CHAPTER II

BASIC ANALYSIS OF DEMAND AND SUPPLY

Demand is generally affected by the behavior of consumers, while supply is usually affected by the
conduct of producers. The interplay between these two is the foundation of economic activity. Thus,
the consumer identifies his/her needs, wants, and demands, while producers address these by
producing goods and services accordingly. In the end, the consumer gains satisfaction while the
producer gains profit.

As the economy cannot operate without this interaction between the consumer and the
producer, it is essential, therefore, that students understand the different movements of the demand
and supply curve, as well as the concept of market equilibrium.

This chapter provides an introduction to the basic elements of demand and supply A
understanding of these concepts is essential in the study of economics.

THE MARKET

A market is where buyers and sellers meet. It is the place where they both trade or exchange
goods or services in other words, it is where their transactions takes place. There are different kinds of
markets, such as wet and dry. A wet market is where people usually buy vegetables, meat etc. On the
other hand, a dry market is where people buy shoes, clothes, or other dry goods. However, in
economic parlance, the term market does not necessarily refer to a tangible area where buyers and
sellers could be seen transacting. It can represent an intangible domain where goods and services are
traded, such as the stock market, real estate market, or labor market-where workers offer their
services, and employers look for workers to hire.

DEMAND

Demand pertains to the quantity of a good or service that people are ready to buy/
purchase at given prices within a given time period, when other factors besides price are
held constant (ceteris paribus). Simply put, the demand for a product is the quantity of a good or
service that buyers are willing to buy given its price at a particular time.

Demand therefore implies three things:

● desire to possess a thing;

● the ability to pay for it or means of purchasing it; and

● willingness to utilize it.

LAW OF DEMAND

The Law of Demand states that if price goes UP, the quantity demanded will go DOWN
Conversely, if price goes DOWN, the quantity demanded will go UP ceteris paribus. The reason for this
is because consumers always tend to MAXIMIZE SATISFACTION.

DEMAND SCHEDULE

A demand schedule is a table that shows the relationship of prices and the specific quantities
demanded are each of these prices. The information provided by a demand schedule can be used to
construct a demand curve showing the relationship between price and quantity demanded, in
graphical form. Table 2.1 presents a hypothetical demand schedule for rice per month.
DEMAND CURVE

It is a graphical representation showing the relationship between price and quantities

demanded per time period. A demand curve has a negative slope, thus it slopes downward from left to
right. The downward slope indicates the inverse relationship between price and quantity demanded.

Most demand curves slope downwards because (a) as the price of the product falls, consumers
will tend to substitute this (now relatively cheaper) product for others in their purchases; (b) the price
decline of the product serves to increase their real income, allowing them to buy more products (Pass
& Lowes 1993). Figure 2.1 illustrates a typical demand curve.

DEMAND FUNCTION

A demand function shows the relationship between demand for a commodity and the factors
that determine or influence this demand. These factors are- the pric of the commodity itself and of
other related commodities, level of incomes, tast and preferences size and composition of level of
population, distribution of income etc. Demand fuctions is expressed as a mathematical function. Thus,

QD=f (own price, income, price of related goods, etc.)

CHANGE IN QUANTITY DEMANDED VS. CHANGE IN DEMAND

CHANGE IN QUANTITY DEMANDED

There is change in quantity demanded if the movement is along the same demand curve. A
change in quantity demanded is brought about by an increase (decrease) in the product's price. The
direction of the movement is inverse considering the Law of Demand.

Figure 2.2 illustrates the concept of change in quantity demanded. We can see in this figure
that the original price is at P, and the corresponding quantity demanded is at Q The point of interaction
between P and Q is at Point a along the demand curve. Now let us assume that price decreases to P,.
As a result, quantity demanded will increase to Q. Quantity demanded will move to Point b along the
same demand curve because of the decrease in price. The reverse however will happen if the price will
increase. Change in quantity demanded therefore happens if the price of the good changes; this is
illustrated by movement from one point to another, along the same demand curve.

CHANGE IN DEMAND

There is a change in demand if the entire demand curve shifts to the right side resulting in
increased demand. Therefore, goods or services that remain at the same price are demanded in higher
amounts by consumers. Figure 2.3a illustrates an increase in demand. In the figure, we can observe
that the entire demand curve shifts upward or to the right (indicated by the arrow) from D to D'. We
can also observe that at the same price (P), more goods will be demanded by consumers (from Q, to
Q).

Conversely, demand decreases or falls if the entire demand curve shifts downward or to the
left. Fewer amounts of a good or service (at the same price) are demanded by consumers. A decrease
in demand is illustrated in Figure 2.3b. We can observe in the figure that the entire demand curve
shifted downward or to the left (indicated by the arrow) from D to D'. If price remains at same, demand
for the product or service will decrease (from Q, to Q).

Increase (decrease) in demand is brought by factors other than the price of the good itself,
such as tastes and preferences, price of substitute goods, etc., resulting in the shift of the entire
demand curve either upward or downward.

FORCES THAT CAUSE THE DEMAND CURVE TO CHANGE

There are several reasons why demand changes, and thus, causes the demand curve to change. The
following are the general reasons for the change in demand.

TASTE OR PREFERENCE

Taste or preference pertains to the personal likes or dislikes of consumers for certain goods
and services. If tastes or preferences change so that people want to buy more of a commodity at a
given price, then an increase in demand will result, and vice versa.

As an illustration: Remember the craze for Apple iPods? It was at its height in the Philippines in
2006, everyone just wanted to have one. At that time, there were quite a number of MP_{3} player
brands being sold in the market. However, for some reason, consumers were s engrossed with the
Apple iPod that some shops sold out all their stocks. This is a clear example of consumer preference
for MP3 players at that period. Consumers preferred the Apple iPod to other brands because at that
time, pop culture deemed it was the coolest gadget to have Consumer preference towards a certain
product increases the demand for that product. On the other hand, products that consumers do not
prefer suffer a decrease in demanded.

CHANGING INCOMES

Increasing incomes of households raise the demand for certain goods or services, and vice
versa. This is because an increase in one's income generally raises his capacity or power to demand
for goods or services which (s)he cannot purchase at a lower income. On the other hand, a decrease in
one's income reduces their purchasing power, and consequently, the demand for some goods or
services ultimately declines.

Take, for example, Juan who is receiving a monthly salary of P10,000.00; he loves to buy shirts
during payday. With his income, he can only buy 3 shirts per month. After a year, however, he was
promoted to a higher position. Due to his promotion, his salary increased to P20,000.00 per month.
Because of the increase in Juan's salary, he can now afford to buy more shirts, say 6 shirts per month.
His capacity to buy more shirts (and other goods or services for that matter) is simply the result of the
increase in his monthly income.

OCCASIONAL OR SEASONAL PRODUCTS

The various events or seasons in a given year also result to a movement of the demand curve,
with reference to particular goods. For example: During Christmas season, demand for Christmas
trees, parols, and other Christmas decors increase. Moreover, demand for food items like ham and
quezo de bola also increase. Similarly, as Valentine's Day approaches, the demand for red roses and
chocolates also rises. It should be noted, however, that after these events, demand for these products
returns back to the original level.

POPULATION CHANGE

An increasing population leads to an increase in the demand for some types of goods or
services, and vice-versa. More people simply mean that more goods or services are to be demanded.
In particular, Increase in population generally results to an increase in demand for basic goods, such as
food and medicines. On the other hand, a decrease in population results in a decline in demand.

SUBSTITUTE GOODS

Substitute goods are goods that are interchanged with another good. In a situation where the
price of a particular good increases, a consumer will tend to look for closely related commodities.
Substitute goods are generally offered at cheaper prices, consequently making it more attractive for
buyers to purchase. For instance, Juan wants to buy a pair of Nike rubber shoes worth P5,000.
Considering the price and his budget of P3,000, he will end up settling for an alternative brand of
shoes with a lower price, say, Converse shoes. In this situation, Nike and Converse shoes are
substitutes of each other.

EXPECTATIONS OF FUTURE PRICES

If buyers expect the price of a good or service to rise (or fall) in the future, it may cause the
current demand to increase (or decrease). Also, expectations about the future may alter demand for a
specific commodity,

Take for example the fluctuating prices of rice. If households expect that a drastic increase in
the price of rice will happen after a week, their natural behavior is to purchase and stock-up on rice
before the price goes up. Thus, at that given point in time there will be an increase in demand for rice
due to the expectant consumer stockpiling before any anticipated price increase.

SUPPLY (FIRMS/SELLER'S SIDE)

Supply is the quantity of goods or services that firms are ready and willing to sell at a given price
within a period of time, other factors being held constant. It is the quantity of goods or services that a
firm is willing to sell at a given price at a given time. Thus, supply is a product made available for sale
by firms. It should be remembered that sellers normally sell more at a higher price than at a lower
price. This is because higher price results to higher profits.

LAW OF SUPPLY

The Law of Supply states that if the price of a good or service goes up, the quantity supplied
for such good or service will also go up; conversely, if the price goes down, the quantity supplied also
goes down, ceteris paribus.

The law of supply implies that higher price is an incentive for business firms to produce more
goods or services as this will maximize their profits.

SUPPLY SCHEDULE

A supply schedule is a schedule listing the various prices of a product and the specifie
quantities supplied at each of these prices: Generally, the information provided by a supply schedule
can be used to construct a supply curve showing the price vs. quantity supplied relationship in
graphical form. Table 2.2 presents a hypothetical supply schedule for rice per month.

SUPPLY CURVE

It is a graphical representation showing the relationship between the price of the

product/factor of production (e.g. labor) and the quantity supplied per time period. The typical market
supply curve for a product slopes upward from left to right, indicating that as price rises (falls), more
(less) is supplied. The upward slope indicates the positive relationship between price and quantity
supplied.

Consistent with the Law of Supply, as prices increase (decrease), the quantities of commodities
offered by producers also increase (decrease). This is illustrated in Figure 2.4

Given the higher price, producers or sellers normally increase their supply of goods or services
to increase profits, because they always prefer high prices. On the other hand, only those producers or
sellers who are more efficient in their operations survive at lower prices. These producers or sellers are
able to maximize their resources, handle their budget and these kinds of situations well. Producers or
sellers who are less efficient and possess a bad budgeting system run the risk of losing profits, or may
even be removed from the market (Sicat 2003). This is what we mean by the Law of Supply: higher
prices entice producers or sellers to supply more goods or services because of their profit motive,
while lower prices diminish their goal of putting additional investment because of the possibility of
incurring a loss.
 SUPPLY FUNCTION

A supply function is a form of mathematical notation that links the dependent variable
(quantity supplied, Qs), with various independent variables that determine quantity supplied. Among
the factors that influence the quantity supplied are price of the product, number of sellers in the
market, price of factor inputs, technology, business goals, importations, weather conditions, and
government policies. Thus,

Qs = f (own price, number of sellers, price of factor inputs, technology, etc.)

CHANGE IN QUANTITY SUPPLIED VS. CHANGE IN SUPPLY

CHANGE IN QUANTITY SUPPLIED

There is change in quantity supplied if the movement is along the same supply curve. A
change in quantity demanded is brought about by an increase (decrease) in the product's own price.
The direction of the movement is positive, considering the Law of Supply.

Figure 2.5 illustrates the concept of change in quantity supplied. We can see in this figure that
the original price is at P, and the corresponding quantity supplied is at Q, The point of interaction
between P, and Q, is point A along the supply curve. Now, let us assume that price increases to P_{s}
As a result, quantity supplied will increase to Q_{2} Quantity supplied will therefore move from Point a
to Point b along the same supply curve because of the increase in price. The reverse however will
happen if price will decrease. Change in quantity supplied therefore occurs if the price of the good
(being sold in the market by sellers) changes, and this is illustrated by movement from one point to
another point along the same supply curve.

CHANGE IN SUPPLY

There is change in supply when the entire demand-supply curve shifts upward or downward. At the
same price, producers or sellers are able to supply more amounts of a good or service. Figure 2.6a
illustrates an increase in supply. In the figure, we can see that the entire supply curve moves
downward (indicated by the arrow) from S to S'. We can also observe that at the same price P1, more
goods will be offered for sale by producers (from Q1 to Q2).

On the other hand, supply decreases if the entire supply curve shifts upward. Producers sell
fewer amounts of a good or service at the same price. A decrease in supply is illustrated in Figure 2.6b.
We can see in the figure that the entire supply curve shifted upwards (indicated by the arrow) from S
to S. We can also see that at the same price P1, supply for the product will decrease (from Q1 to Q2).

Increase (decrease) in supply is caused by factors other than the price of the good itself such
as change in technology, business goals, etc., resulting to the movement of the entire supply curve
downward (upward).

FORCES THAT CAUSE THE SUPPLY CURVE TO CHANGE

Just like demand, there are also forces that cause the supply curve to change. Below are some of the
reasons that cause the supply curve to change:

OPTIMIZATION IN THE USE OF FACTORS OF PRODUCTION

An optimization in the utilization of resources will increase supply, while a failure to achieve
such will result to a decrease in supply. Optimization refers to the process, or methodology of making
something as fully perfect, functional, or effective as possible. Simply put, it is the efficient use of
resources. In business parlance, it could mean maximum production of output at minimum cost.

Thus, the optimization of the various factors of production (i.e., land, labor, capital, and
entrepreneurship) result to an increase in supply, and vice versa (Sicat 2003).

TECHNOLOGICAL CHANGE

The introduction of cost-reducing innovations in production technology increases supply on

one hand. On the other hand, this can also decrease supply by means of freezing the production,
through problems that the new technology might encounter, such as technical trouble (Samuelson and
Nordhaus 2004).

Take for example AST Motors Corporation, which uses Machine "A" in the production of its cars.
Machine "A" can produce 20 cars per week. However, after 3 years of production, AST Motors
Corporation decided to replace Machine "A with the newer and faster Machine "B", which can fully
produce 8o cars per week. Because of the introduction of new technology (Machine "B"), the quantity
of cars supplied by AST Motors Corporation increased from 20 cars per week to 80 cars per week.
However, if Machine "B" malfunctions and is not fixed immediately, AST Corporation's production of
cars would decrease and thus not meet the optimum level of production using Machine "B".

FUTURE EXPECTATIONS

This factor impacts sellers as much as buyers. If sellers anticipate a rise in prices, they may
choose to hold back the current supply to take advantage of the future increase in price, thus
decreasing market supply. However, if sellers expect a decline in the price for their products, they will
increase present supply.
 For example: If MVB Meat Company expects a drastic increase in prices of meat within the
following week, it may opt to hold its supply of meat for the meantime and sell it only upon application
of the price increase; thus, reducing the present supply of meat in the market.

Conversely, if NKR Company, a producer of pagers, expects that its product will be rendered
obsolete after 2 years due to the introduction of cellular phones in the market, it may decide to sell all
its stock of pagers in order to presently earn profit from their sale, rather than have them unsold in the
following years, considering its impending obsolescence in the near future.

NUMBER OF SELLERS

The number of sellers has a direct impact on quantity supplied. Simply put, the more sellers there are
in the market, the greater supply of goods and services will be available. For example, during the
Christmas season, more tiangge stores sell t-shirts and RTWs resulting to an increase in the available
shirts and RTWs in the market. Moreover, if more farmers will plant rice instead of other crops, the
supply of rice in the market will increase due to more production, assuming that no destructive
calamities will strike the country.

WEATHER CONDITIONS

Bad weather, such as typhoons, droughts, or other natural disasters, reduces the supply of
agricultural commodities, while good weather has an opposite impact. For instance, if a typhoon
destroys the vegetable farms in Benguet Province, the supply of vegetables particularly in markets of
Metro Manila will decline.

GOVERNMENT POLICY

Removing quotas and tariffs on imported products also affect supply. Lower trade restrictions
and lower quotas or tariffs boost imports, thereby adding more supply of goods in the market.

Duties and taxes are imposed by the Government on imported products that enter the country
Importers must also abide by the quotas imposed by the government on certain products. Quotas are
limitations on the number or quantities of imported goods that could enter a country. This is used in
order to protect domestic or local products

MARKET EQUILIBRIUM

From a separate discussion of demand and supply, we now proceed to reconciling the two The
meeting of supply and demand results to what is referred to as a 'market equilibrium. As earlier said,
the market referred to here is a situation 'where buyers and sellers meet', while equilibrium is
generally understood as a 'state of balance'.

EQUILIBRIUM

Equilibrium generally pertains to a balance that exists when quantity demanded equals
quantity supplied. Equilibrium is the general agreement of the buyer and the seller at a particular price
and a particular quantity. At equilibrium point, there are always two sides of the story, the side of
buyer and that of the seller.

For instance, given the price of P10.00 the buyer is willing to purchase 20 units. On the seller
side, he is willing to sell the quantity of 20 units at a price of Pio.oo. It simply shows that the buyer and
seller agree on one particular price and quantity. This is the main concept of equilibrium: there is a
balance between price and quantity of goods bought by consumers and sold by sellers in the market.

EQUILIBRIUM MARKET PRICE

Equilibrium market price is the price agreed by the seller to offer its good or service for sale
and for the buyer to pay for it. Specifically, it is the price at which quantity demanded for a good is
exactly equal to the quantity supplied.
 The equilibrium market price and quantity can best be depicted in a graph. As illustrated in
Figure 2.7, the demand curve depicts the quantity that consumers are willing to buy at particular
prices; the supply curve depicts the quantity that producers are prepared to sell at a particular price.
The equilibrium market price is generated by the intersection of the demand and supply curves. A
higher initial price (say at P40.00) results in excess supply (Qs = 200 units and QD = 100 units). The
excess supply is depicted by the area abe. In this case, the oversupply of 100 units forces the price
down in order to eliminate the excess supply. A lower initial price (say at P20.00) results in excess
demand of 100 units (Qs = 100 units and QD= 200 units). This is depicted by the area cde. In this case
price is forced up in order to eliminate the excess demand. Only at price P30.00 are demand and
supply initiations fully synchronized.

WHAT HAPPENS WHEN THERE IS MARKET DISEQUILIBRIUM?

When there is market disequilibrium, two conditions may occur: a surplus or a shortage, as shown in
Figure 2.7.

SURPLUS

Surplus is a condition in the market where the quantity supplied is more the quantity
demanded. When there is a surplus, the tendency is for sellers to lower market prices in order for the
goods to be easily disposed from the market. This means that when there is a surplus there is a
downward pressure on price, in order to restore equilibrium to the market. This is depicted in Figure
2.7 by the arrow from point a going down to the equilibrium point.

As we can observe in the graph, surplus is a situation above the equilibrium point. This is
because quantity supplied (say at P=P40.00, Qs=200 units) is greater than quantity demanded (at
P=P40.00, Qs=100 units), resulting in an extra 100 units of goods being supplied in the market.

SHORTAGE

Shortage is a condition in the market in which demand is higher than supply. When the market
is experiencing shortage, there is a possibility that consumers can be abused, while the producers
enjoy imposing higher prices for their own interest.

Shortage exists below the equilibrium point. When there is a shortage, there is an upward
pressure on prices to restore equilibrium to the market. This is due to the fact that consumers bid for
prices in order for them to acquire the goods or services that are in short supply. This is depicted by
the arrow going from point d up to the equilibrium point.

As we can see in Figure 2.7, shortage happens when quantity demanded is greater than
quantity supplied. For instance, at price P20.00 quantity demanded QD= 200 units, while quantity
supplied Qs=100 units. This is because sellers are not willing to sell at the lower price yet consumers
demand for more.

What happens if disequilibrium in the market persists at a longer period of time? If this
happens, the government may intervene by imposing price controls. Price control is the specification
by the government of minimum and/or maximum prices for goods and services. The price may be fixed
at a level below the market equilibrium price or above it, depending on the objective in mind. In the
former case, for instance, the government may wish to keep the price of some goods (eg, food) down
as a means of assisting poor consumers. In the latter case, the aim may be to ensure that producers
receive an adequate return (price support for farmers, for instance). Generally, price controls may be
applied across a wide range of goods and services as part of price and income policy, aimed at
combating inflation

Price controls are classified into two types: floor price and price ceiling.

Floor price

It is the legal minimum price imposed by the government. This is undertaken if a surplus in the
economy persists. In this case, the government may impose a minimum price on producers'
commodities. This move is resorted to in order to prevent bigger losses on the part of the producers
(e.g. farmers). Floor price is a form of assistance to producers by the government for them to survive
in their business. Generally, floor prices are imposed on agricultural products by the government,
especially when there is bumper harvest.

Price ceiling

It is the legal maximum price imposed by the government. Price ceiling is utilized by the
government if there is a persistent shortage of goods (e.g. basic commodities like food items and oil
products) in the economy. The government monitors the market and imposes a maximum price on
commodities, which is to be strictly followed by producers and sellers. Price ceiling is generally
imposed by the government to protect consumers from abusive producers or sellers who take
advantage of a shortage situation. This is usually done by government after the occurrence of a
calamity, like a typhoon or severe flooding.

Could you think of concrete examples of price ceilings and floor prices imposed by
government? What do you think are the reasons why government imposes such price controls?

THE PARTIAL EQUILIBRIUM ANALYSIS

THE EQUATION SYSTEM:

CHAPTER SUMMARY
 ● A market is where buyers and sellers meet.

● Demand pertains to the quantity of a good or service that people are ready to buy/ purchase at
given prices within a given time period when other factors besides price are held constant
(ceteris paribus).
● The Law of Demand states that if price goes UP, the quantity demanded will go DOWN.
Conversely, if price goes DOWN, the quantity demanded will go UP ceteris paribus.
● A demand schedule is a table that shows the relationship of prices and the specific quantities
demanded are each of these prices.
● The forces that cause the demand curve to change are taste or preference, change in incomes,
occasional or seasonal products, population change, substitute goods and expectation of
future prices.
● Supply is the quantity of goods or services that firms are ready and willing to sell at a given
price within a period of time, other factors being held constant.
● The Law of Supply states that if the price of a good or service goes up, the quantity supplied
for such good or service will also go up; if the price goes down the quantity supplied also goes
down, ceteris paribus.
● Supply curve is a graphical representation showing the relationship between the price of the
product or factor of production (e.g. labor) and the quantity supplied per time period.
● The forces that cause the supply curve to change are optimization in use of factors of
production, technological change, future expectation, number of sellers, weather conditions
and government policy.
● Equilibrium generally pertains to a balance that exists when quantity demanded equals
quantity supplied.

CHAPTER III

THE CONCEPT OF ELASTICITY

ELASTICITY OF DEMAND

You may have encountered the term elasticity in your Physics subjects, which refers to the expansion
or contraction of physical matter. In economics, however, elasticity means responsiveness. In general,
it is the ratio of the percent change in one variable to the percent change in another variable. It is a
tool used by economists for measuring the reaction of a function to changes in parameters in a relative
way.

Demand elasticity, in particular, is a measure of the degree of responsiveness of the quantity

demanded of a product to a given change in one of the independent variables that affect demand for
that product. We can classify demand elasticity according to the factors that cause it to change. Thus,

Price elasticity of demand is the responsiveness of consumers' demand to change in price of

the good sold.

Income elasticity of demand is the responsiveness of consumers' demand to a change in their

income.

Cross elasticity of demand is the responsiveness of demand for a certain good, in relation to
changes in price of other related goods.

When we speak of the price elasticity of demand, we are dealing with the sensitivity of
quantities bought to a change in the product price. Thus, this concept describes an action that is within
the producer's control (Keat and Young 2006).

We can therefore define demand price elasticity as the percentage change in quantity
demanded caused by a 1-percent change in price. Thus, we can derive price elasticity of demand using
the following equation:
 where the symbol A (Greek letter 'delta') signifies an absolute change. You may have observed that
the most common method used by economics textbooks in the measurement of demand price
elasticityis the arc elasticity. The formula for this indicator is:

The numerator of this coefficient (Q2-Q1)/[(Q1+Q2)/2], indicates the percentage change in the
quantity demanded. The denominator, (P2-P1)/[(P1+P2)/2], indicates the percentage change in the
price.

We can illustrate the concept of elasticity through the following example:

Assume that we want to determine how consumers would react if the price of good X
decreased. We can solve the elasticity coefficient by applying the formula, assuming that price will
decrease from Php6.00 to Php4.00, and quantity will increase from o to to units.

Now, try solving the elasticity coefficient for the other price and quantity combinations Do they
have the same elasticity coefficient?

As you may have observed, price elasticity is always negative, although when we analyze and
interpret the coefficient, we ignore the negative sign, thus only the absolute value is interpreted. What
could be the reason for this? It is always negative due to the very nature of demand: if price increases,
less quantity of a good is demanded, therefore quantity change is negative and leads to a negative
price elasticity of demand. Conversely, if price falls, this negative value will lead to a negative (or
positive?) price elasticity of demand value
INTERPRETATION OF THE ELASTICITY COEFFICIENT

For economists, solving the elasticity coefficient is only a tool rather an end in itself. What is
important to them (and to us) is to understand the meaning of the computed elasticity. Our concern
now is how to analyze and interpret the elasticity coefficient. There are only certain rules to remember
in analyzing and interpreting the elasticity coefficient, as you will note in the following discussion.

Demand for a product is said to be inelastic if consumers will pay almost any price for the
product, while demand for a product may be elastic if consumers will only pay a certain price, or a
narrow range of prices, for the product. Inelastic demand means that a producer or seller can raise
prices without much hurting demand for its product, and elastic demand means that consumers are
sensitive to the price at which a product is sold and will only buy it if the price rises by what they
consider too much.

We already know that a fall in the price of a good results in an increase in the quantity
demanded by consumers. However, the demand for a good is inelastic when the change in quantity
demanded is less than the change in price. Thus, we can say that demand is inelastic if the computed
elasticity coefficient is less than 1 (Ep < 1). Generally, goods and services for which there are no close
substitutes are inelastic. Basic food items (e.g. rice, pork, beef, fish, vegetables, etc.), medicines (like
antibiotics), and oil products are some examples of goods that are inelastic.

Conversely, demand for a good is elastic if the change in quantity demanded is greater than
the change in price. Therefore, we can say that demand is elastic if the computed elasticity coefficient
is greater than 1 (Ep > 1). In general, goods and services that have many substitutes (which
consumers may switch to) are elastic. Clothes, appliances, and cars are examples of elastic goods.

GRAPHICAL ILLUSTRATION

The price elasticity of demand can also be illustrated graphically. Figure 3.1 illustrates an
elastic demand curve while Figure 3,.2 shows an inelastic demand curve. Take note of the slope of the
two demand curves.

We can observe in Figure 3.1 that the slope of an elastic demand curve is flatter. The more the
demand curve becomes horizontal, the greater its elasticity. This is because a small change in price,
say from P3.00 to P1.00, can result to a larger change in quantity demanded, say from 5 units to 35
units. Take note of the broken line, ab, is shorter than broken line be This means that more quantities
of a good are demanded when price changes, even with a small amount. In this case, we can say that
consumers respond greatly to a small change in price.

On the other hand, we can see in Figure 3.2 that the slope of an inelastic demand curve is
steeper. In fact, the more the demand curve becomes vertical the greater it becomes inelastic. This is
so since a large change in price, say from P3.00 to P1.00 still only results in a small change in quantity
demanded, say from 15 units to 20 units. As illustrated in the graph, we can observe that broken line
ab is longer than broken line bc, implying that less quantities of a good are purchased when there is a
large change in price. Under this situation, consumers' response in buying a good is lesser than the
change in price.

At the extremes, demand can be perfectly price inelastic, that is, price changes have no effect
at all on quantity demanded. A perfectly inelastic demand curve is a straight vertical line (See Figure
3.3a). On the other hand, demand can be perfectly price elastic, that is, any amount will de demanded
at the prevailing price. A perfectly elastic demand curve is a straight horizontal line (See Figure 3.3b).
 Now that we have described what elasticity is, let us examine the reasons why demand for
some goods is elastic, whereas for others it is inelastic. The question therefore is: what determines
elasticity? However, before we look into these reasons, we have to remember that the elasticity for a
particular product may differ at different prices. For instance, although the demand elasticity for rice is
low at its current price, it may not be so inelastic at P70.00 to P75.00 per kilo.

Going back to our question: what determines elasticity? Important factors that influence
demand elasticity include (a) ease of substitution, (b) proportion of total expenditures, (c) durability of
product which may include: (i) possibility of postponing purchase, (ii) possibility of repair, and (iii) used
product market, and (d) length of time period (Keat and Young 2006).

Accordingly, the most important determinant of elasticity is ease of substitution. If there are
many good substitutes for the product sold in the market, elasticity for that product will be high.
Moreover, if the product itself is a good substitute for other goods, its demand elasticity will also be
high. However, the broader the definition of a commodity, the lower its price elasticity will tend to
become, simply because there is less opportunity for substitutes.

Another major determinant of demand elasticity is the proportion of total expenditures spent
on the product. For example, if the current price of rice is P5.00 per kilo and it will increase to P6.00
per kilo, we may shrug off the P1.00 increase since its effect on our total expenditure is very negligible.
However, for a product like appliances and other kinds of technology, the situation may be entirely
different. Thus, we can expect that the demand for an air conditioning unit will be considerably high
than that for rice. Another reason for the high elasticity of this product is that an appliance purchase
can be postponed because there is a choice between buying and repairing. Faced with a higher
purchase price, a consumer may choose to repair instead of purchasing a brand new product.

Lastly, as markets broaden, more and more product substitution becomes possible. Advances
in mode of transportation and communication accompanied by decreases in their cost have increased
the size of markets over time. Thus, the number of substitutes competing for consumers' demand has
increased. In fact, markets have not only widened on a national scale; they have crossed national
borders brought about by increase in international trade due mainly to international agreements like
the World Trade Organization (WTO) and other regional trade blocks like the ASEAN Free Trade
Agreement (AFTA) among ASEAN member countries.

ELASTICITY OF SUPPLY

Supply elasticity refers to the reaction or response of the sellers or producers to price changes in
goods sold. In other words, it is a measure of the degree of responsiveness of supply to a given change
in price. Moreover, it is the percentage change in quantity supplied, given a percentage change in
price. Thus,

If a change in price results in a more than proportionate change in quantity supplied, then
supply is price elastic (See Figure 3.3). Take note that an increase in the price from P1.00 to P3.00
(represented by the broken line bc) resulted in a larger increase in quantity supplied from 5 units to 25
units, represented by the broken line ab. This simply indicates that the response of suppliers to a small
change in price is to increase the quantity of goods supplied more than the increase in price. Just like
an elastic demand curve, the slope of an elastic supply curve is also flatter compared to a normal
supply curve. In fact, the more the supply curve tends to be horizontal, the more that it becomes
highly elastic.

Conversely, if a change in price produces a less than proportionate change in the quantity
supplied, then supply is price inelastic (See Figure 3.4). Observe in the figure that an increase in the
price from P1.00 to P3.00 (represented by the broken line bc) resulted in a small increase in quantity
supplied from 7 units to 10 units represented by the broken line ab. The small change in quantity
supplied simply tells us that suppliers are not that responsive to price changes under an inelastic
supply condition. We can also see that inelastic supply curve is more vertical than a normal supply
curve. In fact, the more vertical the supply curve, the more it becomes highly inelastic.
 At the extremes, supply can be perfectly price inelastic, that is, price changes have no effect at
all on quantity supplied. A perfectly inelastic supply curve is illustrated by a straight vertical line (See
Figure 3.6a). On the other hand, supply can be perfectly price elastic, that is, any amount will be
supplied at the prevailing price. A perfectly elastic supply curve is a straight horizontal line (See Figure
3.6b).

Just like demand elasticity, what determines supply elasticity? Two important factors can be
identified: (a) time, and (b) time horizon involved in which production can be increased.

Time is a determinant of supply elasticity as the producer responds to changes in prices from
time to time, given a certain period. Some producers change the number of supply of their
commodities depending on the movement of prices, which shifts from time to time.

Also, the degree of responsiveness of supply to changes in price is affected by the time horizon
involved in the production process. In the short run, supply can only be increased (or decreased) in
response to an increase (or decrease) in demand/price by working a firms' existing plant more
intensively, but this usually adds only marginally to total market supply. Thus, in the short run, the
supply curve tends to be price inelastic. In the long run, firms are able to enlarge their supply
capacities by building additional plants and by extending existing ones so that supply conditions in the
long run tend to be more price elastic. However, in some cases, like petrochemicals, the long-run
supply responses can take around five years or more.

Now that you have a clear idea

why some goods that you purchase are more (or less) than the price changes, it is now time for you to
apply the concept that you have learned in your everyday activity as a consumer. It is expected that
this concept

CHAPTER SUMMARY

● Elasticity means responsiveness or reaction.

● Demand elasticity 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.
● Price elasticity of demand is the responsiveness of consumers' demand to change in price of
the good sold.
● Income elasticity of demand is the responsiveness of consumers' demand to a change in their
income.
● Cross elasticity of demand is the responsiveness of demand for a certain good, in relation to
changes in price of other related goods.
● The demand for a good is inelastic when the change in quantity demanded is less than the
change in price.
● The demand for a good is elastic if the change in quantity demanded is greater than the
change in price
● The demand for a good is unitary if the change in quantity demanded is equal to the change in
price.
● The demand can be perfectly price inelastic, that is, price changes have no effect at all on
quantity demanded.
● The demand can be perfectly price elastic, that is, any amount will de demanded at the
prevailing price.
● Supply elasticity refers to the reaction or response of the sellers or producers to price changes
of goods sold.
● The supply for a good is inelastic when the change in quantity supplied is less than the change
in price.
● The supply for a good is elastic if the change in quantity supplied is greater than the change in
price
● The supply for a good is unitary if the change in quantity supplied is equal to the change in
price.
● The supply can be perfectly price inelastic, that is, price changes have no effect at all on
quantity supplied.
● The supply can be perfectly price elastic, that is, any amount will de supplied at the prevailing
price.