TOPIC 3 ► MARKET EQUILIBRIUM

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Demonstrate how equilibrium quantity and price is achieved using diagrams and equations;
2. Explain how market equilibrium can change;
3. Calculate price elasticity of demand, elasticity of supply, cross elasticity coefficient and income elasticity;
4. Interpret price elasticity of demand, elasticity of supply, cross elasticity coefficient and income elasticity; and
5. Apply the concept of elasticity in market analysis.

INTRODUCTION

We have seen in Topic 2 how quantity demanded correlates negatively with price while quantity supplied correlates positively with price. However, those relationships are general. We may have to know how much the quantity demanded will decrease if the price is increased by 10 percent. In Topic 3, you will learn about market equilibrium. In other words, we want to know about the level of sensitivity of quantity demanded towards price change. This information is important for price determination by firms. On the other hand, for an economist, this information is vital for policy analysis.
The sensitivity of quantity towards price change can be measured using the elasticity concept, which will be discussed in this topic.

3.1 MARKET EQUILIBRIUM

What is  market equilibrium? How can demand and supply correlate?

Demand and supply are models that explain the respective behaviour of consumers and sellers in the market.

To show how both interact in determining price and quantity, we need to draw the demand and supply curves in one diagram.

The point of intersection between the demand and supply curves is the market equilibrium point.

The term equilibrium is used in economics to explain a condition when all variables have reached an established position with no tendency to change any further. Equilibrium change will only happen if there is change in other influence or determinants.
At the point of market equilibrium, the need of buyers is equal to the need of sellers, that is, quantity demanded is equal to quantity supplied at a certain price level. The particular quantity and price are known as equilibrium quantity and equilibrium price.
From the past discussions, we know that a demand curve has a negative gradient whereas a supply curve has a positive gradient. Figure 3.1 depicts both curves drawn in the same diagram. Both curves intersect at point E. Point E is known as theequilibrium point, while P_e and Q_e represent the equilibrium price and quantity respectively.

Figure 3.1: Market equilibrium

3.1.1 Equilibrium, Surplus and Shortage

Table 3.1 describes the concept of equilibrium, excess demand and excess supply. Sometimes excess in demand is referred to as shortage, while excess in supply is known as surplus. Hence, excess in demand is shown using a negative value whereas excess in supply uses a positive value. Zero surplus value indicates an equilibrium.

Price (RM)	Quantity Demanded (Unit)	Quantity Supplied (Unit)	Shortage (-) Surplus (+)	Pressure on Price
1	18	2	-16	Increased
2	16	4	-12	Increased
3	14	6	-8	Increased
4	12	8	-4	Increased
5	10	10	0	Equilibrium
6	8	12	+4	Decreased
7	6	14	+8	Decreased
8	4	16	+12	Decreased
9	2	18	+16	Decreased

Shortage occurs when quantity demanded exceeds quantity supplied at a certain price level. From Table 3.1, shortage or excess demand occurs at the price of RM1 to RM4 per unit. At the price of RM1, shortage is at 16 units and at the price of RM4, shortage had decreased to 4 units. Shortage will increase the pressure on price. Therefore, increase in price will reduce shortage.
Surplus occurs when quantity supplied exceeds quantity demanded at a certain price level. Surplus will be reduced when there is a decrease in price. Hence, surplus reduces the pressure on price. From Table 3.1, we can see that surplus decreases from 16 units to 4 units when price is reduced from RM 9 to RM6 per unit.
Equilibrium will be achieved when there is no shortage or surplus. Thus, there is no pressure for a price change. In Table 3.1, equilibrium is achieved at the price of RM5 per unit for a quantity of 10 units. Do notice that shortage will cause a price increase; whereas surplus will result in price decrease.
Figure 3.2 illustrates the condition of shortage, surplus, equilibrium and pressure on price.

Figure 3.2: Condition of shortage, surplus, equilibrium and pressure on price

SELF-CHECK 3.1

Quantity demanded exceeds quantity supplied
= 
Quantity supplied exceeds quantity demanded
= 
Think of which refers to shortage and which refers to surplus.

ACTIVITY 3.1

In your own words, describe how a market can achieve equilibrium. Share your answer with your classmates.

3.1.2 Change in Market Equilibrium

Market equilibrium will remain unchanged as long as there are no market forces affecting demand and supply. However, demand and supply always shift to the left or to the right as a response to changes in other determinant variables. Hence, change in other variables will result in the change of quantity and price equilibrium.

1. Demand Change Generally, changes in demand or supply lead to predictable effects on equilibrium quantity and price, such as:
   1. When demand increases while supply remains unchanged, the equilibrium price and quantity will also increase. To get a clearer picture of the effect of increase in demand on market equilibrium, let us look at Figure 3.3(a). Curve D₀and S are the original demand and supply curve respectively. Point E₀ is the point of equilibrium for the initial market, that is, where demand curve D₀ intersects with supply curve S. Equilibrium price and equilibrium quantity are P₀ and Q₀ respectively. When demand increases, demand curve D₀ will shift to D₁. D₁ and E₁ are the new demand curve and new point of market equilibrium.
   2. When demand decreases while supply remains unchanged, the equilibrium price and quantity will decrease [Refer to Figure 3.3(b)].



Figure 3.3: Effect of demand curve shifts towards equilibrium

2. Supply Change
   1. When supply increases and demand remains unchanged, equilibrium price will decrease whereas equilibrium quantity will increase [Refer to Figure 3.4(a)].
   2. When supply decreases and demand remains unchanged, equilibrium price will increase whereas equilibrium quantity will decrease [Refer to Figure 3.4(b)].

   

   Figure 3.4: Effect of supply curve shifts towards equilibrium

3. Changes in Demand and Supply Changes in both demand and supply lead to predictable effects on equilibrium quantity or price.
   1. When both demand and supply increase, equilibrium quantity will increase [Refer to Figure 3.5(a)].
   2. When both demand and supply decrease, equilibrium quantity will decrease [Refer to Figure 3.5(b)].

   

   Figure 3.5: Effect of shifts of demand curve and supply curve in the same direction

   Figure 3.5 illustrates both these conditions. Effect towards price cannot be determined because it depends on a few other matters, especially the degree of curve shifts and curve elasticity.
   
   1. When demand increases and supply decreases, equilibrium price will increase [Refer to Figure 3.6(a)].
   2. When demand decreases and supply increases, equilibrium price will decrease. Effect on quantity cannot be determined because of the same reason as above [Refer to Figure 3.6(b)].

   

   Figure 3.6: Effect of shifts of demand and supply curves in opposite directions

3.2 MARKET IN THE FORM OF EQUATION

We can present the relationship between market demand and market supply for a particular good and their respective determinants in the form of equations.
Equations can be stated in the form of general functions or by assigning certain values to determinant variables. The equations are known as demand function and supply function respectively. Besides that, market equilibrium can also be calculated from the particular equations.

3.2.1 Demand Function

Demand function shows the relationship between quantity demanded and its determinants in the form of a function.
The general function of demand can be stated as:

Q_d = f(P_g, P_s, P_c, Y, T, P_eg)

This general function states broadly that demand quantity, Q_d, is a function to the price of the good itself, P_g; price of substitute goods, P_s; price of complementary goods, P_c; income, Y; preferences, T; and price prediction of the good itself, P_eg.
The demand function commonly used shows the relationship between quantity demanded with the price of the good itself. The equation may be in the form of Q_d = a – bP, where

Qd	=	quantity demanded
a	=	constant
b	=	demand curve gradient
P	=	price of good

This simple equation is based on the assumption that all other determinant variables remain unchanged. All constant variables values are included in the value of constant a. If a change due to change in other determinant variables, the demand curve will shift. The gradient of demand curve will change if the value of b changes. Figure 3.7 is the demand curve drawn from the demand function Q_d = 20 – 2P.

Figure 3.7: Demand curve

3.2.2 Supply Function

Like demand, supply also can be presented in the form of equation or function.
The general function of supply can be stated as:

Q_s = f(P_g, C_g, P_s, P_c, P_eg)

This general function states that quantity supplied is a function of the price of the good itself, P_g; production cost, C_g; the price of substitute goods in production, P_s; price of jointly produced goods, P_c; and price prediction, P_eg.
A simple supply function shows the relationship between quantity supplied with the price of the good itself. Other determinant variables are assumed to remain unchanged. The equation may be in the form of Q_s = c + dP.

Qd	=	quantity supplied
c	=	constant
d	=	supply curve gradient
P	=	price of good

Figure 3.8: Supply curve

3.2.3 Market Equilibrium

We know that market equilibrium will occur when demand quantity is equivalent to supply quantity or Q_d = Q_s. Based on the functions we have developed before, equilibrium price and quantity can therefore be obtained from the equations:

Qd	=	Qs
20 – 2P	=	–5 + 3P
5P	=	25
P	=	5

Substitute the value of P into the demand function or supply function to obtain the value of equilibrium quantity (You will obtain the same value).

Qd	=	20 – 2P	or	Qs	=	–5 + 3P
	=	20 – 2(5)			=	–5 + 3(5)
	=	10			=	10

Figure 3.9 shows the market equilibrium achieved at the equilibrium price of RM5 and equilibrium quantity of 10 units.

Figure 3.9: Market equilibrium

3.3 ELASTICITY AND SENSITIVITY

What is  elasticity?

Elasticity can be defined as the sensitivity measurement of a particular variable (for example, quantity demanded or quantity supplied) towards change in one of its determinants (for example, price or income).

In general, the value of elasticity can be calculated from:

Elasticity = 

We measure elasticity by using percentage of change due to a number of reasons:

1. Elasticity allows comparisons to be made towards the change for two subjects measured in different units. For example, we can compare the change of quantity with the change of price in the value of currency.
2. We can avoid the problem of determining the size of units used. For example, an increase from RM1 to RM2 is considered as increase of 1 price unit, but the change from 100 cents to 200 cents is 100 price units. By turning it into the form of percentage, the same value will be obtained without considering the price units being used.
3. Absolute change is not able to describe whether a change is significant or insignificant. It can only be known if the initial value is given. For example, the change of RM1 for a good with an initial price of RM5 is considered significant. But if the initial price of the good is RM100, a change of RM1 is considered as an insignificant change. In other words, we look at the percentage of change in determining the size of price change. The concept of elasticity can be applied by policy makers, producers, and even consumers. For example, firms can use the elasticity concept to determine the substitution of resource utilisation when one of the input price increases. Thus, if capital price decreases, firms can substitute labour into capital, but the rate of substitution is determined by value of elasticity.

There are four types of elasticity normally used, namely, price elasticity of demand, price elasticity of supply, income elasticity of demand, and cross elasticity of demand. We will discuss  the  types of demand elasticity before looking at supply elasticity.

Figure 3.10:Types of elasticity

ACTIVITY 3.2

In your opinion, why do we measure elasticity? How important is elasticity in our daily lives?

3.4 PRICE ELASTICITY OF DEMAND

Price elasticity of demand measures the response of quantity demanded of a particular good towards a change in the price of the good.

It is measured from the percentage of change in quantity demanded caused by one percent of price change. It is a measurement without units.

ACTIVITY 3.3

The increase in price of goods will cause a decrease in quantity demanded. This is a very clear situation. But will you be able to know the degree of change in quantity demanded? How do we calculate the particular change or decrease?

3.4.1 Calculation of Price Elasticity of Demand

Back to the price elasticity of demand, its coefficient value can be calculated from:

E_d =

A 10 percent increase in price causes 20 percent decrease in quantity demanded, the price elasticity of demand is –20% / 10% = –2.

Point elasticity measures the value of elasticity on one point on a curve, while arc elasticity is the average elasticity between two points on a curve.

The value of elasticity can be calculated using two methods, namely, point elasticity, and arc elasticity or midpoint elasticity.
The formula to calculate point elasticity is as shown below:

where, Q₀ is the initial quantity and Q₁ is the new quantity, while P₀ is the initial price and P₁ is the new price. The symbol ∆ is used to represent change, for example:
∆DQ = Q₁ – Q₀
Notes:
Calculation using the point elasticity formula may bring about some problems because it will give different elasticity values when calculation on price increase and price decrease is carried out. Even at the same price range, elasticity during price decrease differs from the elasticity during price increase. This problem is caused by the different values of the denominator. This condition can be clarified by using the example shown below:
Example:
Assume that price X decreases from RM10 to RM5 and quantity demanded increases from 4 units to 7 units.

Calculation using the formula of point elasticity will produce:

Point elasticity obtained when price X decreases from RM10 to RM5 is –1.5.
Now we will try to look at the condition if price is increased from RM5 to RM10 and quantity decreases from 7 units to 4 units. Hence, point elasticity is

Even when we are calculating at the same price range, the value of elasticity differs more than 1. This condition becomes a problem because we find that when price decreases, demand is elastic, but when price increases, demand is inelastic. The difference between the two values may not be a problem if we are looking at an insignificant price change, but as price change becomes more significant, hence the difference between the two values will also become bigger.
The problem with point elasticity formula can be overcome by using the arc elasticity formula, also known as midpoint elasticity.
Arc elasticity measures the average elasticity of an arc between two points on one curve.

 

From the example given earlier, the midpoint elasticity is

The value 0.7 means that, one percent of price change will result in 0.7 percent quantity change. Hence, demand is less elastic along the particular price range. We will obtain the same value whether the price increases or decreases.
The value of point elasticity can also be calculated or estimated by looking at Figure 3.11.

Figure 3.11: Calculation of elasticity

Elasticity at point B is:

at point C

ACTIVITY 3.4

Assume that the price of petrol increases as much as 60%. This condition will result in decrease of quantity demanded by 15%. What is the price elasticity for petrol?
If price of wheat flour decreases as much as 10% and quantity increases by 30%, what is the demand price elasticity for wheat flour?
In your opinion, which is more elastic?

3.4.2 Degrees of Elasticity

To facilitate the analysis of price elasticity of demand, we will usually ignore the negative sign and only consider the absolute value, since we will surely obtain a negative value due to the negative relationship between price change and change in quantity demanded.
Generally, elasticity can be pictured in the shape of a demand curve. However, as explained earlier, elasticity changes along one curve, except in the case of three conditions, which are, horizontal, vertical and hyperbola-shaped demand curves.
Horizontal demand curve is said to be perfectly elastic and the elasticity values remain the same along the curve, that is, infinity or undefined. Vertical curve, on the other hand, has zero elasticity along the curve. The curve that shows unitary elasticity value along the curve is hyperbola in shape. Table 3.2 summarises the relationship between elasticity value, degrees of elasticity and shape of demand curve.

Elasticity Value	Degrees of Elasticity	Shape of Demand Curve
Ed = ∞	Perfectly elastic	Horizontal
1 < Ed < ∞	Elastic	Tilted
Ed = 1	Unitary elastic	Hyperbola
0 < Ed < 1	Inelastic	Steep
Ed = 0	Perfectly inelastic	Vertical

SELF-CHECK 3.2

How can we say that demand of a particular good is elastic?

3.4.3 Price Elasticity of Demand and Total Expenditure/Revenue

Before this, we have stated that one of the uses of the elasticity concept is to make decisions regarding production and utilisation. Sensitivity of quantity towards price enables us to calculate the sensitivity of total revenue towards price because total revenue (TR) is calculated from price (P), times quantity (Q) or TR = P x Q. Besides helping producers to predict changes towards total revenue, consumers can also use it to predict changes in total expenditure.

Figure 3.12: Total revenue

Figure 3.12 illustrates how the total revenue is calculated. For example, 1,000 units sold at the price of RM2 per unit will generate RM2,000. In Figure 3.12, this amount is shown as the mottled area, total revenue is price (RM2) times quantity (1,000 units).
What if a firm intends to increase its total revenue? Can it be done by increasing or reducing the price? Firms can make their decisions based on the value of elasticity of demand price.

1. Elastic Demand When demand is elastic, the ratio of change in quantity is bigger than the ratio of price change. Therefore, change in quantity gives a more significant effect towards the total revenue compared to price change.
   Hence,
   
   
   If P increases, the percentage of decrease for Q is larger. Therefore, TR decreases. If P decreases, the percentage of increase for Q is more significant. Thus, TR increases.
   From here we can see that when demand is elastic, change in total revenue is in the same direction as quantity change.
   

   

   Figure 3.13: Total revenue in elastic demand

   Figure 3.13 illustrates the difference of total revenue obtained from two different price tiers on one elastic demand curve. Assume that price increases from RM5 to RM6. TR will decrease from RM100 to RM60. But if price decreases from RM6 to RM5, TR increases from RM60 to RM100. Thus, if demand is elastic, the firm should reduce the price to increase total revenue.
2. Inelastic Demand When demand is inelastic, the opposite will happen. The ratio of price change is bigger compared to the ratio of quantity change. Price change gives a more significant effect compared to quantity change.
   
   If P increases, percentage of decrease for Q is smaller. Thus, TR will increase.
   If P decreases, percentage of increase for Q is smaller. Thus, TR will decrease.
   Change in total revenue occurs in the same direction as price change. This condition is illustrated in Figure 3.14.
   

   

   Figure 3.14: Total revenue in inelastic demand

   If price decreases from RM6 to RM4, TR decreases from RM60 to RM48. Contrary to this, if price increases from RM4 to RM6, TR will increase from RM48 to RM60.
   Therefore, if the firm has an inelastic demand curve, the price can be increased to increase the total revenue.
3. Unitary Elastic Demand If the percentage of price change is equivalent to the percentage of change in quantity demanded, the demand curve is unitary elastic. When one percent of price increase is followed by one percent of decrease in quantity, the effect of price increase will be eliminated by a decrease in quantity, resulting in unchanged total revenue. Figure 3.15 is a demand curve that is unitary elastic along the curve. As you can see, total revenue at the price of RM10 per unit is TR = RM10 x 2 = RM20, similarly at the price level at RM5, TR = RM5 x 4 = RM20.
   

   

   Figure 3.15: Elasticity of unitary demand and total revenue

4. Perfectly Elastic Demand A perfectly elastic demand is depicted by a horizontal demand curve, with infinity elasticity value along the curve. At a price higher than market price, demand is null, but at a price lower than the market price, demand is infinity. Percentage of change in total revenue is equivalent to the percentage of change in quantity. In this condition, the only way to increase total revenue is by increasing the quantity.
   
   

   

   Figure 3.16: Perfectly elastic demand curve

   This condition is shown in Figure 3.16. Total revenue (shown by the shaded area) increases when quantity increases from Q₀ to Q₁.
5. Perfectly Inelastic Demand This type of demand is represented by a straight vertical demand curve, with zero elasticity value along the curve. Demand quantity is insensitive towards change in price. Percentage of change in total revenue is equivalent to percentage of price change. In this condition, total revenue can definitely be increased by increasing the price.
   
   Figure 3.17 illustrates the increase of total revenue, shown as the shaded area, from P₀ to P₁.
   
   

   

   Figure 3.17: Perfectly inelastic demand curve

ACTIVITY 3.5

Assume that demand of a particular good is inelastic. Will consumers’ expenditure increase if there is an increase in price?

3.4.4 Elasticity of Straight-Line Demand Curve

In the previous discussions, we know that elasticity of a vertical and horizontal demand curve remains the same along the curve. However, a straight-line demand curve that slopes downward has elasticity that changes along the curve.
Like what has been explained earlier, change in elasticity occurs because elasticity is measured in the form of ratio. Therefore, when price changes, the ratio of change is large when the initial price (or quantity) is small, but the value becomes lesser at a higher price (quantity) level.
Earlier we have also explained about the correlation between total revenue and elasticity of demand. When elasticity changes along one curve, then the direction of change in total revenue will also change.
Here, we will look at an example of a demand curve with a gradient of -1. Table 3.3 and Figure 3.18(c) is calculated and drawn based on the demand equation Q_d = 100 – 10P. Meanwhile, Figure 3.18(a) shows elasticity based on the function Q_d = a – bP. Figures 3.18(b) and 3.18(d) are curves that illustrate the relationship between total revenue and quantity respectively.

Table 3.3: Function of Straight-line Demand

Price (RM)	Quantity Demanded	Total Revenue	Types of Elasticity
0	100	0	Inelastic
1	90	90	Inelastic
2	80	160	Inelastic
3	70	210	Inelastic
4	60	240	Inelastic
5	50	250	Unitary elastic
6	40	240	Elastic
7	30	210	Elastic
8	20	160	Elastic
9	10	90	Elastic
10	0	0	Elastic

Based on Table 3.3 and Figures 3.18(b) and 3.18(d), look at how the total revenue increases with the increase in price when the demand curve is inelastic, that is, from P = 1 to P = 4. However, when the demand curve is elastic, that is, from P = 6 until P = 10, total revenue decreases when price increases.

Figure 3.18: Straight-line demand curve and total revenue

3.4.5 Elasticity of Demand Determinants

Degrees of elasticity of demand price can be influenced by a number of determinants, including:

1. The Number of Substitute Goods The most important determinant for elasticity of demand price is the number of substitute goods available, and the similarity among the particular substitute goods. The more substitute goods there are and the closer the similarities with the substitute goods, the larger the elasticity of the good.
   
   Take petrol as an example. In general, demand for petrol is inelastic since there are not many substitute goods for petrol available. But if we look at a petrol brand name, an increase in price of that particular brand will result in consumers moving on to another brand. Therefore, demand for one petrol brand is more elastic. Here, we can say that the substitution effect due to price change becomes more significant when the number of substitutes increase.
2. Budget Ratio The higher the ratio of income we spend on a particular good, the larger the possibility that we can reduce the use of the good when price increases. Therefore, demand will become more elastic, for example, clothes and petrol. Elasticity is low for goods that take up only a small portion of our income such as salt or bread.
3. Time When price of a product increases, we need time to make amendments in the budget and look for substitutes. Therefore, the longer the time taken, the more elastic demand price becomes.
4. The Number of Uses of Goods The more uses of a particular good, the larger the elasticity of demand price.

SELF-CHECK 3.3

1. Why do some particular goods have a high elasticity of demand while other goods have a high inelasticity of demand?
2. What are the factors that cause elasticity of demand price?

3.5 CROSS ELASTICITY OF DEMAND

Cross elasticity of demand or cross elasticity measures the demand sensitivity of a good towards the price change of other goods, namely substitute goods or complementary goods.

This measurement enables us to make predictions towards the demand shift of a product when price of other goods change.
Cross elasticity is measured by:

EXY

=

Percentage of change in quantity demanded for good X Percentage of change in price of good Y

3.5.1 Calculation of Cross Elasticity

Cross elasticity is:

EXY

=

Percentage of change in quantity demanded for good X Percentage of change in price of good Y

Value of elasticity can be calculated using the point elasticity formula:

Or midpoint elasticity formula:

 

Now, you must be confident in calculating the value of elasticity. Try calculating the cross elasticity value between good X and good Y, and between good X and good Z from Table 3.4 using the midpoint elasticity formula.

Table 3.4: Calculation of Elasticity Value

Price of Good X (RM)	Quantity Demanded (Units)
	Good Y	Good Z
2	10	20
3	5	30

3.5.2 The Use of Cross Elasticity

If good Y is the substitute for good X, demand for X will increase when price of Y increases. Therefore, cross elasticity has a positive value. But if Y is the complementary good for X, demand for X will decrease when price of Y increases. Hence, cross elasticity will carry a negative value.
To make it clear, cross elasticity between bread and butter is negative since bread and butter are complementary to each other. On the other hand, cross elasticity of butter and margarine has a positive value because both goods are considered as a substitute for one another. Cross elasticity between margarine and shoes is zero, since there is no connection between the two.

1. EXY < 0, good X and good Y are complementary
2. EXY > 0, good X and good Y are substitutes
3. EXY = 0, good X and good Y are not related

The higher the degree of substitution between the goods, the higher the positive value derived. The same applies when the closer the goods are as complements, the higher the negative value derived. The high positive and negative values shown illustrate the extent of the effect of price change of the second good towards demand of the first good.
Firms apply this concept of cross elasticity to identify the effect of price change of their competitors’ goods towards their own goods, for the purpose of planning.

ACTIVITY 3.6

Film and camera are complements to one another while beef and chicken are substitute goods. Determine the cross elasticity value of both sets of goods, whether they are positive or negative, and give the reasons.

3.6 INCOME ELASTICITY OF DEMAND

We know that income is one of the main determinants that shifts the demand curve. Hence, income elasticity of demand is a measurement of demand sensitivity towards change in income.

Income elasticity of demand or income elasticity is a measurement that enables us to estimate the shift in demand when there is a change in income.

3.6.1 Calculation of Income Elasticity

Income elasticity is calculated from:

EY

=

Percentage of change in quantity demanded Percentage of change in income

When Y is income, the point elasticity formula of income elasticity is:

And the midpoint elasticity formula is:

3.6.2 The Use of Income Elasticity

Income elasticity can be used to categorise goods as luxury goods, normal goods, necessities or inferior goods. It is also used to predict market size. If one product has a high income elasticity value, sales are predicted to increase rapidly when national income increases, and decrease rapidly if national income decreases.

Table 3.5: Value of Income Elasticity and Types of Goods

Value of Income Elasticity	Degrees of Elasticity	Types of Goods
EY = 0	Perfectly inelastic	Necessity
EY > 1	Elastic	Luxury good
O < EY < 1	Inelastic	Normal good
EY < 0	Negative elasticity	Inferior good

You may need some guidance in order to interpret the degrees of elasticity summarised in Table 3.5.
For example, when E_Y = 0, any changes of income will not affect change in quantity demanded. Therefore, these goods are considered as necessities. If        E_Y > 1, the rate of change in quantity demanded is bigger than the rate of change in consumers’ income. Thus, these are luxury goods. But when E_Y < 0, income elasticity is negative. The rate of change in quantity demanded is smaller compared to the rate of change in consumers’ income, hence, these goods are considered as inferior goods.
Now, try to interpret the meaning of income elasticity value 0 < E_Y < 1.

Figure 3.19: Various degrees of income elasticity

Figure 3.19 illustrates the relationship between consumers’ income and quantity demanded of a particular good. The curve is also known as an Engel curve (Engel curve will be discussed further in Topic 4).
Necessity is shown by a vertical curve while normal good and luxury good are both shown by a curve with a positive slope. Inferior good, on the other hand, is shown by a curve with a negative slope.  

3.7 ELASTICITY OF SUPPLY

Elasticity of supply is the measurement of supply sensitivity towards price change. This elasticity is calculated from:

ES

=

Percentage of change in quantity supplied Percentage of change in price

Calculation of the value for elasticity of supply is the same as the calculation for elasticity of demand. However, quantity refers to the quantity supplied.
Similar to elasticity of demand, elasticity of supply also consists of:

1. Perfectly elastic;
2. Elastic;
3. Unitary elastic;
4. Inelastic; and
5. Perfectly inelastic.

A vertical supply curve is perfectly inelastic, while a horizontal supply curve is perfectly elastic.
Table 3.6 illustrates the relationship between value of elasticity, degrees of elasticity and the shape of supply curve.

Table 3.6: Degree of Elasticity of Supply

Value of Elasticity	Degrees of Elasticity	Shape of Supply Curve
ES = 0	Perfectly inelastic	Vertical
ES < 1	Inelastic	Intersects with the quantity-axis
ES = 1	Unitary elastic	Starting from the origin
ES > 1	Elastic	Intersects with the price-axis
ES = ∞	Perfectly elastic	Horizontal

Something exceptional about elasticity of supply is that the value can easily be obtained from the intersections on the axes. If the supply curve intersects the price-axis (P), as in Figure 3.20(a), then supply is elastic (E_S > 1). If the supply curve intersects the quantity-axis (Q) as in Figure 3.20(b), then supply is inelastic (E_S < 1). A supply curve with a straight line starting from the origin has unitary elasticity along the curve, even with different gradient values, as illustrated by Figure 3.21.
Using your knowledge on elasticity obtained thus far, you know how to prove particular conditions. You can also try using the method such as the one shown in Figure 3.21.

Figure 3.20: Elasticity of supply

Figure 3.21: Demand curve of unitary elastic

3.7.1 Elasticity of Supply Determinants

The elasticity of supply value is determined by a number of factors:

1. Time Factor Time gives producers a chance to make amendments in supply. Therefore, time can be divided into three stages, namely, very short run, short run and long run.
   
   In a very short run, firms may not be able to alter supply amount much. Supply is fixed or can only have little change based on the amount of inventory. Hence, supply is very inelastic.
   
   

   

   Figure 3.22: Elasticity of supply at different time periods

   
   Referring to Figure 3.22, S₁ is the very short-run supply curve showing increase in demand, from D₀ to D₁, resulting in a high price increase from P₀ to P₁, but a very small change in quantity, from Q₀ to Q₁.
   
   While in a short-run, a few types of inputs can be added in order to increase supply. This is shown using curve S₂ in Figure 3.22, where the equilibrium quantity is increased from Q₀ to Q₂, but increase in price is also high, from P₀ to P₂.
   
   When firms have the opportunity to increase all inputs in the long term period and there may be new firms entering the industry, the supply curve becomes more elastic, as shown by curve S₃ in Figure 3.22. Increase in demand results in a higher percentage of increase in quantity compared to percentage of price increase where price increases from P₀ to P₃, and quantity increases from Q₀ to Q₃.
2. Size of Industry/Change in Production Cost Supply in small industries is more elastic compared to the supply in large industries. Small industries utilising a small number of inputs can purchase the inputs from market without influencing the price of the particular input. Therefore, production cost is not increased and supply is more sensitive towards price change. But for large industries, the increase in input demand will increase the price of inputs; hence, supply in large industries is less elastic.
3. Mobility of Production Factors Elasticity of supply is higher for goods using production factors that can easily change its utilisation or using a production process which can be shared without involving a high cost. Take the example used earlier on the production of rice flour and glutinous rice flour. In order to change the use of a grinder from grinding rice to grinding glutinous rice, manufacturer will not be needing a high modification cost, therefore, if the demand on glutinous rice flour increases rapidly due to certain reasons, the manufacturer can easily increase the production of glutinous rice flour by reducing the production of rice flour.If the production of a particular good requires specialised equipments or skills, or its usage cannot be easily altered, hence, supply of the good becomes less elastic.
   Take legal services as an example. Even though demand for legal services had increased rapidly, the number of lawyers cannot be easily increased since it is a specialised skill.

ACTIVITY 3.7

Using your creativity, draw a graph that summarises all the factors that affect and determine elasticity of supply. Present it during your tutorial. Compare your answer with your friends. Get feedback from them.

3.8 APPLICATION OF THE ELASTICITY CONCEPT

One of the applications of the elasticity concept is in analysing the question of who actually bears the burden of tax implemented by the government. Similarly, who actually deserves the right to get subsidies from the government?
Tax reduces the incentive of sellers to sell and consumers to buy. Therefore, tax generally causes output and sales reduction, and also leads to low input utilisation. Therefore, tax may cause inefficiency and some economists describe the effect of tax as adisincentive effect. However, sometimes tax does not involve a decrease in output, as what we will find out in the discussion below.

3.8.1 Tax Burden

When tax is implemented by the government towards sellers for every unit of good sold, the tax causes the price paid by buyers to differ from the price accepted by the sellers. The difference between both prices is the revenue for the government. Tax gives burden to sellers in the form of a lower price received from every unit and a lower selling quantity.
For consumers on the other hand, burden is in the form of a higher price that needs to be paid and a lower usage quantity. The tax burden is normally carried by both sellers and buyers, but the ratio of burden is determined by the elasticity or gradient of both demand curve and supply curve.

Figure 3.23: The effect of tax towards market equilibrium

Tax involves increase in cost for sellers; hence, tax will shift the supply curve to the left. Figure 3.23 illustrates the effect of tax towards the supply curve and the ratio of tax burden carried by both sellers and consumers. Without tax, an equilibrium is achieved at point A, with equilibrium price and quantity as P₀ and Q₀ respectively. Assume that tax t for every unit is collected by the government from the sellers; the supply curve will shift vertically at the value of t at every quantity level. Meanwhile, the demand curve does not shift.
When the supply curve shifts from S₀to S₁, market equilibrium will move from point A to point B. At point B, quantity demanded after tax is equivalent to supply quantity after tax, that is, Q₁. However, the price paid by consumers and price received by sellers are different at the tax value of t.
The increase in price that has to be paid by consumers is the tax portion that needs to be borne by the consumers. From Diagram 3.23, the amount of tax collected by the government is depicted by area P₁P₂BC; amount borne by consumers is the area P₀P₂BE and the remaining, area P₁P₀EC, is the tax borne by the sellers.
In general, the ratio of tax burden can be summarised as follows:

1. Given the same demand curve, the lower the elasticity of supply, the bigger the tax burden that has to be borne by sellers; while the higher the elasticity of supply, the larger the burden being shifted to the consumers.
2. Given the same supply curve, the lower the elasticity of demand, the larger the tax burden transferred to the consumers; and the higher the elasticity of the demand curve, the larger the tax burden that has to be borne by the sellers.

Figure 3.24: Tax burden based on elasticity of supply curve

To prove the formula, look at Figures 3.24 and 3.25. Figure 3.24 shows two shapes of supply curves where Figure 3.24(a) illustrates an inelastic supply curve and Figure 3.24(b) shows an elastic supply curve.
Point A in both diagrams is the initial equilibrium point and point B is the market equilibrium after tax is implemented. From Figure 3.24(a) you can see that more tax burden is carried by producers, depicted by area GHEF, while consumers have to bear as much as area HCBE. You can make your own analysis on Figure 3.24(b).

Figure 3.25: Tax burden based on elasticity of demand curve

Meanwhile, Figure 3.25(a) and (b) shows the ratio of tax burden for two demand curves with different elasticity. Based on the diagram, you must be able to analyse and make your own conclusion.
Other than in terms of tax burden, we can also see the effect of tax towards equilibrium output. From the observation in Figures 3.24 and 3.25, we can summarise that as elasticity of demand or supply becomes lesser, the output decrease due to tax also becomes lesser (for example, from Q* to Q₁).
Thus, you can prove by using diagrams that if demand and supply curves are perfectly inelastic, equilibrium output is totally unchanged. Meanwhile, for tax burden, if demand is perfectly inelastic, all burden is borne by the consumers. When supply is perfectly inelastic, all burden is borne by the producers.
From the analysis of tax burden, we can also summarise that if the government wants to obtain a higher tax revenue, tax can be implemented towards commodities with low elasticity of demand and elasticity of supply. This is because tax does not result in a high reduction of equilibrium quantity. Take cigarettes for example. We know that smoking can lead to addiction. Therefore, consumers are not very sensitive towards price change because demand is inelastic. Tax implemented on cigarettes will definitely be borne more by the consumers.

3.8.2 Benefits of Subsidies

Subsidy (Ŝ) can be assumed as a form of negative tax because it is a payment made by the government to retailers, farmers, consumers or anyone as a way to promote production or utilisation.  Therefore, subsidy is the opposite of tax.
Production cost will decrease when subsidies are given to producers. Therefore, supply curve will shift vertically to the right at the rate of subsidy amount accepted. In Figure 3.26, it is illustrated as the shift of supply curve from S₀ to S₁, and the amount of subsidy per unit accepted is BC(Ŝ).

Figure 3.26: Effect of subsidy

The equilibrium quantity before subsidy is Q₀ and increased to Q₁ after subsidy. Likewise, equilibrium price falls from P₀ to P₁. The price accepted by seller is P₂ while buyers pay a price of P₁. The ratio of benefits from giving subsidy also depends on the elasticity of demand or supply.
Now you must have gained confidence to make your own analysis towards the effect of subsidy when demand and supply curve have different elasticity values. Among the conclusions you will obtain from your analysis are, the more elastic the demand curve is, the bigger the benefit of subsidy that will be enjoyed by the sellers; and the more elastic the supply curve is, the bigger the benefit of subsidy that will be accepted by the buyers.
You can also make related analysis if the subsidy is given to consumers.

SUMMARY

• Market equilibrium is achieved when demand is equivalent to supply. The equilibrium quantity and price will not change as long as there is no change in demand and supply.
• Excess in demand or shortage, causes increasing pressure towards price and excess in supply or surplus, will result in decreasing pressure towards price.
• Equilibrium quantity and/or price can change when either the demand curve or supply curve shifts, or if there are shifts in both the demand curve and supply curve.
• Price elasticity of demand measures the response of quantity demanded towards change in price.
• Demand can be elastic, unitary elastic, inelastic, perfectly elastic, or perfectly inelastic depending on the value of coefficient calculated. The bigger the value of coefficient, the bigger the elasticity is.
• The main determinants of elasticity of demand are the number of substitute goods available, time and the importance of the good in budget.
• Income elasticity is the percentage of change in quantity divided by percentage of change in income. Negative value is for inferior goods, zero for necessities, and positive for normal goods and luxury goods.
• Cross elasticity is the percentage of change in the quantity of a good, divided by the percentage of change of other goods.
• If the elasticity coefficient is positive, both goods are said to be the substitute of one another. If the elasticity coefficient is negative, both goods are said to be the complementary of one another.
• Elasticity of supply is the percentage of change in quantity supplied, divided by percentage of price change.
• The main determinants of elasticity of supply are time period, size of industry, and mobility of production factors.
• Among the application of elasticity concept is in determining the actual burden for tax, and the actual benefits from subsidies.