MODULE BASIC MICROECONOMICS

CHAPTER 3: ELASTICITY OF DEMAND AND SUPPLY

Objectives:
1. Understand the concept of elasticity of demand and supply.
2. Differentiate arc and point elasticity.
3. Compute elasticity values of demand and supply with given
chances in price and quantity.
4. Distinguish the different degrees of elasticity of demand and
supply.
5. Apply the concept of elasticity to various economic situations.
6. Recognize the value of elasticity in relation to a seller’s revenue

INTRODUCTION
An analysis demand and supply entails a subsequent study on their responsiveness or
elasticity with respect to changes in their determinants. This chapter focuses on their respective
elasticity with reference to price and income. For every elasticity topic discussed, the
measurements are first presented followed by the analysis and interpretation.

PRICE ELASTICITY OF DEMAND

Price elasticity of demand is the degree of responsiveness of quantity demanded to a

change in price It is measured by dividing the percentage change in price. The following
discussion illustrates the computation of the absolute value of elasticity relationship (i.e without
considering any negative sign) as derived from Table 4.

Table 4: Market Demand for Pork for a Period of One Day

Quantity Let us suppose that price
Point Price (in peso) Demanded (in changes from ₱35 to ₱40 and
kilo) consequently, quantity demanded
A ₱30 120 decreases from 100 to 80. The
decrease in quantity demanded,
B 35 100 which is 20, is a 20% change based
C 40 80 on the original quantity of 100. The
price change of ₱5 represents a
D 45 50 14.3% change based on the original
price of ₱35. The percentage change in quantity demanded is obviously higher than the
percentage change in price and the elasticity of coefficient is greater than 1, this means that the
demand for good is elastic. If the quantity demanded registers a percentage change in quantity
demanded less than the percentage change in the price, the elasticity coefficient is less than one
and demand is described as inelastic. Should quantity demanded change in the same proportion
as the change in price, then the elasticity coefficient is equal to one or unitary.
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Arc and Point Elasticity

Price elasticity of demand has two measures: arc elasticity and point elasticity.

Arc Elasticity – is the coefficient of the price elasticity of demand between two points along the
demand curve.

𝜟𝑸 ∆𝑷
𝐄𝐩𝐚 = +
(𝑸𝟏 + 𝑸𝟐) + 𝟐 (𝑷𝟏 + 𝑷𝟐) + 𝟐

The coefficient is preceded by negative sign because of the inverse relationship between
quantity demand and price. In determining the degree of responsiveness of demand to 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 and
measures as follows. ΔQ represents a change in quantity demanded and ΔP a change in price,
arc elasticity is given as:

∆𝑸/𝑸
𝐄𝐩𝐚 =
∆𝑷/𝑷
Let us use the following demand schedule to show how the formula woks.

Computing the point elasticity for a

Point P (P) Q change from points B to C, we get:
𝜟𝑸 𝑷
𝐄𝐩𝐚 = .
A 8 0 (𝑸) (∆𝑷)

B 7 10 𝟏𝟎 𝟕 𝟕𝟎
= . =
C 6 20 𝟏𝟎 𝟏 𝟕𝟎
= 𝟕. 𝟎
D 5 30
This gives an elasticity coefficient of
E 4 40
more than 1, which means that the
F 3 50 percentage change in quantity
G 2 60 demanded is greater than the
percentage change in price. The
H 1 70 demand is thus described as elastic.
I 0 80

Point Elasticity

The measurement of point elasticity is more than that of arc elasticity. Arc elasticity
becomes point elasticity when the distance between the two points originally measured becomes
zero.
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Commodities and Their Elasticity

We already learned that the more essential a good is to the consumer, the more inelastic
will be the demand for the good. The less of a necessity a good is, more elastic is the demand for
it. Based on elasticity coefficients, the following goods have elasticity which are less than one: (1)
infant milk, (2) electricity, (3) medicine, (4) salt, (5) rice, and (6) sugar, On the other hand, the
following goods have elasticity which are greater than one; (1) signature bags, (2) chocolates, (3)
imported shoes, (4) perfumes and (5) high-end furniture.

An increase in price will benefit the producer if demand is inelastic because it will cause
an increase in his total revenue. The increase in price will result into a significant decrease in
demand, consequently using the total revenue to decrease.

A decrease in price may ultimately benefit the seller if demand is elastic. However, if
demand is unitary elastic, neither an increase nor a decrease in price will affect the seller’s total
revenue.

Substitution and Price Elasticity of demand

The degree of substitution between a product and related products determine its price
elasticity demand. The extent of substitution depends on the substitution effect.

One factor of substitution is the number of competing products More competing products
mean more market shares for a product to gain or lose when its price decreases or increases
respectively. This kind of competition is evident and adjacent retail outlets for the same products
of more or less the same size like supermarkets, department stores, book stores, and the like. In
this examples demand said to be price elastic.

Another factor of distribution is the desirability of a product relative to its substitutes due
to quality. Thus, it would be difficult for a product to lose its market share when its price increases
if quality were its primary selling point.

On the other hand the absence of substitutes makes the demand for a product highly price
inelastic and since it is only income effect that is behind price-demand relationship.

Finally, the relative importance of consumer’s needs determines the degree of substitution
between the commodity items in the consumption basket, (e.g., essentials and nonessentials.

A decrease in price would increase earnings if demand were price elastic enough to
stretch quantity demanded and revenue in order to offset the increase in cost with more quantity
produced. The price elasticity of demand to maximize revenue and earnings is also true even
without a change in cost.

Increasing quantity demanded, without changing price highlights the effect of decreasing
price and increasing quantity demanded with a very elastic demand on revenue earnings.
Conversely, increasing price without changing quantity demanded highlights the effect of
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increasing price and decreasing quantity demanded with a very inelastic demand on revenue and
earnings.

Point Price Increase Price Decrease

Elastic Decrease Increase

Inelastic Increase Decrease

The Tax Burden

When a good is sold, a sales tax has to be paid to the government on the sale of that
commodity. The seller has to shoulder a bigger tax burden if the demand for the good is highly
elastic. However, it is also possible for a buyer to shoulder a bigger potion of the tax burden. This
happens when the buyer cannot do away with the consumption of a good and thus considers it
essential. Therefore in spite of a tax levy that could jack up the price of the good, he would still be
willing to buy it and the producer can afford to pass on a bigger portion of the tax to the buyer.

INCOME ELASTICITY OF DEMAND

The coefficient of income elasticity of demand measures a producer’s percentage change

in demand and ratio of the percentage change in income, which caused the shift in the demand
curve.

∆𝐃 ∆𝐃
𝐃 𝐨𝐫 𝐃 ∙ 𝐘
𝐄𝐘 𝐢𝐬 𝐠𝐢𝐯𝐞𝐧 𝐚𝐬 = ∆𝐘
∆𝐘 𝐃
𝐘
%∆𝐃
Or simply = %∆𝐘
Where ΔD represents the change in demand and ΔY the change in income. The absolute
value of the coefficient of income elasticity is also a measure of how responsive demand id to
change in income. As income increases, a coefficient of:

˃ 1 means demand is elastic and the good is superior;

˂ 1 means demand is inelastic and the good is inferior; and

= 1 means demand is unitary and the good is normal.

According to Engel’s Law, Ernest Engel’s study of income elasticity for food, “when
income increases, the percentage that is spent for food tends to decrease”. The resulting
coefficient is less than one because food is necessity. When income increases, the increase goes
mostly to the purchase of luxury items, education, travel and leisure.
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An analysis of income elasticity figures is shown in Table 5 on the next page.

Table 5: Analysis of Income Elasticity

Income Elasticity Degree of Demand Type of Good

2 Elastic Normal luxury

1.5 Elastic Normal luxury
.75 Inelastic Normal necessity
.50 Inelastic Normal necessity
.30 Inelastic Inferior
.22 Inelastic Inferior

To express in quantitative terms:

%𝚫𝑫 𝚫𝑪
= 𝟏− = 𝒄𝒐𝒏𝒔𝒕𝒂𝒏𝒕
%𝚫𝐘 𝚫𝒀
𝑪
(𝒀) ₁ = (𝑪𝒀)₂ = 𝒄𝒐𝒏𝒔𝒕𝒂𝒏𝒕

Where:

𝑪
(𝒀) ₁ = the consumption of the product as a ratio of total income before change

𝑪
(𝒀) ₂ = the consumption of the product as a ratio of total income after change

∆𝑪
(∆𝒀) = incremental consumption of the product for every unit increase in income

However, elasticity greater than 1 means that the product gains importance in the
allocation of incremental income as the following relationship illustrates.

%∆𝑫 ∆𝑪 𝐶 𝐶
> 𝟏 _____ ( ) increases ( ) ₁ ˂ ( ) ₂
%∆𝒀 ∆𝒀 𝑌 𝑌
Conversely, some products lose importance because others do otherwise as income
increases. A product of such nature is inferior as its elasticity is less than 1 and its share in the
allocation of incremental and therefore diminishes in the allocation of total income.

The Consumption Line

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Figure 22: Hierarchy of Budget Line and Indifferences Curves

Figure 22 represents a hierarchy of budget lines and indifference curve which determines
levels of consumption through the points of tangency between the two factors. The curve
connecting these points of tangency represents the consumption of the two commodities (apples
and banana) at varying levels of income, otherwise known as the consumption line. The
consumption line is upward sloping from the point of origin of the graph. The increase in apple
production (Y-axis) accelerates for every unit increase in the consumption of bananas (X-axis)
implying that:

For apples:
∆D D
%∆D ˃ %∆Y ___ ↑ ___ ↑
∆Y Y

For bananas:
∆D D
%∆D ˃ %∆Y ___ ↓ ___ ↓
∆Y Y

Therefore, apples is superior as its

elasticity is more than 1; whereas
bananas in inferior with its elasticity of less
than 1. Moreover apples gains importance
in the consumption basket as a substitute
for bananas as income increases. It
should already be clear at this point that
as income increases, some products gain
importance (superior goods) while some do otherwise (inferior goods) in the consumption basket.
Moreover, superior goods will eventually become inferior as income continues to increase to give
way to new superior goods.

Demand Curves and Elasticity

As a result of the different degrees of elasticity, there are different ways of representing
the demand curve.
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Relatively Elastic – A change in price leads to a significant change in quantity demanded.

Relatively Inelastic – A change in price leads to a very slight change in quantity demanded.

Perfectly Elastic – At a given price quantity demanded can change infinitely.

Perfectly Inelastic – At any price, the quantity demanded will remain the same

PRICE ELASTICITY OF SUPPLY

If demand varies in response to a change in its determinants, so does the supply. The
coefficient of price elasticity supply measures the percentage change in the quantity supplied of
a commodity compared with a percentage change in price of such a commodity.

The difficulty or ease of increasing or decreasing the supply of goods determines its
elasticity. Goods which are relatively easy to manufacture tend to have elastic supplies; whereas,
goods which are difficult to produce have inelastic supplies.
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Relatively Elastic - A change in price results in a significant change in quantity supplied.

Relatively Inelastic – A change in price results in a slight change in quantity supplied.

Perfectly Inelastic – At a given price, quantity supplied may change infinitely.

Perfectly Elastic – At a given price, quantity supplied remains constant (or Q is equal to zero).

PROJECTING THE FUTURE

Important decisions about what and how many goods to produce depend very much on
the entrepreneur’s estimate of future demand, If the entrepreneur produces much ‘more than what
is demanded, he would have an inventory in his hand. If this inventory is much more than what is
necessary, it becomes an additional cost in the form of money tied up with too much inventory, in
addition to storage and spoilage costs. However, if the entrepreneur produces much less than
what is demanded, he would be missing out on what could have been additional profits earned.
Thus, it is very important that the entrepreneur knows forecasting techniques.

There are different methods of making a forecast. The simplest way is the use of the
average arithmetical growth rate method. Another way is a more sophisticated statistical
method called regression analysis or least squares regression method.

1. Average Arithmetical Growth Rate Method

The computation of this method is carried out by getting the percentage change between
two values which is simply the ratio of change between two years expressed in percentage form.
The average growth rate is then computed by getting the sum of the percentage changes divided
by the number of period covered. Let us try this method by looking at historical sales figures
shown in the following table:

Year Sales % Growth Rate

1996 ₱23.2M -
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1997 24.1 3.9 175.67

Average Growth Rate =
1998 40.3 67.22 8
1999 30.2 (25.06)
2000 35.8 18.54
2001 15.6 (56.42)
2002 24.9 59.62
2003 25.8 3.61
2004 52.7 104.26
175.67%
= 21.96%

Projected Vlues
2005 ₱52.7 x 21.96%= 11.57
+52.7
₱64.27M

14.11
2006₱64.27 x 21.96%= +64.27
₱78.38M

Table 7: Historical Sales Figure of Company X for 1996-2004

2. Trend Line Using Least Squares Regression Method

This method uses statistical tools and is the most commonly used method of computing
long term trend of time series. The least squares regression method, as the name implies, fits a
trend line to the date in a manner such that the sum of squared deviations of actual data from
estimated or trend data at a minimum. On these grounds, the resulting trend line can be
characterized as a “line of best fit” since the sum of the square deviations is at minimum. The
trend values thus best approximate the total values.

The equation for the straight line trend is Yt = a + bx where X is the independent variable.
Since their values must be determined for each of the series analysed, a and b are referred to as
unknowns. They are also called constants because once their values are determined they do
not change.

Let us illustrate this method by using the same data in Table 7. Our straight line trend
equation is:
 MODULE BASIC MICROECONOMICS
Yt = a + bx

Where:
Ʃ𝑌 Ʃ𝑋𝑌
𝑎= 𝑏=
𝑁, Ʃ𝑋 2
Going back to the aforementioned equation, we can now substitute our values based on
the table, thus: Y₁ = a + bx
Table 8: Historical Sales Figure of Company X for 1996-
Year X Sales Y XY X² 2004
1996 -4 ₱23.2 -92.8 16 Where:
Ʃ𝑌 272.60
1997 -3 24.1 -72.3 9 𝑎= = = 30.29
𝑁, 9
1998 -2 40.3 -80.6 4
1999 -1 30.2 -30.2 1
2000 0 35.8 0 0
2001 1 15.6 15.6 1
2002 2 24.9 49.8 4
2003 3 25.8 77.4 9
2004 4 52.7 210.8 16
0 272.60 77.7 60

Ʃ𝑋𝑌 77.7
𝑏= = = 1.30
Ʃ𝑋², 60

Our trend equation is:

Yt = 30.29 + 1.30X

We can now compute our forecasts for 2005 and 2006. Since last year (2004), in Table 8 is
given an X value of 4, the X values of 2005 and 2006 should be 5 and 6, respectively. Our forecast
for 2005 and 2006 would then be completed thus:

(2005) Y = 30.29 + 1.30(5) (2006) Y = 30.29 + 1.30(6)

= 30.29 + 6.60 = 30.29 + 7.80

= 36.79 = 38.9
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SUMMARY
Price elasticity of demand is the degree of responsiveness of quantity demanded to a
change in price. It is measured by dividing the percentage change in quantity demanded by the
percentage change in price.

Two Measures of Price Elasticity

1. Arc Elasticity – is the coefficient of the price elasticity of demand between two points along
the demand curve.

2. Point Elasticity – is the elasticity at one point along the demand curve

Elastic Inelastic Unitary

Percenatge change in quantity
Percenatge change in quantity
is higher than the percentage Quantity is proportionate
is lesser than change in price.
change in price. with change in price.

Elastic coeffecient is more Elastic coeffecient is more Elastic coeffecient is more

than 1 than 1 than 1

Substitution Has 3 factors:

1. The number of competing products;

2. Desirability of a product relative to its substitutes due to quality; and

3. Relative importance of consumer’s needs.

Consumption line - is the curve connecting the points of tangency that represent the
consumption of any two given commodities at varying levels of income

Income elasticity of demand – measures a product’s percentage change in demand as a ratio

of the percentage change in income, which causes shift in demand curve.

Engels Law – states that when income increases, the percentage that is spent for food tends to
decrease.

Two Methods in Making a Forecast

1. Average arithmetical growth rate method; and

2. Trend line using the least squares regression method.

MODULE BASIC MICROECONOMICS

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