ELASTICITY AND ITS APPLICATIONS

The Price Elasticity of Demand and Its Determinants

Elasticity - A measure of the responsiveness of quantity demanded or quantity supplied to one of its
determinants.
Law of Demand : P, Q
Price Elasticity of Demand : A measure of how much the quantity demanded of a good responds to a
change in the price of that good.
Demand is elastic if the quantity demanded respondes substantially to changes in the price.
Demand is inelastic if the quantity demanded responds ony slightly to changes in the price.

Four rules determines the price elasticity of demand :

- Availability of Close Substitutes : Good with close substitutes tend to have more elastic demand bcause
it is easier to switch from that good to others. [Exmple : Butter and Margerine]

- Necessitites Versus Luxuries : Necessitites tend to hve inelastic demands whereas luxuries have elastic
demands. [Example : Price visit doctor (necessary) and sailboats (luxury)]

- Definition of the Market : Depends on how we draw the boundaries of the market. Defined markets
tend to hve more elastic demand than broadly defined market bcause it is easier to find close
substitutes for narrowly defined goods.

- Time Horizon : Goods tend to have more elastic demand over longer time horizon. [Example : Price of
Petrol]

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided
by the percentage change in price.

Price elasticity of demand =

Example :
- If the price of an ice cream cone increase form rm2.00 to rm2.20 and the amount you buy falls from 10
to 8 cones, then your elasticity of demand would be calculated as :
The Midpoint Method : A Better Way to Calculate Percentage Changes & Elastcities

- The midpoint formula is preferable when calculating the price elasticity of demand because it gives
same answer regardless of the direction of the price change.

Price elasticity of demand =

Example :

- If the price of an ice cream cone increase form rm2.00 to rm2.20 and the amount you buy falls from 10
to 8 cones, then your elasticity of demand would be calculated as :

The Variety of Demand Curves

Ineslatic Demand
- Quantity demanded does not respond strongly to price changes.
- Price elasticity of demand is less than one.

Elastic Demand
- Quantity demanded responds strongly to changes in price.
- Price elasticity of demand is greater than one.

Perfectly Inelastic
- Quantity demanded does not respond to price changes.

Perfectly Elastic
- Quantity demanded changes infinitely with any changes in price.

Unit Elastic
- Quantity demanded changes by the same percentage as the price.
Total Revenue and the Price Elasticity of Demand
Total Revenue : The amount paid by buyers and received by sellers of the good.
- Total Revenue : P X Q , The price of the good times the quantity of the good sold.

Example :
P = RM4
Q = 100

TR = RM4 X 100 = RM400.

Elasticity and Total Revenue along a Linear Demand Curve

- With an inelasticity demand curve, an increase in price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue increases.

- 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.
Other Demand Elasticities

Income Elasticity of Demand

- measures how much the quantity demanded of a good responds to a changes in consumers income.
- It is computer as the percentage change un the quantity demanded divided by the percentage change
in income.

Formular Income Elasticity

Income elasticity of demand =

Income Elasticity
- Types of Goods
Normal Goods
Inferior Goods
- Higher income raises the quantity demanded for the normal goods but lowers the quantity demanded
for inferior goods.
- Goods consumers regard as necessitites tend to be income elastic
Example : Sports cars

The Cross-Price Elasticity of Demand

- Measures of how much the quantity demanded of one good responds to a change in the price of
another good, computed as the percentage change in quality demanded of the first good divided by the
percentage change in the price of the second good.

THE ELASTICITY OF SUPPLY

Law of Supple : P, Q
- The price of Elasticity of supply : measures how much the quantity supplied responds to changes in the
price.
- Elastic if the quantity supplied responds substantially to changes in the price
- Inelastic if the quantity supplied responds only slightly to chnges In the price.
- The price elasticity depends on the flexibility of sellers to change the amount of the good they produce.
- A key determinant of the price elasticity of supply : Time Period
- Supply is usually more elastic in the long run than in short run.
Computing the Price Elasticity of Supply
- The price elasticity of supply is computed as the percentage change in the quantity supplied divided by
the percentage change in price.

Example :
The price of milk increases from RM2.85 per liter to RM3.15 per liter and the quantity supplied rises
from 9,000 to 11,000 liters per month.

Answer :
Percentage change in price = [(3.15 - 2.85)/3.00] x 100% = 10%

Percentage change in quantity supplied = [(11,000 - 9,000)]/10,000 x 100% = 20%

Price elasticity of supply = (20%)(10%) = 2