Mic 4

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
4– 1

CHAPTER

4 Elasticity and its
Application

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INTRODUCTION TO ELASTICITY

Elasticity is an important concept as it is vital
and applicable in the daily of households, lives
businesses and researchers.
Elasticity it is not limited to the concept of
demand, supply and income elasticity but also
to the concept of growth and development.

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DEFINITION TO ELASTICITY

Elasticity measures the magnitude of
responsiveness of any variable to a change in
one of the determinant’s factors.
For example, quantity demanded or supplied
would change if price or income changes.

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FORMULA OF ELASTICITY
• The value of elasticity can be
measured by:

Elasticity = Percentage change in
Quantity Demanded
Percentage change in
Quantity Supplied

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APPLICATION OF ELASTICITY
Policy makers, producers and consumers use
elasticity in their daily decision making .
Firms use the application of elasticity to
determine the substitution of inputs if one of the
inputs price goes up.
Policy makers use the application of elasticity to
determine which factors contribute most to the
growth of the Gross Domestic Product (GDP).
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TYPES OF ELASTICITY

• Price elasticity of demand
• Price elasticity of supply
• Cross price elasticity
• Income elasticity

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PRICE ELASTICITY OF
DEMAND
• Measures how much the quantity demanded
of a good responds to a change in the price of
that good.
• It is computed as a percentage change in
quantity demanded divided by a percentage
change in price.

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FORMULA FOR PRICE
ELASTICITY OF DEMAND USING
THE POINT FORMULA
• The point formula is used to calculate the price
elasticity of demand between two points on a
demand curve.
• The formula is shown below:
Price elasticity : Percentage Change in Quantity

Demanded
Microeconomics Percentage Change in Price Rights Reserved
All
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FORMULA FOR PRICE,
ELASTICITY OF DEMAND USING
THE MIDPOINT FORMULA (CON’T)
• Computes a percentage change by dividing the change by
the midpoint (average) at the initial and endpoint.
• The formula is shown below:
Q1-Q0
[ (Q1-Q0)/2 ] ∆Q (P0 + P1)/2
= X
P1-P0 ∆P (Q0 + Q1)/2
[ (P1-P0)/2 ]
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TYPES OF PRICE ELASTICITY
OF DEMAND
• Elastic, E>1
• Inelastic, E < 1
• Unit Elastic, E = 1
• Perfectly Inelastic, E = 0
• Perfectly Elastic, E = α

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FACTORS AFFECTING
ELASTICITY OF DEMAND
Availability of close substitutes
Necessities versus luxuries
Market
Time horizon
Proportion of consumer’s expenditure

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PRICE ELASTICITY AND
TOTAL REVENUE

Inelastic: P ↑ Q ↓ TR ↓
P ↓ Q ↓TR ↓

Elastic : P ↑ Q ↑ TR ↓
P ↑ Q ↓ TR ↓

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ELASTICITY OF A LINEAR
DEMAND CURVE
• At points with low
price and high
quantity, the demand
curve is inelastic. Unitary elasticity is equal to 1

• At points with high
price and low
quantity, the demand
curve is elastic.

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INCOME ELASTICITY OF
DEMAND

• Measures how much the quantity demanded
of a good responds to a change in consumers
income.
• It is computed as a percentage change in
quantity demanded divided by a percentage
change in income.

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FORMULA FOR INCOME

The formula for income elasticity of demand is
shown below:
Percentage Change in
Income Quantity Demanded
elasticity of =
demand Percentage Change in
Income
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THE USES OF INCOME
ELASTICITY

Used to classify goods into luxury goods, normal
goods, necessary goods or inferior goods.
Used to predict market potential.
If one good has a high value income elasticity,
the producer can predict an increase and
decrease in sales when the elasticity coefficient
falls.
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DEGREES OF INCOME
ELASTICITY

• EY= 0, perfectly elastic necessary goods

• EY >0, elastic, luxury goods

• 0 < EY < 1, inelastic, normal goods

• EY < 0, negative elastic, inferior goods

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CROSS PRICE ELASTICITY OF
DEMAND

Measures how the quantity demanded of a
good responds to a change in the price of
another good.
It is computed as a percentage change in
quantity demanded of good 1 divided by the
percentage change in the price of good 2.

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FORMULA FOR CROSS PRICE

The formula for cross price elasticity of
demand is shown below:
Cross price Percentage change in quantity
elasticity of demanded of good 1
demand =
Percentage change in
price of good 2

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DEGREE OF CROSS PRICE
ELASTICITY

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PRICE ELASTICITY OF SUPPLY

Measures how much the quantity supplied of
a good responds to a change in price of that
good.
It is computed as a percentage change in the
quantity supplied divided by a percentage
change in price.

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FORMULA FOR PRICE
ELASTICITY OF SUPPLY

• The formula of price elasticity of supply is
shown below:
Percentage change in quantity
Price elasticity = demanded supplied
of supply Percentage change
in price

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TYPES OF PRICE ELASTICITY
OF SUPPLY
Elastic, E >1
Inelastic, E < 1
Unit Elastic, E = 1
Perfectly Inelastic, E = 0
Perfectly Elastic, E = α

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FACTORS AFFECTING
ELASTICITY OF SUPPLY
Flexibility of sellers to produce
Time period
Technology improvement
Availability and mobility of factors of
production
Perishability
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APPLICATION OF CONCEPT OF
ELASTICITY- TAXES AND SUBSIDIES

The imposition of tax on goods is an
example of government intervention in the
market.
Subsidies are another example government
intervention in the market.

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BURDEN OF TAXES

When the government imposes tax on sellers
for each unit of good they sell, the tax imposed
will cause customers to buy at different prices
than what is received by the sellers.
Tax will be a burden to a seller in terms of
lower price received for each unit of good sold.

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EFFECT OF TAX ON THE
EQUILIBRIUM

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SUBSIDY

Subsidy is a direct or indirect payment,
economic concession, or privilege granted
by a government to private firms,
households or other governmental
units in order to promote a
public objective.

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BENEFITS OF SUBSIDY

• When a subsidy is given to the producer, the
cost of producing is reduced.
• This means that the supply curve will shift to
the right which shows that the equilibrium
quantity rises.

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EFECT OF SUBSIDY ON THE
EQUILIBRIUM

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