Elasticity and

Consumer Theory:
Analysis of Demand
Elasticity of Demand
 Own Price Elasticity of Demand: the
responsiveness of demand due to a change in
its own price of the relative change in demand
due to a relative change in its price
Price Elasticity of Demand
 Factors influencing
own price elasticity of
demand
 Type of product: basic
necessity is relatively
price inelastic
compared with a luxury
commodity
 Availability of
substitutes: more
substitutes, more
elastic
 Use of product: more
uses, more elastic
Price Elasticity of Demand
 If the absolute value of the coefficient is greater than 1,
the demand is elastic. This means that quantity demand
is responsive to changes of its own price. If a commodity
has this feature, it is beneficial for producers to decrease
their price in order to increase their demand and their
revenue.
 If the absolute value of the coefficient is less than 1, the
demand is inelastic. This means that quantity demand is
not responsive to the changes in its own price. If a
commodity has this feature, a producer would prefer to
increase its price because it would result in an increase
in sales. Why? Because even if there is a decrease in
demand, the % decline in demand is lower than the %
increase in price.
 Price Elasticity of Demand
Different Types of Price Elasticity of Demand

Value Descriptive Terms

|ε|=0 Perfectly inelastic demand

|ε|<1 Inelastic or relatively inelastic demand

|ε|=1 Unit elastic

|ε|>1 Elastic or relatively elastic demand

|ε|=∞ Perfectly elastic demand

Cross Elasticity of Demand
 Cross Elasticity of Demand: measures the
responsiveness of the demand for a commodity
due to the changes of the prices of other goods
and services
Cross Elasticity of Demand
ρ<0 ρ>0 ρ=0

Two goods that are Two goods that are

Two goods that
substitutes (substitute independent have a
complement each other
goods) have a positive zero cross elasticity
(complementary goods)
cross elasticity of of demand: as the
show a negative cross
demand: as the price of price of good Y
elasticity of demand: as
good Y rises, the rises, the demand
the price of good Y
demand for good X for good X stays
rises, the demand for
rises constant
good X falls
Income Elasticity of Demand
 Income Elasticity of Demand: the relative change
in quantity demand due to a percentage change
in income of the consumer.
Income Elasticity of Demand
 Different Types of Income Elasticity of Demand:
 When θ > 0 or θ = 1, normal good
 When θ > 1, luxury good
 When θ < 1, necessity good
 When θ < 0 , inferior good
 When θ = 0, sticky good (an increase in income
is not associated with a change in the demand of
a good)
Maslow’s Hierarchy of Needs
The Role of Utility in Shaping the
Preference of Consumers
 A rational individual will continue to
consume if he can get satisfaction from
consumption and if the additional
satisfaction he gets is greater than the
additional sacrifice or cost from his
continued consumption.
 The satisfaction of an individual in his
consumption is called utility.
Analysis of Demand: Cardinal
Utility Approach
 The law of demand can be explained by
means of looking into utility or satisfaction
derived by the buyer in consuming
products and services.
 There are several assumptions made in
the formation of this approach.
Analysis of Demand: Cardinal
Utility Approach
 Assumptions:
 Consumption is based on the utility derived from the
product or service
 The level of satisfaction derived from consumption
can be measured cardinally or absolutely. (monetary
value)
 Individual buyers are rational in their preferences. In
making decisions, the buyers aim to increase their
satisfaction.
 Consumption is based on the principle of diminishing
marginal utility
Analysis of Demand: Cardinal
Utility Approach
 Principle of Diminishing Marginal Utility
 As the consumer increases his consumption
of a product, the overall utility gained by the
individual increases, while the additional or
marginal utility decreases. With the increase
of the total utility, the consumer will reach the
highest level of satisfaction and after that
point, the continued consumption of the
product would create a lower level total
satisfaction to the buyer.
Diminishing Marginal Utility
Total Utility and Marginal Utility of the MU = ΔTU /ΔQ
Consumption of Moon Cake
For the 2nd moon cake:
Marginal
Amount Total Utility Utility MU = [(45-25)/(2-1)] = 20
Consumed (TU) (MU) utils
1 25 utils 25 utils For the third moon cake:
2 45 20
MU = [(60-45)/(3-20] = 15
3 60 15
utils
4 70 10
5 75 5 As for the 7th mooncake,
MU is negative because of
6 75 0
the lack of interest by the
7 70 -5 consumer (he is already
full).
 Diminishing Marginal Utility
ScheduleofTUfortheConsumptionof ScheduleofMUfortheConsumptionof
MoonCake MoonCake

80 30

Utility( M U )
T o ta l Utility ( T U )

25
60 20
40 15
10
20 M arg i n al 5
0
0
-50 2 4 6 8
0 2 4 6 8 -10
AmountofMoonCake AmountofMoonCakes
Diminishing Marginal Utility
 Relating marginal utility and price
 A consumer would be willing to pay a
higher price for a limited amount of
consumption because it can give him a
high level of marginal utility.
 As the price of the commodity decreases,
the consumption for that commodity
increases.
Analysis of Demand: Ordinal Utility
Approach
 In the previous approach we measured
utility by its monetary value. However,
there are cases where consumer behavior
is not based on the absolute measurement
of satisfaction but based on the ordering or
comparison of satisfaction.
Analysis of Demand: Ordinal Utility
Approach
 Assumptions:
 The measurement of utility of the consumer can only
be ordered into preferences and compared instead of
being measured absolutely.
 Consumers are rational in their behavior (prefers
more to less).
 There is transitivity in consumption and consumers
are consistent in their behavior.
 There is a diminishing marginal rate of substitution
when a product becomes relatively scarce as it is
being substituted or replaced by a relatively abundant
product in consumption.
Concept of Indifference Curves
 Indifference
Curve: a locus of
points that shows
different
combinations of
consumption of
several
commodities that
will give the
consumer the
same level of
satisfaction or
utility.
Concept of Indifference Curves
 The indifference curves are convex from the
origin. This curvature is influenced by the slope
of the indifference curve which is the rate in
which fish crackers are being substituted by
rides in consumption to maintain the same level
of utility for the individual which is called the
marginal rate of substitution or MRS.
 MRS = MURides / MUFish Crackers
Concept of Indifference Curves
 Indifference curves
do not intersect!
Intersection of
indifference curves
is a violation of the
assumption of
transitivity and
consistency in the
behavior of
consumers
Concept of a Budget Line or
Budget Constraint
 Budget Line or Budget Constraint: a
graphical representation showing the
various combinations of the amount of
commodities that the consumer can
consume from his budget given the prices
of the commodities
Concept of a Budget Line or
Budget Constraint
 Budget 70php
 Fish Crackers 10php
 Ride 5php
 Highest Level of Fish
Crackers = 7 units
(70/10), Highest Level
of rides = 14 (70/5)
 Slope of the budget
line = Prides/ P fish crackers
Condition for Consumer Equilibrium
 The equilibrium
will give a
consumption
point that has the
highest utility for
the consumer
given his budget
and the prices of
commodities
Condition for Consumer Equilibrium
 Point E can be  Thus,
interpreted as the equality
between the rate fish
crackers are substituted  Further manipulation
for a ride as a preference of the equality gives
consumption and the rate us,
at which fish crackers are
exchanged for a ride in
the market
 Changes in Prices and the Demand
Curve
 Suppose, budget = 200,
good x = 20, good y = 10.
RM can be derived
(equilibrium condition
attained when budget line
is tangent to the highest
indifference curve at E1).
Optimal consumption 14
units of y, 3 units of x.
 If x = 10, y = 10. new
budget line RN (can
purchase up to 20 units of
x), optimal consumption 9
units of y, 10 units of x.
 If x = 8, y =10, new budget
line RO (can purchase up
to 26 units of x), optimal
consumption 8 units of y,
14 units of x.
Optimal Consumption and the
Demand Curve
 If we connect the
equilibrium
consumption
points, we can
derive a demand
curve that is
downward sloping
Substitution Effect and Income
Effect
 Substitution Effect: shows the change in
consumption toward a cheaper good as a result
of a change in the relative price of commodities
while the consumer’s utility is unchanged
 Income Effect: shows the change in
consumption resulting from a change in the
purchasing power of the consumer arising from
the change in the relative price of commodities
Substitution Effect and Income
Effect
Conclusion
 The demand curve is downward sloping because it reflects
the diminishing marginal utility derived by consumers as
they consume more of a product.
 From the ordinal utility point of view, the negative
inclination of the demand curve is derived from the optimal
consumption of consumers at various alternative prices.
 A price change results in a substitution effect and income
effect. The substitution effect shows the replacement of a
more expensive product with a cheaper product. The
income effect shows the change in consumption due to a
change in the purchasing power of a consumer arising
from a price change.
 The responsiveness of the demand curve is due to the
changes in its own price, price of related goods and the
income of the consumer.