CHAPTER 4

ELASTICITY OF DEMAND
CHAPTER 4
AND SUPPLY

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 LEARNING OUTCOMES

At the end of the chapter, you should be able to:

• Calculate price elasticity of demand, and discuss its concept
and determinants.
• Calculate and interpret income elasticity of demand.
• Calculate and interpret cross-elasticity of demand.
• Calculate price elasticity of supply, and discuss its concept
and determinants.
INTRODUCTION
 ELASTICITY OF DEMAND
Definition
Measures the sensitivity/ responsiveness of the quantity
demanded due to a change in its price of goods, price of
related goods and income

Types of elasticity
• Price elasticity of demand
• Cross elasticity of demand
• Income elasticity of demand

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PRICE ELASTICITY OF DEMAND
FORMULA:

d = %  Quantity Demanded
%  Price

d = Q2 – Q1 x P1

Q1 P2 – P1
 DEGREE OF ELASTICITY
Perfectly Inelastic Demand
Price (RM) Inelastic Demand
A condition in which the quantity demanded does
d =0 not change as the price changes.
A large percentage of change in the price of a good
d < 1 will only affect a small percentage of change in the
Elastic Demand
quantity demanded.

A small percentage of change in the

Unitary
price of a good will leadElastic
to larger
percentage of change in quantity
d =  demanded.
Demand
A condition in which
Perfectly
percentage Elastic
changes in price
Demand
equals to percentage
changes in quantity
A condition in which a small
demanded.
percentage of change in
d = 1 price leads to an infinite
d > 1 percentage of change in the
quantity demanded.

Quantity Demanded
Degrees of Responsiveness in Price Elasticity of Demand

• Perfectly inelastic, Ɛd = 0
• Inelastic, 0 <Ɛd< 1
• Unitary elastic, Ɛd = 1
• Elastic,  >Ɛd>1 
• Perfectly elastic, Ɛd = 
 1. Price Elasticity of Demand (p)
•   demanded change
To measure how much quantity
due to a change in the PRICE of a good
 
Formula:
Ep = Q1 - Q0 X P0
Q0 P1 - P 0

where ; Q1 = new quantity P1 = new price

Q0 = original quantity P0 = original price

Note:
Price elasticity of demand will always result in negative coefficient

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 Example 1:
If the price of pens decreases from RM3 to RM1 and the quantity
demand for pens increases from 40 to 50 units, calculate the price
elasticity of demand.

Solution
Q0 = 40; Q1 = 50; P0= 3; P1 = 1 (Fill up the figures in the formula)

Ep = Q1 - Q0 x P0
Q0 P 1 - P0

=50-40 x 3
40 1-3
= 0.25 x -1.5
= - 0.375 9
 Example 2:
• Identify the value of P0,P1,Q0 and Q1
• Formula:
Ep = (Q1 – Q0) x P0
Q0 (P1 – P0)
= (5 – 10) x 2
10 (3 – 2)
= -1
 ELASTICITY OF DEMAND (cont.)

Factors Influencing Price Elasticity of Demand 

• Number of substitutes
• The important of good
• Proportion of income spent on a product
• Time frames
• Consumer’s habits
• Level of income
 Determinants of Price Elasticity of Demand:
Demand
1. Number of substitutes

 For product with many substitute, demand turn to be elastic

because any change in the price result in a larger change in
quantity demanded.
- Eg: if the price of apple increase, quantity demanded of apple
will decrease in a large portion because consumer can
substitute apple with other fruits.

 For product with low or no substitutes, demand turn to be

inelastic because any change in the price result in a smaller
change in quantity demanded
- Eg: If the price of cigarettes increase, quantity demanded of
cigarettes will decrease in a small portion because consumers
have no substitute for cigarettes. 12
2. The importance of the goods

• More important goods will have inelastic demand. Eg:

demand for necessity goods such as sugar, rice, flour,
water and etc. This is because, any change in the price
of necessity good result in a small change in quantity
demanded.

• Less important goods will have elastic demand. Eg:

demand for luxury goods such as cars,jewelleries, tv
and etc. This is because, if the price of a product
changed, quantity demanded will change in a large
portion.
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3. Proportion of income spent on the goods

• Income spent refers to the amount of money income that the

consumers spent on a good. Is it large or small portion of
income used to pay for a good?
• Goods that contribute a large portion of one’s income
(eg:houses and cars) will have elastic demand.
• Goods that contribute a minor portion of one’s income (eg;
sweets, pencil) will have inelastic demand.

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4. Time period

• In the short term, demand of goods is said to be

inelastic towards changes in the price because
substitutes are harder to find at short notice.
Therefore, consumers will continue to purchase
the goods despite the increase in the price.

• In the long term, demand for goods is said to be

elastic towards changes in the price because
consumers have more time to find a substitute
goods. Therefore, in the long term, consumers will
shift to relatively cheaper substitutes when the
price of the goods increases.
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5. Habits
• Habitual smokers and coffee drinkers tend to
have inelastic demand for cigarettes and
coffee respectively.

6. Income level
• High income earners may have inelastic
demand because as being richer, they are less
sensitive to price changes.
• Low income earners have elastic demand
because they are sensitive with price changes.
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STUDY QUESTIONS
Price of good W rises
1. Given the following information:

Price of Good Quantity Demanded for

W per kg (RM) Good W per kg (unit)
10.00 90
20.00 60

 Calculate the price elasticity of demand for good

W, if the price of good W increase from RM 10
to RM 20 per kg. what type of price elasticty

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 Price of good Z rises

2. When price of good Z is RM2, the quantity

demanded is 10 units and when price
increases to RM3 the quantity demanded is 5
units. Calculate the price elasticity of demand
`
when price increases. What type of price
elasticity?

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2. CROSS ELASTICITY OF DEMAND

DEFINITION:

Measures the sensitivity/responsiveness

of the quantity demanded of one product
due to a change in the price of a related product.
 2. Cross Elasticity of Demand (Ec)
•  
To measure how much quantity demanded change due to changes in
the price of other goods.
• Formula:

Ec = Q1x - Q0x X P0y

Q0x P1y - P0y

Ec = %  Qdx = percentage change in Qd of good x

%  Py percentage change in Price of good y

where ; Q1x = new quantity of good X

Q0x = original quantity of good X
P1y = new price of good Y
P0y = original price of good Y
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 RESPONSES OF CROSS ELASTICITY

Price of Good X Positive Cross Elasticity

x =0
-Good X and Y are substitute goods

Negative Cross Elasticity

-Good X and Y are complementary goods

Zero Cross Elasticity

-Good X and Y have no relationship

x > 0 x < 0

Quantity
Demanded of Good
Y
 Interpretation of Cross Elasticity;
Relationship between goods
Value of
coefficient Relationship Description Examples

Positive Substitute Price of good y , Increase in the price of

Demand for good x  Toyota Altis, increase
in the demand for
Perodua Myvi

Negative Complementar Price of good y , Price of car increase,

y Demand for good x  demand for petrol will
decrease
Zero Not related Price of good y , Increase in price of
no change in demand salted fish, has no
for good x effect on the demand
for a airplane ticket

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 Example:
• Example:
Price of ayam Quantity itik Quantity ikan
RM10 60 15
RM18 25 45
RM25 30 40

• Calculate the cross elasticity of demand for good itik

when the price of ayam increases from RM18 to
RM25
P0ayam=18 q0itik=25
P1ayam=25 q1itik=30
 Working:
• Identify the value of Py0,Py1,Qx0 and Qx1

• Formula :

= (Qx1 – Qx0) x Py0

Qx0 (Py1 – Py0)
= 30 - 25 x 18
25 25 - 18
= 0.51

• Conclusion;
If Ec is positive, goods x and y are substitutes
 Price of Good A Quantity Demanded (units)
(RM per unit) Good A Good B Good C

1 100 1 000 10
2 50 500 20
3 25 250 40
4 20 200 80
5 18 180 180
2. Suppose the price of good A increases from RM3 per unit to RM4 per unit,
calculate:
a i) Cross elasticity of demand for Good B.

GOOD A GOOD B
P0=3 QO= 250
P1=4 Q1= 200

= -0.6
 Price of Good A Quantity Demanded (units)
(RM per unit) Good A Good B Good C

1 100 1 000 10
2 50 500 20
3 25 250 40
4 20 200 80
5 18 180 180
2. Suppose the price of good A increases from RM3 per unit to RM4 per unit,
calculate:
a ii) Cross elasticity of demand for Good C with respect to Good A.

b) What the relationship between:

ii) Good A and C?
INCOME ELASTICITY OF DEMAND

DEFINITION:

Measures the sensitivity/responsiveness

of the quantity demanded
due to a change in income.
INCOME ELASTICITY OF
DEMAND (cont.)

FORMULA:

Y = %  Quantity
Demanded
%  Income

Y = Q2 – Q1 x Y1

Q1 Y2 – Y1
 RESPONSES OF INCOME ELASTICITY
Elastic Income
-Type of good: Luxury goods such as antique
furniture and diamonds
Income
y =0
Inelastic Income
-Type of good: Normal goods such as food
and clothing

Negative Income Elasticity

-Type of good: Giffen/ Inferior goods such
as used car and low grade potatoes

0< y < 1 Zero Income Elasticity

-Type of good: Necessity Goods such as rice
and vegetables
y > 1 y< 0
Quantity Demanded
 Interpretation of Income Elasticity;
Type of goods
Value of Type Description Examples
coefficient
As income increase,
Positive Luxury I  , big  in Qd demand for that product
(Ei  1) goods increase in larger portion.
Eg: diamond, luxury car
As income increase, the
Positive Normal I  , small  in more demand for that good.
(0 < Ei < 1) goods Qd Eg: table, chair, cloth

As income increase, the

Zero Necessity demand for that product not
I  , no change
(Ei = 0) goods change. Eg : bread,rice,
in Qd
flour.
As income increase, less
Negative Inferior I  , Qd 
demand for that good. Eg :
(Ei < 0) goods
salted fish, sardine
 Example:
• Example:
Income Qty A Qty B Qty C
100 10 20 20
120 15 20 18
150 17 20 14

Calculate the income elasticity of demand for goods A,

B and C when income increases from RM120 to RM150.
GOOD A
Y0=120 Q0=15
Y1=150 Q1= 17
 Working:
• Good A:
Ey = (QA1 – QA0) x Y0
QA0 (Y1 – Y0)

= (17 – 15) x 120

15 (150 – 120)

= 0.53

• Since Ey is positive and < 1, good A is a necessity

 Working:
• Good B:
Ey = (QB1 – QB0) x Y0
QB0 (Y1 – Y0)

= (20 – 20) x 120

20 (150 – 120)

= 0
(Good B is inferior good)
 Working:
• Good C:
Ey = (QC1 – QC0) x Y0
QC0 (Y1 – Y0)

= (14 – 15) x 120

15 (150 – 120)

= - 0.27

• Good C is an inferior good

 4. PRICE ELASTICITY OF SUPPLY

DEFINITION:

Measures the sensitivity/responsiveness

of the quantity supplied due to a change
in the price of a product or service.
PRICE ELASTICITY OF SUPPLY (cont.)

FORMULA:

ss = %  Quantity
Supplied
%  Price

SS = Q2 – Q1 x P1

Q1 P2 – P1
 DEGREE OF ELASTICITY
Elastic Supply
A small percentage of change in the price of a good will lead to
larger percentage of change in the quantity supplied.

Inelastic Supply
Price (RM)
ss =0 A large percentage of change in the price of a good
ss = 1 will only affect a small percentage of change of the
quantity supplied.
ss < 1
Unitary Elastic Supply
Percentage change in price equals the percentage
change in the quantity supplied.

Perfectly Elastic Supply

An almost zero percentage of change in price brings
ss =  a very large percentage of change in the quantity
supplied.

Perfectly Inelastic Supply

ss > 1 A percentage of change in price has no effect on
the percentage of change in the quantity supplied.

Quantity Demanded
 ELASTICITY OF SUPPLY
1. Price Elasticity of Supply
Definition-To measure how much quantity supplied change due to changes in
the price of a good
 
• Es = Q1 - Q0 X P0
Q0 P1 - P0
or;
• Es =   %  Qs = percentage change in QS
%P percentage change in price
where ; Q1 = new quantity P1 = new price
Q0 = original quantity P0 = original price

Note:
Price elasticity of demand will always result in positive coefficient
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 Determinants of price Elasticity of supply
1. Production cost
• If the change in supply requires only a small change in production costs, most
likely supply will be elastic.
• However if the change in supply involves a major change in costs supply
tends to be inelastic.

2. Availability of resources (FOP)

• If the resources necessary for production of the goods are limited and
cannot be obtained easily, the supply of goods tends to be inelastic.
• However, if the resources necessary for production of goods easily to
obtained, the supply of goods tends to be elastic.
3. TIME
In the short run, supply would be inelastic, it is not possible to
increase supply immediately in response to change in price.
In the long run, supply would be more responsive to price
changes, i.e. is more elastic. In the long run sellers or producers
can fully adjust their supply to the change in prices.
4. NATURE OF THE GOOD
If it takes too long to produce a product, supply is fairly
inelastic. Otherwise supply will be elastic. For example, the
supply of agricultural product (primary products) is fairly
inelastic
Whereas the supply of manufactured goods (secondary
products) is fairly elastic.

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