ELASTICITY AND ITS

APPLICATION

M. Zepeda
Price Elasticity of Demand
and Pricing Decisions
• Price elasticity of demand (εD) – is the
degree of responsiveness of quantity
demanded to a change in price.
• a useful concept and indicator especially for
producers who want to have a guide as to
when or when not to increase / decrease the
price of their products and to determine the
likely effects of such price increase /
decrease on their total revenues.
Price Elasticity of Demand

Price Elasticity of Demand = % change in Qd

% change in P

= change in Qd
average Qd
change in P
average P
Interpretations of εD

Price Elasticity of Interpretation

Demand
|E|=0 Perfectly Inelastic
|E|<1 Inelastic
|E|=1 Unitary Elastic
|E|>1 Elastic
|E|=∞ Perfectly Elastic
Interpretations of εD
Importance of Total Revenue in
Pricing Decisions
• Total Revenue – the total sale of
products by the producer or seller.

TR = P x Q

where: TR is the total revenue; P is the

price; and Q is the quantity
Importance of Total Revenue in
Pricing Decisions
• In comparing two Total Revenues,
whichever yields a higher TR, holding
other things constant, the price
charged is the best price of the good,
whether it is the old price or the new
price.
Example 1.
• Mr. Right sells bangus for
PHP 100 and his Qd1 = 500.
When he decides to sell it for
PHP 125, his Qd2 becomes
450. Should Mr. Right sell
his bangus at PHP 100 or
PHP 125?
Example 2.
• If June sells tilapia for PHP 80
per kilo, the demand for it is
200. When he raises it by PHP
20, the quantity demanded
diminishes to 100. At what
price will June maximize his
profit? Is the demand elastic or
Example 3.
• Grace sells tuyo for PHP 20 per pack
and gets 200 quantity demanded.
However, if she lowers her price to
PHP 15, quantity demand doubles. Is
the demand for tuyo elastic or
inelastic? At what price will Grace get
a bigger revenue.
Price Elasticity and Total Revenue
Price Elasticity of Supply
• refers to the measure of the degree of
responsiveness of quantity supplied of a certain
good to changes in the price of that good.
• A useful concept and indicator especially for
policy making purposes since it helps “predict”
the likely response of producers to increases
decreases in the price of their products.
Price Elasticity of Supply

Price Elasticity of Supply = % change in Qs

% change in P

= change in Qs
average Qs
change in P
average P
Interpretations of Es

Price Elasticity of Interpretation

Supply
|E|=0 Perfectly Inelastic
|E|<1 Inelastic
|E|=1 Unitary Elastic
|E|>1 Elastic
|E|=∞ Perfectly Elastic
Example 1.
• 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?
Example 2.
• A 14-inch TV is originally sold at PHP
5,000. At this price, an appliance store
is able to sell 100 TVs in the market.
The following month, the new price of
TV is PHP 7,500. However, the store
has only increased its output by 5
units. How elastic was the supply of
the store’s TV?
Income Elasticity of Demand
• The degree of responsiveness of a
percentage change in quantity
demanded with a percentage change
in income.
 Income Elasticity of Demand

Income Elasticity of Demand = % change in Qd

% change in Y

= change in Qd
average Qd
change in Y
average Y

where: Qd is the quantity demanded and Y is income

Income Elasticity of Demand

Income Elasticity of Interpretation

Demand
>1 Luxury good
<1 Necessity
>0 Normal good
<0 Inferior good
Example 1.
• Cerome earns a monthly salary of PHP
5,000 and he consumes PHP 1,000 worth
of chicken per month. When his income
increased by PHP 2,500/month, he started
to consume PHP 2,000 worth of chicken
meat a month. Is Cerome’s demand for
chicken meat normal, inferior, necessity, or
luxury?
Example 2.
• Every month, Aling Lydia earns PHP
5,000 as a fish vendor. During this
period, she also consumes PHP 100
worth of tuyo. When her income
increased by PHP 2,500, she began
lessening her monthly consumption of
tuyo to PHP 50. From the given, is
tuyo a normal, an inferior, or a
common good for Aling Lydia?
Cross Elasticity of Demand

•The degree of
responsiveness of a
percentage change in
quantity of a good with a
percentage change in the
price of other goods.
The Classification of Goods and Their Income
Elasticity
NOTE 1: The coefficient of the income elasticity of demand can take
either positive or negative values depending upon the nature of good
in question. For positive coefficients, the range may either be (I
between zero and one or ii) greater than one. Thus,
• If n > 0 , ( e. g. , n = 2 ) the good is normal good.
• If n 0 < n < 1, , ( e. g. , n = 0.8 ) the good is normal and is considered
a necessity e . g. , rice and other basics
• If n > 1 , ( e. g. , n = 1.5 ) , the good is normal and is considered a
luxury
e. g. , appliance, jewelry, etc.
• If n < 0, ( e.g., n = -0.75 ), the good is inferior e. g., salt, “dilis”, etc.
NOTE 2: The “inferiority “ or “normality” of a good is relative to income
levels, i. e., at low incomes, a commodity may be normal but at high
income levels ., the same commodity may turn out to be inferior
e. g. , dried fish -- inferior for high income families
-- normal for low income families
Cross Elasticity of Demand

Cross of Demand Relation of Goods

=0 X and Y are not related
> 0, positive Substitutes
< 0, negative Complements
Cross Elasticity of Demand
Example

Good Qd1 Qd2 P1 P2

X 4 5 4 5
Y 2 3 2 3