ELASTICITY
An analysis of demand and supply necessitates a subsequent study on their
responsiveness or elasticity with respect to changes in their determinants. The
discussions will focus on their elasticity with respect to price and income. For every
elasticity topic, the measurements are first presented followed by the analysis and
interpretation.
Price Elasticity of Demand
Price elasticity of demand or the degree of responsiveness of quantity demanded to a
change in price is measured by dividing the percentage change in quantity demanded by
the percentage change in price. Demand elasticity refers to the reaction or response of
the buyers to changes in price of goods and services.
Elasticity Formula
/\ Q
-------Q
ep (Elasticity)
/\ Q
=
Q
/\ P
=
=
P
=
=
--------------/\ P
-------P
the difference between the original quantity and the new quantity.
(Disregard negative sign)
original quantity.
the difference between the original price and the new price.
(Disregard negative sign)
original price.
Table 1 (Theoretical Example)
Price
Qd
ep Coefficient
4
100
5
60
1.60
7
55
____
10
48
____
14
40
____
15
35
____
Year/Point
2009/A
2010/B
2011/C
2012/D
2013/E
2014/F
Classification
Elastic
_______
_______
_______
_______
Solution for the year 2004 & 2005 only:
/\Q = 40 ; Q = 100 ; while /\P = 1 ; P = 4
40
----100
---------- =
1
----4
40
----100
x
4
----1
=
160
------ = 1.60 (Let’s make it 2 decimal places)
100
1
If elasticity coefficient (answer) is:
More than 1 = elastic demand
Equal to 1 = unitary demand
Less than 1 = inelastic demand
If zero = perfectly inelastic demand
If undefined = perfectly elastic demand
Price elasticity of demand has two (2) measures: arc elasticity and point elasticity.
The coefficient of the price elasticity of demand between two points along the demand
curve is called arc elasticity.
The coefficient is preceded by a negative sign because of the inverse relationship
between the quantity demanded and price. In determining the degree of
responsiveness of demand to a change in price, the negative sign is set aside and only
the absolute value of the coefficient is considered. On the other hand, the elasticity at
one point along the demand curve is called point elasticity.
Let us graph table 1 and presenting each year/point of different degrees of elasticity.
As a result of the different degrees of elasticity, there are different ways of presenting
the demand curve.
P
D1 is relatively elastic, a change in
price leads to a significant change
D1
in quantity demanded
Qd
P
D2 is relatively inelastic, a change
in price leads to a slight change in
quantity demanded
D2
Qd
P
D3 is unitary, a change
in price results to an equal
change in quantity demanded
D3
Qd
2
P
D4 is perfectly elastic. At a given
price, quantity demanded can
change infinitely
D4
Qd
P
D5
D5 is perfectly inelastic. At any
price, the quantity demanded will
remain the same.
Qd
Determinants of Demand Elasticity
1. Number of good substitutes. Demand is elastic for a product with many good
substitutes. An increase in the price of such product induces buyers to look for
good substitutes. On the other hand, products without good substitutes have an
inelastic demand. Buyers have no or little choice except to purchase them if they
really need them. Example, electricity for a factory.
2. Price increase in proportion to income. If the price increase has very little effect
on the income or budget of the buyers, demand is inelastic. For example, a 40
percent increase in the price of a needle or candy means only a few centavos.
Thus, the result is only a slight decrease in quantity demanded. But if the price
increase involves a substantial amount in proportion to the income of consumers,
demand is elastic. For example, a 40 percent increase in tuition fees is likely to
discourage many very poor families from sending their children to college. In fact,
in the Philippines, university education has become a privilege of the few.
3. Importance of the product to the consumers. Luxury goods are not very important
to many Filipinos. So, these are elastic. Examples are diamond rings, sports car,
expensive wines, elegant clothing, etc… Rice is important to all consumers.
Electricity is important to factory owners. Gasoline is important to the
transportation industry. All of these are inelastic.
Economic Significance of Demand Elasticity
The concept of elasticity of demand is not just a theoretical exercise but also has several
implications in both private business and government planning. For instance, a good
knowledge of demand elasticity helps the businessmen in planning their pricing
strategies. In the case of the government, it guides the economic managers in
formulating appropriate tax programs. Clearly, the market price of a product influences
wages, rents, interests, and profits. With the right pricing strategy, businessmen may
attain the following goals:
- Achieve target return on investment
- Maintain or improve a share in the market
- Meet or prevent competition; and
- Maximize profits
3
Price Elasticity of Supply
If demand varies in response to a change in its determinants, so does supply.
Supply elasticity refers to the reaction or response of the sellers/producers to price
change of goods. The coefficient of price elasticity of supply measures the percentage
change in the quantity supplied of a commodity compared to a percentage change in
the price of such a commodity.
With respect to the formula in measuring the degree of elasticity of supply, the one
which is used in demand elasticity is also applicable. Just change the “quantity
demanded” into “quantity supplied.”
Year/Point
2009/A
2010/B
2011/C
2012/D
2013/E
2014/F
Table 2 (Theoretical Example)
Price
Qs
ep Coefficient
4
35
5
40
____
7
48
____
10
55
____
14
60
____
15
100
____
Classification
_______
_______
_______
_______
_______
Let us graph table 2 and presenting each year/point of different degrees of elasticity.
As a result of the varying degrees of elasticity of supply, the following supply curves are
also possible.
P
S1 is relatively elastic, a change in
price leads to a significant change
S1
in quantity supplied
Qs
P
S2
S2 is relatively inelastic, a change
in price leads to a slight change in
quantity supplied
Qs
4
P
S3
S3 is unitary, a change
in price results to an equal
change in quantity supplied
Qs
P
S4 is perfectly elastic. At a given
price, quantity supplied can
change infinitely
S4
Qs
P
S5
S5 is perfectly inelastic. At any
price, the quantity supplied will
remain the same.
Qs
Determinants of Supply Elasticity
The principal determinant of supply elasticity is the time involved in the ability of
producers to respond to price changes. If it takes a short time to produce the products
to take an advantage of an increase in price, then supply is elastic. Factory products are
generally elastic. If a factory has sufficient available raw materials, it can increase its
output by hiring more workers and let them work overtime. However, if such factory is
already under full plant capacity, it can no longer respond to price change (increase). In
the long run, the factory has to set up more buildings and machines, and hire more
workers if prices are still favorable.
On the other hand, if it takes a long time to produce the products, the supply is inelastic.
Agricultural or farm products are usually highly inelastic. It takes months or years to
produce vegetables, fruits and crops. Clearly, this is one of the disadvantages of
agriculture or farming. Producers can not immediately respond to a price increase.
Therefore, goods that are relatively easy to manufacture tend to have an elastic supply,
while, goods that are relatively difficult to manufacture tend to have an inelastic supply.
Price Elasticity and Pricing Decision
The producer’s pricing decision depends on how responsive demand is to a change in
price. For example, if demand is inelastic, a decrease in price is not an advantage since
the consumers will buy practically the same quantity of the commodity, thus decreasing
total revenue.
Example:
Original Price: P6
Original Qd: 2,000
Original TR: P12,000
New Price: P4
New Qd: 2,100
New TR: P8,000
5
Conversely, an inelastic demand gives the producers an opportunity to increase price
without suffering a decline in sales volume and total revenue. With this type of demand,
a producer can easily pass on the burden of higher production costs to the consumers in
the form of higher price. Therefore, an increase in price will benefit the producer if
demand is inelastic because this will cause an increase in his total revenue.
Example:
Original Price: P6
Original Qd: 2,000
Original TR: P12,000
New Price: P7
New Qd: 1,900
New TR: P13,300
If demand is elastic, an increase in price may not benefit the producer. The increase in
price has resulted in a significant decrease in demand consequently causing the total
revenue to decrease.
Example:
Original Price: P6
Original Qd: 2,000
Original TR: P12,000
New Price: P7
New Qd: 1,500
New TR: P10,500
A decrease in price may ultimately benefit the seller if demand is elastic.
Example:
Original Price: P6
Original Qd: 2,000
Original TR: P12,000
New Price: P5
New Qd: 2,500
New TR: P12,500
However, if demand is unitary elastic, neither an increase nor a decrease in price will
affect the seller’s total revenue.
Example A:
Original Price: P4
Original Qd: 5,000
Original TR: P20,000
New Price: P2
New Qd: 10,000
New TR: P20,000
Example B:
Original Price: P4
New Price: P8
Original Qd: 5,000
New Qd: 2,500
Original TR: P20,000
New TR: P20,000
Table 3 (Theoretical Example)
Quantity
TR = P X Q
Coefficient
1
____
2
____
____
3
____
____
4
____
____
5
____
____
6
____
____
7
____
____
8
____
____
9
____
____
10
____
____
Price
10
9
8
7
6
5
4
3
2
1
Explanation
Inelastic
Elastic
Unitary
P
P
P
P
P
P
TR
TR
TR
TR
TR =
TR =
Classification
____________
____________
____________
____________
____________
____________
____________
____________
____________
Basic needs, rice
Basic needs, tooth paste
Luxuries
Sale
Basic needs or luxuries
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Income Elasticity of Demand
Income elasticity of demand measures the degree of responsiveness in the quantity
demanded to a change in consumers’ income. Thus,
Elasticity Formula
/\ Q
-------Ave. Q
ey (Elasticity)
/\ Q =
Ave. Q =
/\ Y =
Ave. Y =
Income (Y)
0
2000
4000
6000
8000
10000
12000
=
--------------/\ Y
-------Ave. Y
the difference between the original quantity and the new quantity.
the sum of the original and new quantity divided by 2.
the difference between the previous income and the new income.
the sum of the previous and new income divided by 2.
Quantity
(Q)
10
20
30
36
40
38
36
Table 4 (Theoretical Example)
Income
Degree of
Elasticity (ey)
Demand Elasticity
_____
_____
_____
_____
_____
_____
____________
____________
____________
____________
____________
____________
Type of Good
_______________
_______________
_______________
_______________
_______________
_______________
The absolute value of the coefficient of income elasticity is also a measure of how
responsive demand is to change in income. A coefficient of:
-
If > 1 means demand is income elastic and the good is normal/superior (normalluxury).
If < 1 means demand is income inelastic and the good is normal (normalnecessity) under positive elasticity, but, if negative elasticity the good is inferior.
= 1 means elasticity is unitary and the good is normal (neither luxury nor
necessity).
7
By using the cross elasticity of demand, we may be able to identify the category of
goods from the choice of the consumer. Cross Elasticity of Demand measure the degree
of responsiveness in quantity purchased to a change in price related goods.
Formula:
QX2 – QX1
-------------Ave. QX
eXY
Commodity
Product X
Product Y
Product X
Product Y
=
--------------------PY2 – PY1
-------------Ave. PY
Table 5 (Theoretical Example)
Before
After
Price
Qty
Price
Qty
Coefficient
40
400
40
300
80
600
60
800
______
____________
40
100
____________
Therefore:
Elasticity Coefficient
Positive
400
20
40
120
360
18
Category
Substitute
Negative
Complements
Zero
Independent
______
Category
Explanation
An increase in price of
coffee causes an increase in
demand for tea.
A decrease in price of
coffee leads to an increase
in the demand for sugar.
Goods that are unrelated in
consumption.
Substitutes are goods that satisfy similar needs and may be used in place of one
another. While complementary are goods that use together.

“The possibilities of thought training are infinite, its
consequences eternal, and yet few take the pains to direct their
thinking into channels that will do them good, but instead
leave all to chance.”
- - Marden
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Exercises:
1. Compute for the price elasticity demand.
Year/Point
Price
Qd
2009/A
4
100
2010/B
6
60
2011/C
9
55
2012/D
13
48
2013/E
18
40
2014/F
24
35
2. Compute for the price elasticity supply.
Year/Point
Price
Qs
2009/A
4
35
2010/B
5
43
2011/C
7
48
2012/D
10
55
2013/E
14
68
2014/F
15
100
3. Compute for income elasticity
Income (Y)
Quantity
Income
(Q)
Elasticity (ey)
0
10
5000
20
_____
10000
30
_____
15000
36
_____
20000
40
_____
25000
38
_____
30000
36
_____
4. Compute for cross elasticity
Before
Commodity
Price
Qty
Product X
40
400
Product Y
80
600
Product X
Product Y
40
100
400
20
Classification
____
____
____
____
____
_______
_______
_______
_______
_______
ep Coefficient
Classification
____
____
____
____
____
_______
_______
_______
_______
_______
Degree of
Demand Elasticity
Type of Good
____________
____________
____________
____________
____________
____________
_______________
_______________
_______________
_______________
_______________
_______________
After
Price
Qty
45
300
60
800
50
120
ep Coefficient
360
18
Coefficient
Category
______
____________
______
____________

9