Lecture 2 Demand and Consumer Preferences in Elasticity

ECO0006
Economics for Managers
© 2022 Singapore Institute of Management Group Limited

Lecture 2
Demand and Consumer Preferences
in Elasticity
Ref:
Tan Khay Boon, Economics for Managers Module Book,
SIM Global Education, 2014
Session 2
Learning Objectives
At the end of the lesson, students will be able to:
1. Calculate various elasticity of demand
2. Comprehend the implications of demand elasticity
3. Comprehend the concept of marginal utility
4. Explain the use of indifference analysis

Definition of elasticity of demand
A measure of the sensitivity or responsiveness of

quantity demanded to changes in price of the
good itself, income or the price of other goods.
3 types of demand elasticities:

1) Price elasticity of demand;
2) Income elasticity of demand; and
3) Cross price elasticity of demand
Definition of Price Elasticity of Demand
A measure of the responsiveness of a

change in the quantity demanded to a
change in the price of the good itself.
Price elasticity of demand looks at a

movement along a given demand curve.
Formula of Price Elasticity of Demand
Normally, we use the point elasticity formula
below when calculating percentage changes
PED = %  Q =  Q/Q = Q2-Q1 x P1

%P  P/P P2-P1 Q1
Formula of Price Elasticity of Demand
Midpoint/arc elasticity formula:
PED = Q2-Q1 x (P1+P2)/2

P2-P1 (Q1+Q2)/2
Price Elasticity of Demand
• Price elasticity is always negative because
of the law of demand. According to the law,
price and quantity demanded are inversely
related.
• Since the denominator and numerator of the
equation moves in opposite directions,
hence the coefficient of PED is always
negative.
• It is difficult to work with the negative sign,
hence drop the negative sign. To change it
into a positive figure, economists take its
absolute value.
Example:
Suppose price increases from $0.9 to $1.10
and quantity demanded decreases from 105
to 95, calculate the PED.
Point formula:
PED= 95 – 105 x 0.9 = - 10 x 0.9 = -0.43
1.1 – 0.9 105 0.2 105
Example:
Suppose price increases from $0.9 to $1.10 and
quantity demanded decreases from 105 to 95,
calculate the PED.
Arc formula:
95 – 105 x (0.9+1.1)/2 = -10 x 1 = -0.5
1.1 – 0.9 (105+95)/2 0.2 100
Coefficients of Price Elasticity of Demand
The coefficients of price elasticity of

demand can range from zero to infinity.
Elasticity is always measured

with respect to the value 1.
Elastic Demand (PED> 1)

Elastic demand is a ‘condition in which the
percentage change in quantity demanded is
greater than the percentage change in price’.
% Q
EP  1
% P
 %  Q  % P
Quantity demanded changes MORE than
proportionately to a change in price
Elastic Demand (PED > 1)
Graphically, the demand curve is relatively flat
Q
Inelastic Demand (PED < 1)

Inelastic demand is a ‘condition in which the
less than the percentage change in price’.
% Q
EP  1
% P
 % Q  %  P
Quantity demanded changes LESS than
proportionately to a change in price
Inelastic Demand (EP < 1)
Graphically, the demand curve is relatively steep
D
Q
Unitary Demand (PED =1)
Unitary demand is a ‘condition in which the
equal to the percentage change in price’.
% Q
EP  1
% P
 % Q  % P
Quantity demanded and price changes
proportionately
Unitary Demand (PED =1)
Graphically, the demand curve is a rectangular
hyperbola.
Q
Perfectly Elastic Demand (EP =∞)
• Demand is perfectly elastic P
when an unlimited amount
of good is demanded at
that one price.
• Any change in price
P D
causes quantity demanded
to fall to zero.
• Graphically, a perfectly
elastic demand curve is
horizontal. Q
Perfectly Inelastic Demand (EP =0)
Perfectly inelastic demand is a ‘condition in
which quantity demanded does not change as
the price changes.’
% Q
EP  0
% P
Perfectly Inelastic Demand (EP =0)

• Demand is perfectly P
inelastic when a change D
in price results in NO
change in quantity
demanded.
• Graphically, a perfectly
inelastic demand curve is
represented by a vertical
straight line. Q0 Q
Determinants of Price Elasticity of
Demand
Availability of substitutes:
• The more & closer the substitutes, the more

elastic is demand.
• When the price of a good increases [i.e.
becomes relatively more expensive], it is
easier to switch to consuming the substitute.
• Demand for a good or service is price
inelastic if the good has no close substitutes.
Demand
Availability of substitutes
Example:
If the price of apple juice increases, consumers can
switch to orange or lime juice. Large reduction in
consumption of apple juice.
Example:
If the price of water increases, consumers will
reduce consumption by only a little as there is no
close substitute for water.
Demand
Share of budget spent on the product
• Demand for a good that takes up a small
proportion of the consumer’s budget tends
to be inelastic.
• The good is likely to be rather cheap.

Any percentage increase in the price of the
good is likely to affect our budget only
marginally.
Demand
Example:
Price of bread  by 10% lead to a
negligible decrease in quantity demanded
by less than 10%.
Demand
• However, demand for a good that takes up a

large proportion of the consumer’s budget
tends to be elastic.
• The good is likely to be expensive.

Any percentage increase in the price of the
good will dent our budget significantly.
Demand
Example:
Price of car  by 1% lead to a
significant decrease in quantity demanded
e.g 10%.
Demand
Time
With time, demand for a good tends to become

more elastic because:
• more substitutes become available over
time;
• given more time, consumers become more
willing to substitute / switch to other goods.
Demand
Time
Example:
Taste and preference for apple juice cannot
change immediately. Demand only becomes
more responsive to price increase when
consumers become accustomed to other
types of juices.
Usefulness of Price Elasticity
• The concept of price elasticity of demand is

closely linked to a firm’s total revenue.
• Definition of total revenue (TR):

The total number of dollars a firm earns
from the sale of a good or service, which is
equal to its price multiplied by the quantity
sold’.
Total revenue (TR):

Formula:
TR = P x Q
where P = price at which the good is sold

Q = quantity of the good sold
TR = P x Q
• Since price and quantity change in opposite

directions, what happens to TR will depend
on which variable changes more.
• How much price and quantity change in turn
depends on price elasticity of demand.
• Knowledge of PED assist the producer / firm
in deciding whether to raise or lower its price
(which affects Q and hence TR) in order to
maximise its profit (Profit = TR – TC)
• Elastic demand: TR & P are inversely related, i.e. TR

 when P  and vice- versa.
Price
P1
-TR
P2
Demand curve
+TR
Quantity demanded
Q1 Q2
• Inelastic demand: TR & P are directly

related, i.e. TR  when P  & vice-versa.
Price
P1
-TR
P2
Demand curve
+TR
Quantity demanded
Q1 Q2
• Unitary demand: TR remains unchanged no

matter whether P /.
P
P1
TR
P2 D
TR
Q
Q1 Q2
Summary:
Inelastic Unit elastic Elastic
(0 < Ed < 1) (Ed = 1) (Ed > 1)
When P  When P  When P 
%Q < %P %Q = %P %Q > %P
 TR   TR unchanged  TR 
When P  When P  When P 
%Q < %P %Q = %P %Q > %P
 TR   TR unchanged  TR 
Income Elasticity of Demand
This measures the responsiveness of

change in demand to changes in income
EY = % Change in Demand for Good

% Change in Income
= %DD / %Y
The point elasticity formula for YED
YED = %  Q =  Q/Q = Q2-Q1 x Y1

%Y  Y/Y Y2-Y1 Q1
Midpoint/arc elasticity formula for YED:
YED = Q2-Q1 x (Y1+Y2)/2

Y2-Y1 (Q1+Q2)/2
Interpretation of the Income Elasticity
Coefficient
Sign Type of Good

Positive Normal
(As Y=> DD) Necessities EY < 1 Inelastic
Luxury EY > 1 Elastic
Negative Inferior
(As Y=> DD)
Normal Goods
Income ($) Demand for Good X
100 20
120 25
140 32
Income increases from $100 to $120
YED = +25% / +20% = +1.25

YED = +28% / +16.7% = +1.67
Inferior Goods
Income ($) Demand for Good X
100 20
120 18
140 16
YED = -10% / +20% = -0.5
Importance of the Income Elasticity figure
Application of Income Elasticity
• Be able to forecast accurately changes in consumer
demand as well as develop new products to meet
changes in consumer preferences as income
changes.
• For governments, such information is important

where taxation is concerned. To tax products with
high income elasticity of demand to raise revenue.
Cross Elasticity of Demand
Measures the responsiveness of demand for
one good to changes in the price of another
good
CED = % Change in Quantity of Good A

% Change in Price of Good B
= %QA / %PB
The point elasticity formula for CED
CED = %  QA =  QA/QA = QA2-QA1 x PB1

%  PB  /PB PB2-PB1 QA1
Midpoint/arc elasticity formula for CED:
CED = QA2-QA1 x (PB2+PB1)/2

PB2-PB1 (QA1+QA2)/2
Substitute Goods
Price of Butter Demand for Margarine
$1.00 100 kg
$1.20 150 kg
If price of butter increases from $1.00 to $1.20
Cross elasticity coefficient = +50%/+20%

= +2.5
Complement Goods
Price of Butter Demand for Bread
$1.00 100 kg
$1.20 90 kg
If price of butter increases from $1.00 to $1.20
Cross elasticity coefficient = -10%/+20%

= -0.5
Interpretation of the Cross Elasticity
Coefficient
Sign of the Relationship between the 2

coefficient goods
Positive Substitutes
Negative Complements
Zero Independent
Size of the Cross Elasticity Coefficient
The size of the coefficient indicates

the closeness of the relationship of
the two goods.
Importance of the Cross Elasticity figure
Application of Cross Elasticity
• It is important to know what effect a change in

the price of its competitor’s product will have
on a firm’s sales.
• This information may be useful in the
formulation of the firm’s own pricing and
marketing strategies.
Analysis of Utility
• Consumer objective is to maximise satisfaction from

consumption under a budget constraint
• Satisfaction is known as utility
• Measure in utils
Total Utility vs Marginal Utility
• Total utility is the total satisfaction gained from

consuming various quantities of a product within a
period of time.
• Marginal utility is the change in total utility gained

from consuming one addition unit of a product.
Quantity of Total Utility Marginal
buns (utils) Utility (utils)
0 0 -
1 8 8
2 14 6
3 18 4
4 20 2
5 21 1
6 19 -2
Total utility is maximised at 5 buns, after which

total utility drops and marginal utility is negative.
Marginal Utility
Law of Diminishing marginal utility

• As total utility increases with increase in
consumption, the rise in utility is by a diminishing
amount
• Consumer derives less and less utility as
consumption of the same product increases
• Less value is attached to products that are less
scarce
• TU curve is concave,
Utils
reaches max and
eventually falls
• MU curve typically
TU Curve
TUmax downward sloping
• MU = 0 when TU is max
• MU<0 when TU falls
MU Curve
Quantity
Q1 Consumed
Optimal Consumption Rule
• How should a consumer with income Y spend on

two goods, A & B with prices PA and PB respectively?
• MUA/PA = extra utility gained from spending an

additional dollar on Good A
• MUB/PB = extra utility gained from spending an

additional dollar on Good B
• If MUA/PA > MUB/PB => Purchase more A
• If MUA/PA < MUB/PB => Purchase more B
• Optimal consumption occurs when
MUA/PA = MUB/PB
Tom who has $100 to spend on food and clothing. The
price of food is $10 per unit and the price of clothing is
$20 per unit. Tom has computed his marginal utility
for both products at various quantities as shown
below. Determine the optimal consumption bundle for
food and clothing for Tom.
Food MU for Clothing MU for
Food Clothing
1 60 1 150
2 50 2 140
3 20 3 120
4 5 4 100
Food MU for MU/P Clothing MU for MU/P
Food for Clothing for
Food Clothin
g
1 60 6 1 150 7.5
2 50 5 2 140 7
3 20 2 3 120 6
4 5 0.5 4 100 5
• Two optimal consumption bundles.

• 1 unit of food & 3 units of clothing costing $70;
• 2 units of food & 4 units of clothing costing $100. Budget
must be fully utilised => 2 units of food with 4 units of
clothing is the optimal consumption bundle.
Budget Line
• Budget line shows all the combinations of two

goods that can be purchased with a given income
based on prices of both goods.
Prawn
10
E
C
5
Budget Line
B
Fish
10 20
Budget Line
Prawn
10
E
C
5
Budget Line
B
E Fish
10 20
• Income = $100, Pprawn = $10/kg, Pfish = $5/kg
• Max fish = 20 kg (X intercept), Max prawn = 10 kg (Y
intercept)
• D => underutilisation of budget
• E => unattainable
Budget Line
Budget line as an equation:

PAQA +PBQB = Y
or
QB = Y/PB – (PA/PB)QA
where PA & PB are prices of Goods A & B, QA & QB are
quantities of Good A & B.
Y - intercept Slope
Indifference Curve
• An indifference curve shows all combinations of

two goods that provide the same utility to the
consumer
• Typically downward sloping and convex to the

origin.
Indifference Curve & Map
Good B
P1 C
IC2
IC21
D
P2 (TU = 10 utils)
IC0
F2 Good A
F1
Indifference Map
• Indifference map consists of multiple indifference

curves
• Assume ability to rank according to preferences
according to 3 rules
– More (higher utility) preferred to less;
– Ranking is consistent and curves don’t intersect
– Diminishing marginal utility and convex curves
Optimal Consumption Bundle
Good B
C
E
B*
IC2
IC1
D
IC0
Good A
A*
Budget Line – Increase in Income
• Income increase result in parallel outward shift in

income
• If both goods are normal goods, higher

consumption of both goods
• If one good is an inferior good, smaller consumption

of the inferior good and larger consumption of the
normal good
Budget Line – Increase in Income
Good B
E1
B1
E0
B0 IC1
IC0
BL0 BL1
Good A
A0 A1
Budget Line – Price Decrease
• Price decrease in one good leads to

– Substitution effect leads to increase in demand
for cheaper good
– Income effect leads to increase in demand for
normal good
Good B
Y/PB
B1 E1
B0 E0
IC1
BL0 IC0 BL1

Good A
A0 A1 Y/PA0 Y/PA1
Normal Good:
• Income & substitution effect indicate higher
quantity of Good A consumed
• Consumption of Good B can be higher, lower or
unchanged
Inferior Good:
• Substitution effect > Income effect
• Higher quantity of Good A consumed
Derivation of Demand Curve
Price of Good A
F
PA0
G Demand Curve of
PA1
Good A
Quantity of Good A
Q0 Q1 demanded
Optima consumption
Discussion Question 1
According to a study of the price elasticities of products
sold in common supermarkets, the price elasticity of
demand for toothbrushes is estimated at -0.22. Which of
the following could most suitably explain why the price
elasticity of demand for toothbrushes is so low?
A. Toothbrushes are heavily endorsed by dentists.

B. The toothbrush industry is highly competitive.
C. There are few close substitutes for toothbrushes.
D. Toothbrushes are relatively cheap compared to other
goods sold in the supermarkets.
Which of the following group of people are likely to have
the highest price elasticity of demand for travel via the
Mass Rapid Transit (MRT)?
A. Retirees who use it to travel to meet their friends for

coffee.
B. Workers who can only reach their workplace via MRT.
C. Business executives who work in the city central where
car parking charges are very high.
D. High income earners.
If a 4% decrease in price leads to an increase in
the quantity demanded of 8%:
A. Supply is price elastic.

B. Demand is income elastic.
C. Price elasticity of demand is -2.
D. Demand is price inelastic.
The demand for Nike running shoes is more price
elastic than the demand for running shoes as a
whole. This is best explained by:
A. Nike running shoes are a luxury and not a necessity.
B. Nike running shoes are the best made.
C. There are more complements for Nike running shoes
than running shoes in general.
D. There are more substitutes for Nike running shoes
than running shoes in general.
Air-conditioners and electricity are complementary
goods and have a cross elasticity demand of -2.5. If the
government wants to reduce electricity consumption by
5%, it should place a tax on air-conditioners such that
the unit price of air-conditioners:
A. rise from $1000 to $1,200

B. rise from $1000 to $1,020
C. fall from $1,020 to $1,000
D. fall from $1,200 to $1,000
Discussion Question 6(a)
Suppose the demand schedule for soft toys is
as follows:
Quantity
Price
Demanded
$8 40
$10 32
$12 24
Use the point method to calculate the price

elasticity of demand for soft toys as the price
of soft toys increases from $8 to $10.
Discussion Question 6(b)
The seller of Good X feels that the number of units sold
for Good X is somehow affected by the price of Good Y.
By experimenting with the price, he realises that when
price of Good Y is $50, he can sell 12,000 units of Good
X. However, when the price of Good Y becomes $60, he
can now sell 10,000 units of Good X. Calculate the cross
elasticity of demand between Good X and Y. Analyse
the effect on the seller’s revenue when price of Good Y
falls.
You are given the following information for two goods Alpha and
Omega
Good Percentage Change in:
Price Quantity Income
Alpha 1.2 -3.3 2.2
Omega -2.1 1.82 4.68
i. Calculate the price elasticity of demand for Good Alpha and

comment on your result.
ii. Calculate the cross elasticity of demand between Good Alpha
with respect to Good Omega and comment on your result.
iii. Calculate the income elasticity of demand for Good Omega and
comment on your result.
Thank you

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ECO0006

Economics for Managers

© 2022 Singapore Institute of Management Group Limited

1. Calculate various elasticity of demand

2. Comprehend the implications of demand elasticity

3. Comprehend the concept of marginal utility

4. Explain the use of indifference analysis

A measure of the sensitivity or responsiveness of

3 types of demand elasticities:

A measure of the responsiveness of a

Price elasticity of demand looks at a

PED = %  Q =  Q/Q = Q2-Q1 x P1

Midpoint/arc elasticity formula:

PED = Q2-Q1 x (P1+P2)/2

The coefficients of price elasticity of

Elasticity is always measured

Elastic Demand (PED> 1)

Inelastic Demand (PED < 1)

Perfectly Inelastic Demand (EP =0)

• The more & closer the substitutes, the more

• The good is likely to be rather cheap.

• However, demand for a good that takes up a

• The good is likely to be expensive.

With time, demand for a good tends to become

• The concept of price elasticity of demand is

• Definition of total revenue (TR):

Total revenue (TR):

where P = price at which the good is sold

• Since price and quantity change in opposite

• Elastic demand: TR & P are inversely related, i.e. TR

• Inelastic demand: TR & P are directly

• Unitary demand: TR remains unchanged no

This measures the responsiveness of

EY = % Change in Demand for Good

YED = %  Q =  Q/Q = Q2-Q1 x Y1

Midpoint/arc elasticity formula for YED:

YED = Q2-Q1 x (Y1+Y2)/2

Sign Type of Good

Income increases from $120 to $140

• For governments, such information is important

CED = % Change in Quantity of Good A

CED = %  QA =  QA/QA = QA2-QA1 x PB1

Midpoint/arc elasticity formula for CED:

CED = QA2-QA1 x (PB2+PB1)/2

If price of butter increases from $1.00 to $1.20

Cross elasticity coefficient = +50%/+20%

Cross elasticity coefficient = -10%/+20%

Sign of the Relationship between the 2

The size of the coefficient indicates

Application of Cross Elasticity

• It is important to know what effect a change in

• Consumer objective is to maximise satisfaction from

• Satisfaction is known as utility

• Total utility is the total satisfaction gained from

• Marginal utility is the change in total utility gained

Total utility is maximised at 5 buns, after which

Law of Diminishing marginal utility

• How should a consumer with income Y spend on

• MUA/PA = extra utility gained from spending an

• MUB/PB = extra utility gained from spending an

• If MUA/PA > MUB/PB => Purchase more A

• If MUA/PA < MUB/PB => Purchase more B

• Optimal consumption occurs when

• Two optimal consumption bundles.