Chapter 3
Managerial Economics
ELASTICITY
and its
APPLICATION
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What is
Elasticity is a measure of the impact of one variable
Elasticity?
over the other. Mathematically speaking, if there are two
variables, a and b, then we can say that the “a elasticity
of b” is the percent increase in a when there is a percent
increase in b assuming all other factors that affect b are
constant.
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• The price elasticity of demand is the measure of how much the quantity
demanded of a good responds to a change in the price of that good.
• The income elasticity of demand is the measure of how much the quantity
demanded of a good responds to a change in consumer’s income, computed as
a percentage change in quantity demanded divided by the percentage change
in income.
• The cross-price elasticity of demand is the measure of how much the
quantity demanded of one good responds to a change in the price of another
good,computed as the percentage change in quantity demanded of the first
good divided by the percentage change in the price of the second good.
• The price elasticity of supply is the measure of how much the quantity
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Price Elasticity
The price elasticity of demand (PED) is the measure of percent decrease in the
Demand
quantity demanded of goods and services when there is a percent increase in their
price. This will remain true assuming all other factors are constant.
Let us assume that:
the price of sardines increases by 5%, and
the quantity demanded decreases by 10%.
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Because we get the absolute value whenever we get PED, then the PED of
cappuccino in this example is 0.45. If we get a PED of 0.45, that means every 1%
increase in price will lead to a 0.45% decrease in quantity demand.
Why do we get the absolute value with the formula? We can explain this by
determining the law of demand. The law states that as price increases, quantity
demand will decrease ceteris paribus.
Because they have a negative relationship, we can always expect PED to be
negative.
As it is a fact that PED is always negative, there is no need to specifically
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Table 3.1. Hypothetical Demand
Schedule of a Cup of Coffee in Batangas
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Table 3.2. Hypothetical Demand Schedule of an Iced Blended Drink at a
Coffee Shop
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Using Midpoint Formula on Price
From Tables 3.1 and 3.2, we can see that PED can be determined by establishing an old value and a
Elasticity of Demand
new value. This means that we can distinguish such by setting a Q2 and Q1 as well as P2 and P1.
However, what if we do not know where to locate Q2 and Q1 as well as P2 and P1? The formula is
contingent on the change at one point alone. What if we are not concerned on the change relative to P1 and
QD1 alone, but on both points? If you want to get rid of these constraints, it is best to use the midpoint
formula. The midpoint formula is shown in Equation 3.3.
We can see that the only difference between Equation 3.3 and Equation 3.2 is the denominator. From a
denominator of the previous value (see Equation 3.2), the denominator was changed to a typical midpoint
formula relative to its corresponding variable. Let us have an example using this formula through word
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A researcher would like to know the impact of price change to the detergent
bar in Muntinlupa City. If the price of detergent bar changed from Php 20 to
Php 25, what is the PED if demand changed from 100 to 95? We can use
Equation 3.3 to answer this question.
Because the PED is 0.23, which is greater than 1, we can conclude that the
PED of detergent bar in Muntinlupa City is inelastic. The same procedure
applies as we compute for tabular values. Let us look at the next example.
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Graphical Representations of PED
Perfectly Inelastic Demand is the commodities with an
elasticity of zero. This means that even if the price
changes, the quantity demand would still remain the
same.
Figure 3.1. PED with
Perfectly Inelastic
Demand
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Table 3.3. Hypothetical Demand
Schedule of the Detergent Bar
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Figure 3.2. PED with Inelastic Figure 3.2. PED with Unit Elasti
Demand Demand
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Figure 3.4. PED with Figure 3.5. PED with Perfectly
Perfectly Elastic Demand is a commodity with an elasticity that equals to infinity. Figure 3.5 shows a
Elastic Demand Elastic Demand
demand curve of perfectly elastic demand. We can see that if the demand curve is perfectly elastic, if the price
remains the same, the quantity demand would be infinite. That means if you set a price, say 50, you would
have an infinite demand. This means that if you are a producer and you remain with a certain price, you would
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Income Elasticity
The income elasticity of demand (IED) is the measure of percent increase in the quantity
of Demand
demanded of goods and services when there is a percent increase in the income. This will remain true
assuming all other factors are constant. We can compute for IED using 3.4:
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We can read this as value of the Percent Change in Quantity Demand divided by the Percent
Change in Income. Again, let us have a hypothetical example of this measurement.
Let us assume that:
the income of people increases by 20% and
the quantity demanded decreases by 10%
The PED is (-10)÷20 = -0.5. Because we get a value of -0.5, we can say that if there is a 1% change
in income, we can expect a 0.5% decrease in quantity demand. For income elasticity of demand,
we already removed the absolute values because we know that income may have either a positive or
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For IED, we measure and determine whether the good or a service is a normal good or an inferior good.
Normal goods are those with an IED greater than zero (IED > 0). By definition again, normal goods are
goods or services that have an increasing demand whenever income increases. As income elasticity
measures the ∆QD/∆I, we can expect normal goods to be positive because there is a positive relationship
between Income and normal goods. Normal goods can be either a necessity or a luxury. If IED has a value
greater than one (IED > 1), then good is considered as income inelastic or a necessity. Example of goods
and services that can fall under this are food, water, clothing, fuel, electricity, medical services, and other
daily essentials.
If IED has a value less than 1 (IED < 1), then the good is considered as income elastic or a luxury.
Example of goods and services that can fall under this are expensive drinks, luxury bags, sports car, and
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Meanwhile, inferior goods are those with an IED of less than zero (IED < 0). Higher income increases the
quantity demanded for normal goods, but decreases the quantity demanded for inferior goods.
Now, let us have another example to further understand this concept further. Supposing that the income of
Pateros residents increases from an average annual income of Php 300,000 to Php 500,000. What is the IED
of good A if its demand increases from 100 to 190? We can use Equation 3.3 to answer this question, which is
more precisely shown in Equation 3.5:
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To answer the example given, let us substitute the values provided in Equation 3.5:
The IED of good is 1.35. Because the value is greater than zero and
greater than one, we can conclude that this good is a normal and luxury
good. This means that this commodity is often purchased if income
increases at a high level.
Let us have another example using tables. Let us assume that the
values in Table 3.4 are the income schedule of Malolos, Bulacan, and their
deman for paper bags.
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Table 3.4. Hypothetical Demand
Schedule for Paper Bags
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Tabel 3.5 Hypothetical
Demand Schedule for
Pandesal
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Using Midpoint Formula on IED
Just like the example in the PED, using midpoint formula is preferable when you would like to get
an answer regardless of the direction of the change. This can also be used if we are not concerned on
the change relative to P1 and I1 alone, but on both points. The formula for the midpoint formula is
shown in Equation 3.6 below:
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Let us have an example using this formula.
A faculty would like to know the impact of price change of a special
type of pencil in the City of Manila. If the average weekly income of the
people in Manila changed from Php 10,000 to Php 15,000, what is the
IED if demand changed from 1,000 to 1,050? We can use Equation 3.6
to answer this question.
Because the IED is 0.07, which is less than 1, we can conclude that
the IED of the special type of pencil is a necessary good. People will still
likely buy this type of pencil because an increase in income will allow a
certain number of people to purchase such. The same procedure applies
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Cross-Price Elasticity of Demand
The cross-price elasticity of demand ( CPED) is the measure of percent increase in the
quantity demanded of goods and services when there is a percent increase in the price related
goods of a commodity. This will remain true assuming all other factors are constant. The formula
can be depicted like the value below ( Equation 3.7 ) :
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We can read this as value of the Percent Change in Quantity Demand of commodity Y divided by the
Percent Change in Price of commodity X. In our discussion of the price of related goods in the previous
chapter, we also learned that quantity demand may have either a positive or negative relationship to the price
of related goods. This is the reason why we also remove the absolute values in this measurement. Let us have
another hypothetical example of this measurement.
Let us assume that:
the price of commodity X increases by 30%, and
the quantity demanded of commodity Y increases by 10%.
The CPED is 10 A÷ 30 = 0.3333.... Because we have a value of 0.33, we can say that if there is a 1%
change in the price of commodity X, we can expect a 0.33% increase in quantity demand of commodity Y.
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In our discussion in Chapter 2, we learned that if the price of a commodity increases, we can expect the demand of its
substitute good to increase. Because the relationship of the two commodities are positive or direct, we can expect
those commodities with positive elasticity to be substitute goods. Meanwhile, complementary goods are those with a
CPED less than zero ( CPED < 0 ).
Let us assume that all badminton rackets in the world suddenly increased their price 100 times than the usual. Can
we expect people to buy more shuttlecocks with this increase? A decrease in demand is possible because of the price
increase. Let us use a hypothetical example of badminton racket and shuttlecock using Table 3.6:
Table 3.6. Hypothetical Demand Schedule for Badminton Racket and
Shuttlecock
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Before we start using this formula, we should first set what will be commodity Y and
commodity X. If we want to know how the change in the price of badminton rackets will
affect the quantity demand of the shuttlecock as our Y. If we would like to know the other
way around, meaning the change in the price of shuttlecock will affect the quantity
demand of the racket, then we set the shuttlecock as our X and the racket as our Y. Let
us use the former; this means that we set the racket as our X and the shuttlecock as our
Y. Let us substitute the formula on the previous page with the values in the table. The
CPED of a badminton racket and a shuttlecock in this example is —0.70. Because the
value is less than zero, we can conclude that the two goods are complementary goods.
Let us use this formula using a larger table. This time, we would like to know whether
chicken and tofu are substitutes or complements. Let us use the hypothetical demand
schedule of the two commodities and set chicken as commodity X and tofu as
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Table 3.7. Hypothetical Demand
Schedule of Chicken and Tofu
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Using Midpoint Formula on CPED
Just like in PED and IED, using midpoint formula is preferable when you would like to get an
answer regardless of the direction of the change. The formula for the midpoint formula is shown
in Equation 3.9:
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Exam
A curious lady would like to know the impact of price change of peanuts on the quantity
ple:
demand of hotdogs. If the said commodities will have a hypothetical demand schedule as below,
what will be the relationship of the two commodities?
Soluti
Table 3.8 Hypothetical Demand on:
Schedule of Hotdogs and Peanuts
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Table 3.9. Hypothetical Demand
Schedule for Dress and Mobile Phones
Table 3.10. Computed Values for the Demand
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Price Elasticity of Supply
The Price Elasticity of Supply ( PES) is the measure of percent increase in the quantity supplied of
goods and services when there is a percent increase in the price of such. This will remain true assuming
all other factors are constant. The formula can be depicted like the value below ( Equation 3.10):
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We can read this formula as the absolute value of the Percent
Change in Quantity Supply divided by the Percent Change in
Price. To make this formula clearer, let us have a hypothetical
example.
Let us assume that:
the price of sardines increases by 5%, and
the quantity supplied increases by 20%.
Equation 3.11.
The PED is 20÷5= 4. Just like the analysis on the other elasticities,
the value that we get ( which is 4) means that if there is a 1%
change in the price, we can expect 4% increase in quantity
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For example, the price of lotion increases from Php 90 to
Php 110. What is the PES if demand increases from 100 to
120? We can use Equation 3.11 to answer this question. Let us
substitute Equation 3.11
If we get a PES of 0.9, that means every 1% increase in
price will lead to a 0.9% increase in quantity demand. Just like
PED, PES is also considered as elastic if it is greater than
one (PES > 1). Inelastic goods are goods with PES less than
one (PES < 1). Unit elastic exists if PES is equal to one (PES
= 1).
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Graphical
There are five graphical representation for a PES.
Representation of
These are: (1) PES with Perfectly Inelastic Supply, (2)
PES with Inelastic Supply, (3) PES with Unit Elastic
Supply, (4) PES with Elastic Supply, and (5) PES with
PES
Perfectly Elastic Supply.
An Inelastic Supply is a good or service with an
elasticity that equals to zero. This means that even if
there is a change in price, quantity supply would still
Figure 3.6. PES with Perfectly
remain the same. This can be seen in Figure 3.6. Inelastic Supply
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The second graphical representation that this chapter will
Figure 3.7 PES with Inelastic Supply
present is the PES with Inelastic Supply. Figure 3.7 shows a
typical supply curve if the supply is inelastic. We can see that if
the supply curve is inelastic, despite the large increase in price
(25% because it changed from 40 to 50), quantity supply would
have a very minimal increase (10% increase because it changed
from 100 to 110). This happens when the product does not
have a high market demand, so the producers are preparing
not to have an increasing loss. One thing you can observe with
the inelastic supply is that it is steep.
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Figure 3.8. PES with Unit Elastic Supply
Figure 3.9. PES with Elastic
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Perfectly Elastic Supply is the commodities with an elasticity that equals to infinity.
Figure 3.8. PES with
