Victoria Junior College

2020 JC1 H1 Economics

Module 3 – Price Elasticity of Demand and Supply
Unit Summary

• In the previous module, we learnt that, in any competitive market, the demand curve
represents the consumers’ behaviour and the supply curve represents the producers’
behaviour. The interaction between consumers and producers in the market moves the prices
up/down in the event of a demand or supply shock to bring the market into equilibrium
eventually.

• The concept of elasticity allows us to analyse changes in markets with greater precision as it
is a measure of how much (instead of just how) consumers or producers respond to market
conditions. When we study how an event affects a market, we should discuss both the
direction of the effects on equilibrium price and quantity and their magnitude. For example,
bad weather that causes a fall in the supply of agricultural products leads to a shortage and
thus higher prices. While the severity of bad weather matters (e.g. this affects the direction
and magnitude of the shift in supply), the impact on equilibrium price (e.g. how much price
rises) depends also on the elasticities of demand and supply.

MODULE SYNOPSIS

1. Price Elasticity of Demand

1.1. Definition and Formula
1.2. Interpretation of values of Price Elasticity of Demand
1.3. Factors affecting Price Elasticity of Demand

2. Application of Price Elasticity of Demand to Total Revenue

2.1. Relationship between Price Elasticity of Demand and Total Revenue

3. Price Elasticity of Supply

3.1. Definition and Formula
3.2. Interpretation of values of Price Elasticity of Supply
3.3. Factors affecting Price Elasticity of Supply

4. Application of Elasticity Concepts to Price, Quantity and Total Revenue/Total

Expenditure
4.1 Application of Price Elasticity of Demand and Price Elasticity of Supply on the Extent of the
Change in Price
4.2 Application of Elasticity Concepts to Determine the Change in Price and Quantity for
Simultaneous Shifts in Demand and Supply
4.3 Prediction of Change in Total Revenue/Total Expenditure for Simultaneous Shifts in Demand
and Supply

5. Application of Elasticity of Demand and Supply to Decision Making of Producers and

Governments
5.1. Pricing and marketing strategies of a firm
5.2. Government policy-making
5.3. Limitations of Using Elasticity in Decision Making

2020 H1 Economics
Economics Department
Victoria Junior College 1
 REFERENCES

1. Sloman J., Wride A.and Garrat D., Economics (10th edition), Chapters 3.1-3.3
2. Mankiw N. G., Quah E., Wilson P., Principles of Economics (An Asian Edition), (2nd edition),
Chapter 5
3. O’ Sullivan A., Sheffrin S., Lim Kim Lian and Seevaratnam V., Principles of Economics,
Chapter 5
4. McEachern W. A., Economics: A Contemporary Introduction (Eighth Edition), Chapter 5

Big Ideas

The magnitude/extent of price and quantity changes of a good depends on the causes of
the change in demand and supply as well as the relevant demand and supply elasticities
of the good.

Essential Questions Enduring understandings

At the end of the topic, you will
understand that

1. Why do the prices of certain goods

fluctuate more sharply than others?
1. The magnitude of a price change of a
good when demand or supply changes
depends on its price elasticity of demand
and supply.

2. Why might consumers spend more (and

hence producers earn more revenue) 2. The direction of change in total
even though consumers buy a lower expenditure (or total revenue) that results
quantity in response to a rise in price, from a change in price depends on
ceteris paribus, and vice versa? whether demand is price elastic or
inelastic.

3. How useful are the concepts of elasticity

to a producer (in explaining the impact 3. While elasticity concepts are useful to
on sales, revenue and possible both producers and governments in their
strategies) or the government in the decision making, they have their
formulation of policies? limitations.

2020 H1 Economics
Economics Department
Victoria Junior College 2
 1. PRICE ELASTICITY OF DEMAND
1.1 Definition and Formula
Definition

Price elasticity of demand (PED) measures the responsiveness of

quantity demanded for the good to a change in its price, ceteris paribus.

• It is the percentage change in quantity demanded of a good resulting from a percentage

change in price of that good, ceteris paribus.

• When price changes with all other (non-price) demand factors remaining constant (i.e. ceteris
paribus), price elasticity of demand will measure how much (extent) quantity demanded will
change.

Formula
percentage change in quantity demanded of a good
PED =
percentage change in price of a good
∆Q
× 100%
Q
=
∆P
× 100%
P

Where:
∆Q = change in quantity demanded of the good ∆P = change in price of the good
Q = original quantity demanded of the good P = original price of the good

Exercise 1: Calculating PED

a. If a 10% rise in the price causes the quantity demanded to fall by 5%, then the price elasticity
of demand for chicken rice is:

PED = % change in quantity demanded

% change in price
= −5% / 10% = −0.5

b. If a 10% fall in price causes the quantity demanded to rise by 20%, then the price elasticity of
demand for chicken rice is:

PED = % change in quantity demanded

% change in price
= 20% / −10% = −2

Characteristics of PED
• Mathematically, PED has a negative sign because of the inverse relationship between price
and quantity demanded. But this is usually ignored.

2020 H1 Economics
Economics Department
Victoria Junior College 3
1.2 Interpretation of values of Price Elasticity of Demand

PED varies from zero to infinity.

Value of PED Explanation

PED = 0 For a given percentage fall (rise) in price, the quantity
demanded for the good remains the same. The demand for the
good is said to be perfectly price inelastic.

0 < PED < 1 When a given percentage rise (fall) in price brings about a less
than proportionate fall (rise) in quantity demanded, the
demand for the good is said to be price inelastic.

In Exercise 1 example (a), a 10% rise in price leads to a

decrease in quantity demanded by 5%, or Ep = 0.5, hence
demand for chicken rice is price inelastic.

PED >1 When a given percentage rise (fall) in price brings about a more
than proportionate fall (rise) in quantity demanded, the
demand for the good is said to be price elastic.

In Exercise 1 example (b), a 10% fall in price leads to an

increase in quantity demanded by 20%, or Ep = 2, hence
demand for the chicken rice is price elastic.

PED = ∞ When at the given price, quantity demanded is infinitely large,

any increase in price will cause quantity demanded to drop to
zero. The demand for the good is said to be perfectly price
elastic.

THINK!

What are some real – world examples of goods that come close to perfectly price elastic
and perfectly price inelastic demand?
Perfectly price elastic demand: Consumers could choose to buy foreign currency from
many different sellers as the product (e.g. dollars) is identical. Perfect information about
the cheapest rate would be easy to find.

Perfectly price inelastic demand occurs when buyers have no choice in the
consumption of a good. Eg: insulin injections for a type I diabetic. Demand for such life-
saving drugs are perfectly price inelastic to the individuals who require them

2020 H1 Economics
Economics Department
Victoria Junior College 4
 Varying Price Elasticity along a Straight-Line Demand Curve

Mathematically, every point along any straight-line demand curve has varying price elasticity.

Diagram 1: Price Elasticity Varies along a Straight-Line Demand Curve

Price/unit

PED = ∞

1< PED < ∞

midpoint PED = 1

0< PED < 1

PED = 0
0 D

Quantity/period

• Along a straight-line demand curve, the absolute values of PED (i.e. PED) vary from infinity
to zero as you move down the demand curve.
• Demand is price elastic on the top half, unitary price elastic at the midpoint and price inelastic
at the bottom half of a straight-line demand curve.

The price elasticity of demand does not measure the gradient of slope of the demand curve.

Extra information

The mathematical calculation below is to illustrate the different absolute values of PED when
a straight-line demand curve is plotted.

Demand schedule for potato chips

Price Quantity PED

($/Bag) demanded
(Bag)
6 0 ∞
5 1 5
4 2 2
3 3 1
2 4 ½
1 5 1/5
0 6 0

2020 H1 Economics
Economics Department
Victoria Junior College 5
 1.3 Factors affecting Price Elasticity of Demand

1. Number and ‘closeness’ of available substitutes

• The more numerous and the closer the substitutes, the more price elastic is the demand for
the good.
The substitutes need not be
cheaper in absolute terms!
• The number of substitutes
An increase in the price of a good causes its substitutes to become relatively cheaper. If there
are numerous substitutes, a percentage increase in price tends to lead to a larger percentage
fall in quantity demanded for that good because consumers can easily switch to other
substitutes.

For example, the demand for eggs is less price elastic than the demand for Coke, as Coke
and other types of drinks are easily substitutable while there is a lack of ‘close’ substitutes for
eggs.

• The ‘closeness’ of substitutes

There are a few factors affecting the closeness of substitutes.

a. Definition of the good

Depends on the how widely or narrowly the good is defined. The demand for narrowly defined
goods / services (e.g. Pasar brand fresh chicken or Farmland brand frozen sirloin steak) will
be price elastic as there are many ‘close’ substitutes available. On the other hand, the demand
for goods which are widely defined (e.g. meat or food) is price inelastic as there are very few
‘close’ substitutes available.

b. Price range
Recall from section 2.3 that ‘close’ substitutes must also be within the same price range. The
smaller the price difference, the ‘closer’ the substitutes.

c. Advertising
Successful advertising raises demand by bringing the product to more people's attention and
increases people's desire for it. At the same time, it reduces the price elasticity of demand
for the good (i.e. demand becomes more price inelastic) because it creates greater brand
loyalty. Consumers perceive the competitors’ brands as poor substitutes. This will allow the
firm to raise its price above that of its rivals with no significant fall in sales (i.e. quantity
sold).

2020 H1 Economics
Economics Department
Victoria Junior College 6
 2. Proportion of Income spent on the good

The larger the proportion of the consumers’ income (or budget) the good takes up, the greater
is the price elasticity of demand. This is because, when the price of such goods rises,
consumers’ ability to afford them is lowered more significantly, and so quantity demanded for
these goods will fall more than proportionately. For example, a rise in the price of cars will lead
to a more than proportionate fall in quantity demanded for cars as consumers’ ability to
purchase cars falls significantly, ceteris paribus.

3. Time period: Demand will be more price elastic in the long run than in the short
run

• Time is needed for consumers to find suitable substitutes after a price change and to alter
their expenditure patterns.

• Habits take time to change – habitual expenditure on items such as alcohol, tobacco, water,
electricity, etc. does not change in the short run. Thus, demand for them tends to be price
inelastic in the short run.

• Imperfect knowledge about price changes. Consumers do not have perfect and
instantaneous knowledge of all market prices at all times. E.g. if the price of a good falls,
quantity demanded may not initially rise because consumers are still unaware of price
changes. However, as time passes, more consumers will be able to respond to the fall in price
of the good by reallocating their expenditure from other goods to this relatively cheaper good.

THINK!

Why do some of the goods & services listed below have low price elasticity of demand,
while others have much higher values?

Table 1: Price elasticities of demand for selected products

Product Price elasticity of demand
Salt 0.1
Water 0.2
Coffee 0.3
Eggs 0.3
Automobiles 1.2
Restaurant meals 2.3
Nescafe coffee 5.6
From: O’ Sullivan, Sheffrin, Lim and Seevaratnam, Principles of Economics, page 118

Demand for items like salt, water, coffee and eggs are very price inelastic because there is no
availability of close substitutes. Demand for automobiles like cars are price elastic because it
takes up a large proportion of income. Restaurant meals are very price elastic because there
are close substitutes e.g. hawker meals. Demand for Nescafe coffee is very price elastic
because of its narrow definition – there are many close substitutes e.g. instant coffee from
other brands like Owl, as well as brewed coffee like Starbucks coffee.

2020 H1 Economics
Economics Department
Victoria Junior College 7
2. APPLICATION OF PRICE ELASTICITY OF DEMAND TO
TOTAL REVENUE / TOTAL EXPENDITURE
The concept of price elasticity of demand helps business owners make pricing decisions so
that he can increase his revenue.

2.1 Relationship between Price Elasticity of Demand and Total Revenue

/ Total Expenditure

The amount of expenditure paid by consumers on the purchase of goods is equal to the total
revenue received by producers from the sale of the goods in the absence of government
intervention. Hence

Households’ expenditure (TE) = Price (P) x Quantity bought/sold (Q)

= Total revenue (TR) received by firms

The table below shows how a change in price of the good will affect a producer’s total
revenue earned, depending on the price elasticity of demand of the good. A producer with
an aim to increase his revenue can then decide to increase or decrease price, by influencing
supply.

Price Elastic A change in price brings about a change in total revenue (TR) in the
Demand opposite direction to the price change.

PED > 1 Price/

unit
a b

c d e

D
0
f g Quantity/period
P↓ => TR↑
If price falls from a to c, TR ↑ because the loss in revenue from the fall in
price (area abdc) is less than the gain in revenue from the more than
proportionate rise in quantity demanded (area degf).

P↑ => TR↓
If price rises from c to a, TR ↓ because the gain in revenue from the rise
in price (area abdc) is less than the fall in revenue from the more than
proportionate fall in quantity demanded (area degf).

2020 H1 Economics
Economics Department
Victoria Junior College 8
 Price A change in price brings about a change in TR in the same direction as
Inelastic the price change.
Demand
Price/
unit
0 < PED < 1 D

u
t
v x
w
0
y z Quantity/period

P↓ => TR↓
If price falls from t to v, TR ↓ because the loss in revenue from the fall in
price (area tuwv) is more than the gain in revenue from the less than
proportionate rise in quantity demanded (area wxzy).

P↑ => TR↑
If price rises from v to t, TR ↑ because the gain in revenue from the rise
in price (area tuwv) is more than the loss in revenue from the less than
proportionate fall in quantity demanded (area wxzy).

Suppose a chicken rice producer wants to increase his total, should he raise,
lower or leave the price unchanged for his chicken rice?
Lower price if |PED| > 1 and raise price if |PED| < 1. Due to the number of other stalls in the
canteen offering other kinds of food (availability of close substitutes), demand is likely to be price
elastic. In this case, he should lower price to increase revenue.

Why may a restaurant charge very high prices for wine and bottled water, yet
quite reasonable prices for food?

The demand for food is relatively price elastic due to availability of close substitutes, hence
people will compare restaurant food prices when deciding where to eat. The demand for drinks
in a particular restaurant, however, is likely to be relatively price inelastic. People’s decision on
where to eat is unlikely to be influenced by drink prices. Then, once people are eating in a
restaurant, there is little or no substitutes to the drinks offered by the restaurant. People either
have to pay the high prices or go without. i.e. |PED|<1. Thus, raising prices on wine or bottled
water will cause a smaller % fall in Qd and hence a rise in TR.

2020 H1 Economics
Economics Department
Victoria Junior College 9
 3. PRICE ELASTICITY OF SUPPLY

3.1 Definition and Formula

Definition

Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a

change in price, ceteris paribus.

• It is the percentage change in quantity supplied of a good resulting from a percentage

change in its price, ceteris paribus.
• Value of price elasticity of supply is positive as there is a positive relationship between price
and quantity supplied of a good.
Formula
percentage change in quantity supplied of a good
PES =
percentage change in price of a good
∆Q s
× 100%
Qs
=
∆P
× 100%
P

Where:
∆Qs = change in quantity supplied of the good
∆P = change in price of the good
Qs = original quantity supplied of the good
P = original price of the good

2020 H1 Economics
Economics Department
Victoria Junior College 10
 3.2 Interpretation of values of Price Elasticity of Supply
Value of Explanation Diagram
PES
Price/unit
Price • A given percentage
Elastic change in price brings
Supply S
about a more than
proportionate change in
PES > 1 quantity supplied.
• e.g. A 1% rise in price will
lead to a more than 1%
rise in quantity supplied
0 Quantity/period

Price/unit
Price • A given % change in price
Inelastic brings about less than S
Supply proportionate change in
quantity supplied.
0 < PES < 1 • e.g. A 1% rise in price will
lead to a less than 1%
rise in quantity supplied

0
Quantity/period
Price/unit
Perfectly
price elastic • Producers are able to sell
supply at whatever quantity they S
want at the given price.
PES = ∞
0
Quantity/period
Price/unit
Perfectly • A fixed quantity that the S
price inelastic producer can sell
Supply regardless of the price

PES = 0

0 Quantity/period

2020 H1 Economics
Economics Department
Victoria Junior College 11
 THINK!

What are some real – world examples of goods that come close to perfectly price elastic
and perfectly price inelastic supply?
Such goods are uncommon in reality. Goods with readily available inputs and whose
production can be easily expanded will have highly price elastic supply. Close
examples include books and bread. Example of goods with perfectly price inelastic
supply are famous paintings such as the Mona Lisa since even if people offer higher
prices, there will still only be one painting for sale.

3.3 Factors affecting Price Elasticity of Supply

1. Time Period

Price elasticity of supply depends on the ease with which output can be expanded or reduced
in response to a change in price, and this in turn depends on the time period firms have to
adjust their production processes. Supply is more price elastic in the long run than in the short
run because producers have more time to make changes to production processes.

Price elasticity of supply depends on the following time period:

(a) Very short run (Momentary Period) (SM)

Period is so short that all factors of production cannot be varied. Hence quantity supplied
is unable to respond to a change in price. Supply is perfectly price inelastic.
Example: Christmas trees, pussy-willow (already cut) on holiday eve.

(b) Short run period (SSR)

Short run is defined as a period of time in which there is at least one fixed factor of
production (i.e. other factors can be variable). In the short run, when price rises, firms can
only adjust by using more of the variable factors to increase production. Supply is relatively
price inelastic.
A variable factor refers to an input that can be
increased in supply within a given period of time.
(c) Long Run Period (SLR)

Long run is defined as a time period in which all factors of production are variable but the
state of technology remains unchanged. Long run supply is more price elastic than short
run supply because

i. Existing firms can increase output by increasing ALL factors of production, i.e. it is no
longer constrained by its existing production facilities
ii. New firms respond by entering the industry as it is now more profitable. Quantity supplied
is likely to increase more than proportionately in response to the rise in price.

2020 H1 Economics
Economics Department
Victoria Junior College 12
 Diagram 2: Time and price elasticity of supply

Price/unit SM
SSR

SLR

0
Quantity/period

As time period increases from momentary to short run to long run, supply becomes more price
elastic; thus a small change in price in the long run yields a relatively bigger change in quantity
supplied compared to that in the short run.

2. Behaviour of marginal costs as output changes in response to price changes.

Supply is likely to be more price elastic if:

• Firms have plenty of spare capacity (e.g. plant) to raise production without a huge rise in
marginal costs. Firms will be able to respond to a given rise in the price of a good by
producing a more than proportionate amount if they have existing resources that are easily
available and affordable.

• Firms can switch away from producing alternative products easily (i.e. factors of production
are mobile – they can be easily transferred from the production of one good to that of another
without a large rise in marginal costs. E.g. printing machine that can easily be used to produce
greeting cards rather than magazines.)

3. How the good is defined

Price elasticity of supply is greater for more narrowly defined goods. E.g. the supply of Nike
shoes is more price elastic than that of shoes in general. This is because it is easier for Nike
to obtain factors of production from other shoe firms compared to the shoe industry obtaining
factors of production from other industries.

2020 H1 Economics
Economics Department
Victoria Junior College 13
 4. APPLICATION OF ELASTICITY CONCEPTS TO CHANGES IN
PRICE, QUANTITY and TOTAL REVENUE/TOTAL
EXPENDITURE

4.1 Application of Price Elasticity of Demand and Price Elasticity of

Supply on the Extent of the Change in Price

When demand or supply changes (i.e. when demand or supply curve shifts), the extent of the
change in the equilibrium price depends on both the price elasticity of demand and
supply.

For example, when supply falls, the immediate effect is a shortage at the existing price, which
in turn will put upward pressure on the price to rise. If both demand and supply are price
inelastic (i.e. unresponsive to changes in price), it will take a very large increase in price to
eliminate the shortage.

That is, a given fall in supply will cause a very sharp rise in price if both demand and supply
are price inelastic. Referring to Diagram 3, a fall in supply to S2 causes a shortage of Q1Q3
units at original price 0P1, causing an upward pressure on price. As demand and supply are
price inelastic, a rise in price leads to a less than proportionate fall in quantity demanded and
a less than proportionate increase in quantity supplied. There is a significant increase in
price from P1 to P2 to eliminate the shortage.

Diagram 3: Effects of shift in Supply on the Market for Primary Product

Price / S2
S1
Unit

P2

P1
D

0 Q3 Q2 Q1 Quantity/period

An example of goods whose demand is price inelastic are primary products. A primary
product refers to a good that has not been processed and is therefore in its natural state,
specifically agricultural products (e.g. wheat, grains, meat) and mining (e.g. crude oil, iron ore).
The demand for such products tends to be price inelastic in nature as there are few close
substitutes. When there is a rise in price, consumers have few alternatives to switch to and
2020 H1 Economics
Economics Department
Victoria Junior College 14
 therefore quantity demanded will fall less than proportionately. This is in contrast to
manufactured goods like soft drinks, where demand is likely to be more price elastic.
Supply for primary products is price inelastic too since the factors of production to produce
such products cannot be increased easily (e.g. land to grow wheat, oil reserves) in the short
run. Hence, when there is a rise in price, quantity supplied will increase less than
proportionately.

Since demand and supply are both price inelastic, a shift in supply in this case will result in
price changing by a large extent.

4.2 Application of Elasticity Concepts to Determine the Change in Price

and Quantity for Simultaneous Shifts in Demand and Supply

In this section, we explore how PED and PES concepts help us to analyse the impact of
simultaneous changes in demand and supply on the market equilibrium price and quantity.

In the last module of Demand and Supply Analysis, we learnt that when both market demand
and supply curves shift simultaneously, the equilibrium price and quantity will change
depending on the direction of the change as well as the relative magnitude/extent of the
change in demand and supply.

Diagram 4: Effect of Shifts in both Demand and Supply on the Market for Primary
Products
S2
Price S1

E2
P2

P1 E1

DI
D2
0 Q2 Q1 Quantity of agricultural produce/t

Refer to Diagram 4. Suppose the market for agricultural produce (e.g. wheat, grains) is initially
at equilibrium E1 with price P1 and quantity Q1. Suppose the demand for these agricultural
products falls due to a fall in income. The fall in income will result in a fall in consumers’
purchasing power and they have less ability to buy food products made from agricultural
produce, causing demand to fall from D1 to D2.

2020 H1 Economics
Economics Department
Victoria Junior College 15
 On the other hand, suppose prolonged floods have caused production shocks, leading to a
fall in the producers’ ability to supply agricultural produce and cause supply to fall from S1 to
S2. It is likely that the prolonged flood would have caused a severe fall in production and supply
of agricultural produce may have decreased significantly from S1 to S2.

Application of price elasticity concepts to explain the adjustment process to new equilibrium
price and quantity

In Diagram 4, the larger fall in supply relative to demand will cause a shortage at the
existing price, causing an upward pressure on price to eliminate the shortage.

The demand for agricultural products tends to be price inelastic in nature as there are few
close substitutes for wheat or grains. When there is a rise in price, consumers have few
alternatives to switch to.

Supply for agricultural produce is price inelastic too since the factors of production to produce
such produce cannot be increased easily (e.g. land to grow wheat).

Since demand and supply are both price inelastic, a large rise in price is required to
eliminate the shortage. Price will increase sharply (P1 to P2) relative to the fall in quantity
(Q1 to Q2) at the new equilibrium E2.

4.3 Prediction of Change in Total Revenue/Total Expenditure for

Simultaneous Shifts in Demand and Supply

To analyse the impact of the total revenue of agricultural producers, we will need to analyse
the impact of the changes in supply and demand on total revenue step-by-step.

Holding demand constant, the fall in supply from S1 to S2 will cause a rise in price (from P1
to P’). Since demand is price inelastic, the rise in price (P1 to P’) will lead to a less than
proportionate fall in quantity demanded (Q1 to Q’). This causes the gain in revenue from the
rise in price (P1P’E’B) to be greater than the fall in revenue from the less than proportionate
fall in quantity demanded (Q’BE1Q1). Total revenue thus increases from 0P1E1Q1 to 0P’E’Q’
as the equilibrium point moves from E1 to the intermediate point E’.

Holding supply constant at S2, the decrease in demand from D1 to D2 would result in a fall in
total revenue (from 0P’E’Q’ to 0P2E2Q2) since both price and quantity decreases as demand
falls.

Since demand is likely to fall by a smaller extent than the fall in supply due to the prolonged
flood and that demand for agricultural produce is income inelastic, the increase in total
revenue from the fall in supply will outweigh the fall in total revenue from the fall in demand,
causing an overall rise in total revenue of (0P2E2Q2 - 0P1E1Q1) for agricultural producers.

Note: If demand falls to a larger extent than the fall in supply, then the fall in demand will
dominate the effect on total revenue, causing an overall fall in total revenue.

2020 H1 Economics
Economics Department
Victoria Junior College 16
 Summary
Types of Sign Magnitude Application of
Elasticity elasticity concepts

Price Negative PED = 0 (perfectly • PED can be used to

elasticity of price inelastic) determine the
demand 0 < PED < 1 (price change in TR/TE
(PED) inelastic) when there is a
PED >1 (price change in price due
elastic)
to a shift in supply
PED = ∞ (perfectly
price elastic)
• PED and PES can
Price Positive PES = 0 (perfectly
price inelastic) be used to determine
elasticity of
supply (PES) 0 < PES < 1 (price the extent of the
inelastic) change in price (e.g.
PES > 1 (price sharp change in
elastic) prices)
PES = ∞ (perfectly
price elastic)

2020 H1 Economics
Economics Department
Victoria Junior College 17
 5. APPLICATION OF ELASTICITY OF DEMAND AND
SUPPLY TO DECISION MAKING OF PRODUCERS AND
GOVERNMENTS
From the earlier section, we know that the elasticity concepts determine the sharpness of
change in the equilibrium market price given changes in demand and supply. In this section,
we will analyse how producers and governments use these concepts in their decision-making.

5.1 Pricing and Marketing Strategies of a Firm

Recall that firms aim to maximise profits, which is the difference between Total Revenue and
Total Cost (TR-TC). Assuming that total cost remains constant, any increase in total revenue
leads to a rise in profits. How then should the producers price their products to raise their
revenue?

For goods with price inelastic demand, firms could consider raising the prices of such
goods since this will lead to a less than proportionate fall in quantity demanded. As a result,
total revenue of the firms will rise.

On the other hand, firms selling goods with price elastic demand can consider lowering
price. Since a fall in price will lead to a more than proportionate increase in quantity demanded,
the total revenue of the firms will rise.

To reduce the price elasticity of demand of a good, firms can adopt strategies like
advertising to create brand loyalty. One way big brand names such as Tag Heuer, Emporio
Armani and NIKE have done this is through endorsements by famous celebrities and athletes
like Tiger Woods, Beyonce and Roger Federer.

5.2 Government Policy-Making

The government can use price elasticity concepts to raise tax revenue and / or change
consumer behaviour:

If a government wants to raise tax revenue, then it should impose indirect tax on goods with
price inelastic demand (e.g. tobacco and liquor) as tax revenue will rise given a less than
proportionate fall in quantity demanded. On the other hand, if the aim of the government is to
alter the consumers’ behaviour by discouraginng the consumption of these goods, then this is
likely to be ineffective since the fall in consumption will be minimal given the addictive nature
of the goods and hence its price inelastic demand.

2020 H1 Economics
Economics Department
Victoria Junior College 18
 5.3. Limitations of using Elasticity Concepts in Decision-Making

The earlier sections show that demand and supply elasticities have many applications,
especially in the business world and government. However, they are to be treated with caution
as there are some factors that limit their use. These factors are:

• Elasticity measures are based on the assumption of ceteris paribus. This is rarely true for
very long periods, so such elasticity estimates may be unreliable. For example, a firm selling
products with a price elastic demand may cut price with the aim of increasing its total revenue
but total revenue may not rise as other firms may also cut price (i.e. ceteris paribus condition
may not hold). This tends to happen when there is intense rivalry between firms, for instance
in the petrol industry. A reduction in petrol price by Shell may lead to other firms like Caltex
and Exxon Mobil cutting prices as they do not want to lose market share and total revenue.

Similarly, if the Singapore government intends to raise electronic road pricing (ERP) rate to
reduce congestion, this will be ineffective if income is rising and people can now afford the
higher rate.

• Elasticity values are based on past data – data collection issues may not reflect current
changes in tastes and preferences, etc.

• Calculations of elasticities are based on small changes in price, income or price of other
goods. If there is a large percentage change, then the estimate of elasticity may be inaccurate
and a false prediction of future demand will result.

2020 H1 Economics
Economics Department
Victoria Junior College 19
 VICTORIA JUNIOR COLLEGE
2020 H1 ECONOMICS
Mini Case Study 1

Figure 1: Global Food & Oil Price Changes

300 160
140
250

Brent Crude Oil ($/barrel)

FAO Food Price Index

120
200
100
150 80
60
100
40
50
20
0 0
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16

FAO Food Price Index Brent crude oil

Source: Federal Reserve Economic Data, UN Food and Agricultural Organization

Extract 1: Oil prices have a big influence on the price of food Step 1: Scan data
and Questions
The prices of staple crops fell to their lowest level for eight years in
August 2015, down by over 41% from their peak in 2011. That is not Context: Oil and
because people are eating less, or because farmers have become much food markets.
more productive. Nor is it because of a slowdown in Chinese growth, in
contrast to many other commodities. Food prices are largely driven by Issue: Changes in oil
other factors, among them oil prices and government policy. prices and impact
on related market –
Cheap fuel means cheaper food. Natural gas, whose price is tied to that food.
of oil, is used for producing fertiliser; other hydrocarbons are used for
Content: Factors
machinery and transport. Roughly 20% of the cost of producing grain
affecting price of oil
comes from oil. Cheap oil also means less demand for biofuels, which
and hence food
in turn frees up land vital for growing biofuels to grow food crops.
prices.
Relate these factors
Adapted from The Economist, 10 Oct 2015
to the tool of
analysis.
Extract 2: Why did the price of oil drop?
- Sort into
demand/supply
The stunning fall in oil prices, from a peak of $115 per barrel in June factors
2014 to under $35 at the end of February 2016, has been one of the - Consider elasticity
most important global macroeconomic developments of the past 20 concepts i.e.
months. The sharp fall is broadly similar in magnitude in 2008-2009 at PED/PES
the outset of the global financial crisis. The drop in 2008-2009 was
almost entirely due to a collapse in demand. The recent price decline Step 2: Review Case
appears to be a mix of both demand and supply factors. Materials

2020 H1 Economics
Economics Department
Victoria Junior College 20
 United States domestic production has nearly doubled over the last Time series of the
several years due partly to the shale boom, pushing out oil imports that prices of oil and
need to find another home. Saudi, Nigerian and Algerian oils that once food.
sold in the United States are suddenly competing for Asian markets, and Oil - absolute price
the producers are forced to drop prices. of Brent crude oil
per barrel.
Increasingly, consumers are embracing more energy-efficient vehicles Food – FAO Food
and electrical appliances. In addition, slowing growth in Europe and Price Index.
emerging markets such as China have led to sharp drops in commodity
prices across the board. Take note: Entire
period in chart
Adapted from World Economic Forum, 2 Mar 2016 & New York Times, started in 2007 to
12 Dec 2016 2016.

2020 H1 Economics
Economics Department
Victoria Junior College 21
 Questions

a (i) With reference to Figure 1, describe the trend of Brent crude oil prices [2]
from 2012 to 2015.

When describing a trend,

highlight the overall trend
(direction of change) and
refinement of trend.

For trend data without

major turning points, the
overall trend can be
determined by comparing
the start and end points.

a(ii) Explain why prices of food and oil change in tandem. [4]

Consider the following:

1. Identify the relationship
between oil and food
using evidence from the
extract.

2. Explain the impact of

the change in oil prices on
price of food using the tool
of analysis (DDSS).

Use the mark allocation to

determine how many
points to include.

b. With the aid of a diagram, discuss the significance of the factors [8]
contributing to the sharp fall in oil prices in 2014.

Consider the
following:
1) Identify the
concept(s). Price can
be explained using
price mechanism.
(Shifts in the DDSS
curves determine
whether prices
increase or decrease
(direction) + elasticity
concepts explain the
extent of changes).

2) Identify the
factor(s) which are
considered in the
data. Briefly explain
2020 H1 Economics
Economics Department
Victoria Junior College 22
 the factors (DD, SS,
elasticity concepts) to
show understanding.
Apply relevant
concepts or theory in
the explanation,
making clear
reference to the
DD/SS diagram.

3) Explain the price

adjustment process
with reference to the
diagram.

4) The command
word “Discuss”
requires that you
make a judgment
(which addresses the
question stem
directly). Assess the
relative importance
of factors (DD and SS
factors) to come to a
conclusion.

Do not quote chunks

of evidence from
extracts without
further analysis.

2020 H1 Economics
Economics Department
Victoria Junior College 23
 Mini Case Study 2

Step 1: Scan data

Extract 1: When the World (of food) is at Your Fingertips and Questions

Context: Food
Foodpanda, Deliveroo and UberEATS are the three biggest players of
delivery service,
food delivery service in the Singapore market. WhyQ, the new kid on
hawker food
the block that began operations in February, is among the new crop of
markets and related
start-ups that has invaded the increasingly crowded space of food markets.
delivery but with a twist: Picking up meals from hawker centres or small
eateries serving up local delights. The explosive growth of food delivery Issue: Rising trends
services has also had a positive effect on firms selling disposable food in cooked food
packaging. This industry is expected to see further domestic growth markets and related
owing to the increase in the consumption of delivered packaged food. markets.

However, as Singaporeans embrace having food delivered to their Content: factors

doorsteps, the demand for delivery staff has soared - and wages for the affecting price of
service have risen with it. With the surge in orders, firms are finding it food delivery
difficult to hire riders, and struggle to cope during peak periods like service and hawker
Chinese New Year. Mr Andreani pointed that it is very difficult to hire food.
riders as more e-commerce firms are competing for a limited supply. Relate these factors
to the tool of
Mr Paul Lim, founder and president of industry body Supply Chain Asia, analysis.
estimates that a full-time rider's earnings have grown by about 40 per - Sort into
cent in the last two years to about $3,500 a month. Food-delivery demand/supply
services have emerged as a bright spot in a weak job market. Firms factors
have plans to expand their full-time delivery staff and freelancers. They - Consider elasticity
have extended their network to non-traditional sources – students concepts i.e.
above 18 years of age and retirees. This will expand the pool of delivery PED/PES
staff by 25 per cent in the next year. - Impact on related
goods e.g.
Adapted from todayonline.com January 2018 complements
(disposable food
Extract 2: Keeping Singapore’s Hawker Food Affordable and packaging).
Accessible
Step 2: Review Case
Food costs are going up — according to the Department of Statistics, Materials
What is the
food prices have risen 2.2 per cent a year since September 2015. This
relationship
would inevitably affect the price of hawker food, which most
between food
Singaporeans enjoy.
delivery, hawker
food and disposable
Hawker food prices in newer estates, or in estates with fewer eateries,
food packaging?
tend to be higher. Sengkang and Punggol, located in the north east of
Singapore, have relatively few eateries and higher hawker food prices.
Residents in older, more established estates, like Bukit Merah,
Queenstown and Toa Payoh, have more hawker centres, coffeeshops
and restaurants and therefore the residents have more dining options.

Adapted from todayoneline.com November 2016

Questions:

2020 H1 Economics
Economics Department
Victoria Junior College 24
 (a) Explain how the “explosive growth of food delivery services” (Extract 1) [3]
affects the price of disposable food packaging.

1. What is the relationship

between food delivery
services and disposable
food packaging based
on data evidence?

2. Explain the impact of a

rise in food delivery
services on price of
disposable food
packaging using tool of
analysis.

(b) With reference to Extract 1, explain why the price elasticity of supply of [3]
food delivery services may change over time.

1. What factors determine

PES value?

2. What is the current PES

values of food delivery
service based on data
evidence?

3. With reference to data

evidence, which factors
determining PES change
which will then affect
the PES values?

(c) “Price of hawker food is affected by changes in price of raw materials

such as sugar and meat.”

With reference to Extract 2, explain how an increase in the price of raw

materials is likely to affect the total expenditure on hawker food of different
consumers living in estates such as Sengkang and Bukit Merah. [6]

Consider the following:

1. With reference to Ext
1, does DD and/or SS of
hawker food change?

2. Explain the impact of

the rise in raw material
prices on the TE on
hawker food using DDSS
analysis and relevant
elasticity concepts.

2020 H1 Economics
Economics Department
Victoria Junior College 25
 3. Consider different
types of consumers who
purchase hawker food,
and how the rise in raw
materials might affect
them differently. What
economic concepts can
we apply to explain the
impact on different
consumers?

2020 H1 Economics
Economics Department
Victoria Junior College 26