Lecture 3 (i)

Markets In action

Reading:
Sloman and
Garratt,
chapter 3

Prepared by:
Dr. Bawani
ECN1014 Lelchumanan &
INTRODUCTORY Dr. Chong Poh
Ling (DEF, SBS)
ECONOMICS
LEARNING OBJECTIVES
(LO)

After this lecture, you should be able to:

LO1: Explain price elasticity of demand and how it can
be applied
LO2: Identify the usefulness of the total expenditure
test for price elasticity of demand
LO3: Explain price elasticity of supply and how it can
be applied
LO4: Explain and examine the relevance of cross-
elasticity of demand and income elasticity of demand
LO5: Assess the desirability of government controlling
market prices
Introduction
Direction of price and quantity will move.
How much do they change?
Example: When price increase by RM10, by how much the quantity
demanded decrease? Will it be 10 units? 15 units? 5 units?
Elasticity: measure by how much a variable will change with the change in
another variable.
Percentage/numerical

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Price Elasticity Of Demand

Measures the percentage change in the quantity demanded of a good

or service, that results from a change in price.

Formula:

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Price Elasticity of Demand
If the price of a ballpoint pen decreases from RM2 to RM1 and the quantity demand for
ballpoint pens increases from 40 to 50 units, calculate the price elasticity of demand. Calculate
price elasticity using the two formulas.

Write this down first:

Q1 = 40; Q2 = 50; P1 = 2; P2 = 1

= (Q2 – Q1 / Q1) X (P1 / P2 – P1)

= (50 – 40/40) X (2/1 – 2)
= 10/40 X (-2)
= 0.25 X (-2)
= - 0.5

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MEASURING ELASTICITY USING
THE ARC METHOD
10

m DQ DP
Ped = ¸ mid P
8 mid Q

7 P = –2 10 -2
= ¸
n 15 7
6 = 10/15 x -7/2
Q = 10
P (£) Mid P = -70/30
= -7/3 = -2.33
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
 Degree of Price Elasticity Of
Demand
The price elasticity of demand can yield five basic results (coefficient):
1) Elastic Demand (Ed > 1).
2) Inelastic Demand (Ed < 1).
3) Unit Elastic Demand (Ed = 1).
4) Perfectly Elastic Demand (Ed = ¥).

5) Perfectly Inelastic Demand (Ed = 0).

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Degree of Price Elasticity of Demand
1) Elastic Demand (Ed > 1)
%Qd > %P
Change in quantity demanded greater than change in price
The coefficient is greater than 1 and demand is elastic.
A change in price will cause a larger opposite change in quantity

The flatter the demand curve,

the more elastic is the good.

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DEGREE OF PRICE ELASTICITY OF
DEMAND
2) Inelastic Demand (Ed < 1)
Qd < %P
Change in quantity demanded is lesser than change in price.
The coefficient is less than 1, and demand is inelastic.
A change in price will cause a smaller opposite change in quantity.

The steeper the demand curve,

the more inelastic is the good.

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Degree of Price Elasticity of Demand
3) Unit Elastic Demand (Ed = 1)
%Qd = %P
The coefficient is equal to one.
The quantity demanded changes proportionally to a change in price.

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Degree of Price Elasticity of Demand
4) Perfectly Elastic Demand (Ed = ¥)
If quantity demanded is extremely responsive to changes in price, demand is said to be
perfectly elastic.
A small change in price causes an extremely large percentage change in quantity
demanded (from buying all to buying nothing).

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Degree of Price Elasticity of Demand
5) Perfectly Inelastic Demand (Ed = 0)
Quantity demanded is completely unresponsive to a change in price.
A change in price causes no change in quantity demanded.

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Degree of Price Elasticity of Demand

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Determinants of Price Elasticity Of Demand
Four (4) factors determine the price elasticity of demand.

1) Number of substitutes
The more substitutes for a good, the higher the price elasticity of demand;
the fewer substitutes for a good, the lower the price elasticity of demand.

2) Necessities vs luxuries
The more that a good is considered a luxury rather than a necessity, the higher the price
elasticity of demand.

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DETERMINANTS OF PRICE ELASTICITY OF
DEMAND
3) Percentage of budget spent on the good
The greater the percentage of one’s budget that goes to purchase a good, the higher the
price elasticity of demand;
the smaller the percentage of one’s budget that goes to purchase a good, the lower the
elasticity of demand.

4) Time
The more time that passes (after a price change), the higher the price elasticity of
demand for the good.
Price elasticity is higher in the long run than in the short run.

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Cross Elasticity Of Demand
Cross elasticity of demand (Ec) measures the responsiveness in the
quantity demanded of one good to changes in the price of another good.
Percentage change in the quantity demanded of one good divided by the
percentage change in the price of another good.

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Cross Elasticity of Demand

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Cross Elasticity of Demand

if EC > 0,
- the two goods (x and y) are substitutes.
- the higher the Ec, the greater the degree of substitution.

if Ec < 0,
- the two goods are complements.

if Ec = 0,
- the two goods are unrelated.

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Cross Elasticity of Demand
Consider two goods: Skippy peanut butter and Jif peanut butter.
When the P of Jif peanut butter rises by 10%, quantity demanded for Skippy peanut butter
rises by 45%. What is the relationship between Jif peanut butter and Skippy peanut
butter?

Solution: C

45%/10% = 4.5

4.5 is greater than 0.

Therefore, Jif and Skippy are substitutes.

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Cross Elasticity of Demand
Consider 2 goods: cars and car tyres.
When P of cars rises by 5%, Qd of car tyres falls by 10%.
What is the relationship between cars and car tyres?

Solution: C

-10%/5%
= -2

2 is lesser than 0.
Therefore, cars and tyres are complementary goods.

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Income Elasticity of Demand
Measures the responsiveness of changes in the quantity demand for a
product due to a change in income.
Defined as the percentage change in quantity demanded of a good divided
by the percentage change in income.
is used to distinguish between normal and inferior goods.

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Income Elasticity Of Demand
Formula:

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Income Elasticity of Demand
1. If : Inelastic Income
Quantity demand for a product increases as income increases.
And income increases faster than the quantity demanded (%∆Q<%∆Y)
This type of goods are normal goods.

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INCOME ELASTICITY OF DEMAND
2. If : Elastic Income
Quantity demanded for a product increases as income increases.
And quantity increases faster than income (%∆Q>%∆Y)
This type of goods are luxury goods.

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INCOME ELASTICITY OF DEMAND
3. If : negative income elasticity of demand

Quantity demanded for a product decreases as income increases.

This type of goods are inferior goods.

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INCOME ELASTICITY OF DEMAND
4. If : zero income elasticity of demand
Quantity demanded for a product does not change even though income
increases.
This type of goods are necessity goods.

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INCOME ELASTICITY OF DEMAND
Example:
If there is a decrease of 8 percent in income, quantity demanded of a good increases by
12 percent.
What is the income elasticity of the good? What type of good is this?

= 12/-8 = -1.5
This is an inferior good because the income elasticity of demand is negative or <0.

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Price Elasticity Of Supply
Measures the responsiveness of quantity supplied due to a change in the price of a
product or service.
Defined as the percentage change in quantity supplied of a good divided by the
percentage change in the price of the good.
Formula:

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PRICE ELASTICITY OF SUPPLY
Elasticity or Terms Means Diagram
Coefficient
Elastic Supply Percentage change in quantity
supplied greater than
percentage change in price.

Inelastic Percentage change in quantity

Supply supplied less than percentage
change in price.

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PRICE ELASTICITY OF SUPPLY
Elasticity or Terms Means Diagram
Coefficient
Unitary Percentage change in quantity
Elastic Supply supplied equal to percentage
change in price

0 Perfectly A percentage change in price

Inelastic has no effect on the
Supply percentage change in quantity
supplied

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PRICE ELASTICITY OF SUPPLY
Elasticity or Terms Means Diagram
Coefficient
Perfectly An almost zero percentage
Elastic Supply change in price brings a very
large percentage change in
the quantity supplied

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Summary

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MARKETS WHERE PRICES
ARE CONTROLLED
Minimum prices
 justification
 effects
 dealing with resulting surpluses

Maximum prices
 justification
 effects
Government Intervention in the Market
Floor price/Minimum price. Eg: in agriculture sectors and wage rate
Advantage:
1. The income of the producers are protected and lower paid workers are better off.
Disadvantages:
2. Consumer have to pay more for goods and services
3. Surplus exists
4. Creates unemployment

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MINIMUM PRICE: PRICE
FLOOR
P
S

surplus
minimum
price

Pe

O Qd Qs Q
Government Intervention in the Market

Ceiling/Maximum price. Examples: sugar, cooking oil, petrol, wheat flour.

Advantage:
1. Consumers can buy products at lower prices.
Disadvantages:
2. Create an excessive demand for a market: shortage exists
3. Give rise to black markets: buying and selling at a prohibited price.

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MAXIMUM PRICE: PRICE
CEILING

P
S

Pe

maximum
price
shortage

O Qs Qd Q