Managerial Economics

Module 5
THE CONCEPT OF ELASTICITY
In this module you will learn the meaning of elasticity. You will learn why this concept is very important to our
everyday decision making processes as consumers. You may have wondered why there are goods that you
purchase more (less) when prise becomes less (more), while there are goods that you still purchase the same
quantity of even if their prices become high. If you have asked yourself why and tried to look for an answer,
you are actually applying the concept of elasticity.
In economics, the concept of elasticity measures the responsiveness of one variable to a certain change of
another variable. There are two significant words: measure, reported as numbers or coefficients
and responsiveness, which means reaction to change. Thus, any change causes people to react, and elasticity
measures this extent to which the people react.
Elasticity is a measure of how much the quantity demanded of a service/good changes in relation to its
price, income or supply. Elasticity can be applied to demand in order to measure its responsiveness to the
changes on its selected determinants.
WHY ELASTICITY MATTERS:
Elasticity is important because it describes the fundamental relationship between the price of a good and the
demand for that good.
The concept of elasticity has several applications both in business and economic decision making. Having
knowledge of elasticity helps every policy formulating body develop and/or formulate appropriate strategies
and programs. It can determine the effect of price changes on the revenue. Hence, producers can assess
consumers’ responsiveness with respect to any change in the price of commodity.
Two aspect of elasticity:
1. Whether it is positive or negative.
2. Whether it is greater than 1 or less than 1.
Below are the list of types of Elasticity, its definition and its formula. As we go through in our course we will
discuss each type one by one.
Values of price elasticity of demand ranges from zero to infinity. Price elasticity of demand is categorized
depending upon the response of quantity demanded to a change in price as follows:

Determinants of Price Elasticity of Demand

Some goods are more responsive to any change in price while others are not. Some are prone to being elastic or
inelastic than others. There are several reasons behind these elasticity differences:
1. The importance or degree of necessity of the goods. The more essential or necessary the goods or
services, the more inelastic the demand. Necessities tend to have inelastic demands, whereas luxuries
have elastic demands.
2. Number of available substitutes. Demands for goods with greater number of substitutes are elastic,
while goods with less or no substitute have inelastic demand. This is because an increase in the price of
a certain product encourages consumers to look for alternative or substitute goods available in the
market. Power distributors like MERALCO are good examples.
3. The proportion in income in price changes. Demand is inelastic for a product whose changes in price
seemingly have no effect on the consumer income or budget. However, any change in price resulting to
a substantial effect on consumers’ income has elastic demand.
4. The time period. The longer the time period is the more elastic or less inelastic the demand will be.
This is because consumers have enough time to adjust their buying behaviour.
Price Elasticity of Demand, Total Revenue and Pricing Decisions
Total revenue responds differently with the result given by the degrees of elasticity or how the consumer will
respond in price changes. Notice that every time we discuss elasticity, we speak of total revenue. This is
because any change in price has a direct effect on the total revenue, such that if a decrease in price leads to a
decrease in total revenue, inelastic demand occurs; if a certain decrease in price leads to an increase in total
revenue, elastic demand occurs; and if decrease in price leads to no change in total revenue, unitary elastic exist.
Applying this knowledge about elasticity will help us in making an appropriate pricing decision.
The price elasticity of demand measures the responsiveness of the quantity demanded with respect to the
changes in its price. The price elasticity of demand for any good measures how willing consumers are to buy
less of the good as its price rises. The basic formula used to calculate the coefficient of price elasticity of
demand is:
Demonstration Problem #1
Cecilia sells bangus for Php100 and her quantity demanded is 500. When she decides to sell it at Php125, her
quantity demanded becomes 450. Should Cecilia sell her bangus at Php100 or Php125? Is Qd elastic or
inelastic?
 
Let us now compute for the price elasticity of demand, total revenue and determine the pricing decision.

Pricing Decisions: Cecilia should sell her bangus at P125, for she can get higher revenue with her new price.
Interpretation of the value:
In price elasticity of demand, the computed value is 0.4 in absolute term. This value indicates that consumers
are relatively not sensitive to any change in price. The bangus that Cecilia sells are essential to the consumers.

Demonstration Problem #2
If Theresa sells tilapia for Php80 per kilo, the demand for it is 200. When she raises it by Php100, the quantity
demanded diminishes to 100. At what price will Theresa maximize her profit? Is the demand elastic or
inelastic?
 
Let us now compute for the price elasticity of demand, total revenue and determine the pricing decision.

Pricing Decisions: Theresa can maximize her profit by selling her tilapia at her new price of Php100/kilo,
where she can get higher revenue.
 
Interpretation of the value:
In price elasticity of demand, the computed value is 4 in absolute term. This value indicates that consumers are
relatively sensitive to any change in price. The figure shows that a 25% change in price of tilapia results to a
100% declines on its quantity demanded.