ELASICITY CONCEPTS

ELASTICITY OF DEMAND
 It is the responsiveness of quantity demanded due to changes in the determinants of demand i.e.
price, income, price of other goods.
 They are basically 3 types of elasticity of demand.
a) Price elasticity of demand
b) Income elasticity of demand
c) Cross elasticity of demand
Price elasticity of demand
 This is the degree of responsiveness of quantity demanded due to changes in price.
 Its calculated by the formula:
% change in quantity demanded
% change in price

Categories of price elasticity of demand

 Perfectly inelastic demand shows a situation where a change in price will lead to the same amount
being purchased.
 In other words the same quantity of a product is brought irrespective of price.
 A fixed amount of a product is purchased no matter the price.

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 Demand is said to be inelastic when price elastic of demand is greater than zero but less than one.
 Demand is inelastic when % change in quantity demanded is less than % change in price.
 If producers are faced with an inelastic demand curve they can raise more revenue by increasing
price.
 This is because the % fall in quantity demanded is smaller than the change in price

 Occurs when % demand in quantity demand is equal to % demand in prices.

 If producers are forced with a unitary demand curve they cannot increase total revenue by decreasing
or increasing prices because the change in price is offset by changes in quantity demand.
 This is shown by a rectangular hyperbola.

 If demand is perfectly elastic consumers will purchase an infinite amount of a product at the current
price.
 If the price is raised even fractionally demand falls to zero.

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 If producers are faced with an elastic demand they get more revenue by decreasing price this is
because of the increase in quantity demand is greater than the demand in price.
 This is shown by the diagrams below:
Calculating price elasticity of demand
Formula = % demand Quantity demanded
% demand in price
Where % change in quantity demand is equal to Q 2 – Q1
Q1
And % change in price is equal to P2 – P1
P1
Examples
 Price demand from $8 to $5, quantity demand from 4 units to 10 units.
1 2

P 8 5

Q 4 10

% demand Quantity demanded

% demand in price
𝑄2−𝑄1
𝑄1

𝑃2−𝑃1
𝑃1
5 – 8 = 3 = 0.4
8 8
10 – 4 = 6 = 1.5
4 4
ANSWER = 0.266 (Inelastic)

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1 2

P 10 15

Q 100 100

% demand Quantity demanded

% demand in price
𝑄2−𝑄1
𝑄1

𝑃2−𝑃1
𝑃1
15 – 10 = 5 = 2
10 10

100 – 100 = 0 = 0
100 100
ANSWER = 0 (perfectly elastic)

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

 There are a number of factors which together determine the value of price elasticity of demand of a
given product.
Availability of Close Substitutes
 If a product has close substitutes then it is likely that demand for that product will fall if the price
increases.
 The closer the substitute the greater the fall in demand.
 This means that the demand is elastic.
 The reason for this is that when consumers are faced with a price increase they will switch their
expenditure to close substitutes.
 If the product is inelastic the fall in the quantity demand will be small e.g. a product like petrol has
no close substitute.
Type of Good.
 If the product is a necessity an increase in price will mean that consumers will continue to buy the
product.
 If however it is a luxury there could be a substantial reduction of quantity demanded or quantity
purchased as its price increases.
 That being the case, it is likely that necessities will have an elasticity of demand when is less than
one while luxuries will have a PED that is greater than one.

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Whether The Product Is Habit Farming

 If the product is habit farming e.g. cigarettes the PED is more likely to be an elastic with the value
(less than one) while luxury will have a PED greater than one.
Time
 The demand for certain products is likely to be inelastic soon after price change but becomes more
elastic with time.
 This is because it takes time for the consumers to change their spending habits.
 Overtime consumers can shop around and search for substitutes.
Number of Uses the Product Has
 If a product has a large number of use it is inelastic because consumer find it difficult to switch from
it.
Percentage of Income Spent On the Goods
 Products that make up a very small percent in the budget tend to be inelastic e.g. consumer spends
small percent of income on salt.
 They are not very sensitive to price changes.
 By comparison, washing machines and computers take a greater percentage of income thus
household are likely to look around for the best prices.
 Consumers are price sensitive for such goods
PED PRICE EFFECT REVENUE

Great than one Falls Rises

Elastic Rises Falls
PED = 1 Falls No change
Unitary Rises No change
PED is less than 1 Falls Falls
Inelastic Rises Rises

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INCOME ELASTICITY OF DEMAND

 Measures the responsiveness of quantity demanded due to changes in income.
 It is measured by the formulae % demand in quantity demand
% demand in income (y)

Where % change in income = Y2 – Y1

Y1
And % change in quantity = Q2 – Q1
Q1

In other words ∆ Q divided by ∆Y

Q Y
 The income elasticity of demand for normal good is always positive.
 The income elasticity of demand for inferior goods is always negative.
% ∆ in Income % ∆ in Quantity Ratio Types of YED
Product
a) 10 +15 +1.5 Normal Positive YED
b) 10 +1 +1 Normal Unitary YED
c) 10 +5 +0.5 Normal Positive YED
d) 10
0 +0 Normal Zero YED
e) 10
-5 -0.5 Normal Negative YED

 The table above displays the response of demand from changes in income.
The following situations can be noted:
a) The percentage increase in quantity demand is greater than percentage change in Y and this shows a
normal product with a greater than one elasticity, e.g. luxuries like holidays abroad and a private
health care.
b) The increase in the income leads to a proportionate increase in quantity demand.
c) Demand increases as income increases but by a smaller percentage.
Elasticity is less than one but greater than zero.
Demand is inelastic e.g. demand for basic food stuffs like bread.
This is because we do not expect a substantial increase in the quantity of basic food stuffs as Y
increases.
d) Shows a situation where an increase in Y has no effect in quantity demand.
e) Shows an inferior or a giffen good where quantity demand falls as Y increases.
Income elasticity is negative with more people switching from this good to a more superior good e.g.
they switch from a super market products to a more exclusive brand name.
Another example is a change from using buses to using a car.

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 Income elasticity can be further explained by the diagram below:

CROSS ELASTICITY DEMAND

 It refers to the responsiveness of quantity demand of one good due demands in the price of other
good.
 YED 1 CED = % demand in quantity of good A
% demand in price of good B

= ∆Qa or Qa2 – Qa1

Qa Qa1

∆P b Pb2 – Pb1
Pb Pb1

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Possible Outcomes
Price of B situation 3
Situation 1

Situation 3

Quantity of A
Situation 1
 As the price good B increases quantity demand of A also increases.
 The cross elasticity of demand is therefore positive and the products concerned are substitutes e.g. as
the price of beef increases the quantity demand for the pork increases.
Situation 2
 Relates to complementary products as the price of B decreases quantity of good A will increase.
 The cross elasticity of demand is therefore positive.
 If the price of a car decreases quantity demand of petrol will increase.
Situation 3
 Refers to the products which are totally unrelated.
 E.g. if the price of sop increases it is unlikely to result in a change in demand of pencils.

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USES OF ELASTICITY OF DEMAND

Pricing Decisions
 It helps businesses to make decisions on how to price their produces.
Goods with inelastic demand
 A producer whose products are inelastic will raise or increase revenue by increasing prices.

Goods with elastic demand

 A producer faced with elastic demand will raise more revenue by reducing prices.

Planning
 Firms use PED to plan.
 For example by estimating the effects of the price demand, firms can plan
a) A number of goods to produce.

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b) Number of people to employ.

c) The impact on the cash flows of the business as a result of price changes.
 Price elasticity of demand can be used to estimate the impact on consumer spending producers’
revenue and income from a change in price.
Price Discrimination in Monopoly
 Knowledge of elasticity can help a firm to practice price discrimination i.e. charge two prices for the
same product in different markets.
 In order for price discrimination to be successful one market must be elastic and another inelastic.
 A firm will charge a higher price in a market which is inelastic and a lower price in the market that is
elastic.
 Knowledge of price elasticity helps the monopolies to discriminate successfully.
 Price discrimination increases revenue for the firm
Pricing Of Joint Supply Product
 The goods that are produced by a single production process are joint supply products, the cost of
production of these goods is also joint e.g. Wool and mutton.
 If the demand for wool is inelastic compared to the demand of mutton, higher price for both goods
can be charged
Provides Guidelines for Producers
 It gives a guideline o producers on the amount to be spent on advertising.
 If the demand is elastic producers will spend large money on advertising to increase sales.
Used In Factor Pricing
 Factors of production e.g. (capital and labour) which have inelastic demand obtain a higher price in
the market than those with elastic demand.
 Firms can easily raise wages for workers if products that have inelastic demand.
 Knowledge of elasticity concepts can be used in wage bargaining by firms when dealing with trade
unions
Shifting the Tax Burden
 The extent to which the producer can shift the tax burden of an indirect tax to buyers depends on the
degree of elasticity of demand.
 If the demand is inelastic the larger part of the indirect tax can be shifted to buyers by increasing
prices, on the other hand if the demand is elastic then the larger burden of the tax will be borne by
the producer as a diagram shown below:

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Elastic Demand Inelastic Demand

Usefulness Of Cross Elasticity of Demand

Pricing Strategies for Substitutes
 If a competitor cuts the price of a rival product, firm use estimates of cross elasticity of demand to
estimate the effects on total quantity demanded and total revenue for their own product.
Pricing Strategies for Complementary Product
 Firms can estimate the impact on demand for their product if firms cuts the price of complement.
 E.g. if Apple cuts the price of computers, how much will the demand for software increase.
Advertising and Marketing
 In highly competitive markets where brand name carries substantial value, many business spend
huge amounts of money on persuasive marketing and advertising every year.
 They are many aims behind this including attempting to shift out the demand curve for a product and
also to build consumer relations.
 When consumers became habitual purchasers of the product the cross elasticity of demand will
decrease.
 This reduces the size of the substitution effect following price change and makes demand less
sensitive to price.
 The result is that the firm is able to change high prices, increase their revenue and turn consumer’s
surplus into profits.

Uses of Income Elasticity

 Can determine what goods to produce or stock e.g. as the economy grows firms may want to avoid
inferior goods and increase the stock of normal goods.
 The reason behind this is that economic growth brings about an increase in income and when
people’s income increase they demand less of inferior goods and more of normal goods.
 The opposite is true if an economy shrinks.
 It helps firms to plan production and employee requirements as the economy grows.

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 As the economy grows people get more income and demand more of certain goods (normal goods).
 Firms now have to increase output and this may require more workers or the need to organize extra
working hours.
 Income elasticity of demand can help firms to estimate potential changes in demand e.g. as overseas
income grows new markets for the firm’s products can be created.

Importance of Elasticity to the Government

Determination of terms of trade
 Terms of trade between two countries are based on the elasticity of demand of the traded goods.
 The elasticity of demand for imports and exports influences term of trade.
 If demand for a country’s exports is less elastic as compared to imports. The terms of trade will tend
to be favourable because exports can tend to command high price than imports.
 On the other hand if the demand for imports is less elastic terms of trade will likely be unfavorable.
Determination of Rates of Foreign Exchange
 The rate of foreign exchange depends on the elasticity of imports and exports of a country.
 Usually the buyers of foreign exchange react to changes in the rate of exchange but in different
degree.
 This is phenomenon is described as elasticity of demand.
 It may be defined as the ratio percentage change in the amount of foreign exchange demand for the
percentage change in the rate.
 If the demand is elastic the curve will be flatter and if it steeper demand is inelastic.
 Government uses the concept of elasticity to determine how much one currency can be exchanged
for another.
De – valuation
 Government use devaluation to try and improve the balance of payment.
 If the effect of devaluation is to raise the price of imported goods and lower the price of exports.
 If the demand of a country’s exports is elastic de – valuation makes them cheaper and increases
revenue and at the same time increases the price of imports making them more expensive.
 HOWEVER: De – valuation does not work if the demand of exports and imports is inelastic because
it will adversely affect the balance of payment.
Explanation of the Paradox of poverty midst the Plenty
 The concept of elasticity of demand helps to explain the so called paradox of plenty in agriculture.
 Namely that a bumper crop reaped by farmers brings a smaller income to them.
 The fall in income or revenue is as a result of the bumper crop is due to the fact with greater supply
the prices of crops decline drastically.
 And because crops have inelastic demand total expenditure on the crop declines bringing about a fall
in income of farmers.
 Thus bumper crop instead of raising their incomes reduces them.

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 Therefore in order to ensure that farmers do not lose their incentives in raising production the
government assures them by using minimum price and sometimes by paying them not to grow.
Importance in taxation policies
 Elasticity is important in terms of government finance.
 When the finance minister raise a tax for a certain product he has to know whether demand is elastic
or inelastic
 The introduction of a tax will increase prices
 This will have an impact on the equilibrium price and quantity
 If demand is relatively inelastic compared to price, the burden of the indirect tax will fall on the
buyer rather than the supplier
 The impact is on the price rather than the quantity
 If demand is more price elastic than supply, the burden of the indirect tax falls on the supplier and
the impact is on quantity rather than price
 Taxing products such as cigarrates and petrol has a relatively big effect on the final product paid by
consumers compared to the quantity consumed
 When the demand of the product is elastic the minister will increase the tax and thus increase the
revenue
 But if the demand is elastic he is not in a position he is not in a position to increase the tax because
total revenue is reduced
Effect on indirect tax
 If government imposes an indirect tax the supply curve with move by the exact amount of the tax

 When we look at the market equilibrium we start with the original equilibrium. We then add tax
which pushes the supply curve inwards and look at new equilibrium to see the changes the tax has
made.

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QUESTIONS
1. Explain the price elasticity of demand and income demand. (10)
2. The government is proposing to increase the tax on petrol. Examine the relevant of price elasticity of
demand concepts that are taken into account before making this proposal. (15)
3. The manager of a firm selling chocolates and cigarettes heard that the government will be raising
indirect taxes across the board. He approaches you seeking advice of the tax implications on his
business. “With sales” and (tax incidence) in mind advice the manager on the impact of the tax
review on his business. (25)
4. The demand of primary product turns to be inelastic in terms of price and income while the demand
of manufactured of goods is elastic. discuss (25)
5. Explain how the price elasticity of demand affects the revenues of farmers. (10)
6. Discuss the extent to which price elasticity of demand causes price instability for agricultural
produce. (15)
7. Explain the factors that influence price elasticity of demand. (10)
8. Discuss whether different elasticity of demand concepts could be useful to a tobacco farmer.
9. Explain factors that affect cross – elasticity of demand. (10)
10. Discuss the significance of elasticity of demand to a supermarket in the city Centre. (15)
11. Explain the factors that influence price elasticity of demand for your product. (10)
12. Discuss the relevance of elasticity concepts to a farmer. (15)
13. Discuss the relevance of elasticity of demand concepts to farmers in Zimbabwe exporting their
produce. (25)
14. With examples from your economy explain what is meant by goods with price elastic and price
inelastic demand. (12)
15. Are price an income elasticity concept of importance in formulating government policy in your
country. (15)
16. Distinguish between normal and inferior goods. (10)
17. Discuss the practical applicability of elasticity concepts, to a government. (15)
18. Explain the 3 concepts of elasticity of demand. (12)
19. Zimbabwe is promoting tourist attractions in order to get the much needed foreign currency. (12)
20. Discuss whether the difference elasticity concepts are useful for the tourism industry. (13)
21. Explain the concepts of elasticity of demand. (12)
22. Discuss the applicability of elasticity of demand concepts to a bookshop. (13)
23. Explain the following concepts:
a. Price elasticity of demand
b. Income elasticity of demand
c. Cross elasticity of demand (12)
24. In your own opinion is knowledge of elasticity of demand of any economic relevance. (15)
25. Discuss usefulness of elasticity concepts to a small scale miner in Zimbabwe. (13)
26. Explain factors that influence price elasticity of demand on products. (12)
27. Discuss the importance of elasticity concepts to retail shops. (15)

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28. Analyze the factors influencing price elasticity of demand for cement in Zimbabwe. (12)
29. Evaluate the applicability of price and income elasticity of demand to the government. (13)

ELASTICITY OF SUPPLY
 Measures of the responsiveness and sensitivity of quality supplied due to changes in the price of a
good.
 In the other words it is the degree of responsiveness of quality supplied due to changes in the price
of the good.
 It is calculated as follows:
%∆ in quality supplied
% ∆ in price
 The magnitude of the value will tell us whether quantity supplied response to changes in price; it can
be inelastic, perfectly inelastic, unitary elastic, relatively and perfectly elastic depending on various
factors.

Interpretation of price elasticity of supply

Perfectly inelastic supply
 This is whereby PES is equal to zero .
 A change in price has no effect on quantity supply. I.e. when price changes quantity supply remains
the same.
 It is usually associated with long run supply curves.
 The supply curve will be a vertical line as shown below:

Perfectly elastic supply

 PES is equal to infinity.
 An infinity amount is supplied at that price.
 An increase in the price will reduce quality supplied to zero.
Relatively inelastic supply
 Price elasticity of supply is greater than zero but less than one.

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 This means that quantity supply response by a smaller magnitude to a change in price.
 The supply curve will be steep and starts from the horizontal axis as shown below.
Relatively elastic supply
 PES is greater than one.
 Quality supply response by a greater magnitude than the change in price.
 The supply curve will start from the vertical axis and slope upwards.
Unitary elastic
 This is where PES is equal to one meaning that percent change in quantity supplied will be equal to
percent change in price i.e. quantity supplied response by the same magnitude.
 Any supply curve that starts from the origin is said to be price unitary elastic.

Determinants of elasticity of supply

Number of Products
 The more producers there are the easier it should be to increase output in response to an increase in
price.
The Existence of Spare Capacity
 The more spare capacity there is in an industry the easier it should be to increase output.
Ease of Storing
 If it is easy to store goods if the price raises the firm can sell these stocks.
Time Period
 Overtime the firm can invest in training programme and purchase more equipment.
Factor mobility
 The easier it is for resources to move into the industry more supply elastic will be.
Length of Production
 The quicker a good is to produce the easier it will respond to a change in price.

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PERIODS OF SUPPLY
MOMENTARY

SHORT RUN

LONGRUN

 Momentary – supplies totally inelastic.

 Short run – one factor of production is fixed and supply is fairly inelastic.
 Long run – all factors of production are variable and supply tends to be fairly elastic.
Limitations of Elasticity Concepts
 Data from which elasticity is calculated is not scientific knowledge (they are not absolute truth they
are instead based on market surveys on small samples).
 They are based or calculations on the basis of other factors remaining constant (ceteris paribus)
therefore such data can be inaccurate or even wrong because over periods of time other factors do
change data becomes outdated.
 Business managers may not know how to calculate elasticity.

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