Micro 3: Elasticities of Demand and Supply

Micro 3: Elasticities of Demand and Supply

At the end of this set of notes, you should be able to explain:

1. Price Elasticity of Demand (PED) ..............................................................................2

2. PED and total revenue (TR).........................................................................................3
3. Factors affecting PED ...................................................................................................4
4. How firms use PED........................................................................................................5
5. Income Elasticity of Demand (YED) ..........................................................................6
6. How firms use YED........................................................................................................7
7. Cross Elasticity of Demand (XED) ............................................................................8
8. How firms use XED........................................................................................................9
9. Price Elasticity of Supply (PES).................................................................................9
10. Factors affecting PES .............................................................................................10

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Micro 3: Elasticities of Demand and Supply

1. Price Elasticity of Demand (PED)

1.1 Price elasticity of demand (PED) measures the degree of responsiveness of

quantity demanded of a good to a change in the price of the good itself,
ceteris paribus.

1.2 It involves a movement along the demand curve in response to a price change.

1.3 PED can be expressed mathematically as:

% ∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

PED of Good A = % ∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

∆𝑄
𝑥 100%
𝑄
= ∆𝑃
𝑥 100%
𝑃

∆𝑄 𝑃
= 𝑥
∆𝑃 𝑄

1.4 PED is always negative, because of the inverse relationship between

the price and quantity demanded of the good.

1.5 The magnitude of PED, as illustrated accordingly in Figure 1 can take

the following values:
a. PED = ∞ ;
i.e. the demand for the good is perfectly price elastic – for a given change
in the price of the good, there will be an infinite change in the quantity
demanded of the good.
b. ∞ > PED > 1;
i.e. the demand for the good is price elastic – for a given change in the
price of the good, there will be a more than proportionate change in the
quantity demanded of the good.
c. PED = 1;
i.e. the demand for the good is unitary – for a given change in the price of
a good, there will be a proportionate change in the quantity demanded of
the good.
d. 0 < PED < 1;
i.e. the demand for the good is price inelastic – for a given change in the
price of a good, there will be a less than proportionate change in the
quantity demanded of the good.
e. PED = 0;
i.e. the demand for the good is perfectly price inelastic – for a given
change in the price of a good, there will be no change in the quantity
demanded of the good.

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Micro 3: Elasticities of Demand and Supply

Figure 1: Demand curves with differing PED

2. PED and total revenue (TR)

2.1 When demand is price inelastic, an increase in the price leads to a less than
proportionate decrease in quantity demanded, causing an increase in TR.

2.2 Referring to Figure 2, an increase in price from P0 to P1 causes:

a. TR gained represented by P 1 ABP 0 , which is larger than;
b. TR lost represented by BCQ 0 Q 1 .

Figure 2: Effect on TR when price falls for price inelastic demand

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Micro 3: Elasticities of Demand and Supply

2.3 When demand is price elastic, an increase in the price leads to a more than
proportionate decrease in quantity demanded, causing a decrease in TR.

2.4 Referring to Figure 3, an increase in price from P0 to P1 causes:

a. TR gained represented by P 1 ABP 0 , which is smaller than;
b. TR lost represented by BCQ 0 Q 1 .

Figure 3: Effect on TR when price falls for price elastic demand

3. Factors affecting PED

a. Availability of substitute goods

3.1 The greater the availability of substitutes for a good and the closer these
substitutes are to the good demanded, the more price elastic the good will be.

3.2 The number and similarity of substitutes depends on how the good is defined –
the more broadly it is defined, the fewer substitutes it will have and the less
price elastic its demand will be.

3.3 For some goods there are simply no close substitutes, and the demand for
such goods tends to be price inelastic (e.g. insulin for diabetics).

3.4 Producers can make the demand for their products price inelastic through
branding/advertising, which allow them to raise prices and earn higher TR.

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Micro 3: Elasticities of Demand and Supply

b. Nature of the good

3.5 The PED is lower for necessities (e.g. food, water and utilities) than for luxury
goods (e.g. vacations, amusement park tickets).

3.6 The PED is lower for raw materials because the demand for such goods tend
to depend on the demand for the final good, rather than by their price changes.

c. Proportion of income spent on the good

3.7 The greater the proportion of income spent on a good, the greater its PED.

3.8 For relatively inexpensive goods, no significant effort would be made to look
for substitutes when price increases, with the opposite being true when the
good is relatively expensive for the individual.

d. Durability

3.9 The greater the durability of a good, the greater its PED.

3.10 This is because when price increases for durable goods (e.g. electronics or
furniture), the consumer can hold off purchase in response.

e. Addiction

3.11 Demand tends to be price inelastic for goods with addictive effects (e.g.
cigarettes), because the consumer finds reducing consumption more difficult
when prices increase.

f. Time period

3.12 The longer the time period under consideration, the greater the PED would be
because:
a. News of price changes take time to spread;
b. Habits take time to be broken;
c. Durability of the commodity.

4. How firms use PED

4.1 It will assist the firm in selecting an appropriate pricing policy:

a. If price elastic (e.g. luxury goods), it should lower the price of
the good in order to increase the total revenue of the firm.
b. If price inelastic (e.g. addictive goods), it should increase the
price of the good in order to increase the total revenue of the firm.

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4.2 Secondly, it helps the firm to determine how much to produce if it alters the
price of its product.

4.3 For example, if the PED of a good is -2, this means that if the firm lowers the
price by 10%, the quantity demanded would increase by 20% and the firm
should expand its output by 20%.

5. Income Elasticity of Demand (YED)

5.1 Income elasticity of demand (YED) measures the degree of responsiveness

of quantity demanded of a good to a change in income, ceteris paribus.

5.2 It involves a shift in the demand curve in response to a price change.

5.3 YED can be expressed mathematically as:

% ∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

YED of Good A = % ∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

∆𝑄
𝑥 100%
𝑄
= ∆𝑌
𝑥 100%
𝑌

∆𝑄 𝑌
= 𝑥
∆𝑌 𝑄

5.4 YED can take the following values:

a. YED > 1;
i.e. for a given increase in income, there will be a more than proportionate
increase in the quantity demanded of the good. Such demand is described
as income elastic and termed as luxury goods.
b. 0 < YED < 1;
i.e. for a given increase in income, there will be a less than proportionate
increase in the quantity demanded of the good. Such demand is described
as income inelastic and termed as necessities.
c. YED < 0;
i.e. for a given increase in income, there will be a fall in the quantity
demanded of the good. Such goods with demand exhibiting negative
elasticity are termed as inferior goods.

5.5 A normal good is one where income elasticity is positive (unlike inferior good).

5.6 The income elasticity of demand for a good may change as income
changes, and often follows what is known as the Engel Curve, as illustrated in
Figure 4.

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5.7 Consider a product such as potatoes:

a. If an economy is very poor, then as income rises people will be
pleased to eat more potatoes (normal good);
b. As income continues to increase, people will buy other types of
food to supplement their diet, and the demand for potatoes will
remain constant.
c. As the economy become richer, people consume large
quantities of meat and other vegetables, and less potatoes
(inferior good).

5.8 Therefore, income elasticity is related to standard of living – as income

rises in the less developed countries, the demand for goods such as television
sets, cars and refrigerators will be income elastic, while in the richer countries,
the demand for these goods will be income inelastic.

Figure 4: Engel Curve

6. How firms use YED

6.1 It will assist the firm in selecting the types of goods it should sell as a result of
a change in income:
a. During a boom, it should sell goods with positive (and high) income
elasticity of demand, so that the firm’s total revenue increases.
b. During a recession, it should sell goods with negative income
elasticity of demand, so that the firm’s total revenue increases.

6.2 Secondly, it helps the firm to determine how much to produce as income
changes.

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Micro 3: Elasticities of Demand and Supply

6.3 For example, if the YED of a good is 2, this means that if income increases by
10%, the quantity demanded would increase by 20% and the firm should
expand its output by 20%.

7. Cross Elasticity of Demand (XED)

7.1 Cross elasticity of demand (XED) of good A with respect to the price of good B
measures the degree of responsiveness of quantity demanded of good A
to a change in the price of good B, ceteris paribus.

7.2 It involves a shift in the demand curve of good A in response to a price change
for good B.

7.3 XED can be expressed mathematically as:

% ∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

XED of Good A w.r.t to Good B =
% ∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐵

∆ 𝑄𝑎
𝑥 100%
𝑄𝑎
= ∆ 𝑃𝑏
𝑥 100%
𝑃𝑏

∆𝑄𝑎 𝑃𝑏
= 𝑥
∆𝑃𝑏 𝑄𝑎

7.4 XED can take the following values:

a. XED > 1;
i.e. for a given increase in price of good B, there will be a more than
proportionate increase in the quantity demanded of the good A. This
indicates that both goods are close substitutes.
b. 0 < XED < 1;
i.e. for a given increase in price of good B, there will be a less than
proportionate increase in the quantity demanded of the good A. This
indicates that both goods are weak substitutes.
c. -1 < XED < 0;
i.e. for a given increase in price of good B, there will be a less than
proportionate decrease in the quantity demanded of the good A. This
indicates that both goods are weak complements.
d. XED < -1;
i.e. for a given increase in price of good B, there will be a more than
proportionate decrease in the quantity demanded of the good A. This
indicates that both goods are strong complements.

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8. How firms use XED

8.1 It will assist the firm in responding to an action taken by another rival or
complementary firm.

8.2 If a strong rival (i.e. XED > 1) lowers its price, the firm may:
a. Lower its price just as much to avoid revenue loss;
b. Adopt non-price competition (i.e. branding to reduce substitutability)
to maintain its sales.

8.3 For strong complementary firm (i.e. XED < -1), the firm could
cooperate with it for win-win situations (e.g. pooling resources for joint
branding campaign to jointly increase attractiveness).

8.4 Secondly, it helps the firm to determine how much to produce as the price
charged by the other firm changes.

8.5 For example, if the XED of good A with respect to good B is 2, this means that
if the price of good B increases by 10%, the quantity demanded of good A would
increase by 20% and the firm should expand its output by 20%.

9. Price Elasticity of Supply (PES)

9.1 Price elasticity of supply (PES) measures the degree of responsiveness of

quantity supplied to a change in the price of good itself, ceteris paribus.

9.2 It involves a movement along the supply curve in response to a price

change.

9.3 PES can be expressed mathematically as:

% ∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

PES of Good A = % ∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝐺𝑜𝑜𝑑 𝐴

∆𝑄
𝑥 100%
𝑄
= ∆𝑃
𝑥 100%
𝑃

∆𝑄 𝑃
= 𝑥
∆𝑃 𝑄

9.4 The magnitude of PES, as illustrated accordingly in Figure 5 can take

the following values:
a. PES = ∞ ;

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Micro 3: Elasticities of Demand and Supply

i.e. the supply for the good is perfectly price elastic – for a given change
in the price of the good, there will be an infinite change in the quantity
supplied of the good.
b. ∞ > PES > 1;
i.e. the supply for the good is price elastic – for a given change in the price
of the good, there will be a more than proportionate change in the quantity
supplied of the good.
c. PES = 1;
i.e. the supply for the good is unitary – for a given change in the price of a
good, there will be a proportionate change in the quantity supplied of the
good.
d. 0 < PES < 1;
i.e. the supply for the good is price inelastic – for a given change in the
price of a good, there will be a less than proportionate change in the
quantity supplied of the good.
e. PES = 0;
i.e. the supply for the good is perfectly price inelastic – for a given change
in the price of a good, there will be no change in the quantity supplied of
the good.

Figure 5: Supply curves with differing PES

10. Factors affecting PES

a. Time period

10.1 The shorter the time period, the more difficult firms find it to switch resources
from making one product to another, thus the lower the PES.

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Micro 3: Elasticities of Demand and Supply

10.2 When prices increase, existing suppliers are induced to increase quantity
supplied, but there is a period of adjustment as resources are being re-
allocated accordingly.

10.3 Thus, the increase in quantity supplied is initially less than proportionate to the
change in price.

10.4 As suppliers engage more suitable resources to aid in production, and the
higher prices attract new firms to the market, the quantity supplied increases
further for the same higher price, increasing PES.

b. Existence of spare capacity

10.5 In the short run, firms and industries with spare productive capacity will tend
to have higher PES.

10.6 In particular, shortages of factor inputs (skilled workers, components, fuel)

will often lead to inelastic PES.

c. Availability (durability) of stocks

10.7 Where a product can be stored without loss of quality or undue expense,
supply will tend to be elastic at least while stocks last.

10.8 This explain why supply of processed food will tend to be more elastic than the
supply of fresh food.

d. Factor mobility

10.9 The higher the factor mobility (ease with which factors of production can
moved from one use to another), the more elastic will be the supply.

e. Behaviour of cost as output expands

10.10 When firms are subject to relatively small increases in average costs as
output expands supply will tend to be more elastic.

10.11 However, if firms experience diminishing returns or diseconomies of scale

which are severe enough, costs will rise steeply as output expands, causing
supply to be less elastic.

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f. Barriers to entry

10.12 In certain cases, it might be difficult for additional firms to enter an industry and
undertake production, hence barriers to entry will tend to make supply less
elastic than otherwise.

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