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1

ELASTICITY AND
ITS
APPLICATIONS

Terminologies
Elasticity - a measure of a variable's sensitivity to a change in
another variable (i.e. demand to price, supply to price)
Elastic - an economic term meant to describe a change in the
behavior of buyers and sellers in response to a price change
for a good or service.
Inelastic - an economic term used to describe the situation in
which the quantity demanded or supplied of a good or service
is unaffected when the price of that good or service changes.
Producer - someone who creates and supplies goods or
services

Terminologies
Supply - a fundamentaleconomicconcept that
describes the total amount of a specific good or
service that is available to consumers.
Price Elasticity of Demand degree of
responsiveness of quantity demanded to a
change in price.
Pricing Decisions decisions made by top
management/ marketing managers on how much
to charge for a product or service.

Price Elasticity of Demand


and Pricing Decisions
Why is price elasticity of demand important?
Mastering managerial economics involves
calculating values, with the ultimate goal of
determining how to maximize profit. The usefulness of
the price elasticity of demand depends upon
calculating a specific value that measures how
responsive quantity demanded is to a price change.

Price Elasticity of Demand

= Price elasticity of demand


Q0 = Initial quantity of demand that exists when P0

Q1 = New quantity demanded that exists when the


price changes to P1

Price Elasticity of Demand


Price Elasticity of Demand
=1
>1
<1

Interpretation
Unitary elastic
Elastic
Inelastic

Unitary elastic proportional change between change in price and the change in demand

Elastic change in price is relatively small


Inelastic change in price is relatively large

Price Elasticity of Demand


Graphs can also show the elasticity of goods:
- shallow slopes show elasticity; a little more horizontal
- steep slopes show inelasticity; a little more vertical

Price Elasticity of Demand


EXAMPLES:
1. Assume that when gas prices increase by 50%, gas
purchases fall by 25%.

2. A pint of ice cream costs Php 40.00 and at a grocery


store, 60 people buy that ice cream in a day. The
following day, the manager decides to up the price to
Php 60.00, and only 48 people end up buying the same
pint that day.

IMPORTANCE OF
TOTAL REVENUE
IN PRICING
DECISIONS

We refer to TOTAL REVENUE as the


TOTAL SALES of products by the
producer or the seller. This is
expressed as:
TR= P x Q

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IN COMPARING 2 TRS,
WHICHEVER YIELDS A
HIGHER TR, HOLDING
OTHER THINGS CONSTANT,
IT IS THE BEST PRICE FOR
THE GOOD.

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EXAMPLE:

Cecilia sells bangus for


PHP100 and her Qd1 = 500.
When she decides to sell it for
PHP125, her Qd2 becomes
450. Should Cecilia sell her
bangus at PHP100 or PHP125?

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SOLVE FOR Q

% change in Qd= change in Qd /


average Qd

= 450-500 / 500+450/2

= -50 / 475

= - 0.11

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SOLVE FOR P

% change in P = change in P /
average P

= 125-100 / 100 + 125 /2

= 25 / 112.5

=0.22

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PRICE ELASTICITY OF DEMAND

% change in Qd / % change in P

-0.11 / 0.22

= - |0.5| or 0.5

0.5 < 1 hence, quantity


demanded is inelastic.

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COMPARE THE OLD TR WITH THE NEW


TR

TR= P x Q

TR1= 100 x 500 = 50, 000

TR2= 125 x 450 = 56, 250

TR2 is higher, thus, Cecilia should


sell her bangus for PHP125 to get
a higher total revenue.

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INCOME ELASTICITY OF
DEMAND

It 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:

INCOME
INTERPRETATIO
ELASTICITY OF
N
DEMAND

>1

Luxury good

<1

Necessity

>0

Normal good
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<0

Inferior good

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CROSS
ELASTICITY
OF DEMAND

degree of responsiveness of a
percentage change in QUANTITY OF A
GOOD with a percentage change in
the PRICE OF OTHER GOODS

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COMPLEMENTARY
GOODS
-Products which are consumed together
-The benefit of one good will be reduced if
used alone

SUBSTITUTE GOODS
-in the case that a product increases its price,
consumers may opt to find a replacement of
that specific product
-products that can be consumed in
replacement of another product

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CROSS ELASTICITY OF DEMAND


CROSS OF
DEMAND

RELATION OF
GOODS

=0

X and Y are not


related

> 0, positive

substitutes

< 0, negative

complements

CROSS ELASTICITY OF DEMAND

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SAMPLE PROBLEMS:
#2

#1
GOOD

GOOD

PRICE ELASTICITY OF SUPPLY

Price Elasticity of Supply


measures the percentage
change in supply quantity
compared to the percentange
change in the price.

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PRICE ELASTICITY OF
SUPPLY

Elastic when producers are able to


increase production even with an
increase in the cost of production
Inelastic when producers are
hindered to produce more
Unitary Elastic when producers
increased the percentage of supply
and is equal to the percentage of price

PRICE ELASTICITY OF
SUPPLY
Price Elasticity of Supply

Qa

=1

Unitary elastic

>1

Elastic

<1

Inelastic

Formul
a =

change of Qs
Price
averange in Qs
%
change
of
Q
s
Elasticity =
=
% change in P change of P
of
averange in P
Supply

PRICE ELASTICITY OF SUPPLY

Example 1
Old price of sardines is PHP 10. At
PHP 10, a producer can supply 100
cans of them. When the sellong price
changes to PHP 12, the producer was
able to increase its production to 120
units. How elastic was the supply?

PRICE ELASTICITY OF SUPPLY

Example 2
Suppose that the old price of instant
noodles is PHP 5 and a seller can
produce 100 packs of them. When
the price rose by PHP 2, the producer
has doubled his production. How
elastic is his supply of noodles?

PRICE ELASTICITY OF SUPPLY

Example 3
A 14-inch TV is originally sold at PHP
5,000. At this price, an appliance
store is able to sell 100 TVs in the
market. The following month, the new
price of TV is PHP 7,500. However, the
store ha only increased its output by 5
units. How elastic was the supply?