Objectives for Chapter 4

At the end of the Chapter, you will be able to answer the

following:
1. Define the following terms:
a. Price Elasticity of Demand
Inelastic Demand
Elastic Demand
Unit Elastic Demand
Perfectly Inelastic Demand
Perfectly Elastic Demand
b. Income Elasticity of Demand
c. Cross-Price Elasticity of Demand
2. Illustrate the various types of price elasticity of
demand.
3. Compute for the coefficient of elasticity and be able
to analyze whether a good is:
a. Elastic, inelastic, or unitary elastic
b. Normal or inferior good
c. Substitute, complement, or an independent
good

Chapter 4
Elasticity and Its Application

Too many people think that economics is this subject that

should wait until the university level. But it can't wait that
long.
-Robert
Duvall

Imagine that some event drives up the price of gasoline in

the Philippines. It could be a war in the Middle East that

disrupts the supply of oil, a booming Chinese economy that
boosts the world demand for oil, or a new tax on gasoline
passed by the congress. How would the Filipino consumers
respond to the higher price?
It is easy to answer this question in broad fashion:
Consumers would buy less. That is simply the law of
demand we learned in the previous chapter. But you might
want a precise answer. The law of demand tells us some
information that is useful. If we, as a company, charge a
higher price, people will buy less of our product. But this
information is not enough.
By how much would
consumption of gasoline fall? This can be answered using a
concept called elasticity, which we will develop in this
chapter.
Elasticity is a measure of how much buyers and sellers
respond to changes in market conditions. However, in this
chapter, we will only concentrate on the various elasticity
of demand. When studying how some event or policy
affects a market, we can discuss not only one direction of
the effects but their magnitude as well. Elasticity is useful
in many applications, as we will see toward the end of this
chapter.

The Elasticity of Demand

As mentioned in the previous chapter, we noted that
consumers usually buy more of a good when the prices are
lower, when their incomes are higher, when the prices of
the substitutes for the good are higher, or when the prices
of the complements of the good are lower.
Our previous discussion of the demand was qualitative, not
quantitative. That is, we discussed the direction in which
quantity demanded moves but not the size of the change.
To measure how much the consumers respond to the
changes in these variables, economists use the concept of
elasticity.

The Price Elasticity

Determinants

of

Demand

and

Its

The law of demand states that a fall in the price of a good

raises the quantity demanded. The price elasticity of
demand measures how much the quantity demanded
responds to a change in price. Demand for a good is said to
be elastic if the quantity demanded responds substantially
to changes in the price. Demand is said ti be inelastic if the
quantity demanded responds only slightly to changes in
price.
The price elasticity of demand for any good measures how
willing consumers are to buy less of a good as its price
rises. Thus, the elasticity reflects the many economic,
social, and psychological forces that shape the consumer
preferences. Based on experience, however we can only
state some general rules about what determines the price
elasticity of demand.
Availability of Close Substitutes T
his is probably the most important factor influencing the
elasticity of a good or service. In general, the more
substitutes, the more elastic the demand will be. For
example, if the price of a cup of coffee went up by 5,
consumers could replace their morning caffeine with a cup
of tea. This means that coffee is an elastic good because a
raise in price will cause a large decrease in demand as
consumers start buying more tea instead of coffee.
However, if the price of caffeine were to go up as a whole,
we would probably see little change in the consumption of
coffee or tea because there are few substitutes for
caffeine. Most people are not willing to give up their
morning cup of caffeine no matter what the price. We
would say, therefore, that caffeine is an inelastic product
because of its lack of substitutes. Thus, while a product
within an industry is elastic due to the availability of
substitutes, the industry itself tends to be inelastic.
Usually, unique goods such as diamonds are inelastic
because they have few if any substitutes.
Amount of income available to spend on the good
This factor affecting demand elasticity refers to the total a
person can spend on a particular good or service. Thus, if
the price of a can of Coke goes up from 20 to 40 pesos
and income stays the same, the income that is available to

spend on coke, which is 80, is now enough for only two

rather than four cans of Coke. In other words, the
consumer is forced to reduce his or her demand of Coke.
Thus if there is an increase in price and no change in the
amount of income available to spend on the good, there
will be an elastic reaction in demand; demand will be
sensitive to a change in price if there is no change in
income.
Time
The third influential factor is time. If the price of cigarettes
goes up 80 per pack, a smoker with very few available
substitutes will most likely continue buying his or her daily
cigarettes. This means that tobacco is inelastic because
the change in price will not have a significant influence on
the quantity demanded. However, if that smoker finds that
he or she cannot afford to spend the extra 80 per day and
begins to kick the habit over a period of time, the price
elasticity of cigarettes for that consumer becomes elastic
in the long run.

Computing the Price Elasticity of Demand

We want to know precisely what will happen to the quantity
demanded of our product if we raise the price by a given
amount. In particular, we want to know what is called the
price elasticity of demand. As a formula, this is:
Price Elasticity of Demand = Percentage Change in
Quantity Demanded
Percentage Change in
Price
In words, this is
the
percentage
change
in
the
quantity
demanded of a
given product that
results because of
a
given
percentage

Decision tool for Price Elasticity

of Demand
If the coefficient is:
Demand is:
<1
Inelastic
>1
Elastic
=1
Unit
Elastic
=0
Perfectly Inelastic
Infinitely Large
Perfectly Elastic

change in the price of that product.

It measures how much buyers respond to the change in the
price. (Notice that we use "percentage change" instead of
"change in amount". This allows us to compare different
products. People will respond much differently to a tencent increase in the price of a candy bar than to a ten-cent
increase in the price of an automobile. So we measure the
change in percentage terms to allow comparison.)
When we calculate our formula, we get a number, we call
as the coefficient of the price elasticity of demand, and we
take its absolute vale. If the number is more than zero but
less than one, we say that demand is relatively inelastic.
This means that buyers reduce their buying, but very little,
as the price of the product rises.
If the number is more than one, we say that demand is
relatively elastic. This means that buyers not only reduce
their buying, but they reduce it considerably, as the price
rises. If the number exactly equals one, we say that
demand is unit elastic. "Unit" means one. If the number
exactly equals zero, we say that demand is perfectly
inelastic. This means that buyers do not change their
quantity demanded at all if the price rises. Perfectly
inelastic demand would be a violation of the law of
demand.
We will not encounter any examples of perfectly inelastic
demand. Finally, if the number is infinitely large, we say
that the demand is perfectly elastic. We will encounter
several examples of this. It means that the market is
infinitely large; the seller can sell as much as he or she
wants at the price that exists in the market.
Let us try to compute for the price elasticity of demand
given this situation. The price of gasoline increased from
55 to 60 per liter due to the devastating effects of the
war in the Middle East. Consequently, the daily average
market quantity demanded for gasoline in Manila changed
from 150 liters to 145 liters.
Coefficient of price elasticity =

% Qd
%P

Or

Q2 Q1

Ed =

Where:

____
Q1______
P2 P1
P1

Ed = Coefficient of price elasticity of

demand
Q1 = Previous quantity demanded
Q2 = Current quantity demanded
Y1 = Previous price
Y2 = Current price

Solution:

Ed

Ed

Ed

150-145
_______ 145________
50-45__
45
0.03448__
0.111111
0.31

The computed coefficient of the price elasticity of demand

in this case is 0.31. Using the decision tool above, since,
the coefficient is less than 1, therefore the demand for
gasoline by the market is inelastic.

How to Illustrate the Price

Elasticity of Demand
Economists classify demand curves
according
to
their
elasticity.
Demand is considered elastic when
the elasticity is greater than 1, thus
graphically; it is shown by Figure 2
wherein it illustrates the shallow
slope of the demand curve.
Demand is considered as inelastic
when the coefficient of elasticity is
less than 1, which means the
quantity moves proportionately less
than the price. It is shown by the
steep slope of the demand curve in

Figure 2.

Figure 3.

Figure 4.

figure 3. If the coefficient of

elasticity is exactly equal to 1, the
quantity moves the same amount
proportionately as the price, and
demand is said to be unit elastic,
shown in Figure 4.

Figure 5 and
6
illustrate
the perfectly
elastic
and
perfectly
inelastic
demand
respectively.
In
the
extreme case of a zero elasticity, demand is perfectly
inelastic, where in the demand curve is vertical. In this
case, regardless of the price, the quantity demanded stays
the same. Perfectly elastic demand curve on the other
hand, approaches infinity and the demand curve becomes
horizontal, reflecting the fact that the very small changes
in the price lead to huge changes in the quantity
demanded.
Figure 5.

Figure 6.

Other Demand Elasticities

In addition to the price elasticity of demand, economists
use other elasticities to describe the behavior of buyers in
the market.
The Income Elasticity of Demand
The income elasticity of demand measures how the
quantity demanded changes as consumer income changes.
It is calculated as the percentage change in quantity
demanded by the percentage change in income. That is,
Income Elasticity of Demand = Percentage Change in
Quantity Demanded
Percentage Change in
Income

As we have discussed in the last chapter, most goods are

normal goods: Higher income raises the quantity
demanded. Because quantity demanded and income move
in the same direction, normal goods have positive income
elasticities. A few goods, such as jeepney rides, tuyo, are
inferior goods: Higher income lowers the quantity
demanded. Because quantity demanded and income move
in opposite directions, inferior goods have negative income
elasticities.
Even among normal goods, income elasticities vary
substantially in size. Necessities, such as food and clothing,
tend to have small income elasticities because consumers
choose to buy some of these goods even when their
incomes are low. Luxuries, such as diamonds and i-phones,
tend to have large income elasticities because consumers
feel that they can do without these goods altogether if
their incomes are too low.
Let us try to actually compute for the coefficient of income
elasticity.
If the coefficient of income elasticity is greater than one,
demand for the item is considered to have a high income
elasticity. If however the coefficient of income elasticity is
less than one, demand is considered to be income
inelastic. Luxury items usually have higher income
elasticity because when people have a higher income, they
don't have to forfeit as much to buy these luxury items.
Let's look at an example of a luxury good: air travel.
Mang Pandoy has just received a 10,000 increase in his
salary, giving him a total of 80,000 per month. With this
higher purchasing power, he decides that he can now
afford air travel twice a year instead of his previous once a
year. With the following equation we can calculate income
demand elasticity:
Coefficient of income elasticity = % Qd
%Y
Or
Edy =

Q2 Q1
____
Q1______
Y2 Y1
Y1

Where:

Solution:

Edy = Coefficient of income elasticity

Q1 = Previous quantity demanded
Q2 = Current quantity demanded
Y1 = Previous income
Y2 = Current income

Edy

=
2-1
_________ 1________
80,000-70,000__
70,000

Edy

1__
0.14

Edy

Income
elasticity
of
demand
for
Mang
Pandoy's air travel is
seven
highly
elastic. Using
the
decision tool below, we
may conclude that air
fare relative to Mang
Pandoys demand is a
normal good but it is
not a necessity, thus air
fare is a luxury good.

Decision Tool for Income

Elasticity
Normal Goods (E>0). These are
goods whose consumption
increases with an increase
in income.
Necessity (E<1). These are
goods whose consumption
increases an amount
smaller than an increase in
income.
Luxury Good (E>1). These are
goods whose consumption
increases an amount larger
than an increase in income.
Inferior Good (E<0). These are

With some goods and

services,
we
may
actually
notice
a
decrease in demand as
income
increases.
These are considered
goods and services of inferior quality that will be dropped
by a consumer who receives a salary increase. An example
may be the increase in the demand of DVDs as opposed to
video cassettes, which are generally considered to be of
lower quality. Products for which the demand decreases as
income increases have an income elasticity of less than
zero. Products that witness no change in demand despite a
change in income usually have an income elasticity of zero
- these goods and services are considered necessities.

Here are more examples for the various types of good

dependent on the consumer income.
A good example of a normal good is the type of clothes you
buy. While you are in college and your income is low, you
may shop at Divisoria for your clothing. However, after you
complete your degree, and you are making a lot of money
as an economist, you are more likely to buy more
expensive clothes from retailers in a shopping mall like SM
Department store and other exclusive brands. In other
words, your consumption increases as your income
increases as you buy more expensive clothing.
An example of a necessity is drinking water. While you may
upgrade to an I-phone from Cherry Mobile with an increase
in income, however, it is unlikely that your consumption of
water will increase an amount more than your increase
income. For instance, if your income were to increase by
25%, you will probably not consume 25% more drinking
water.
An example of a luxury good is a round of golf. With low
income, your consumption of rounds of golf will likely be
zero. However, once your income rises enough to afford to
play, your increase in rounds of golf will probably be higher
than the increase in income. In other words, once you
make enough money to play the first round of golf, your
increase in round of golf consumption will be 100% while
the increase in income may have only been 15%.
A classic example of an inferior good is instant noodles.
The idea here is that you will consume fewer instant
noodles as your income increases. For example, after you
graduate from college, you may have higher quality (more
expensive) dinner takeout instead of instant noodles for
some of those quick, late night, meals.
Cross-Price Elasticity of Demand
The cross-price elasticity of demand measures how the
quantity demanded of one good responds to a change in
the price of another good. It is calculated as the
percentage change in quantity demanded of good 1
divided by the percentage change in the price of good 2.
That is,

Cross-Price Elasticity of Demand = Percentage Change in

Quantity
=
___
Demanded of good 1
____
Percentage Change in the
Price of good 2
Whether the cross-price elasticity is a positive or negative
number depends on whether the two goods are substitutes
or complements. As we have discussed in chapter 3,
substitutes are goods that are typically used in place of
one another, such as hamburgers and hotdogs. An increase
in hot dog prices induces people to cook hamburgers
instead. Because of the price of hotdogs and the quantity
of hamburgers demanded move in the same direction, the
cross-price elasticity is positive.
Conversely, complements are goods that are typically used
together, such as computers and software. In this case, the
cross-price elasticity is negative, indicating that an
increase in the price of computers reduces the quantity of
software demanded. There are also instances the two
goods seem to be unrelated with each other, meaning the
price of any of the two goods does not affect the quantity
demanded of the other good. We
call them as independent goods.
Lets try to solve for cross price
elasticity given this situation:
The price of product A increased
from 20 to 40. The demand for
product B went up from 100 units
to 200 units. Calculate the cross
price elasticity of demand, then
analyze whether product A and B
are substitutes, complements, or
independent goods.
Coefficient Elasticity
Or
Edcp =

Decision Tool for

Cross-Price Elasticity

Substitutes (E>0). Are

goods that can be used
in exchange for one
another.
Compliments (E<0).
Are goods that people
tend to consume hand in
hand.
Independent (E=0).
These are goods that
show no relationship.

=
%Qg1
%Pg2

Q2 Q1
____
Q1______

P2 P1
P1
Where:

Edcp = Coefficient of cross-price elasticity

Q1 = Previous quantity demanded of good 1
Q2 = Current quantity demanded of good 1
P1 = Previous price of good 2
P2 = Current price of good 2

Solution:

Edcp =

200 100
__ 100___
40 20
20

Edcp =

__1__
1

Edcp =

The coefficient of cross-price elasticity is 1, there for it is

unitary. At the same time, we may conclude that since the
coefficient is greater than 0, using the decision tool, we
would know that product A and product B are substitutes.

Summary

The price elasticity of demand measures how much

the quantity demanded responds to changes in the
price. Demand tends to be more elastic if close
substitutes are available, if the good is a luxury
rather than a necessity, if the market is narrowly
defined,

The price elasticity of demand is calculated as the

percentage change in quantity demanded divided
by the percentage change in price. If quantity
demanded moves proportionately less than the
price, then the elasticity is less than 1, and the
demand is said to be inelastic. If quantity
demanded moves proportionately more than the
price, then the elasticity is greater than 1 and the
demand is said to be elastic.

cross-price elasticity of demand measures how

much the
quantity demanded of one good responds to
changes in the
price of another good.

Additional elasticity relating to demand is the cross

price elasticity of demand which measures the
responsiveness of quantity demanded of a good to
a change in the price of another good.

Cross-price elasticity of demand determines

whether the good is a substitute, a complement, or
an independent good, that is, the coefficient of
cross-price elasticity is negative for complements,

Questions for Review and Application

1. Answer the following questions:

a. To calculate the price elasticity of demand, you

divide the _____________ by the _________.
b. If the elasticity number is between zero and one, we
say the demand is __________________.
c. If the elasticity number is more than one, we say the
demand is __________________.
d. If the elasticity number is one, we say the demand is
__________________.
e. If the elasticity number is zero, we say the demand
is __________________.
f. If the demand for A is more inelastic than the
demand for B, the graph of the demand for A would
be drawn ___________ (flatter or steeper?)
g. If the demand for A is perfectly elastic, the graph of
the demand for A would be drawn ____________.
2. The demand for airline travel was elastic. Explain why
this would be so using the three factors discussed in this

section.
3. How is price elasticity of supply calculated? Explain
what it measures.
4. Lists the various determinants of the price elasticity of
demand discussed in the chapter.
5. In each case, state whether you believe the demand for
the product is relatively elastic or relatively inelastic?
Then, provide reasons for your conclusion.
a. Services of a doctor to fix a broken arm
b. Services of a doctor for plastic surgery (changing
one's appearance)
c. A new BMW 5 million automobile
d. Use of cigarettes
e. Buying gasoline

Quiz 1 for Chapter 4. Elasticity and Its Application

Name:

____________________________________

Score:

_________________
Section:
_______________
_________________

Date:

____________

Professor:

Direction: Multiple Choice: Choose the best answer.

______1. The price elasticity of demand is the:
A. percentage change in quantity demanded divided
by the percentage change in price
B. percentage change in price divided by the
percentage change in quantity demanded
C. peso change in quantity demanded divided by the
peso change in price
D. percentage change in quantity demanded divided
by the percentage change in quantity supplied
______2. If the price elasticity of demand equals 0.5, the
demand for the product is:
A.inelastic
C. perfectly
inelastic
B.elastic
D. unit elastic
______3. The demand for a product would be more inelastic:
A. the longer is the time under consideration
B. the greater is the number of substitutes available
to buyers
C. the less expensive is the product in relation to
incomes
D. all of the above
______4. For which of the following products would the
demand be most elastic?
A. hamburger
B. beef
C. meat
D.
food
______5. In drawing the demand curve, if the demand for
the product is more inelastic, you would draw the line:
A. flatter
B. steeper C.
horizontal
D. vertical
Direction: Computation. Show the complete solutions.
1. Solve for elasticity in the market for cupcakes. When
cupcakes cost 15 each, Alice is willing to buy 10
pieces, and Joe is willing to sell 10 pieces. When they
cost 18 each, Alice is willing to buy 6 cupcakes, and
Joe is willing to sell 20. Solve for Alice's price
elasticity of demand.
2. Suppose the following table describes Jocelyns

weekly entertainment purchases, which vary

depending on the price of a bag of chips:
Price
of
Movi
Movi
e
Popco
e
Ticke
rn
Ticke
ts
t
Php1
2
3
50
Php2
1
2
00

Arcad
e
(Toke
ns)

Can
of
Cok
e

10

20

a. Compute the cross price elasticity of popcorn

with respect to the price of a movie ticket.
b. Compute the cross price elasticity of Tokens
with respect to the price of a movie ticket.
c. Compute the cross price elasticity of Coke with
respect to the price of a movie ticket.
d. Are movie tickets and popcorn substitutes or
complements? How do you know?
e. Are movie tickets and arcade substitutes or
complements? How do you know?
f. Are movie tickets and coke substitutes or
complements? How do you know?

Quiz 2 for Chapter 4. Elasticity and Its Application

Name:
____________________________________
_________________
Section:
_______________
Date:
____________
_________________

Score:
Professor:

Part I: Multiple Choice: Choose the best answer.

1. Which of the following elasticity requires an absolute
value in analyzing the coefficient of elasticity?
A. Price Elasticity of Demand
B. Income Elasticity of Demand
C. Cross Price Elasticity of Demand
D. Cross Price Elasticity of Supply
E. All of the Above
2. The Price Elasticity of Demand is considered elastic
when the coefficient of elasticity is:
A. Greater than 1
C. Equals to 1
B. Less than 1
D. Zero
3. Which commodity will have a more inelastic
demand?
A. Rice
C. Cellphones
B. Cars
D. Laptops
4. When the coefficient of the Price Elasticity of
Demand of a commodity equals to infinity, we can
conclude that commodity has:
A. Perfectly elastic demand
C.
Perfectly
inelastic demand
B. Elastic Demand
D.
Inelastic
demand
5. When the coefficient of Income Elasticity of Demand
is greater than zero, we can conclude that:
A. The good is a necessity
C. it is a luxury
good
B. It is an inferior good
D. It is a normal good
6. When the coefficient of Income Elasticity of Demand
is less than zero, we can conclude that:
A. The good is a necessity
C. it is a luxury
good
B. It is an inferior good
D. It is a normal good

7. They are those goods which has a coefficient of cross

price elasticity that is greater than zero.
A. Complimentary goods
C.
Independent
goods
B. Substitutable goods
D. Inferior goods
8. The Price Elasticity of Demand is considered unitary
elastic when the coefficient of elasticity is:
A. Greater than 1
C. Equals to 1
B. Less than 1
D. Zero
9. The Cross Price Elasticity of Demand is between two
related goods is equals zero, we can conclude that
the two goods are:
A. Complimentary goods
C.
Independent
goods
B. Substitutable goods
D. Inferior goods
10.
Which of the following best describe the
commodity under this scenario: the income of the
aggregate demand increased by 20%, and the
aggregate quantity demanded decreased by 10%.
A. Necessity good
C. Normal good
B. Luxury good
D. Inferior good
Part II. Analysis :
Which of the following goods are likely to have elastic
demand, and which are likely to have inelastic demand?
Cooking oil
Soft drinks
Chocolate
Water
Heart medication
Oriental rugs
Gasoline
Branded jeans
Part III. Computation:
Problem 1: Yesterday, the price of envelopes was 30 a
box, and Mang Pandoy was willing to buy 10 boxes. Today,
the price has gone up to 37.50 a box, and Mang Pandoy is
now willing to buy 8 boxes. Is Mang Pandoy's demand for
envelopes elastic or inelastic? What is Mang Pandoy's
elasticity of demand?
Problem 2: Aling Norma advertises to sell her special

cookies for 400 a dozen. She sells 50 dozen, and decides

that she can charge more. She raises the price to 600 a
dozen and sells 40 dozen. What is the elasticity of
demand? Assuming that the elasticity of demand is
constant, how many would she sell if the price were 1000
a dozen?
Problem 3: If Sansa's elasticity of demand for hot dogs is
constantly -0.9, and she buys 4 hot dogs when the price is
15.00 per hot dog, how many will she buy when the price
is 10.00 per hot dog?