APPLIED ECONOMICS: ELASTICITY OF DEMAND AND SUPPLY
FACTORS AFFECTING PRICE DETERMINATION D. Government Intervention
A. Product Cost
 The price of a commodity is based on its total
cost.
 There are three types of costs to be
considered: fixed, variable, and semi variable.
 These costs may be incurred during the
production, distribution, and selling of the
products.
TYPES OF COSTS 1.
1. Fixed Costs - are those that remain
unchanged at all levels of transaction.
o Example: salary, rent of building
etc.
2. Variable Costs - are directly related to the
levels of production or sales.
o Example: raw material, labor
costs, etc.
3. Semi-variable Costs- are those that
change with the level of activity, but not
in direct proportion.
o Example: fixed salary plus graded
commission depending on the
volume of sales.
B. The Utility and Demand (Elasticity of Demand)
 When a product has elastic demand, a
little change on its price may have a big
impact on its demand. 2.
 In case of inelastic demand, a variation in
the prices does not really affect demand.
That means consumers would still buy E.
despite a change in price. 1.
 Thus firms cannot easily impose higher
prices on commodities with elastic
demand while they can charge more on
products with inelastic demand.
C. Market Competition
 It is important to consider the nature and 2.
degree of competition in determining
prices.
 When competition is low, firm may
impose higher price for its products.
 However, when the level of competition is
intense, the price of a product must be
determined on the basis of competitors’
price and their product quality F.
 “The higher the competition, the lower
the price”
 Some companies may monopolize an industry
or a sector in an economy.
 Firms usually charge high price for their
products to make more profit. However, in
order to protect public interests, the
government may intervene by imposing price
controls and taxes.
Price Control - refers to the fixing of prices by the
government.
By restricting prices below or above their
equilibrium level, the government creates
shortage or surplus.
 Price Ceiling- a maximum price at
which a good sold.
o Example:
Gasoline price is
regulated in some
countries.
 Price Floor - a legal minimum
price at which a product can be
sold.
o Example:
The minimum wage is
the legal lowest price
for labor that any
employer may pay.
Taxes - “Higher duty and tariff increase the price
vice versa.”
Pricing Objectives
Profit Maximization - this is the usual objective of
any business.
 During a short run, a firm may charge high
prices to earn maximum profit.
 During a long run, a business may reduce its
prices to capture many buyers and therefore
earn more through increased sales.
Obtaining Market Share Leadership
 A firm usually keeps its price low of its
objectives is to obtain a big market share.
 Low price would result to an increase in sales.
 But in a firm has a specific target market, for
instance the upper class, it will surely sell at a
high price.
Marketing Methods Used
 Marketing methods used by a firm like
advertising, packaging, distribution
system, quality of sales team, customer
service, etc. also affect pricing scheme.
 The more expensive these things are, the
higher the final price.
 APPLIED ECONOMICS: ELASTICITY OF DEMAND AND SUPPLY

ELASTICITY
 Involves two variables
 Independent variable – variable that
changes (usually price or the other
determinants of either demand or supply)
 Dependent variable - variable that reacts/
responds to changes (usually quantity
demanded or quantity supplied
 Hence, elasticity measures the responsiveness of
the dependent variable (usually quantity
demanded or quantity supplied) to a change in the
independent variable (usually price or the other
determinants of demand and supply).

DEMAND ELASTICITY
 a measure of the degree of
responsiveness of quantity demanded of
a product to a given change in one of the
independent variables that affect demand
for the product.

PRICE ELASTICITY
 Price elasticity of demand refers to the
degree of reaction or response of the
buyer to changes in price of goods and
service.
 Buyers tend to reduce their purchases as
price increases and tend to increase their
purchases as price falls.
 Income elasticity of demand is the
responsiveness of consumers’ demand to
a change in their income.
CROSS PRICE ELASTICITY
 Cross price elasticity of demand is the TYPES OF ELASTICITY OF DEMAND
responsiveness of demand for a certain
1. Inelastic Demand (PED <1)
good, in relation to changes in the price of
NOTE: If the coefficient of PED is less than 1, then
related goods.
demand is price inelastic. This means that demand
is unresponsive to price change.
PRICE ELASTICITY OF DEMAND (PED)
 It is the measure of responsiveness of quantity Arise in
demanded to price change. price (from
 Gathering and analyzing data on how buyers P1 to P2)
respond to price change can help business reduce leads to an
risk and uncertainty. increase in
 Knowing this concept of PED can definitely assist total
firms set price and forecast sales. revenue.
 APPLIED ECONOMICS: ELASTICITY OF DEMAND AND SUPPLY

 This condition exists only in extremely

competitive markets where there are too
many sellers and therefore none has the
2. Elastic Demand (PED >1)
power to raise the price.
NOTE: If the coefficient of PED is greater than 1,
then demand is price elastic. This means that
demand is highly responsive to price change.

5. Unitary Elastic Demand (PED =1)

A change in
NOTE: If the coefficient of PED is 1, then demand is
quantity
unitary elastic. A change in price is exactly the
demanded is
same with the change in demand.
proportionately
higher than the
price reduction.
Firms gain more
revenue by
reducing their prices.

3. Perfectly Inelastic Demand (PED =0)

 Shift in supply would not result to any
NOTE: If the coefficient of PED is equal to zero,
change in the equilibrium price.
then demand is perfectly price inelastic. This
 This condition exists only in extremely
means that demand is not affected by any price
competitive markets where there are too
change.
many sellers and therefore none has the
power to raise the price.

 Demand for a product is perfectly price

inelastic if consumers are still able and
willing to buy at any price.
 If supply curve shifts to the left, which
means reduction in supply, equilibrium
price may increase but the quantity
demanded remains unaffected.
4. Perfectly Elastic Demand (PED = infinity)
NOTE: If the coefficient of PED is infinite, then
demand is perfectly price elastic. There is only one
price that consumers are willing to pay.
 If the demand for the product is price inelastic,
then you may change (especially increase) the
price because consumers would still buy it.
 While of the demand is elastic, in which consumers
are sensitive to price change, don’t increase the
price (or just minimal increase).
 Otherwise, consumers may switch to competitors’
or substitute products.

INCOME ELASTICITY
 Income elasticity of Demand measures the degree
to which consumers respond to a change in
income by purchasing more or less of a certain
good.
 The coefficient of income elasticity of demand 𝐸𝑖 is
 Shift in supply would not result to any determined by:
change in the equilibrium price.
 APPLIED ECONOMICS: ELASTICITY OF DEMAND AND SUPPLY

 In discussing income elasticity of demand, it is 3. An increase in the price of bananas increase

essential to distinguish a normal good from an the demand for mangoes as consumers
inferior good. substitute mangoes for bananas

4. The price of a burger falls by 10 percent and

Normal Goods the demand for pizza decreases by 5 percent
o A good is considered normal if a rise in income the cross elasticity for pizza with respect the
brings an increase in the demand and a fall in price of a burger is:
income brings a decrease in its demand. 𝐄𝐱𝐲 = −𝟎.𝟎𝟓 −𝟎.𝟏𝟎 = 0.50 (Burger and
o For most goods, the income elasticity coefficient is Pizza are substitutes)
positive.
o This means that more of the goods are demanded
as income rises. 5. The price of soda falls by 10 percent and the
o It can be concluded that a positive income quantity of pizza demand increases by 2
elasticity indicates a positive relationship between percent. The cross price elasticity of demand
income and demand. for pizza with respect to the price of cola is:
𝐄𝐱𝐲 = 𝟎.𝟎𝟐 −𝟎.𝟏𝟎 = − 0.20 (Soda and
Inferior Good Pizza are complements
o An inferior good indicates a rise in income brings a
decrease in demand and a fall in income brings an
increase in demand.
o This means, that the consumption of other
goods/products decrease (or increase) as income
increases (or decreases).
o The income elasticity is negative, revealing a
negative relationship between income and
demand.
CROSS PRICE ELASTICITY
NOTE:
 Two goods are considered substitutes if there is a
positive relationship between the quantity
demanded of one good and the price of the other
goods.
 Two goods are considered complements if there is
a negative relationship between the quantity
demanded of one good and the price of the other
good, hence, the cross elasticity of demand for
complement is negative.
 An estimates of cross elasticity of demand are
useful to retailers in their pricing decisions.
 For example, when a grocery store cuts the price
of bread, the store will sell more bread but will
also sell more complementary goods such as jelly,
peanut butter, ham and cheese.

1. New cars, technological gadgets, and clothes

are products that have positive income
elasticity and considered as a normal good.
2. Used clothing, home cooked food, and riding a
jeepney are considered as an inferior good or
services because consumers of these goods
decrease their purchases as their income rise.