BAC 101 Course Module Week 2

BASIC MICROECONOMICS MODULE WEEK NO.
2
Module 3. Elasticity of Demand
Price Elasticity of Demand and Pricing Decisions
3.1 Demand Elasticity
it is a measure of the degree of responsiveness of quantity demanded of a product to a given

change in one of the independent variables which affect demand for that product.
Classification of Demand elasticity according to factors that cause the change:
1. Price elasticity of demand – is the responsiveness of consumers’ demand to change in price of the
good sold.
2. Income elasticity of demand – is the responsiveness of consumers’ demand to a change in their
income.
3. Cross elasticity of demand – is the responsiveness of demand for a certain good, in relation to
changes in price of other related goods.
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These two 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.
Economists define this mathematically as:

change in Qd
% change in Qd average Qd
Price Elasticity of Demand = =
% change in P change in P
average P
In this equation, when the resulting price elasticity od demand is greater than 1, the consumers’
sensitivity to changes in price is said to be elastic. When it is less than 1, the quantity demand’s response
to changes in price is said to be inelastic. However, when price elasticity equals 1, quantity demand is
unitary elastic.
Price Elasticity of Demand Interpretation

=1 Unitary elastic
>1 Elastic
<1 Inelastic
Remember that demand curves are normally downward sloping as describe 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 curves tend to
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Prepared by: Marjun D. Ligan, MBA
BASIC MICROECONOMICS MODULE WEEK NO.2
slope more horizontally. Meanwhile, when the demand is inelastic, it means there is a relatively large
change in the price of the commodity. Demand curves for inelastic demand tend to slope more vertically.
Importance of Total Revenue in Pricing Decision

We refer to total revenue as the total sale of products by the producer or seller. This is expressed
as:
TR = P × Q
Where: TR is the total revenue; P is the price; and Q is the quantity.
Note that in comparing two TR’s, whichever yields a higher TR, holding other things constant, the
price charged is the best price of the good, whether it is the od price or the new price.
Let us now analyze this equation by looking at the examples provided:
Example 1:
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Cecilia sells bangus for PHP 100 and her Qd1 = 500. When she decides to sell it for PHP 125, her
Qd2 becomes 450. Should Cecilia sell her bangus at PHP 100 or PHP 125? Is Qd elastic or inelastic?
Solution: To get the percentage change in demand, simply divide the change in quantity demanded by
the average quantity demanded. From the above problem, we can express it as:
change in Qd 450 – 500 -50

% change in Qd = = = = -0.11
average Qd 500 + 450 475
2
Then, apply the same formula in getting the percentage change in price.
change in Qd 125 – 100 25

% change in P = = = = 0.22
average Qd 100 + 125 112.5
Since we already know the percentage changes in quality demanded and price, we can now solve for the
price elasticity of demand using the given formula:
% change in Qd -0.11
Price Elasticity of Demand = = = /-0.5/ or 0.5
% change in P 0.22 32
Note that 0.5 <1, hence, quality demanded is inelastic. Price elasticity of demand 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 her bangus at Phpp 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.
TR1 = P1 × Q1 = 100 × 500 = 50,000
TR2 = P2 × Q2 = 125 ×450 = 56,250
Activities 
Activity 1 
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1. If Theresa sells tilapia for PHP 80 per kilo, the demand for it is 200. When she raises it by PHP 20,
the quantity demanded diminishes to 100. At what price will Theresa maximize her profit? Is the
demand elastic or inelastic?
2. Mina sells tuyo for PHP 20 per pack and get 200 packs 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 Mina get a bigger revenue?
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3.2 Income Elasticity of Demand
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:
Qd2 – Qd1
Qd1+ Qd2
% change in Qd 2
Price Elasticity of Demand = =
% change in P Y2 – Y1
Y1 + Y2
2
Where: Qd is the quantity demanded and Y is income.
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When the result of the income elasticity is greater than 1, the product is called a normal good but
is considered as 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 the 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 equals 1. The table
summarizes the 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.
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Solution: To solve for the problem, let us first compute for Cerrine’s percentage changes in demand and
income.
change in Qd 2,000 – 1,000 1,000

% change in Qd = = = = 0.67
average Qd 1,000 + 2,000 1,500
2
change in Y 7,500 – 5,000 2,500

% change in Y = = = = 0.40
average Y 5,000 + 7,500 6,250
2
We can now substitute the values to get the income elasticity of demand:
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% change in Qd 0.67
Income Elasticity of Demand = = = 1.68
% change in Y 0.40
Note that the result is greater than 1, hence the demand for chicken is normal and might even be
considered a luxury.
Activities 
Activity 2 
1. Every month, Aling Laura earns PHP 5,000 as a fish ball vendor. During this period, she also
consumes PHP 100 worth of luyo. When her income increased by PHP 2,500, she began lessening
her monthly consumption of luyo to PHP 50. From the given, is tuyo a normal, an inferior, or a
common good for Aling Laura?
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3.3 Cross Elasticity of Demand
The 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. A positive elasticity indicates that
a good is a substitute of the other while a negative cross elasticity means the goods are
complementing each other. Table provides a summary of cross elasticity.
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 mathematics formula:
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% change in demand for product X

Cross Elasticity of Demand =
% change in the price of product Y
Qd2 – Qd1
% change in demand for product X =
Qd1 + Qd2
P2 – P1
% change in the price of product Y =
P1 + P2
Note that the upper portion of the fraction (quantity) refers to products X; and the lower portion
of the fraction (price) refers to product Y.
Let us consider the next table. It shows the relationship of quantity demanded and price for each
product, X and Y.
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Good Qd1 Qd2 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.
% change in demand for product X

Cross Elasticity of Demand =
% change in the price of product Y
Qd2 – Qd1 5–4 1

% change in demand for product X = = = = 0.22
Qd1 + Qd2 4+5 4.5
2 2
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P2 – P1 3–2 1
% change in the price of product Y = = = = 0.40
P1 + P2 2+3 2.5
2 2
Activities 
Activity 3 
Now, look at the next week schedule for two goods
Good Qd1 Qd2 P1 P2

X 2 5 5 3
Y 2 3 3 1
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3.4 Price Elasticity of Supply
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. In this respect, we will
study how to measure the relationship of quantity supplied and price.
Price elasticity of supply is computed as follows:

Qs2 – Qs1
change in Qs Qs1+ Qs2

% change in Qd average Qs 2
Price Elasticity of Supply = = =
% change in P change in P P2 – P1
average P P1 + P2
2
When supply is elastic, producers can increase production even with an increase in the cost of
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production. However, when the supply of a product becomes inelastic, producers are hindered to
produce more. In this respect, when there is aa considerable increase in price of goods being sold, supply
becomes elastic. However, when the changes in price is insignificant, supply is inelastic.
Price Elasticity of Supply Qs

=1 Unitary Elastic
>1 Elastic
<1 Inelastic
For example, the old price of sardines is PHP 10. At PHP 10, a producer can supply 100 cans of
them. When the selling price changes to PHP 12, the producer was able to increase its production to 120
units. Solve for the price elasticity of supply.
Remember that:
% change in Qs
Price Elasticity of Supply =
% change in P
% change in Qs and P can be computed as:
change in Qs 20 change in P 2
= = 0.18 and = = 0.18
average Qs 110 average P 11
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Substituting for the values, we get the value of price elasticity.
% change in Qs
Price Elasticity of Supply = = 0.18/0.18 = 1
% change in P
The supply of sardines is unitary elastic.
Activities 
Activity 4 
1. Suppose that the old price of instant noodles is PHP 5 and a seller can produce 1100 packs of
them. When the price rose by PHP 2, the producer has doubled his production. How elastic is
his supply for noodles?
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LEARNING APPLICATION
1. Complete the table:

Price Qd TR
1 100 500
2 120 380
2. Using the figure from No. 1, was it a good idea to increase the price?
3. If Coke increased its price, what would happen to Pepsi?
4. When you get stranded in a desert for a long time, which do you think has more value: water or
diamond? Discuss.
5. What does “equimarginal” mean? Discuss it in your own words and use an example.
6. If gasoline prices increased so much that it became unreasonable, would you still ride a jeep?
7. If regular gas is PHP 50/liter at 1:8, and premium gas is PHP 55/liter at 1:8:5. Which would be
better to use?
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PART II – THEORIES OF CONSUMER BEHAVIOR PRODUCTION,
COST, AND PROFIT
Module 4. Theory of Consumption
4.1 Utility and Behavioral Factors
Utility is defined as the satisfaction derived from the satisfaction derived from the consumption
of a commodity which determines consumption and demand behavior. Inter-factor combinations filter
different patterns of consumption behavior down the line. The psychological factors reflect Maslow’s
Hierarchy of Needs as influenced by the said inter-factor combinations.
The model of factors influencing behavior presents the underlying cultural, social, personal, and
psychological factors that affect utility and consumption behavior.
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Cultural
Social
Personal
• Reference Psychological
• Culture groups
• Age and life-cycle
stage • Motivation
• Family • Occupation
• Subculture • Economic
• Perception Buyer
circumstances • Learning
• Roles and •
• Social class
Lifestyle • Beliefs and
statuses • Personality and self-
concept
attitudes
Model of Factors Influencing Behavior
Cultural factors
Cultural factors exert the broadest and deepest influence on consumer behavior. Culture is one
of the most fundamental determinants of a person’s wants and behaviors. While lower creatures are
largely governed by instinct, human behavior is generally earned. A child growing up in society learns
basic set of values, perceptions, preferences, and behaviors through the process of socialization involving
the family and other key institutions.
For example, some people have preference for the music of Bach or Mozart, while others would
go crazy for Justine Bieber; toilet paper may be a common thing for the urban dwellers but could be a
rare commodity for the people who live in the mountain.
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Social classes show distinct product and brand preferences. For instance, komiks tend to be the
reading material for the lower income classes, while magazines and newspapers are preferred by the
middle- and higher-income classes.
Social Factors
A consumer’s behavior is also influenced by social factors such as the consumer’s reference
groups, family, and social roles and statuses.
References groups – are those groups that have a direct or indirect influence on person’s attitudes or
behaviors. A teenager may buy shoes that are in accordance with the taste of his peer group, while a
more matured person would prefer more durable or conservative shoes.
Members of the buyer’s family can exercise a strong influence on the buyer’s behavior. Form the
parents, a person acquires an orientation toward religion, economics, personal ambitions, and love.
Husband-wife involvement in purchases varies widely by product category. Husbands are more dominant
in the purchases of insurances and cars, while wives are more dominant in the purchases of washing
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machines and kitchenware.
A person’s position in each group can be defined in terms of role and status. A role consists of the
activities a person is expected to perform according to the person around him or her. Each role carries a
status reflecting the general esteem accorded to it by society.
Personal Factors
Buyer’s decisions are also influenced by personal outward characteristics such as the buyer’s age
and life cycle, occupation, economic circumstances, lifestyle, personality, and self-concept. People
change the goods and services they buy over their lifetime. Young singe people have different
consumption needs from retiree; newly married couples buy different kinds of furniture compared to
older married couples.
A person’s occupation has an influence the goods and services he buys. A company president will
buy expensive clothes, while a blue-color worker will buy work clothes. A person’s lifestyle and economic
condition will affect the goods and services he buys. The traditionalists would buy the usual kinds of
goods as opposed to those people who would like to experiment; the sports-minded type of person
would prefer different kinds of goods as opposed to those who are the homebody type.
A person’s personality and self-concept will also influence his buying behavior.
Psychological Factors
Person’s purchase is also influenced by psychological factors: motivation, perception, learning,

beliefs, and attitudes.
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Activities 
Activity 5 
• Provide your explanation and example of Maslow’s Theory of Motivation in the table provided.
Maslow’s Theory of
Explanation Example
Motivation
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A motivated person is ready to act. How the motivated person acts are influenced by his
perception and learning of the situation. Two people may act quite differently because their perception
and learning of a situation may be different.
Perception – can be defined as the process by which an individual selects, organizes, and interprets
information to create meaningful picture of the world.
Learning – on the other hand, describes changes in an individual’s behavior arising from experience.
Through perception and learning, people acquire their beliefs and attitudes. These, in turn, influence their
buying behavior.
Belief – is a descriptive thought that a person holds about something.
Attitudes – describes a person’s enduring favorable and unfavorable cognitive evaluations, emotions, and
action tendencies toward some object or ideas.
4.2 The Utility Function

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Utility is the technical term for satisfaction. There is a functional relationship between utility and
consumption as the need for the latter arises.
Total utility (TU) – the total amount of satisfaction derived from consuming foods and services.
Marginal utility – the additional satisfaction derived from consumption of additional goods and services.
This functional relationship assumes two forms and is quantitatively defined as follows:
Utility Schedule
TU = Function of Q (consumption) Consumption Total Utility Marginal Utility
1 7 7
Of TU
2 13 6
MU = 3 18 5
Of Q
4 22 4
Where: = change 5 25 3
6 27 2
7 28 1
8 28 0
9 27 1
10 25 -2
11 22 -3
12 18 -4
13 13 -5
14 7 -6
15 0 -7
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30
25
20
15
Utility
10
Total Utility
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Marginal Utility
5
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0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
-5
-10
Consumption
Table and figure illustrate the concepts with the consumption of water as an example. The
symbol for change carries a positive sign when the variable increases and a negative sign if the variable
decreases. As the consumption level increases, a positive marginal utility (MU) increases total utility (TU),
while the opposite is true when MU is negative. Moreover, marginal utility is also defined as the utility
or dissatisfaction from the last unit of consumption, depending on whether MU carries a positive or
negative sign. For example, the table shows that MU is 2, which is the increases from 5 to 6 units. This
level of MU is simply the utility of the 6th or last unit of consumption.
4.3 Consumption
Indifference Curve
An indifference curve is a graph that shows a combination of two goods that give a consumer
equal satisfaction and utility, thereby making the consumer indifferent. Indifference curves are heuristic
devices used in contemporary microeconomics to demonstrate consumer preference and the limitations
of a budget. Recent economists have adopted the principles of indifference curves in the study
of welfare economics.
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Standard indifference curve analysis operates on a simple two-dimensional graph. Each axis
represents one type of economic good. Along the curve or the line, the consumer has no preference for
either combination of goods because both goods provide the same level of utility to the consumer. For
example, a young boy might be indifferent between possessing two comic books and one toy truck, or
four toy trucks and one comic book.
Graphically, the indifference curve is drawn as a downward sloping convex to the origin. The
graph shows a combination of two goods that the consumer consumes.
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The above diagram shows the U indifference curve showing bundles of goods A and B. To the
consumer, bundle A and B are the same as both give him the equal satisfaction. In other words, point A
gives as much utility as point B to the individual. The consumer will be satisfied at any point along the
curve assuming that other things are constant.
For example, Figure 1 presents three indifference curves that represent Lilly’s preferences for the
tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback
books. Each indifference curve (Ul, Um, and Uh) represents one level of utility. First, we will explore the
meaning of an individual indifference curve and then we will look at the relationship between
different indifference curves.
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Lilly’s Indifference Curves. Lilly would receive equal utility from all combinations of books and
doughnuts on a given indifference curve. Any points on the highest indifference curve Uh, like F, provide
greater utility than any points like A, B, C, and D on the middle indifference curve Um. Similarly, any
points on the middle indifference curve Um provide greater utility than any points on the lowest
indifference curve Ul.
Shape of an Indifference Curve
The indifference curve Um has four points labeled on it: A, B, C, and D (see Figure 1). Since an
indifference curve represents a set of choices that have the same level of utility, Lilly must receive an
equal amount of utility, judged according to her personal preferences, from two books and 120
doughnuts (point A), from three books and 84 doughnuts (point B) from 11 books and 40 doughnuts
(point C) or from 12 books and 35 doughnuts (point D). She would also receive the same utility from any
of the unlabeled intermediate points along this indifference curve.
Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from
left to right; 2) they are convex with respect to the origin. In other words, they are steeper on the left
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and flatter on the right. The downward slope of the indifference curve means that Lilly must trade off
less of one good to get more of the other, while holding utility constant. For example, points A and B sit
on the same indifference curve Um, which means that they provide Lilly with the same level of utility.
Thus, the marginal utility that Lilly would gain from, say, increasing her consumption of books from two
to three must be equal to the marginal utility that she would lose if her consumption of doughnuts was
cut from 120 to 84—so that her overall utility remains unchanged between points A and B. Indeed, the
slope along an indifference curve as the marginal rate of substitution, which is the rate at which a person
is willing to trade one good for another so that utility will remain the same.
Indifference curves like Um are steeper on the left and flatter on the right. The reason behind this
shape involves diminishing marginal utility—the notion that as a person consumes more of a good, the
marginal utility from each additional unit becomes lower. Compare two different choices between points
that all provide Lilly an equal amount of utility along the indifference curve Um: the choice between A
and B, and between C and D. In both choices, Lilly consumes one more book, but between A and B her
consumption of doughnuts falls by 36 (from 120 to 84) and between C and D it falls by only five (from 40
to 35). The reason for this difference is that points A and C are different starting points, and thus have
different implications for marginal utility. At point A, Lilly has few books and many doughnuts. Thus, her
marginal utility from an extra book will be relatively high while the marginal utility of additional
doughnuts is relatively low—so on the margin, it will take a relatively large number of doughnuts to
offset the utility from the marginal book. At point C, however, Lilly has many books and few doughnuts.
From this starting point, her marginal utility gained from extra books will be relatively low, while the
marginal utility lost from additional doughnuts would be relatively high—so on the margin, it will take a
relatively smaller number of doughnuts to offset the change of one marginal book. In short, the slope of
the indifference curve changes because the marginal rate of substitution—that is, the quantity of one
good that would be traded for the other good to keep utility constant—also changes, as a result
of diminishing marginal utility of both goods.
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Hierarchy of Indifference Curve
An indifference curve corresponds to a certain level of utility. Therefore, changing the

consumption levels of commodities at every point of combination along the curve leads to another
indifference curve and utility level. There is a hierarchy consisting of infinite indifference curves as there
are infinite levels of utility.
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In the figure, all points from curve 1, rise to curve 2 as the consumption levels of food and
clothing increase, and the opposite is true with a downward shift in the curve. The shift in the
indifference curve follows the direction of thee upward sloping line from the point of origin of the graph
indicating the consistency of varying the quantity levels of both commodity items for all the points of
combination along the curve.
The Budget Line
To understand how households, make decisions, economists look at what consumers can afford.
To do this, we must chart the consumer’s budget constraint. In a budget constraint, the quantity of one
good is measured on the horizontal axis and the quantity of the other good is measured on the vertical
axis. The budget constraint shows the various combinations of the two goods that the consumer can
afford. Consider the situation of José, as shown in Figure A José likes to collect T-shirts and movies.
In Figure A, the number of T-shirts José will buy is on the horizontal axis, while the number of
movies he will buy José is on the vertical axis. If José had unlimited income or if goods were free, then he
could consume without limit. But José, like all of us, faces a budget constraint. José has a total of $56 to
spend. T-shirts cost $14 and movies cost $7.
Plotting the budget constraint is a fairly simple process. Each point on the budget line must exhaust all
$56 of José’s budget. The easiest way to find these points is to plot the intercepts and connect the dots.
Each intercept represents a case where José spends all his budget on either T-shirts or movies.
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If José spends all his money on movies, which cost $7, José can buy $56/$7, or 8 of them. This means the
y-intercept is the point (0,8). Here, José buys 0 T-shirts and 8 movies.
If José spends all his money on T-shirts, which cost $14, José can buy only 4 of them ($56/$14). This
means the x-intercept is the point (4,0). Here, José buys 4 T-shirts and 0 movies.
By connecting these two extremes, you can find every combination that José can afford along his budget
line. For example, at point R, José buys 2 T-shirts and 4 movies. This costs him:
T-Shirts @ $14 x 2 = $28
Movies @ $7 x 4 = $28
Total = $24 + $28 = $56
This point indeed exhausts José’s budget.

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Figure A.
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Budget Constraints
We now know that José must purchase at some point along the budget line, depending on his
preferences. Note that any point within the budget line is feasible. José can spend less than $56, but this
is not optimal as he can still buy more goods. Since T-shirts and movies are the only two goods, there is
no ability in this model for José to save. This means that not spending his full budget is essentially wasted
income. On the other hand, any point beyond the budget line is not feasible. If José only has $56, he
cannot spend more than that. Notice that areas in the green zone are not necessarily more optimal than
points along the budget line. The optimal point depends on José’s preferences, which we will explore
when we discuss José’s indifference curve.
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Figure B
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Slope
Though we can easily just connect the X and Y intercepts to find the budget line representing all possible
combinations that expend José’s entire budget, it is important to discuss what the slope of this line
represents. Remember, the slope is the rate of change. In economics, the slope of the graph is often
quite important. In this situation, the slope is QY/QX. If we want to represent slope in terms of prices it is
equal to Px/PY. This can seem unintuitive at first, as we are used to seeing slope as Y/X., but the reason
this is not true for prices is because the y-axis represents quantity, not price. As we saw above, as price
doubles, the quantity the consumer could previously purchase is halved.
If José is making $56:
When the price of movies is $7, he can buy 8 of them
When the price of movies is $14, he can buy 4 of them
Since price and quantity have this inverse relationship, we can use either Px/PY or QY/QX to find the
slope. Since price is often the information given, it is important to remember that the slope can be
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calculated either way.
What Does Slope Mean?
The meaning of the budget line’s slope or price ratio is the same as the slope of a PPF. (The difference
between these two curves is that the PPF shows all the different combinations given time a
time/production constraint, whereas a budget line shows different combinations given
budget constraint. Otherwise, the two graphs are basically the same). This means the slope of the curve
is the relative price of the good on the x-axis in terms of the good on the y-axis. The price ratio of
2 means that José must give up 2 movies for every T-shirt. Likewise, the inverse slope of 1/2 means
that José must give up 1/2 a T-shirt per movie.
When Income Changes
Because budget and prices are prone to change, José’s budget line can shift and pivot. For example,
if José’s budget drops from $56 to $42, the budget line will shift inward, as he is unable to purchase the
same number of goods as before.
To plot the new budget line, find the new intercepts:
Budget: $42
Price of movies: $7
Price of T-shirts: $14
Maximum number of movies (y-intercept): $42/$7 = 6
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Figure C.
As a result of the shift, José’s budget line has shifted inward, leaving less consumption opportunities
available.
When Price Changes
In addition to income changes, sometimes the prices of movies and T-shirts rises and falls. Suppose from
our original budget of $56, movies double in price from $7 to $14. Again, to plot the new graph, simply
find the new intercepts:
Budget: $56
Price of movies: $14
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Maximum number of movies (y-intercept): $56/$14 = 4
Maximum number of T-shirts (x-intercept): $56/$14 = 4

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Figure D.
As a result of the pivot, José has fewer consumption opportunities available and the slope of the line
changes. This has two effects:
The Size Effect: There are fewer opportunities for consumption (as a result of the price change, the
purchasing power of José’s dollar has fallen).
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The Slope Effect: The relative price of movies is now higher, while the relative price of T-shirts is now
lower.
When Price and Income Change
The last type of change is when both price and income change. Suppose the price of movies increases
from $7 to $12 and José’s budget increases to $63. To plot the new budget line, follow the same steps as
before:
Budget: $63
Price of movies: $12
Maximum number of movies (y-intercept): $63/$12 = 5.25
Maximum number of T-shirts (x-intercept): $63/$14 = 4.50

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Figure E.
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These changes have interesting effects. José now has access to some new consumption opportunities,
but many others are now unavailable. While the slope effect has clearly made the relative price of T-
shirts lower, the size effect is uncertain. These effects are implicit in the income and substitution effects
we will explore shortly.
Conclusion
Though we understand the different ways by which consumers can exhaust their income, we have not
yet discussed how to determine which bundles of goods different consumers prefer. To finish our
analysis, let us look at Indifference Curves.
Exercises 
1. In the diagram below, a consumer 2. Which of the following diagrams could

maximizes utility by choosing point A, represent the change in a consumer’s budget
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given BL1. line if (i) the price of good y increases AND (ii)
the consumer’s income decreases.
Suppose that both good x is normal and good y

is inferior, and the budget line shifts to BL2.
Which of the following could be the new optimal
consumption choice?
a) B.
b) C.
c) D.
d) Either B or C or D.
Understanding Consumer Theory
If we think about the indifference curves in a slightly different way, we see that MRS describes marginal
benefit. Since MRS represents the maximum amount of y we are willing to give up in exchange for one
unit of x, it also represents how much value our consumer places on x in terms of y.
This means the indifference curve tells us the marginal benefit of good x in terms of good y, and the
budget line tells us the marginal cost of good x in terms of good y. Using marginal analysis, our consumer
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will continue to purchase more of a good until the marginal benefit is equal to the marginal cost. This
means
if MRS > Px/Py, the consumer will consume more x and less y.
If MRS < Px/Py, the consumer will consume less x and more y.
If MRS = Px/Py, the consumer will not change their consumption.
The MRS is the slope of the indifference curve, and Px/Py is the slope of the budget line. This means that
if the slope of the indifference curve is steeper than that of the budget line, the consumer will consume
more x and less y.
The figure shows José’s budget line and possible indifference curves. As Point A, MRS is greater than
Px/Py, so José should consume more x and less y to maximize his utility.
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Moving along the budget line (shown in black), we see this action indeed allows José to consume on a
higher indifference curve. At point B, MRS = Px/Py, so this is the utility maximizing point, given José’s
constraints. Notice that since Point A and Point B are on the same budget line, José could increase utility
without a change in expenditures.
In summary, the consumer will consume at the point where the indifference curve and the budget line
are tangent, meaning the slopes are equal.
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When Prices Changes
We now have all the pieces to develop our model for consumer theory. We examined the law of
demand, which showed that as the price increased our quantity demanded of the good decreased. Now,
let us look at how our consumption choices react to a change in price based on our indifference curve
and budget line.
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Consider a market with 100 consumers like José, each with budgets of $56 and preferences as illustrated
in the figure.
The graph shows the final effect of a price increase on T-shirts. Suppose T-shirts have increased from $14
to $28.
The easiest way to graph a price change is to assume José spends all his money on T-shirts to see how
the intercept will change. Following the price increase, he can only purchase 2 T-shirts. ($56 budget /
$28/T-shirt) Because we are imagining a market with 100 consumers like José, all in all, 200 T-shirts will
be bought. The price increase causes the budget line to pivot inwards and changes the price ratio from
Px/Py = 2 to Px/Py = 4.
Since we know the price of movies has not changed, we know that José can still purchase 8 movies and
can show the new graph with our knowledge of these points.
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Substitution Effect
Breaking up the effects of a price change involves back-tracking from our final effect. To find the
substitution effect, we must do a thought experiment and ask, “where would the consumer’s optimal
bundle be if they were given back enough money to consume along their original indifference curve?”
At point C in the figure, our current budget of $56 brought us to a lower IC. To analyze the SE, we must
hold well-being constant and return to our original IC. To do so, we must increase each consumers
budget by $23, so we can go back to IC1 at Point B. This is an important step because it shows us how
the consumer would respond to the differences in relative prices, holding purchasing power constant.
Note the $23 amount is the exact income increase it would take to bring us back tangent with the
original indifference curve.
We stated that the substitution effect is purely due to changes in relative prices. To examine its effect,
we must compare the two points along our original IC: our first consumption bundle, Point A, and our
new consumption bundle, Point B, which represents how our consumer behaves if they feel no poorer.
This means the substitution effect is the change from Point A to Point B.
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Substitution always has the same effect. People will substitute away from the good which has increased
in price because it is relatively more expensive. Since the price ratio is Px/Py, when the price of x
increases, Px/Py will be greater. Whereas before Px/Py = MRS, now Px/Py is > MRS. This means the
consumer will buy less x and more y until MRS = Px/Py again.
57
Income Effect
To find our SE we had to hypothetically give the consumer some income to bring them back to
their original IC. Though this exercise is simply to show the effect of a price change while holding
purchasing power constant this sometimes actually happens! Take, for example, a government tax
rebate. This is often done to ensure that government increasing prices does not cause consumers to be
any worse off than before.
Price increases reduce a consumer’s purchasing power, making them unable to be as happy as they were
before. At Point C, although our budget is unchanged at $56, we are not able to stay on IC1 without a
large increase in income (back to Point B). The income effect is represented as the movement from Point
B, where we can consume at the same level of utility as before, to Point C, where the decrease in
purchasing power is also represented. This isolates the change to a consumer’s purchasing power,
holding relative prices constant.
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In the figure, we see that the individual consumes more T-shirts and movies following an increase in
income. We said that if QD increases when income increases, the good is normal, and if QD decreases
when income decreases, it is inferior. This means that both T-shirts and movies are normal goods. This is
not always the case. If QD of either good fell after the income increase, it would be inferior.
58
The Final Effect
To determine the final effect, we need to bring together the income effect and the substitution
effect. The SE brought us from Point A to Point B, and the IE from Point B to Point C. We generalize the
sum of these effects using X and Y.
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Substitution Effect: x decreases, y increases
Income Effect: x decreases, y decreases
With this information, we know the consumer will consume less x, but we are uncertain whether they
will consume more or less y. By looking at the movement from Point A to Point C on the graph, we can
see the final effect shows the consumer wanting more y and less x.
This provides us with some useful information. Recall in Topic 3, we determined that if two goods are
substitutes, when the price of one increases, the demand for the other will increase; whereas if they are
complements, when the price of one increases, demand for the other will decrease. In this case, movies
and T-shirts are substitutes.
What We Have Learned
Let us summarize the information we have learned from a simple consumer theory analysis of a price
increase. After a price increase in T-shirts from $14 to $28:
• Consumers buy more Movies and Less T-Shirts

59
• Both Movies and T-Shirts are normal goods (income effect)
• Movies and T-Shirts are substitutes (final effect)
We want to be able to determine these three things for every consumer problem you are given.
Substitutes vs Compliments
To determine whether two goods are substitutes or complements, we look at the final effect, not the
substitution effect. Why call it the substitution effect then? Because to determine the final effect, we
must find whether the income effect or the substitution effect is more powerful.
• When the substitution effect overpowers the income effect, the goods are substitutes. (Figure X)
• When the income effect overpowers the substitution effect, the goods are complements. (Figure Y)
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Figure Y
Figure X.
Normal vs Inferior
You should already have a good understanding of how to tell whether a good is normal or inferior based
on the income effect. In the example above, we determined that both goods were normal since when we
removed the hypothetical income boost, both QD for x and QD for y fell.
Let us look at a case where prices are decreasing. In the figure, the IC and BL are shown for a market
where the price of x has fallen, pivoting the budget line from BL1 to BL2. In this case, we must take away
the hypothetical income to isolate the SE, bringing us from Point A to Point B. The income effect is simply
what happens when we reverse our thought experiment, and either remove the hypothetical income, or
in this case, give it back.
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COURSE MODULE
The figure presents 3 regions. Whether the goods are inferior or normal will determine where the new IC
and Point C end up.
Region 1: QD for X decreases, QD for Y increases

Good X is inferior, Good Y is normal
Region 2: QD for X increases, QD for Y increases

Good X is normal, Good Y is normal
Region 3: QD for X increases, QD for Y decreases

Good X is normal, Good Y is inferior
Conclusion
Consumer theory helps us see how individual consumers behave in a large market. With the model, we
can determine whether goods are substitutes or complements, normal or inferior, and use the final
effects to see how consumers respond to price changes. In Topic 3, we showed how movements along
the demand curve result from changes in prices. In the next section, we will show how this model can be
used to derive demand curves.
61
The Foundations of Demand Curves
Changes in the price of a good cause the budget constraint to shift, and new indifference curves
to form. In this way, the logical foundations of demand curves—which show a connection between
prices and quantity demanded—are based on the underlying idea of individuals seeking utility. The
Figure, shows a budget constraint with a choice between housing and “everything else.” (Putting
“everything else” on the vertical axis can be a useful approach in some cases, especially when the focus
of the analysis is on one good.) The preferred choice on the original budget constraint that provides the
highest possible utility is labelled M0. The other three budget constraints represent successively higher
prices for housing of P1, P2, and P3. As the budget constraint continues to rotate inwards, the utility-
maximizing choices are labelled M1, M2, and M3, and the quantity demanded of housing falls from Q0 to
Q1 to Q2 to Q3. Note that indifference curves have not been represented to keep the graph easy to
follow. M0, M1, M2, and M3 represent the points where IC0, IC1, IC2, and IC3 are tangent to the
changing budget lines.
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Figure A.
62
So, as the price of housing rises, the budget constraint shifts to the left, and the quantity consumed of
housing falls, ceteris paribus (meaning, with all other things being the same). This relationship – the price
of housing rising while the quantity of housing demanded falls – is graphed on the demand curve.
Indeed, the vertical dashed lines stretching between the top and bottom show that the quantity of
housing demanded at each point is the same in both (a) and (b). The shape of a demand curve is
ultimately determined by the underlying choices made to maximize utility subject to a budget constraint.
While economists may not be able to measure utility, they can certainly measure price and quantity
demanded.
Conclusion
In this lesson, we explored the inner workings of the demand curve and showed how consumers strive to
maximize their utility given their budget constraints. This analysis shows us how to determine whether a
good is normal or inferior, and whether two goods are substitutes or compliments. Next, we will
examine the back end of the supply curve with an in-depth analysis of producer theory.
COURSE MODULE
Activities 
Activity 6 
CASE STUDY
Price of Pinoy Tasty Seen To Do Go Up
The price of Pinoy tasty (sliced loaf of bread made of chapter flour) may go up by 10 to Ᵽ15
percent effective this month due to higher cost of flour. Bakers said this yesterday ahead of the
anticipated announcement today of the department of trade and industry(DTI) on the possible
impact of the possible imposition by the Department of Agriculture(DA) of higher tariffs on Turkish
flour, which is use in Pinoy Tasty. Currently price at Ᵽ37 per Ᵽ450-gram loaf, the Pinoy Tasty could
hover near Ᵽ40 per loaf, bakers said.
According to the bakers, supply of Turkish flour is quickly vanishing following the announcement
last Monday of DA secretary Proceso Alcala that he would recommend the imposition of a Ᵽ20-
percent duty on flour coming from Turkey. The source said they have yet to get a copy of the
administrative order that would put in effect the higher duty on the product. But presidential
spokesman Edwin Lacierda did confirm that there is a pending hike in the prices of Pinoy tasty and
Pinoy “pandesal” but assured the public that their prices would remain at their current levels for
now, pending a review of the propose new rates by the DTI.
Lacierda also assured that other bread products are not covered by the proposed increase. The
bakers said the 10 to Ᵽ15 percent increase is based on a formula of major ingredients, the biggest
component of which is flour. They said they were able to justify the increase with the DTI.
63
The bakers met with DTI secretary Gregory Domingo last Tuesday. Bakers said they buy locally milled
flour Ᵽ880 to Ᵽ900 per 25-kilogram bag, but Turkish flour remains cheap at Ᵽ720.The bakers also
told the national price coordinating council two weeks ago that they do not have an alternative for
Turkish flour since the locally milled cheaper variant Harinag Pinoy does not meet their standards.
The Philippine Association of Flour Millers (PAFMIL) has petition with the DA the imposition of
anti-dumping duties against Turkish flour.Based on its petition, PAFMIL said the average price of
Turkish flour in 2010 was $276 per metric ton while its domestic price was $600.The following year,
the export price was at an average of $388 per mt against $600 per mt in Turkey. Last year, the
average export price was down to $340 per mt but the domestic price was at $470 per mt.
PAFMIL claims that export of Turkish flour to the Philippines grew 16 percent in 2011 and by 71
percent last years. This is in contrast with the growth of the local flour milling industry of 1to 2
percent per year. Meanwhile, Lacierda said, the DTI Director Vic Dimagiba through undersecretary
Zeny Maglaya, met with the different millers and bakers association in the country following report
of a pending price increase in bread after the Department of Agriculture proposed a tariff hike on
COURSE MODULE
imported flour from the current 7 percent to 20 percent.
Questions:
1. Do you think the demand for “Pinoy Pandesal” and Pinoy Tasty is elastic? What do you think will
happen to the demand for “pandesal” and tasty when prices increase by 15% and by 100%?
2. What do you think will happen to the supply of “pandesal” and tasty if the price of locally milled
flour increases by 15% and 100%?
3. What are the substitutes for “pandesal” and tasty? Do you think the price of these substitutes will
likewise increase?
4. Do you think the government should implement a price ceiling for “pandesal” and tasty?
64
REFERENCES
WEBSITES:
https://pressbooks.bccampus.ca/uvicecon103/chapter/6-3-understanding-consumer-theory/
https://pressbooks.bccampus.ca/uvicecon103/chapter/6-4-building-demand/
https://pressbooks.bccampus.ca/uvicecon103/chapter/6-1-consumption-choices/
https://courses.lumenlearning.com/wm-microeconomics/chapter/indifference-curves-analysis/
https://economictimes.indiatimes.com/definition/indifference-curve
BOOKS:
▪ Cristobal M. Pagoso, et.al, Introductory Microeconomics Fourth Edition, REX Book Store, 2014
▪ Avila-Bato, Microeconomics Simplified, ANVIL Publishing Inc., 2016
▪ Carlos L. Manapat, Economics, Taxation and Agrarian Reform, C&E Publishing Inc., 201
COURSE MODULE
65

BAC 101 Course Module Week 2

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BASIC MICROECONOMICS MODULE WEEK NO.

3.1 Demand Elasticity

it is a measure of the degree of responsiveness of quantity demanded of a product to a given

Classification of Demand elasticity according to factors that cause the change:

Economists define this mathematically as:

Price Elasticity of Demand Interpretation

Importance of Total Revenue in Pricing Decision

Where: TR is the total revenue; P is the price; and Q is the quantity.

Let us now analyze this equation by looking at the examples provided:

change in Qd 450 – 500 -50

change in Qd 125 – 100 25

TR1 = P1 × Q1 = 100 × 500 = 50,000

TR2 = P2 × Q2 = 125 ×450 = 56,250

Income Elasticity of Demand Interpretation

change in Qd 2,000 – 1,000 1,000

change in Y 7,500 – 5,000 2,500

% change in demand for product X

% change in demand for product X

Qd2 – Qd1 5–4 1

Now, look at the next week schedule for two goods

Good Qd1 Qd2 P1 P2

Price elasticity of supply is computed as follows:

change in Qs Qs1+ Qs2

Price Elasticity of Supply Qs

% change in Qs and P can be computed as:

The supply of sardines is unitary elastic.

1. Complete the table:

4.1 Utility and Behavioral Factors

Model of Factors Influencing Behavior

machines and kitchenware.

Person’s purchase is also influenced by psychological factors: motivation, perception, learning,

4.2 The Utility Function

Shape of an Indifference Curve

An indifference curve corresponds to a certain level of utility. Therefore, changing the

The Budget Line

T-Shirts @ $14 x 2 = $28

Total = $24 + $28 = $56

This point indeed exhausts José’s budget.

If José is making $56:

When the price of movies is $7, he can buy 8 of them

When the price of movies is $14, he can buy 4 of them

calculated either way.

What Does Slope Mean?

When Income Changes

To plot the new budget line, find the new intercepts:

Price of T-shirts: $14

Maximum number of movies (y-intercept): $42/$7 = 6

When Price Changes

Price of movies: $14

Maximum number of movies (y-intercept): $56/$14 = 4

Maximum number of T-shirts (x-intercept): $56/$14 = 4

When Price and Income Change

Price of movies: $12

Price of T-shirts: $14

Maximum number of movies (y-intercept): $63/$12 = 5.25

Maximum number of T-shirts (x-intercept): $63/$14 = 4.50

1. In the diagram below, a consumer 2. Which of the following diagrams could

Suppose that both good x is normal and good y

Understanding Consumer Theory

If MRS = Px/Py, the consumer will not change their consumption.

Substitution Effect: x decreases, y increases

Income Effect: x decreases, y decreases

What We Have Learned