Applied Economics LAS 1 Week 4

*Determine the implications of market pricing on economic decision-making

Lesson 1 Elasticity of Demand and Supply

In the previous lesson about the law of supply and demand, we learned that the price is the
main determinant of the quantity demanded and quantity supplied.
In making economic decision, both the seller and the buyer consider the price of the goods that
they will be buying or selling. As buyers, as mentioned in the law of demand, most of the time
we consider the selling price of an item before deciding to buy it. For sellers, for sure, they want
to produce more of their products if the price is high to yield more profit, but they will also
consider the possibility of losing some customers because of setting higher price.

What is It

When we were in lower grade level, we encountered the word “elastic, usually in our science
subject. We define it as being flexible or having the ability to be stretched but can go back to its
original shape or size like a rubber band.
In economics, the terms elasticity is used to define the change in behavior of the sellers or
buyers because of the change in price and/or other determinants of supply and demand. It
measures how the sellers or buyers respond to the changes in determinants mainly the price.
Elasticity of Demand and Supply
The degree of elasticity of different products vary for several reasons. For the customers and
suppliers, the common determinant of the quantity demanded and supplied is the price.
During the discussion of the law of demand and the law of supply, it was discussed that as the
price increase the quantity demanded by the customers decrease and quantity supplied by the
sellers increases. Do you think what is stated in the law of demand and supply always
applicable? If it is applicable, is the change in quantity demanded for several products still the
same? Does it mean that if the price increase by 1 % the demand will decrease by 1 % and the
supply increases by 1 % also? To answer these questions, it is important to understand the
reactions of customers and sellers to the change in price of different products. The reactions of
the customers vary and so with the elasticity. The higher the change in quantity demanded
compared to the change in determinants the more elastic is the product.

Price Elasticity of Demand and Supply

Price Elasticity of Demand
Price elasticity of demand measures the change in demand in response to the change in price.
For example, the price of pork increases by 5 % the price elasticity will be determined by
identifying the percentage of decrease or increase in demand due to the change in price.

To compute the price elasticity (ep) of demand the formula is:

Percentage change in quantity demanded
ep =
Percentage change in price

(Q2 – Q1)/Q1
=
(P2 – P1)/P1
Where:
Q1 = the original quantity demanded
Q2 = the new quantity demanded
P1 = the original price
P2 = the new price
To illustrate, let us have us have the following example.
Product A has the following demand schedule:
Situation Price Quantity demanded
1 ₱30.00 50
2 ₱40.00 45
3 ₱35.00 45
Example 1:
Let us first consider the Situation 1 and 2 where the price of product A increases from 30 to 40
and the quantity demanded decreases from 50 to 45. To compute for the elasticity coefficient
let us use the given formula for price elasticity of demand.
( 45 – 50) /50
ep =
(40 – 30)/ 30

- 0.1
=
0.33
ep = -0.3

Example 2:
To find out whether the product will be having the same elasticity at different price, let us
consider Situation 2 and 3 for another example.
(45 – 45) /45
ep =
(35 – 40)/ 40

0
=
-0.125
ep = 0

The two examples show that at different price and quantity combination the price elasticity
coefficient may not be the same, a proof that the customers’ reaction to price changes vary.
To understand the meaning of the elasticity coefficient, understanding the types of elasticity
can help us to analyze and interpret it.

Types of Elasticity

Elastic - The percentage change in quantity demanded is greater than the percentage change in
price. It has more than 1 elasticity coefficient.
It means that if the price will increase there is a greater possibility that the consumer will not
buy the product or may decrease the quantity of the product to buy.

Inelastic - The percentage change in quantity demanded is lesser than the percentage change
in price. It has less than 1 elasticity coefficient. It means that the decision of the consumer to
buy the product is not that affected by the increase or decrease in price. The seller cannot
assume that the consumer will buy more if they will decrease the price since the change in
quantity demanded is only minimal.

Unitary - The percentage change in price is equal to the percentage change in quantity
demanded. The elasticity coefficient is 1. It means that if the price increase by 1 % the demand
will decrease by 1 % also and vice versa.

Perfectly elastic - When at the same price, the change of demand is infinite.
It means that a small change in price may cause a huge change in demand.
Perfectly inelastic - When there is no change in demand despite of the changes in price.
Elasticity coefficient is zero. It means that the demand is not affected by price at all. The
demand will still be the same even if there is an increase or decrease in price.

Considering the two examples above let us interpret the elasticity coefficient that we derive. In
example 1, the price elasticity coefficient is -0.3. It is inelastic, which means that for every 1 %
change in price there will be 0.3 % change in demand. The change in price cause a minimal
change in demand. In example 2.
The price elasticity coefficient is 0. It is perfectly inelastic. The change in price does not affect
the demand. In interpreting the price elasticity coefficient, we ignore the negative sign. It is
negative because the price and demand is inversely related.
Demand Curves and Their Elasticity

Figure 1: Elastic Demand Curve

3
2.5
2
1.5
1
0.5
0
0 2 4 6 8 10 12 14

Figure 1 is an example of an elastic demand curve showing that a small change in price cause
the demand to change more.

10 Figure 2. Inelastic Demand Curve

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Figure 2 is an example of an inelastic demand curve showing that a change in price cause a
little change in demand.

Figure 3: Perfectly Inelastic Demand Curve

6
5
4
3
2
1
0
0 1 2 3 4 5 6

Figure 3 is an example of perfectly inelastic demand curve showing that the quantity demanded
is not affected by the change in price.
 Figure 4: Perfectly Elastic Demand Curve
3
2
1
0
0 0.5 1 1.5 2 2.5 3 3.5

Figure 4 is an example of perfectly elastic demand curve. It shows a great change in demand.

Figure 5: Unitary Demand Curve

6

0
0 1 2 3 4 5 6

Figure 5 is an example of unitary demand curve. It shows that the percentage of change in price
is the same with the percentage of change in demand.

Price Elasticity of Supply

Price is the main determinant of supply. Its elasticity describes how the producer or seller
reacts or respond to the change in price.
To compute the price elasticity (ep) of supply the formula is:
Percentage change in quantity supplied
ep =
Percentage change in price

(Qs2 – Qs1)/Qs1
=
(P2 – P1)/P1
Where:
Qs1 = the original quantity supplied
Qs2 = the new quantity supplied
P1 = the original price
P2 = the new price
To illustrate, let us consider the following example:
Price Quantity Supplied
₱150 300
₱175 350
Given the supply schedule above, let us compute for the price elasticity of demand.
(350 – 300) /300
ep =
(175 – 150)/ 150
0.167
=
0.167
ep = 1
Interpretation: The price elasticity coefficient of 1 means unitary. It means that for every 1 %
change in price there will be 1 % change in quantity supplied.
Note: Interpretation is the same with how you interpret the price elasticity of demand.
Supply Curves and Their Elasticity
 Figure 6: Elastic Supply Curve
3
2.5
2
1.5
1
0.5
0
0 2 4 6 8 10 12 14

Figure 7: Inelastic Supply Curve

6

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Figure 8: Perfectly Inelastic Supply Curve

(supply is fixed and zero elasticity )
10

0
0 1 2 3 4 5 6

Figure 9: Perfectly Elastic Supply Curve

(Infinitely Elastic)
2.5
2
1.5
1
0.5
0
0 0.5 1 1.5 2 2.5 3 3.5

Income Elasticity and Cross Price Elasticity of Demand

Demand elasticity can also be determined by:
A. Income elasticity which measures the change in demand in response to the change in income
of the customers.

The formula for income elasticity (ey) is:

Percentage change in quantity demanded
ey =
Percentage change in income

(Q2 – Q1)/Q1
=
(Y2 – Y1)/Y1
Where:
Q1 = the original quantity demanded
Q2 = the new quantity demanded
Y1 = the original income
Y2 = the new income

For example:
An employee who earns P20,000 monthly can afford to buy his favorite milk tea almost 3 times
a week but because of the pandemic in which most of the employees are affected, they are now
reporting to their work 3 days a week only instead of 5 days. His income is affected and so with
their expenses. Instead of their regular monthly salary, he receives P12,000 monthly. The
purchase of his favorite milk tea also reduced to once a week only.
To compute for its income elasticity, let us consider the following:
Q1 = 3 Q2 = 1
Y1 = 20,000 Y2 = 12,000

(1 – 3) /3
ey =
(12,000 – 20,000)/ 20,000

-0.67
=
-0.4
ey = 1.675
For this example, the income elasticity coefficient shows that it is elastic. The income really
affects the demand for that particular product.
B. Cross price elasticity which measures the change in demand for a good in response to the
change in price of related (substitute or complementary) goods.
The formula for cross price elasticity (ec) is:
Percentage change in quantity demanded of Good A
ec =
Percentage of change in price of Good B

(QD2 – QD1)/QD1
=
(P2 – P1)/P1
Note: For quantity demanded (QD) consider the quantity demanded for Good A and for price,
the change in price of another good (Good B).
Example:
The price of Product B increases from ₱35.00 to ₱42.00 which cause some of its consumer to
decide buying Product A, its substitute. The demand for Product A increases from 500 units to
650 units.

Product A: QD1 = 500 units QD2 = 650 units

Product B: P1 = ₱35.00 P2 = ₱42.00
(650 – 500) /500
Ec =
(42 – 35)/ 35

0.3
=
0.2

ec = 1.5
The cross elasticity of 1.5 shows that it is elastic. It means that a change in price of a related
good can cause a change in demand for another good.
 Applied Economics
Parallel Test
3rd Quarter

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