General Economics and Taxation with Financial Literacy

Module 3: Elasticities of Demand and Supply Instructor: Maria Idora C. Lemoneras, CPA

Objectives:
At the end of this module, you will be able to:
1. Define, explain the factors that influence, and calculate the price elasticity of demand.
2. Explain the relationship between price, total revenue, and the price elasticity of demand.
3. Define, explain the factors that influence, and calculate the price elasticity of supply.
4. Define and explain the factors that influence the cross elasticity of demand and the income elasticity of
demand.

Chapter 3: Elasticity and Its Applications

PRICE ELASTICITY OF DEMAND AND PRICING DECISIONS

Price elasticity of demand is a measure of the extent to which the quantity demanded of a good changes
when the price of the good changes. To determine the price elasticity of demand, we compare the percentage
change in the quantity demanded with the percentage change in price.

change in Qd Qd2 - Qd1

% change in Qd average Qd average Qd
Price Elasticity of Demand = = =
% change in P change in P P2 – P1
average P average P

Table 3.1 Summary of Price Elasticity of Demand

Price Elasticity of Demand Interpretation
=1 Unitary elastic
>1 Elastic
<1 Inelastic

Importance of Total Revenue in Pricing Decisions

We refer to total revenue as the total sale of products by the producer or seller.
TR = P x Q
Where: TR is the total revenue; P is the price; and Q is the quantity.

Example:

If Bebie sells mango for Php 80 per kilo, the demand for it is 200. When she raises it by Php20, the
quantity demanded diminishes to 100. At which price will Bebie maximize her profit? Is the demand elactic or
inelastic?

Solution:

change in Qd 100 - 200

% change in Qd = = = - 0.67
average Qd 200 + 100
2

change in P 100 – 80
% change in P = = = 0.22
average P 80 + 100
2

% change in Qd -0.67
Price Elasticity of Demand = = = |-3.05| or 3.05, elastic
% change in P 0.22

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 After solving for price elasticity, we can now proceed in computing the total revenues.

TR1 = P1 x Q1 TR2 = P2 x Q2
= 80 X 200 = 100 X 100
= 16,000 = 10,000

Comparing the two results, we can observe that at an elastic demand for mango, profit is maximized at
the original price.

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is the degree of responsiveness of a percentage change in quantity

demanded with a percentage change in income. It is calculated using the following formula:

Qd2 - Qd1
Qd1 + Qd2
% change in Qd 2
Income Elasticity of Demand = =
% change in Y Y2 - Y1
Y1 + Y2
2
Where: Qd is the quantity demanded and Y is income.

Table 3.2 Summary of Income Elasticity of Demand

Income Elasticity of Demand Interpretation
>1 Luxury good
<1 Necessity
>0 Normal good
<0 Inferior good

Example:

Syndra earns a monthly salary of Php5,000 and she consumes Php1,000 worth of chicken per month.
When her income increased by Php2,500/month, she started to consume Php2,000 worth of chicken meat per
month. Is Syndra’s demand for chicken meat normal, inferior, necessity, or luxury?

Solution:

change in Qd 2000 – 1000

% change in Qd = = = 0.67
average Qd 1000 + 2000
2

change in Y 7,500 – 5,000

% change in Y = = = 0.40
average Y 5,000 + 7,500
2

Subtitute:

Income Elasticity of % change in Qd 0.67 = 1.68, normal and

= =
Demand % change in Y 0.40 considered a luxuy

CROSS PRICE ELASTICITY OF DEMAND

The cross price elasticity of demand is the degree of responsiveness of a percentage change in quantity
of a good X with a percentage change in the price of good Y. A positive cross elasticity indicates that a good is
a substitute of the other while a negative cross elasticity means the goods are complementing each other.

Table 3.3 Summary of Cross Price Elasticity of Demand

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 Cross of Demand Interpretation
=0 X and Y are not related
> 0, positive substitutes
< 0, negative complements

FORMULA:
Qdx2 - Qdx1
Qdx1 + Qdx2
% change in Qd for product X 2
Cross Price Elasticity of Demand = =
% change in the price of product Y PY2 - PY1
PY1 + PY2
2

Example:

Let us consider the table below. It shows the relationship of quantity demanded and price for each
product, X and Y.
P1 P2 Qd1 Qd2
x 4 5 4 5
y 2 3 2 3

Solution:

% change in Qd for Qdx2 - Qdx1 5–4

= = = 0.22
product x Qdx1 + Qdx2 4+5
2 2

% change in the price of PY2 - PY1 3–2

= = = 0.40
product Y PY1 + PY2 2+3
2 2

Subtitute:
= 0.55, greater than 0,
Cross Price Elasticity of = 0.22 hence, products X and Y
Demand 0.40 are substitutes.

PRICE ELASTICITY OF SUPPLY

We discussed the consumers' response to the different factors—price, income, and price changes of
other products—that affect their demand for products. Now, we will consider the price elasticity of supply. In this
respect, we will study how to measure the relationship of quantity supplied and price.

Price elasticity of supply is computed as follows:

Qs2 – Qs1
Qs1 + Qs2
% change in Qs 2
Price Elasticity of Supply = =
% change in P P2 - P1
P1 + P2
2

Table 3.4 Summary of Price Elasticity of Supply

Price Elasticity of Supply Interpretation
=1 Unitary elastic
>1 Elastic
<1 Inelastic

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Example:

Suppose that the old price of instant noodles is Php5 and a seller can produce 100 packs of them. When
the price rose by Php2, the producer has doubled his production. How elastic is his supply for noodles?

Solution:

change in Qs 200 - 100

% change in Qs = = = 0.67
average Qs 100 + 200
2

change in P 7-5
% change in P = = = 0.33
average P 5+7
2

% change in Qd 0.67 = 2.03, elastic

Price Elasticity of Supply = =
% change in P 0.33

References
Carlos L. Manapat and Fernando R. Pedrosa (c 2018): Economics, Taxation, and Agrarian Reform Second
Edition, C&E Publishing, Inc.

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