Supply

• Quantity supplied does not respond price changes

• Price elasticity of supply is equal to ZERO (ED = 0)



The Unity Elastic Supply Curves



The Perfectly Elastic Supply Curve

Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

4 Supply

3. At a price below RM4,

quantity supplied is zero.

2. At exactly RM4,

producers will

supply any quantity.

1. At any price

above RM4, quantity

supplied is infinite (Unlimited).

Th F t th t I fl th El ti it



The Factors that Influence the Elasticityof Supply

1. Mobility of Resources / Factors of Production

2. Time Frame for the Supply Decision

3. Number of firm in a industry

4. Durability



(1) Mobility of Resources

• If the factors of production / resources can be easilymove from one to other production used, then thesupply of the good tend to be more elastic.

• E.g. Labour is more elastic than capital.



(2) Time Frame for the Supply Decision

• Time is the most important determinants that affectthe price elasticity of supply.

• If the price of good changed, producers needsome time to make adjustment in the level of

output. 3 types of time frame, i.e. immediate, short-run and long-run supply.

• If the time frame is short, the supply cannot beexpanded even the price of good increase. Thus,

time frame ↑, supply is more elastic.

• ES of agricultural good < ES of manufacturing good.

Sh t R S l



Immediate Supply Short-Run Supply

Long-Run Supply



Q

PT1

T2

T3

T4

T5

• When the Time Period increase the Supply Curve will rotateclose wise from T1 to T5

• Moving from Perfectly inelastic to Perfectly Elastic of supply



(3) Number of Firm in a Industry

• The larger the number of firm in a industry, the moregood can be produce, thus the higher the priceelasticity of supply.

• E.g. Price of good increase, many firm wish toproduce the same item, thus the supply increasetremendously.



(4) Durability

• If the goods are durable and can be easily store,the supply tends to be elastic than the goods whichare perishable and do not have storage facilities.

• E.g. vegetable, fruits, & seafood.



THE CROSS-PRICE ELASTICITY OF DEMAND

• Cross-price elasticity of demand measures howmuch of the quantity demanded of one goodresponds to a change in the price of another good.

• It can be computed as the percentage change in

quantity demand of the first good divided by thepercentage change in the price of the secondgood.

Percentage change in quantity demanded of good 1

Cross-price elasticity of demand Percentage change in price of good 2 XY E



THE CROSS-PRICE ELASTICITY OF DEMAND

• Cross-price elasticity of demand allow one toidentify whether the goods are classified assubstitute, complementary or independent(unrelated) goods.

• Substitution Goods → EXY > 0 (Positive)

• Complementary Goods → EXY < 0 (Negative)

• Independent (Unrelated) Goods → EXY = 0



THE INCOME ELASTICITY OF DEMAND

• Income elasticity of demand measures how much

of quantity supplied of a good responds to achange in consumers’ income.

• It computed as the percentage change in the

quantity demanded divided by the percentagechange in income.

Computing the Income Elasticity of



Computing the Income Elasticity ofDemand

•

The income elasticity of demand is computed asthe percentage change in the quantity demandeddivided by the percentage change in price.

2 1

1

2 1

1

Percentage change in quantity demandedIncome elasticity of demand =Percentage change in income

100%

Income elasticity of demand =

%100

Y

Y

E

Q Q

Q Q E

Y Y Y Y



Income Elasticity: Type of Goods

• One can uses income elasticity to identify or

provide some insights about the type of goods.

• Type of Goods

• Normal Goods → (EY) > 0 (Positive)

•

Inferior Goods → (EY) < 0 (Negative)

• Among the normal goods, one also candifferentiate them into necessity and luxury.

•Necessity Goods → 0 ≤ (EY) ≤ 1 (or close to zero)

• Luxury Goods → 1 < (EY) < ∞



Summary of Elasticities



Thank You

chapter 4 - elasticity and its application-1

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