Chapter 6

The Price Elasticity of Demand

“He has shown you, o mortal, what is good. And what does the Lord require of you? To act justly and to love mercy and to walk
humbly with your God.” Micah 6:8

Elasticity
• A measure of responsiveness.

Price elasticity of demand

• Measures how much consumers respond in their buying decisions to a change in price (McConnell, Brue, & Flynn,
2012).

• It is denoted by coefficient Ed, which is the ratio of the percentage change in quantity demanded to the percentage
change in price.

• The averages of the two prices and two quantities are used as the base references in calculating the percentage

changes.

• Example: Yesterday, the price of apples was P10 a piece, and Julie was willing to buy 10 pieces. Today, the price
has gone up to P12 a piece, and Julie is now willing to buy 8 pieces. Is Julie's demand for apples elastic or inelastic?
What is Julie's elasticity of demand?

Determinants of Price Elasticity of Demand

• Substitutability
• Generally, the larger the number of substitute goods that are available, the (greater or lesser) the price elasticity of
demand.
• Proportion of Income
• Other things equal, the (higher or lower) the price of a good relative to consumers’ incomes, the greater the price
elasticity of demand.
• Luxuries versus Necessities
• In general, the more that a good is considered to be a luxury rather than a necessity, the (greater or lesser) is the
price elasticity of demand.
• Time
• Generally, product demand is more elastic the (longer or shorter) the time period under consideration.
Interpretations
• When Ed is greater than 1, demand is (relatively) elastic.

That is, the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total
revenue of producers falls, and vice versa.

• When Ed is less than 1, demand is (relatively) inelastic.

That is the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total
revenue of producers rises, and vice versa.

Microeconomics 40
 • When Ed is equal to 1, demand is of unit elasticity.

That is, the percentage change in quantity is equal to that in price.

• When Ed is infinite (∞), demand is perfectly elastic.

That is any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the
price is raised, the total revenue of producers falls to zero.
• When Ed is equal to 0, demand is perfectly inelastic.

That is, changes in the price do not affect the quantity demanded for the good.

The demand curve is a vertical straight line; this violates the law of demand.

• When price changes,

Total revenue will change in the opposite direction if demand is price-elastic. That is, when the price increases, the total
revenue will (increase or decrease).

• In the same direction if demand is price–inelastic and not at all if demand is unit-elastic.

• Demand is typically elastic in the (high-price or low price) (low-quantity) range of the demand curve and inelastic
in the (high-price or low price) (high-quantity) range of the curve.

Microeconomics 41
A ppl ic a t i o n B r a n d L o y a l ty
One reason that substitution effects are larger over longer periods than over shorter ones is that people develop spending
habits that do not change easily. For example, when faced with a variety of brands consisting of the same basic product, you
may develop loyalty to a particular brand, purchasing it on a regular basis. This behavior makes sense because you don’t
need to reevaluate products continually. Thus, your decision-making costs are reduced. Brand loyalty also reduces the
likelihood of brand substitutions, even when there are short-term price differentials. Over the long term, however, price
differences can tempt buyers into trying new brands and thereby switch their loyalties.

Automobiles
The competition between American and Japanese automakers provides a good example of changing loyalties. Prior to the
1980s, Americans exhibited considerable loyalty to U.S. automobiles. Repeat purchases of the same brand were a common
pattern. In the early 1970s, Japanese automobiles began making inroads into the American market on a price basis. The
lower prices of Japanese cars eventually convinced Americans to buy them. Satisfied with their experiences, by the 1980s
many Americans developed loyalty to Japanese brands. This loyalty was encouraged, in part, by differences in quality
between Japanese and U.S. cars, which became especially large in the mid-1980s. Although U.S. automakers have worked
hard to close some of the quality gap, lingering loyalty to Japanese autos has made it difficult to regain market share. By one
estimate, U.S. cars would have to sell for approximately $1,600 less than their Japanese counterparts in order to encourage
buyers of Japanese cars to switch.

Licensing of Brand Names

The advantages of brand loyalty have not been lost on innovative marketers. Famous trademarks such as Coca-Cola,
Harley-Davidson, or Disney’s Mickey Mouse have been applied to products rather different from the originals. For
example, Coca-Cola for a period licensed its famous name and symbol to makers of sweatshirts and blue jeans, in the hope
that this would differentiate the products from their generic competitors. Similarly, Mickey Mouse is one of the most
popular trademarks in Japan, appearing on products both conventional (watches and lunchboxes) and unconventional
(fashionable handbags and neckties).

The economics behind these moves are straightforward. Prior to licensing, products are virtually perfect substitutes and
consumers shift readily among various makers. Licensing creates somewhat lower price responsiveness for the branded
product, so producers can charge more for it without losing all their sales. The large fees paid to Coca-Cola, Disney, Michael
Jordan, or Major League Baseball provide strong evidence of the strategy’s profitability.

Overcoming Brand Loyalty

A useful way to think about brand loyalty is that people incur “switching costs” when they decide to depart from a familiar
brand. Producers of a new product must overcome those costs if they are to be successful. Temporary price reductions are
one way in which switching costs might be overcome. Heavy advertising of a new product offers another route to this end.
In general, firms would be expected to choose the most cost-effective approach. For example, in a study of brand loyalty to
breakfast cereals M. Shum used scanner data to look at repeat purchases of a number of national brands such as Cheerios or
Rice Krispies. He found that an increase in a new brand’s advertising budget of 25 percent reduced the costs associated with
switching from a major brand by about $0.68—a figure that represents about a 15 percent reduction. The author showed
that obtaining a similar reduction in switching costs through temporary price reductions would be considerably more costly
to the producers of a new brand.

Questions
1.Does the speed with which price differences erode brand loyalties depend on the frequency with which products are
bought? Why might differences between short-term and long-term price elasticities be much greater for brands of
automobiles than for brands of toothpaste?

2.Why do people buy licensed products when they could probably buy generic brands at much lower prices? Does the
observation that people pay 50 percent more for Nike golf shoes endorsed by Tiger Woods than for identical no-name
competitors violate the assumptions of utility maximization?

Microeconomics 42
Eco Quiz 14
Name: __________________________________ Date: __________________
1. What are the major determinants of price elasticity of demand? Use those determinants and your own reasoning in
judging whether demand for each of the following products is probably elastic or inelastic:

a. Bottled water
________________________________________________________________________________________________

b. Toothpaste
________________________________________________________________________________________________

c. Colgate toothpaste
________________________________________________________________________________________________

d. Tomato sauce

________________________________________________________________________________________________
________________________________________________________________________________________________

e. Apple iPhone 5s
________________________________________________________________________________________________

f. Microsoft’s Windows operating system

_________________________________________________________________________________________________

3. What effect would a rule stating that the university students must live in university dormitories have on the price
elasticity of demand for dormitory space? What impact might this in turn have on room rates?

____________________________________________________________________________________________________
____________________________________________________________________________________________________

4.Determine what type of elasticity of demand each

graph portrays, and compute for Ed.

Microeconomics 43
Chapter 7
The Price Elasticity of Supply
“Do not exploit the poor because they are poor and do not crush the needy in court.” Proverbs 22:22

“One cannot buy, rent or hire more time. The supply of time is totally inelastic. No matter how high the demand, the supply will not
go up. There is no price for it. Time is totally perishable and cannot be stored. Yesterday's time is gone forever, and will never
come back. Time is always in short supply. There is no substitute for time. Everything requires time. All work takes place in, and uses
up time. Yet most people take for granted this unique, irreplaceable and necessary resource.” Peter F. Drucker

Price elasticity of supply

• Measures the sensitivity of suppliers to changes in the price of a product.

• The price-elasticity-of-supply coefficient Es is the ratio of the percentage change in quantity supplied to the
percentage change in price.

• The elasticity of supply is basically a short-term idea.

• A numerical measure of the responsiveness of the quantity supplied of product (A) to a change in price of product
(A) alone.

• It is the measure of the way quantity supplied reacts to a change in price (Sullivan, 2003).

Market period
• The period that occurs when the time immediately after a change in market price is too short.

• In the immediate market period there is insufficient time to change output, and so supply is perfectly inelastic
(agricultural product is the example).
In the short run,
• Plant capacity is fixed, but changing the intensity of its use can alter output, supply is more elastic.

In the long run,

• All desired adjustments, including changes in plant capacity can be made, and supply becomes still more elastic.
The elasticity of supply varies directly with the amount of time producers have to respond to the price change.
Regardless of the degree of elasticity or inelasticity, the price and the total revenue always move together
(McConnell, Brue, & Flynn, 2012).

Numerical Value Description Diagram Explanation

E of S = 0 Perfectly Inelastic Change in price has NO EFFECT AT ALL on the QS.

E of S < 1 Inelastic % change in price is GREATER than % change in QS.

Microeconomics 44
 E of S = 1 Unit Elasticity % change in price EQUALS % change in QS.

E of S > 1 Elastic % change in price is LESS than % change in QS.

E of S = ° Perfectly Elastic Change in price causes Supply to DISAPPEAR.

Eco Quiz 15
Name: __________________________________ Date: __________________
What is the formula for measuring the price elasticity of supply? Suppose the price of pears goes up from $10 to $12
a box. In direct response, Organo Farms supplies 1,000 boxes of pears instead of 800 boxes. Compute the coefficient
of price elasticity (midpoints approach) for Organo’s supply. Is its supply elastic, or is it inelastic?

Microeconomics 45
A ppl ic a t i o n Luxury Vehicle Sales Decline by 30%
Sales of luxury vehicles in the first quarter dropped by a steep 30 percent as buyers, mostly upwardly mobile middle class,
have become extra careful not to attract the overzealous eyes of the Bureau of Internal Revenue (BIR).

An official from one of the luxury car companies in the country said three luxury car brands— BMW, Mercedes Benz, and
Lexus—only sold 264 units in the January-March period this year or 30 percent lower than the same period for last year.
“Because of the heightened campaign of the BIR, buyers are scared, especially that most of our buyers are middle-class
businessmen, who can now afford to upgrade their lifestyle,” the source said.
Even the corporate clients and legitimate businessmen have shelved their plans to buy luxury vehicles on apprehension they
could face undue scrutiny from this tax agency.
Of the three luxury mobiles, the biggest decrease was registered by Mercedes Benz with 40 percent negative growth.
German vehicle brand, BMW, posted the highest sales but declined by 37 percent, while Lexus posted a modest 2 percent
decrease.
Lexus sold a total of 75 units and is eyeing to sell a total of at least 300 units this year from 264 units last year.

Lexus Manila is set to introduce major model changes this year including its best selling RX, which is selling for ₱1.3
million.
Meantime, the hybrid models of Lexus have not really picked up as hybrids still account for a very small portion of total
industry sales. These hybrid models have sold only 50 units so far. Its hybrid cars are GT200, GS450H, RX450H, LS600H
with GT model accounting for 40 percent of sales, being the most affordable at ₱2.3 million to ₱2.8 million.
There have been a good number of hybrid vehicle brands in the country but only Toyota has full hybrid models, the others
are “mild” hybrid brands.

“We need to educate the market because hybrid is still a little percentage of vehicle sales,” an official said.
Aside from the lack of awareness, the price of hybrid vehicles has remained very prohibitive because of the huge tax burden
imposed on these imported cars.
The robust sales of hybrid vehicles on the US, Malaysia, and Singapore have been largely attributed to the duty-tax
treatment and other perks given to these vehicles. For instance, a Lexus car in the US could sell for $200,000 with all the
taxes but ends up only at $100,000 a unit because of the removal of taxes.
In the Philippines, hybrid vehicles are slapped with import duty, excise tax, VAT, sales tax, and 4 percent municipal tax.
Without these taxes, a ₱2.3 million hybrid could sell at considerably lower price of ₱1.6 million.

Questions:
1.Is the demand for luxury cars elastic or inelastic? Explain and illustrate.
2.What factors influence this elasticity?
3.Is specific tax a better alternative to raise tax revenue? Explain.

Microeconomics 46
Chapter 8
Cross Elasticity and
Income Elasticity of Demand
“Woe to those who call evil good and good evil.” Isaiah 5:20

Cross elasticity of demand

• Measures the responsiveness of the quantity demanded of a good to a change in the price of another good.

Fuel and cars (consists of fuel consumption), are complements –

• That is, a certain good is used with the other.

• In these cases, the cross elasticity of demand will be negative, that is when the price of one goes up, the quantity
demanded of the other will (increase or decrease).

• For example, in response to an increase in the price of fuel, the demand for new cars will (increase or decrease).

• In the case of perfect complements, the cross elasticity of demand is infinitely negative.
Where the two goods are substitutes
• the cross elasticity of demand will be positive, so that as the price of one goes up the quantity demanded of the
other will (increase or decrease).

• For example, in response to an increase in the price of carbonated soft drinks, the demand for non-carbonated soft
drinks will (rise or fall).

• In the case of perfect substitutes, the cross elasticity of demand is equal to infinity.
Illustration
Suppose that Coca-Cola is considering whether or not to lower the price of its Sprite brand. Not only will it want to
know something about the price elasticity of demand for Sprite (will the price cut increase or decrease total revenue),
but it will also be interested in knowing if the increased sales of Sprite will come at the expense of its Coke brand.
How sensitive are the sales of one of its products (Coke) to a change in the price of another of its products (Sprite)?
By how much will the increased sales of Sprite “cannibalize” the sales of Coke? A low cross elasticity would indicate
that Coke and Sprite are weak substitutes for each other and that a lower price for Sprite would have little effect on
Coke sales.
Government also implicitly uses the idea of cross elasticity of demand in assessing whether a proposed merger
between two large firms will substantially reduce competition and therefore violate the anti-trust laws.
Where the two goods are independent
• The cross elasticity demand will be zero: as the price of one good change, there will be no change in quantity
demanded of the other good.

Income elasticity of demand

• The relative response of a change in demand to a change in income. More specifically the income elasticity of
demand is the percentage change in demand due to a percentage change in buyers' income.

• The income elasticity of demand quantifies the theoretical relationship between income and demand identified by
the buyers' income as the demand determinant.

• Positive income elasticity indicates a normal good .

Microeconomics 47
 • Negative income elasticity exists for an inferior good.

Alternative Coeffecient

Normal Good Ed > 0

Superior Good Ed > 1

Inferior Good Ed < 0

Insights

Normal Luxury Normal Necessity Inferior Good

International Air Travel Fresh Vegetables Frozen Vegetables

Fine Wines Instant Coffee Cigarettes

Luxury Chocolates Natural Cheese Processed Cheese

Private Education Fruit Juice Margarine

Private Health Care Spending on Utilities Tinned Meat

Antique Furniture Shampoo / Toothpaste / Detergents Value “own-brand” bread

Designer Clothes Rail Travel Bus Travel

Coefficients of income elasticity of demand provide insights into the economy. For example, when recessions
(business downturns) occur and incomes fall, income elasticity of demand helps predict which products will decline in
demand more rapidly than others.
Products with relatively high income elasticity coefficients, such as automobiles, housing, and restaurant meals, are
generally hit hardest by recessions. Those with low or negative income elasticity coefficients are much less affected.

Microeconomics 48
Eco Quiz 16
Name: __________________________________ Date: __________________
1.Air conditioners are a luxury good.
a. What does this imply about income elasticity?
_____________________________________________________________________________________________

b. Which two countries would you guess have the highest per capita demand for air conditioners at present?
_____________________________________________________________________________________________

c. If people continue to get richer and global warming continues to increase, what is likely to happen to the quantity
of air conditioners demanded?
_____________________________________________________________________________________________

And what will this do to global warming?

_____________________________________________________________________________________________

And hence to the demand for air conditioners?

_____________________________________________________________________________________________

d. Could this process spiral out of control?

_____________________________________________________________________________________________

Microeconomics 49