MODULE 3

Demand Elasticity and Consumer Behavior

Session Topic: Demand Elasticity and Consumer Behavior

Learning Outcomes:

The following specific learning objectives are expected to be realized at the end of the session:

1. Identify the different factors affecting price elasticity of demand

2. Understand the Law of Demand and its applications in business decisions

3. Analyze how consumer equilibrium is achieved using indifference curve and budget line

Key Points:

Price Elasticity Consumer Equilibrium Marginal Utility

Core Content:

Introduction

This module covers the Law of Demand and elasticity concepts and applications. It also includes theories
on consumer behavior.

IN-TEXT ACTIVITY

The 'Law Of Demand' states that, all other factors being equal, as the price of a good or service
increases, consumer demand for the good or service will decrease, and vice versa.

Demand elasticity is a measure of how much the quantity demanded will change if another factor
changes.

Changes in Demand

Change in demand is a term used in economics to describe that there has been a change, or shift in, a
market's total demand. This is represented graphically in a price vs. quantity plane, and is a result of
more/less entrants into the market, and the changing of consumer preferences. The shift can either be
parallel or nonparallel.

Extension of Demand

Other things remaining constant, when more quantity is demanded at a lower price, it is called extension
of demand.

Px Dx

15 100 Original

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 8 150 Extension

Contraction of Demand

Other things remaining constant, when less quantity is demanded at a higher price, it is called contraction
of demand.

Px Dx

10 100 Original

12 50 Contraction

Concept of Elasticity

Law of demand explains the inverse relationship between price and demand of a commodity but it does
not explain to the extent to which demand of a commodity changes due to change in price.

A measure of a variable's sensitivity to a change in another variable is elasticity. In economics, elasticity

It is calculated as:

Elasticity = % Change in quantity / % Change in price

Elasticity of Demand

Elasticity of Demand is the degree of responsiveness of change in demand of a commodity due to change
in its prices.

Importance of Elasticity of Demand

Importance to producer: A producer has to consider elasticity of demand before fixing the price of a
commodity.

Importance to government: If elasticity of demand of a product is low then government will impose
heavy taxes on the production of that commodity and vice – versa.

Importance in foreign market: If elasticity of demand of a produce is low in the international market then
exporter can charge higher price and earn more profit.

Methods to Calculate Elasticity of Demand

Price Elasticity of demand

The price elasticity of demand is the percentage change in the quantity demanded of a good or a service,
given a percentage change in its price

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Total Expenditure Method

In this, the elasticity of demand is measured with the help of total expenditure incurred by customer on
purchase of a commodity.

Total Expenditure = Price per unit × Quantity Demanded

Proportionate Method or % Method

This method is an improvement over the total expenditure method in which simply the directions of
elasticity could be known, i.e. more than 1, less than 1 and equal to 1.

Geometric Method

In this method, elasticity of demand can be calculated with the help of straight line curve joining both axis
- x & y.

Factors Affecting Price Elasticity of Demand

The key factors which determine the price elasticity of demand are discussed below:

Substitutability

Number of substitutes available for a product or service to a consumer is an important factor in

Proportion of Income

Another important factor effecting price elasticity is the proportion of income of consumers. It is argued
that larger the proportion of an individual’s income, the greater is the elasticity of demand for that good at
a given price

Time

Time is also a significant factor affecting the price elasticity of demand. Generally consumers take time to
adjust to the changed circumstances. The longer it takes them to adjust to a change in the price of a
commodity, the lesser price elastic would be to the demand for a good or service.

Income Elasticity

Income elasticity is a measure of the relationship between a change in the quantity demanded for a
commodity and a change in real income.

Following are the Features of Income Elasticity:

•If the proportion of income spent on goods remains the same as income increases, then income
elasticity for the goods is equal to one.

•If the proportion of income spent on goods increases as income increases, then income elasticity for the
goods is greater than one.

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•If the proportion of income spent on goods decreases as income increases, then income elasticity for the
goods is less by one.

Cross Elasticity of Demand

An economic concept that measures the responsiveness in the quantity demanded of one commodity
when a change in price takes place in another good. The measure is calculated by taking the percentage
change in the quantity demanded of one good, divided by the percentage change in price of the substitute
good.

•If two goods are perfect substitutes for each other, cross elasticity is infinite.

•If two goods are totally unrelated, cross elasticity between them is zero.

•If two goods are substitutes like tea and coffee, the cross elasticity is positive.

•When two goods are complementary like tea and sugar to each other, the cross elasticity between them
is negative.

Total Revenue (TR) and Marginal Revenue

Total revenue is the total amount of money that a firm receives from the sale of its goods. If the firm
practices single pricing rather than price discrimination, then TR = total expenditure of the consumer = P x
Q

Marginal revenue is the revenue generated from selling one extra unit of a good or service. It can be
determined by finding the change in TR following an increase in output of one unit. MR can be both
positive and negative. A revenue schedule shows the amount of revenue generated by a firm at different
prices:

Price Quantity Total Revenue Marginal

10 1 10

9 2 18 8

8 3 24 6

7 4 28 4

6 5 30 2

5 6 30 0

4 7 28 -2

3 8 24 -4

2 9 18 -6

1 10 10 -8

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Initially, as output increases total revenue also increases, but at a decreasing rate. It eventually reaches a
maximum and then decreases with further output. Whereas when marginal revenue is 0, total revenue is
the maximum. Increase in output beyond the point where MR = 0 will lead to a negative MR.

Price Ceiling and Price Flooring

Price ceilings and price flooring are basically price controls.

Price Ceilings

Price ceilings are set by the regulatory authorities when they believe certain commodities are sold too
high of a price. Price ceilings become a problem when they are set below the market equilibrium price.

There is excess demand or a supply shortage, when the price ceilings are set below the market price.
Producers don’t produce as much at the lower price, while consumers demand more because the goods
are cheaper. Demand outstrips supply, so there is a lot of people who want to buy at this lower price but
can't.

Price Flooring

Price flooring are the prices set by the regulatory bodies for certain commodities when they believe that
they are sold in an unfair market with too low prices.

Price floors are only an issue when they are set above the equilibrium price, since they have no effect if
they are set below the market clearing price.

When they are set above the market price, then there is a possibility that there will be an excess supply or
a surplus. If this happens, producers who can't foresee trouble ahead will produce larger quantities.

Demand

Demand is a widely used term, and in common is considered synonymous with terms like ‘want’ or
'desire'. In economics, demand has a definite meaning which is different from ordinary use. In this
chapter, we will explain what demand from the consumer’s point of view is and analyze demand from the
firm perspective.

Demand for a commodity in a market depends on the size of the market. Demand for a commodity entails
the desire to acquire the product, willingness to pay for it along with the ability to pay for the same.

Law of Demand

The law of demand is one of the vital laws of economic theory. According to the law of demand, other
things being equal, if the price of a commodity falls, the quantity demanded will rise and if the price of a
commodity rises, its quantity demanded declines. Thus other things being constant, there is an inverse
relationship between the price and demand of commodities.

Things which are assumed to be constant are income of consumers, taste and preference, price of
related commodities, etc., which may influence the demand. If these factors undergo change, then this
law of demand may not hold good.

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Definition of Law of Demand

According to Prof. Alfred Marshall “The greater the amount to be sold, the smaller must be the price at
which it is offered in order that it may find purchase. Let’s have a look at an illustration to further
understand the price and demand relationship assuming all other factors being constant:

Item Price Quantity Demanded (Units)

A 10 15

B 9 20

C 8 40

D 7 60

E 6 80
In the above demand schedule, we can see when the price of commodity X is 10 per unit, the consumer
purchases 15 units of the commodity. Similarly, when the price falls to 9 per unit, the quantity demanded
increases to 20 units. Thus quantity demanded by the consumer goes on increasing until the price is
lowest i.e. 6 per unit where the demand is 80 units.

The above demand schedule helps in depicting the inverse relationship between the price and quantity
demanded. We can also refer the graph below to have more clear understanding of the same:

We can see from the above graph, the demand curve is sloping downwards. It can be clearly seen that
when the price of the commodity rises from P3 to P2, the quantity demanded comes down Q3 to Q2.

Theory of Consumer Behavior

The demand for a commodity depends on the utility of the consumer. If a consumer gets more satisfaction
or utility from a particular commodity, he would pay a higher price too for the same and vice - versa.

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In economics, all human motives, desires, and wishes are called wants. Wants may arise due to any
cause. Since the resources are limited, we have to choose between urgent wants and not so urgent
wants. In economics wants could be classified into following three categories:

Necessities – Necessities are those wants which are essential for living. The wants without which
humans cannot do anything are necessities. For example, food, clothing and shelter.

Comforts – Comforts are the commodities which are not essential for our living but are required for a
happy living. For example, buying a car, air travel

Luxuries – Luxuries are those wants which are surplus and costly. They are not essential for our living
but add efficiency to our lifestyle. For example, spending on designer clothes, fine wines, antique
furniture, luxury chocolates, business air travel

Marginal Utility Analysis

Utility is a term referring to the total satisfaction received from consuming a good or service. It differs
from each individual and helps to show the satisfaction of the consumer after consumption of a
commodity. In economics, utility is a measure of preferences over some set of goods and services.

Marginal Utility is formulated by Alfred Marshall, a British economist. It is the additional benefit / utility
derived from the consumption of an extra unit of a commodity.

Following are the assumptions of Marginal utility analysis:

Cardinal Measurability Concept

This theory assumes that utility is a cardinal concept which means it is a measurable or quantifiable
concept. This theory is quite helpful as it helps an individual to express his satisfaction in numbers by
comparing different commodities.

For example: If an individual derives utility equals to 5 units from the consumption of 1 unit of commodity
X and 15 units from the consumption of 1 unit of commodity Y, he can conveniently explain which
commodity satisfies him more.

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Consistency

This assumption is a bit unreal which says the marginal utility of money remains constant throughout
when the individual spending on a particular commodity. Marginal utility is measured with the following
formula:

MUnth = TUn – TUn – 1

Where, MUnth – Marginal utility of Nth unit.

TUn – Total analysis of n units TUn-1 – Total utility of n-1 units.

Indifference Curve Analysis

A very well accepted approach of explaining consumer’s demand is indifference curve analysis. As we all
know that satisfaction of a human being cannot be measured in terms of money, so an approach which
could be based on consumer preferences was found out as Indifference curve analysis.

Indifference curve analysis is based on the following few assumptions:

• It is assumed that the consumer is consistent in his consumption pattern. That means if he prefers a
combination A to B and then B to C then he must prefer A to C for results.

• Another assumption is that the consumer is capable enough of ranking the preferences according to his
satisfaction level.

• It is also assumed that the consumer is rational and has full knowledge about the economic
environment.

An indifference curve represents all those combinations of goods and services which provide same level
of satisfaction to all the consumers. It means thus all the combinations provide same level of satisfaction,
the consumers can prefer them equally.

A higher indifference curve signifies a higher level of satisfaction, so a consumer tries to consume as
much as possible to achieve the desired level of indifference curve. The consumer to achieve it has to

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work under two constraints namely: he has to pay the required price for the goods and also has to face
the problem of limited money income.

The above graph highlights that the shape of the indifference curve is not a straight line. This is due to the
concept of the diminishing marginal rate of substitution between the two goods.

Consumer Equilibrium

A consumer achieves the state of equilibrium when he gets maximum satisfaction from the goods and
does not have to position the goods according to their satisfaction level. Consumer equilibrium is based
on the following assumptions:

•Prices of the goods are fixed

•Another assumption is that the consumer has fixed income which he has to spend on all the goods.

•The consumer takes rational decisions to maximize his satisfaction.

Consumer equilibrium is quite superior to utility analysis as consumer equilibrium takes into consideration
more than one product at a time and it also does not assume constancy of money.

A consumer achieves equilibrium when as per his income and prices of the goods he consumes, he gets
maximum satisfaction. That is, when he reaches highest indifference curve possible with his budget line.

In the figure below, the consumer is in equilibrium at point H when he consumes 100 units of food and
purchases 5 units of clothing. The budget line AB is tangent to the highest possible indifference curve at
point H.

The consumer is in equilibrium at point H. He is on the highest possible indifference curve given
budgetary constraint and prices of two goods.

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Summary

The law of demand is one of the vital laws of economic theory. According to the law of demand, other
things being equal, if the price of a commodity falls, the quantity demanded will rise and if the price of a
commodity rises, its quantity demanded declines

Utility is a term referring to the total satisfaction received from consuming a good or service. It differs
from each individual and helps to show the satisfaction of the consumer after consumption of a
commodity. In economics, utility is a measure of preferences over some set of goods and services.

Marginal Utility is formulated by Alfred Marshall, a British economist. It is the additional benefit / utility
derived from the consumption of an extra unit of a commodity.

A very well accepted approach of explaining consumer’s demand is indifference curve analysis. As we all
know that satisfaction of a human being cannot be measured in terms of money, so an approach which
could be based on consumer preferences was found out as Indifference curve analysis.

Consumer equilibrium is quite superior to utility analysis as consumer equilibrium takes into consideration
more than one product at a time and it also does not assume constancy of money.

A consumer achieves equilibrium when as per his income and prices of the goods he consumes, he gets
maximum satisfaction. That is, when he reaches highest indifference curve possible with his budget line.

Assessment/ Evaluation

Research Online Assignment/Homework

Activity 1. Answer the following questions:

a. Illustrate and explain how consumer equilibrium is achieved using the indifference curve?

b. How do we measure utility? Explain.

c. Discuss how the demand elasticity of a product changes? Give examples.

Activity 2. Prepare a case study analysis on the uploaded case study entitled “ Price of Pinoy Tasty Seen
to Go up” using the following format.

a. Brief background of the case study

b. Problem Statement

c. Alternative Course of Actions

d. Recommendation and Conclusion

References

Refer to the references listed in the syllabus of the subject.

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