Chapter 3: Elasticity

Definition of Elasticity
Elasticity - A measure of the responsiveness of Qd or Qs to a change in price or other
economic variable. (i.e., income, price of other goods)
Different Concepts of Elasticity
1. Price Elasticity of Demand and Pricing Decision – these two topics are helpful
in understanding how sellers use price elasticity in their pricing decisions.

Price Elasticity of Demand is the degree of responsiveness of quantity demanded

to a change in Price. Economist define this mathematically as:

 In this equation when resulting price elasticity of demand is greater than 1, the
consumers’ sensitivity to changes in price is said to be elastic. (Consumers
show a strong reaction to a price change.)
 When it is less than 1, the quantity demand’s response to changes in price is
said to be inelastic. (Consumers show a weak reaction to a price change.)
 However, when price elasticity equals 1, quantity demanded is unitary elastic.
(Consumers reaction to a price change is neutral.)

Price Elasticity of Demand Interpretation

=1 Unitary Elastic
>1 Elastic
<1 Inelastic

REMEMBER:
 The demand curves are normally downward sloping as described by the law of
demand. However, certain changes in demand curves occur as quantity
demanded reacts to changes in price.
 In elastic demand, the changes in price are relatively small. In this case,
demand curve tend to slope more horizontally.
 Meanwhile, when the demand is inelastic, it means there is a relatively large
change in price of the commodity. Demand curves for inelastic demand tend to
slope more vertically.
Importance of Total Revenue in Pricing Decisions
We refer to Total Revenue as the Total Sale of Products by the producer or
seller. This is expressed as:

TR = P x Q
where: TR is the Total Revenue; P is the Price; and Q is the quantity.
Note that in comparing two TRs, whichever yields a higher TR, holding other things
constant, the price charged is the best price is good, whether it is the old price or the
new price.
Lets us now analyse this equation by looking at the example provided below.
Example:
Cecilia sells bangus for PHP1 100 and her Qd1=500. When she decides to sell it for PHP2
125, her Qd2 becomes 450. Should Cecilia sell her bangus at PHP 100 or PHP 125? Is
Qd elastic or inelastic?
Solution:

Since we know the percentage changes in quantity demanded and price, we can
now solve for the price elasticity of demand using the given formula.
3

Now that 0.5 < 1, hence, quantity demanded is inelastic is expressed in

absolute value.
Now compare the old TR with the new TR and select which price is better.

TR2 is higher than TR1, hence, the new TR is better. Cecilia should sell bangus at
PHP 125.
From the above solution, we can conclude that when Cecilia increases her price while
demand is inelastic, she gets a bigger total revenue. She will then maximize her profit
by raising her price to PHP 125.

2. Income Elasticity of Demand is the degree of responsiveness of a percentage

change in quantity demanded with a percentage change in income. It is calculated
using the following formula:

where: Qd is the quantity demanded and Y is income.

NOTE:
 When the result of the income elasticity is greater than 1, the product is called
normal good but is considered luxury. This happens when an increase in a
consumer’s income has caused a substantial increase in the demand for a
product
 On the other hand, when resulting income elasticity is a negative number, the
good is said to be inferior. A good becomes inferior when an increase in income
brings about a decrease in demand.
 A good is said to be unitary if income elasticity is equal 1.

Summary of Income Elasticity of Demand

Income Elasticity of Demand Interpretation
>1 Luxury Good
<1 Necessity
>0 Normal Good
<0 Inferior Good

Example:
Cerrine earns a monthly salary of PHP 5,000 and she consumes PHP 1,000 worth of
chicken per month. When her income increased by PHP 2,500/month, she started to
consume PHP 2,000 worth of chicken meat a month. Is Cerrine’s demand for chicken
meat normal, inferior, necessity, or luxury?
Solution:

1
2

We can now substitute the values in order to get the income elasticity of
demand:

Note that the result is greater than 1 (1.68 > 1), hence the demand for
chicken is normal good and might even be considered a luxury.

3. Cross Elasticity of Demand is the degree of responsiveness of a percentage

change in quantity of a good with a percentage change in the price of other goods.
NOTE:
 A positive cross elasticity indicates that a good is a substitute of the other.
 A negative cross elasticity means the goods are complementing each
other.

Cross of Demand Relation of Goods

=0 X and Y are not related
>0, positive Substitutes
<0, negative Complements
In economics, the percentage change in demand for the first good in response to the
percentage change in price of the second good is expressed in this mathematical
formula:

NOTE:
 The upper portion of the fraction (quantity) refers to product X.
 The lower portion of the fraction (price) refers to product Y.
Example:
Let us consider the next table. It shows the relationship of quantity demanded and
price for each product X and Y.

Good Q1 Q2 P1 P2
X 4 5 4 5
Y 2 3 2 3

To solve for cross elasticity, we substitute the values to our given formula.
Solution:
1

4. Price Elasticity of Supply

We discussed the consumers’ response to the different factors – price, income,
and price changes of other products – that affect their demand for products. Now
we will consider the price elasticity of supply.
Price Elasticity of Supply is the responsiveness of quantity supplied to a change in
the price. In this respect, we will study how to measure the relationship of quantity
supplied and price.
Price Elasticity of Supply is computed as follows:

NOTE:
 When supply is elastic, procedures are able to increase production
even with an increase in the cost of production.
  However, when the supply of a product becomes inelastic, producers are
hindered to produce more.
 In this respect, when there is a considerable increase in price of goods
being sold, supply becomes elastic. However, when the change in price is
insignificant, supply is inelastic.

Price Elasticity of Supply Qs

=1 Unitary Elastic
>1 Elastic
<1 Inelastic

Example:
Suppose that the old price of instant noodles is PHP 5 and a seller can produce 100
packs of them. When the price rose by PHP 2, the producer has doubled his production.
How elastic is his supply for noodles?
Solution:

2
 Substituting for the values, we get the value of price elasticity.

We can say that the supply of noodles is elastic because 2.03 is greater than 1.