Handout # 5

ELASTICITIES

INTRODUCTION

The word elasticity in Economics refers to the percentage change in an economic variable that
results from a percentage change in another economic variable. The concept of elasticity is useful for
businesses especially in forecasting percentage changes in one variable, say the quantity that consumers buy,
when another variable, say price, changes by one percent.

This lesson covers the types of elasticities, their uses, the estimation and interpretation of different
types of elasticities, as well as the factors affecting products’ elasticities. This topic is expected to
strengthen your skill in solving mathematical problems and in explaining possible applications of the concept
of elasticity in business management.

OBJECTIVES

After finishing this lesson, you are expected to be able to:

1. Define the different types of elasticities;

2. Estimate and interpret the types of elasticities;
3. Apply the elasticity concepts in making business decisions.

LESSON PROPER

Definition of Terms

Elasticity - percentage change in an economic variable resulting from a percentage change in

another variable.
Arc elasticity – elasticity measured between two separate points of the demand or the supply curve.
Point Elasticity – elasticity measured at a specific point of the demand/supply curve.

Range for the values of demand elasticities

1. unitary /E/ = 1 % ΔQ = % ΔP (for example price goes up by 10%, consumers reduce the
quantity they buy by 10% also)

2. elastic /E/ >1 % ΔQ > % ΔP (meaning Qd changes by a proportion greater than the
percentage change in the price.

3. inelastic /E/ <1 % ΔQ < % ΔP (meaning consumers change the quantity that they buy by a
proportion less than the percentage change in the price)

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Relationship of demand elasticity (Ed) and total revenue (TR)

• Total revenue is the amount paid by buyers and received by sellers of a good.
• TR is computed as the price of the good times the quantity sold or TR = P x Q
• For example Dolly harvested 1,000 kilograms of tilapia and sold these at Php 80.00 per kilogram.
Her total revenue (also called total receipt or total peso sales) will be equal to
TR = Php 80.00/kg x 1,000 kgs
= Php80,000

• Below is a Total revenue schedule given: Demand equation : Qd = 22 – 2P and Prices

Price (P) Quantity Demanded (Qd) Total Revenue Elasticity

10 2 20
9 4 36 Elastic
8 6 48
7 8 56
6 10 60 Unitary
5 12 60 Unitary
4 14 56
3 16 48 inelastic
2 18 36
1 20 20

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Determinants of the Price Elasticity of Demand
• Availability of Close Substitutes - Demand tends to be more elastic when there is a large
number of close substitutes. The demand for a brand of sardines , say Yummy sardines,
becomes more elastic when there are many substitute brands in the market. Even a small
percentage change in the price of Yummy sardines may cause buyers to shift to the other
brands, thereby changing the demand for it by a bigger percentage

• Necessities versus Luxuries. – Demand tends to be more elastic for luxury goods than for
necessity goods. For instance, demand for rice tends to be more inelastic than demand for
cakes and pastries. A percentage increase in the price of cakes may cause consumers to
reduce the quantity they buy or postpone buying such products, since these are not necessity
items.

• Definition of the Market. – The more narrowly defined the market, the more elastic is the
demand for the product. The demand for cooking oil in general tends to be more inelastic
than the demand for Brand X cooking oil. This is so because if the price of cooking oil in
general increases consumers will tend to buy the usual quantity of the product just the same
because there are limited close substitutes for it. However, when the price of Brand X
cooking oil increases, demand for it may easily change because buyers tend to shift to other
available substitute brands. The same can be said for the market for fruits in general (more
inelastic) than the market for bananas (more elastic)
• Time Horizon. – Demand is more elastic for longer time periods. When the time available
for making buying/consumption decisions or changing them is longer, demand for the
product tends to be more elastic. For example, demand for liquefied petroleum gas (LPG)
tends to be more elastic in the long run than in the short run. This is so because in the long
run, the consumers can more easily change their purchasing decisions like they may decide
to shift to cheaper alternative sources like charcoal or electricity.

2. Income Elasticity of Demand – measures the percentage change in the quantity of a commodity
purchased per unit of time resulting from a given percentage change in consumer’s income.

Types of Goods

• Normal Goods (Ey>0 or +) : Y increases, Qd increases

• Inferior Goods(Ey < 0 or -) : Y increases, Qd decreases
• Higher income raises the quantity demanded for normal goods but lowers the quantity
demanded for inferior goods.

• Goods consumers regard as necessities tend to be income inelastic

• Examples include food, fuel, clothing, utilities, and medical services.

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 • Goods consumers regard as luxuries tend to be income elastic.
• Examples include sports cars, furs, and expensive foods.

Py increases, Qd of X increases : true for substitute products like butter and

margarine; pork and fish

Py increases, Qd of X decreases : true for complementary goods like coffee and sugar;
cars and gasoline
Or Py decreases, Qd of X increases : also complements (charcoal stoves and charcoal)

4. Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a
change in the price of that good.

Price elasticity of supply is the percentage change in quantity supplied resulting from a
percent change in price.

Example: An Es for corn = 0.7 means

a 1% increase in the price of corn will
result to
0.7 % increase in the quantity supplied of it. Supply is inelastic since Es< 1

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 Determinants of Elasticity of Supply

• Ability of sellers to change the amount of the good they produce.

• Beach-front land is inelastic because even though property owners want to sell more
land in response to higher price, the quantity of land is fixed.
• Books, cars, or manufactured goods are elastic because when producers decide to
increase quantity in response to higher prices, it is easy for them to do so.
• Time period.
• Supply is more elastic in the long run. With more time, producers can adjust
production decisions and acquire additional resources for production.

INTERPRETATION OF ELASTICITY COEFFICIENTS

1. Price elasticity of demand

Absolute value of Demand Description Impact on total revenue of a:
elasticity is: Price increase Price decrease
coefficient
Greater than 1 elastic The percentage change in quantity TR decreases TR increases
demanded is larger than the
percentage change in price
Less than one inelastic The percentage change in quantity TR increases TR decreases
demanded is smaller than the
percentage change in price
Equal to one unitary The percentage change in quantity TR is TR is unchanged
demanded is equal to the percentage unchanged
change in price

2. Income elasticity

Value of coefficient Description Type of good

Positive Ey Quantity demanded of the product Normal or superior
changes in the same direction as the

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 change in income

Positive Ey and > 1 Luxury product

Positive Ey and < 1 Necessity product

Negative Ey Quantity demanded of the product Inferior

changes in the opposite direction from the
change in income

3. Cross Elasticity

Value of coefficient Description Type of goods

Positive Eab Quantity demanded of product a changes in the same Substitutes
direction as the price of product b, that is quantity
demanded of a increases as the price of b increases
Negative Eab Quantity demanded of product a changes in the Complements
opposite direction from the price of product b, that is
quantity demanded of a decreases(increases) as the
price of b increases(decreases)

4. Elasticity of Supply

elasticity coefficient Supply is: Description

Greater than 1 elastic The percentage change in quantity supplied is larger

than the percentage change in price
Less than one inelastic The percentage change in quantity supplied is smaller
than the percentage change in price
Equal to one unitary The percentage change in quantity supplied is equal to
the percentage change in price

SELF ASSESSMENT QUESTIONS

I. TRUE OR FALSE
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_________1. Price elasticity of demand measures the percentage change in the price of a product given a
percentage change in the quantity demanded of it.

_________2. Total revenue is computed as price per unit of the product times the quantity sold.

_________3. When the price of fish increases by 20% , and as a result, the quantity demanded of it
decreases by 10% , then demand for fish is said to be elastic.

_________4. The price elasticity of demand for pizza is estimated to be -0.83. Demand for pizza is elastic.

_________5. Demand tends to be more elastic for luxury goods than for necessity goods.

_________6. Demand for Bear brand powdered milk tends to be more elastic than the demand for powdered
milk in general.

_________7. Burgers and french fries have a cross price elasticity of -2.3. This means burgers and french
fries are complementary goods.

_________8. Products X and Y have income elasticity coefficients of -0.42 and -0.56, respectively. This
means Products X and Y are normal goods

_________9. The price of good A increased by 20%which brought about a 30% reduction in the demand for
it. Demand for good A is elastic

_________10. Demand for TV in general tends to be more elastic than the demand for Samsung TV.

Part II. Solve the following problems.

1. The price of Yummy Quencher turmeric tea went up from P200.00 per pack to P220.00 per pack. The
manufacturer noted that because of this, the market demand for the product went down from 300 packs to
220 packs per day. Compute for:

a. Ep for turmeric tea using the arc elasticity formula.

b. Explain what your answer in letter a means.

c . Is demand for Yummy Quencher tea elastic or inelastic or unitary?

2. The following information on hotel rates are shown below:

Hotel room rate (Pesos/room/day) Occupancy (rooms per day)

Php 1,500 30
2,000 25

1. The price of hotel accommodation increased by

A. 25% B. 500% C. 30% D. 10%
2. The arc elasticity of demand for hotel accommodation is
A. -1.57 B.-0.24 C. -0.64 D. -0.12
3. The elasticity of demand in no. 2 suggests that if price is increased, the total revenue of the hotel owner
will A. increase B. decrease C. remain the same D. be unknown

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