BA 120

Basic
Microeconomics
Chapter 3
Elasticity of Demand and Supply

Learning Checklist:
At the end of this chapter, the student is expected to:
 Understand the concept of elasticity of demand and supply;
 Differentiate arc and point elasticity;
 Compute elasticity values of demand and supply with given changes in price
and quantity;
 Distinguish the different degrees of elasticity of demand and supply;
 Apply the concept of elasticity to various economic situation; and
 Recognize the value of elasticity in relation to a seller’s revenue.

Terms to Remember
 Arc elasticity – the coefficient of price elasticity of demand between two
points along the demand curve
 Coefficient of elasticity – absolute value of elasticity
 Complementary goods – goods that supplement each other and are used
together
 Cross elasticity of demand – measures the percentage change in quantity
demanded of one good compared with the percentage change in the price of
a related good.
 Elasticity – the responsiveness of demand/supply to a change in its
determinant
 Engel curve – a curve depicting the quantities of a good the consumer is
willing to buy at all income levels, assuming all other things remain the same
 Income elasticity of demand – measures the percentage change in quantity
demanded compared with the percentage change in income.
 Inferior goods – goods which are brought when income levels are low, the
demand for which tends to decrease when income increases
 Normal goods – goods for which demand tends to increase when income
increases
 Price elasticity – the percentage change in quantity compared with a
percentage change in price.
 Point elasticity - the coefficient of price elasticity of demand at one point
along the demand curve
 Prestige goods – goods bought for the status and prestige they give to the
consumer and are bought when the prices are high
 Substitute goods – goods used in place of another
 Total revenue – the price of an item multiplied by the number of units of that
item sold
Introduction
The concept of elasticity of demand and supply lies at the very heart of economics,
serving as a fundamental building block for understanding how markets function.
These two interconnected concepts play a pivotal role in determining how
consumers and producers respond to changes in prices and other external factors,
ultimately shaping the dynamics of supply and demand in a given market. In this
report, we delve into the intricacies of elasticity of demand and supply, exploring their
definitions, types, measurement methods, and real-world implications. By gaining a
deeper understanding of these economic concepts, we aim to shed light on how they
influence decision-making processes for businesses, governments, and individuals
alike, and how they underpin the allocation of resources in our ever-evolving
economic landscape. As we embark on this journey, we will uncover the critical role
elasticity plays in driving market behavior, policy formulation, and strategic decision-
making, making it an indispensable tool for economists and stakeholders in the world
of commerce and policy.

Abstraction
This report presents a comprehensive exploration of the vital economic concepts of
demand and supply elasticity. Elasticity is a fundamental pillar of economics, offering
insights into how consumers and producers react to changing market conditions.
This study encompasses an array of topics, including the definition and types of
elasticity, methods of measurement, and practical applications. The analysis extends
to the implications of elasticity for business strategies, government policies, and
individual decision-making. By delving into the intricacies of these concepts, this
report aims to provide a profound understanding of how they shape market
dynamics and resource allocation. Elasticity is a critical tool that guides economic
choices and policies, making it indispensable for economists, businesses, and
policymakers in navigating the complexities of our dynamic economic landscape.

Elasticty of Demand
The elasticity of demand, or demand elasticity, measures how demand responds to a
change in price or income. It is commonly reffered to as price elasticity of demand
because the price of a good or service is the most common economic factor used to
measure it.
 Q−Q P−P
% ∆ QD= % ∆ P=
Q+Q P+ P
2 2
 What is Price Elasticity of Demand?
Price elasticity of demand is the degree of responsiveness of quantity demanded to
a change in price. It is measured by dividing the percentage change in quantity
demanded by the percentage change and
price.

What is Price Elasticity?

Price elasticity is the percentage change in quantity compared with a percentage
change in price.
2 Kinds of Measures of Price Elasticity
1. Arc Elasticity – the coefficient of price elasticity of demand between two
points along the demand curve.
 Letting ∆ Q represent a change in quantity demanded and ∆ P a
change in price, arc elasticity is given as:

 The coefficient is preceded by a negative sign

because of the inverse relationship between quantity demand
and price.
 In determining the degree of responsiveness of demand to a
change in price, the negative sign is set aside and only the
absolute value of the coefficient is considered.

2. Point Elasticity – the coefficient of price elasticity of demand at one point

along the demand curve.
 the measurement of point elasticity is more exact than that of
arc elasticity.
  It is the property where a change in the price of a good or
service will impact the products demand.

Commodities and Their Elasticities

Price elasticity of demand (PED) varies across different commodities based on
factors such as necessity, availability of substitutes, and consumer preferences. The
more essential a good is to the consumer, the more inelastic will be the demand for
the good. The less of a necessity a good is the more elastic is the demand for it.
Here are some examples of commodities and their typical price elasticities of
demand.

Original Price: P6 Original Original

These are the goods that
Qd:2,000 TR: P12,000
have elasticities which
are less than one:
Infant milk Salt
Electricity Rice
Medicine Sugar

These are the goods that have elasticities which are greater than one:
Signature bags Perfumes
Chocolates High-end furniture
Imported shoes

On the other hand, an increase in price will benefit the user if demand is inelastic
because it will cause an increase in his total revenue. For example:
The increase in price has resulted in a significant decrease in demand, consequently
causing the total revenue to decrease.
A decrease in price may ultimately benefit the seller if demand is elastic. For
example:

Original Price: P6 Original Original

Qd:2,000 TR: P12,000

Original Price: P6 Original Original

Qd:2,000 TR: P12,000
However, if demand is unitary elastic neither an increase nor a decrease in price will
affect the seller’s total revenue as can be seen in the example in the next rows. For
example:
Original Price: P4 Original Original Example A
Qd:5,000 TR: P20,000

Original Price: P4 Original Original Example B

Qd:5,000 TR: P20,000
 Substitution and Price Elasticity of Demand
The degree of substitution between a product and related products determines its
price elasticity of demand. The extent of substitution depends on the substitution
effect.
Factors of Substitution
1. Number of competing products.
 More competing products means more market shares for a product to
gain or lose when its price decreases or increases, respectively.
 A seller invites more demand when he under - prices more rivals in a
market where products are homogeneous in type and quality.
 This kind of competition is evident among adjacent retail outlets for the
same products brands of more or less the same size like
supermarkets, department stores, bookstores, and the like. In these
examples, demand is said to be price elastic.
2. Desirability of a product relative to its
substituents due to quality.

In figure 18, the consumption of Product B

decreases from Q3 to Q1 when its price
increases partly because of substitution effect. If
Product B were better, the new indifference
curve from reference point A would be the
steeper one where less of Product B can be given up for an additional unit of
Product A. As a result; consumption of Product B does not decrease all the way to
Q1 but only up to Q2. This is inasmuch as less of Product B would be given up to
match the additional consumption and utility of Product A in the substitution if t were
better and more satisfying. Thus, it would be difficult for a product to lose its market
share when its price increases if quality were its primary selling point.
3. The relative importance of consumers’ needs.
 It determines the degree of substitution between the commodity items
in the consumption basket, e.g., essentials and nonessentials. Going
back to figure 18, the steeper indifference curve in broken lines would
represent more preference for Product B if it were more important
relative to Product A. Likewise, the consumption of Product B would
 only decrease from Q3 to Q2 if its price increases since the more
satisfying Product B would be given up to match more consumption of
Product A in the substitution. Thus, consumers try to maintain their
consumption of rice despite higher prices by paying more of it.

A decrease in price would increase earnings if demand were price elastic enough to
stretch quantity demanded and revenue in order to offset the increase in cost with
more quantity produced. Likewise, an increase in price due to higher production cost
or cost of business would increase earnings if demand were price inelastic enough
to stretch price and revenue in order to offset the said increase in cost. The price
inelasticity of demand to maximize revenue and earnings is also true even without a
change in cost.
Increasing quantity demanded, without changing price highlights the effect of
decreasing price and increasing quantity demanded with a very elastic demand on
revenue and earnings. Conversely, increasing price without changing quantity
demanded highlights the effect of increasing price and decreasing quantity
demanded with a very inelastic demand on revenue and earnings.
Price increase Price decrease
Elastic Decrease Increase
Inelastic Increase Decrease

Thus, revenue increases as price decreases when the increase in quantity

demanded offsets the decrease in price with an elasticity coefficient of more than
one (elastic). The opposite is true when price increases with an inelastic demand.
To emphasize the point, a seller can increase earnings with a decrease in price if the
product were substitutable enough to pull considerable demand from rival products
to maximize elasticity and earnings. An example is when retailers of the same rice
variety underprice one another in the public market for bigger market shares. On the
other hand, a seller can increase earnings with an increase in price if the product
were exclusive enough to be sold even at a higher price to maximize earnings. An
example is the only grocery in a subdivision, which can increase prices without
suffering a decrease in sales volume in the absence of competitors in the area.
Thus, a change in price and quantity demanded can increase revenue and earnings
depending on the substitutionality of the product.
A decrease in price would increase earnings if demand were price elastic enough to
stretch quantity demanded and revenue in order to offset the increase in cost with
more quantity produced. Likewise, an increase in price due to higher production cost
or cost of business would increase earnings if demand were price inelastic enough
to stretch price and revenue in order to offset the said increase in cost. The price
inelasticity of demand to maximize revenue and earnings is also true even without a
change in cost.
 The Tax Burden
When a good is sold, a sale stocks has to be paid to the government on the sale of
that commodity. The question on who between the buyer and the seller shoulders
the burden in dependent mostly on the degree of elasticity of the demand for that
good.
Let us take a bottle of soft drink which the government levies a 100% sales tax as an
example. If the price per bottle is P5.00, the tax consumer has to pay P10.00 on
account of the tax. However, the consumer does not always have to shoulder the
entire tax burden by himself. Let us look at
the following graph in Figure 19 and study
the demand and supply curves of a cola
drink.
The demand and supply curves for the cola
drink are normal sloping curves. On the left
side of S1 is another curve S2, which
represents the supply plus tax curve, showing
various after-tax prices that have to be paid
by the consumers. Before the government
imposes the tax, the market equilibrium is
attained at P7.50 at an equilibrium quantity
of 250 bottles. We can see in figure 19 that
the tax of P5 was shared equally between
the buyer and the seller with an equal tax
share of P2.50.
Let us now take a case when consumers
feel that cola drink is not a necessity, and
they can easily forego its consumption if
the price gets too high because of a tax burden. In the net graph, we have a demand
curve that is highly elastic.
In figure 20, the original equilibrium position is at a price of P8 and a quantity of 400
bottles. With the new supply plus tax curve (S + t) in the graph, a new equilibrium
position is attained at the price of P10 and a quantity of 300. The difference between
the old price of P8 and the new price of P10 represents the consumer’s share in the
tax, which is P2. The remaining P3 of the tax
should be shouldered by the seller. The
reason why the seller has to shoulder a bigger
tax burden in this example is that the demand
for the good is highly elastic, as reflected in
the highly slanting demand curve in figure 20.
Should the price prove to be too high for the
buyer as a result of the tax, he can afford to
decrease his consumption of the good, which
he considers to be non-essential.

However, it is also possible for a buyer to shoulder a bigger portion of the tax
burden. This happens when the buyer cannot do away with the consumption of a
good and thus considers it essential. Therefore, in spite of a tax levy that could jack
up the price of the good, he would still be willing to buy it and the producer can afford
to pass on a bigger portion of the tax to the buyer. This will now be illustrated in the
next graph.

In figure 21, we see a relatively inelastic demand curve for the cola drink. From the
original equilibrium price of P7, the buyer now pays the price of P10 with the P3
difference representing his share in the tax. Here the buyer shoulders a bigger share
in the P5 tax (with only P2 shouldered by the seller) since he is unwilling to do away
with the consumption of the good despite the tax, and is thus willing to pay a higher
price for the commodity.
 Income Elasticity of Demand
Income elasticity of demand measures the percentage change in quantity demanded
compared with the percentage change in income.
The coefficient of income elasticity of demand measures a product’s percentage
change in demand as a ratio of the percentage change in income, which caused the
shift in the demand curve.

Where ∆ D represents the change in demand and ∆ Y

the change in income.
The absolute value of coefficient of income elasticity is also a measure of how
responsive demand is to change in income.
As income increases, a coefficient of:
¿1 means demand is elastic and the good is superior;
¿ 1 means demand is inelastic and the good is inferior; and
¿ 1 means demand is unitary and the good is normal.
Ernest Engel made a study of income elasticity for food. The findings of his study are
depicted in what is now accepted as Engel’s law. According to Engel, when income
increases, the percentage that is spent for food tends to decrease. The resulting
coefficient is less than one because food is a necessity. When income increases, the
increase goes mostly to the purchased of luxury items, education, travel, and leisure.
If elasticity is equal to 1, the share of the product in the allocation of incremental or
additional income is equal to its share in the allocation of total income, thus
maintaining the product’s importance in the overall consumption basket.
Table 5
Analysis of Income Elasticity
Income Elasticity Degree of demand Type of good
2 Elastic Normal luxury
1.5 Elastic Normal luxury
.75 Inelastic Normal necessity
.50 inelastic Normal necessity
.30 Inelastic Inferior
 .22 inelasti Inferio
c r

To express in quantitative
terms:

However, elasticity greater than 1 means that the

product gains importance in the allocation of incremental income and, therefore, in
the allocation of total income as the following relationship illustrates:

Conversely, some products lose importance because others do otherwise as income

increases. A product of such nature is inferior as its elasticity is less than 1 and its
share in the allocation of incremental and therefore diminishes in the allocation of
total income.
 The Consumption Line

Figure 22 presents a hierarchy of budget lines and indifference curves which

determines different levels of consumption
through the points of tangency between the
two factors. The curve connecting these points
of tangency represents the consumption of the
two commodities (meat and dried fish) at
varying levels of income, otherwise known as
the consumption line.
The consumption line is upward sloping from
the point of origin of the graph. The increase in
meat production (Y-axis) accelerates for every
unit increase
in the consumption of dried fish (X-axis) implying
that:

Therefore, meat is superior as its elasticity is more than 1: whereas, dried fish is
inferior with its elasticity of less than 1. Moreover, meat gains importance in the
consumption basket as a substitute for dried fish as income increases.
It should already be clear at this point that as income increases, some products gain
importance (superior goods) while some do otherwise (inferior goods) in the
consumption basket. Moreover, superior goods will eventually become inferior as
income continues to increase to give way to new superior goods.
There are two underlying reasons for the change in the relative importance of
commodity items as income continues to increase.
1. The gradual satisfaction of the consumer’s hierarchy of needs from the
basic to the non-basic. Thus, a consumer shifts the emphasis of
consumption toward shelter at a certain level of income satisfying, up to some
degree, the need for clothing and good. This makes shelter a superior good
 and others as inferior goods at the said level of income. On the other hand, a
smaller budget can constrain a consumer from consuming goods of better
quality due to higher prices and the consumption of which is only possible at a
higher level of income. Thus, those who belong to the higher income groups
can afford to buy imported shoes and clothing, making these products
superior over their local counterparts in their expenditure basket.
2. The theory of diminishing marginal utility that is the cornerstone of the
concept of income elasticity of demand. The shift in consumption from inferior
goods to superior goods as income increases implies that the marginal utility
of the latter is greater than that of the former. Marginal spending shifts to
those commodity items with higher marginal utilities due to their relative
scarcity, thus making them superior as substitutes for inferior goods.
However, these commodity items will eventually lose their superiority as
income continues to increase due to the theory of diminishing marginal utility
and their individual elasticity will decrease at most to zero. This is the point of
maximum satisfaction and incremental spending shifts instead to the
consumption of new and relatively scarce goods.
 Cross Elasticity of Demand
Cross elasticity of demand measures the percentage change in quantity demanded
of one good compared with the percentage change in the price of a related good.
The coefficient of cross elasticity of demand measures the percentage change in the
demand of Good X which is a shift of the demand curve in response to a percentage
change in the price of Good Y, thus:
ec may also have a coefficient of greater than one,
less than one, or equal to one, indicating demand
sensitivity.

Goods X and Y may be related in two ways: first as substitutes; and second as
complements.
If the coefficient ec is positive, this means commodities X and Y are substitutes. An
increase in Py will cause consumers to purchase more of Good X, the substitute
good, thus causing Qx to increase.
On the other hand, if ec is negative, Goods X and Y are complements and are thus
used together. If the price of Y increases, the demand for Y decreases, and hence
the demand for X also decreases. Thus, the coefficient of the cross elasticity of
demand practically measures the degree of substitution or complementation
between products.

Table 6
Numeral Example on How to Solve for Elasticity Demand

Income Original New

Elasticity Price Price
Quantity Quantity
Demand for
Good X 5 3
Good Y 0 0
10 15
 100 60

Let us use the following examples to solve for the elasticity of demand for
Good X with respect to the price of Good Y.

Solving for ec, we get:

The negative sign of the coefficient means Goods X and Y complement each other.
Moreover, the demand for Good X is inelastic to the change in the price of Good Y
because the value of the coefficient is less than 1.
 Demand Curves and Elasticity

As a result of the different degrees of elasticity, there are different ways of presenting
the demand curve.

d1 is relatively elastic. A change in d2 is relatively inelastic. A change in

price leads to a significant change in price leads to a very slight change in
quantity demanded. quantity demanded.

d3 is perfectly elastic. At a given price, d4 is perfectly inelastic. At any price,

quantity demanded can change the quantity deanded will remain the
infinitely. same. Qd is equal to zero.
 Price Elasticity of Supply

If demand varies in response to a change in its determinants, so does the supply.

The coefficient of price elasticity of supply measures the percentage change in the
quantity supplied of a commodity compared with a percentage change in the price of
such a commodity.

The difficulty or ease of increasing or decreasing the supply of goods determines its
elasticity. Goods which are relatively easy to manufacture tend to have elastic
supplies; whereas goods which are difficult to produce have inelastic supplies. Just
as in the
demand
curve,
the
supply
curve is
elastic if
ES  1;
inelastic
if ES  1; and unitary elastic if ES  1. Normally, the coefficient of ES is positive,
because of the direct relationship between price and quantity supplied.

S1 is relatively elastic. A change in S2 is relatively inelastic. A change in

price results in a significant change in price results in a slight change in
quantity supplied. quantity supplied.
S3 is perfectly inelastic. At a given
price, quantity supplied may change
infinitely.

S4 is perfectly elastic. At a given price,

quantity supplied remains constant (or
Qs is equal to zero.
 Projecting the Future

Important decisions about what and how many goods to produce depend very much on
the entrepreneur’s estimate of future demand. If the entrepreneur produces much more
than what is demanded, he would have an inventory in his hand. If this inventory is
much more than what is necessary, it becomes an additional cost in the form of money
tied up with too much inventory, in addition to storage and spoilage costs. However, if
the entrepreneur produces much less than what is demanded, he would be missing out
on what could have been additional profits earned. Thus, it is very important that the
entrepreneur knows forecasting techniques.

There are different methods of making a forecast. Let us use two methods.

1. Average Arithmetical Growth Rate Method

 The computation of this method is carried out by getting the percentage
change between two values which is simply the ratio of the change
between two years
expressed in percentage
from. The average growth
rate is then computed by
getting the sum of the
percentage changes
divided by the number of
period covered. Let us try
this method by looking at
historical sales figures
shown in the following
table:
 175.67
Average Growth Rate 
8

 21.96%
Projected Values
2005: P52.7 x 21.96%  11.57
+ 52.70
P64.27M

2006: P64.27 x 21.96%  14.11

+ 64.27
P78.38M

2. Trend Line Using the Least Squares Regression Method

 This method uses statistical tools and is the most commonly used method
of computing long-term trend of a time series. The least squares
regression method, as the name implies, fits a trend line to the date in a
manner such that the sum of squared deviations of actual data from
estimated or trend data at a minimum. On these grounds, the resulting
trend line can be characterized as a “line of best fit” since the sum of the
square deviations is at a minimum. The trend values thus best
approximate the actual values.
 The equation for the straight line trend is Yt  a + bx where X is the
independent variable. Since their values must be determined for each of
the series analyzed, a and b are referred to as unknowns. They are also
called constants because once their values are determined, they do not
change.
Let us illustrate this method by using the same data in Table 7. Our straight line trend
equation is:

Going back to the aforementioned equation, we can now substitute our values based on
the table, thus:
Y1  a + b x
Our trend equation is:
Yt  30.29 + 1.30X

We can now compute our forecasts for 2005

and 2006. Since the last year (2004), in the
table 8 is given an X value of 4, the X values for
2005 and 2006 should be 5 and 6, respectively.
Our forecasts for 2005 and 2006 would then be

completed, thus:
After all these computations, we can graph our actual sales, the trend line, and the
projections in the following figure
 Summary
 Price elasticity of demand – is the degree of responsiveness of quantity
demanded to a change in price. It is measured by dividing the percentage
change in quantity demanded by the percentage change in price.
 Two measures of Price Elasticity
1. Arc elasticity – is the coefficient of the price elasticity of demand between
two points along the demand curve.
2. Point elasticity – is the elasticity at one point along the demand curve.

Elastic Inelastic Unitary

Percentage change in
quantity is higher than the
percentage change in price.
Elastic coefficient is more
than 1.
Percentage change in Quantity is proportionate
quantity is lesser than with change in price.
change in price.
Elastic coefficient is less Elastic coefficient is equal
than 1. to 1.

 Substitution has 3 factors:

1. The number of competing products;
2. Desirability of a product relative to its substitutes due to quality; and
3. Relative importance of consumer’s needs.
 Consumption line – is the curve connecting the points of tangency that
represent the consumption of any two given commodities at varying levels of
income.
 Income elasticity of demand – measures a product’s percentage change in
demand as ratio of the percentage change in income, which causes the shift in
the demand curve.
 Engels law – states that when income increases, the percentage that is spent for
food tends to decrease.
 Underlying reasons for the change in the relative importance of the commodity
items as income continues to increase:
 1. Gradual satisfaction of the consumer’s hierarchy of needs from the
basic to the non-basic; and
2. Theory of diminishing marginal utility.
 Two Methods in Making a Forecast
1. Average arithmetical growth rate method; and
2. Trend line using the least squares regression method.
DAVAO ORIENTAL STATE UNIVERSITY
SAN ISIDRO EXTENSION CAMPUS (SIEC)
BATO-BATO, SAN ISIDRO, DAVAO ORIENTAL
“A University of excellence, innovation and inclusion”

THEORY OF

CONSUMPTION

Theory of Consumption

The theory of consumption, in economics, it explores how individuals and

households make choices regarding their spending on goods and services. It seeks to
understand the factors influencing these choices and the patterns of consumer behavior.
One fundamental concept in this theory is the idea that consumers allocate their income
to maximize their utility or satisfaction, considering factors like their preferences, income
levels, prices of goods, and future expectations. The theory of consumption plays a
crucial role in analyzing economic trends and policy implications related to consumer
spending.

Terms to Remember
•Budget line - contains infinite points of combinations of commodity items that the same
budget can buy at given price.
•Convergence - often referred to as “catch-up effect” in economics.
•Income effect - potential increase in the consumption of two commodities.
•Indifference curve-a useful tool for analyzing consumption behavior on utility theory.
•Isocost line – shows all combinations of inputs, which cost the same total amount.
•Marginal rate of substitution (MRS)-rate at which a consumer is ready to give up one
good in exchange for another good while maintaining the same level of utility.
•Marginal utility (MU) - additional satisfaction derived from consumption of additional
goods and services; also defined as the utility or dissatisfaction from the last unit of
consumption.
•Maslow’s Theory of Motivation – diagram that why people are driven by needs at
particular times.
•Optimum combination – implies that consumer can increase the level of satisfaction,
despite a fixed income, by a altering the consumption mix.
•Paradox value – discusses why absolute necessities in life (for example: water) are
cheaper as compared to luxuries in life (for example: diamonds)
•Reference groups-groups that have a direct or indirect influence on person’s attitudes
or behaviors.
•Substitution effect – an idea that when price increases or income decreases,
consumers will replace expensive items with cheaper alternatives.
•Total utility (TU) – total amount of satisfaction derived from consuming foods and
services>
•Utility – satisfaction derived from the consumption of a commodity
UTILITY AND BEHAVIORAL FACTORS
Utility is the satisfaction gained from consuming a commodity, influencing
consumption and demand behavior. It is shaped by cultural, social, personal, and
psychological factors.

Figure 24: MODEL OF FACTORS INFLUENCING BEHAVIOR

In Figure 24, it illustrates how cultural, social, personal, and psychological factors
shape utility and consumption behavior. Various combinations of these factors lead to
different consumption patterns, influenced by elements like cultural differences and
psychological needs based on Maslow’s Hierarchy.

Cultural Factors
Cultural factors play a profound role in shaping consumer behavior as they
significantly impact a person’s wants and actions. Unlike instinct-driven lower creatures,
human behavior is primarily learned through socialization within society, including family
and key institutions. For example, music preferences like Bach, Mozart, or Justin Bieber
can vary widely based on cultural exposure. Even everyday items like toilet paper can
be commonplace in urban areas but rare in mountainous regions.

Social Factors
Social factors significantly shape consumer behavior. Reference groups,
including peers, influence choices; teenagers might follow trends, while mature
individuals prioritize durability. Family plays a crucial role; parents pass down values and
aspirations. Husband-wife involvement varies by product category. A person’s role and
status within groups also impact choices, such as clothing reflecting societal esteem.
For example, a company president might drive a luxury car and dine at upscale
restaurants to align with their status.

Personal Factors
Personal factors significantly impact a buyer’s decisions. These include age, life
cycle, occupation, economic situation, lifestyle, personality, and selfconcept. Occupation
shapes preferences: a company president buys luxury items, while a blue-collar worker
prioritizes practical purchases. Lifestyle and economic circumstances influence choices;
traditionalists opt for familiar items, while sports enthusiasts seek different products.

Psychological Factors
Psychological factors significantly impact purchasing decisions. Abraham
Maslow’s Hierarchy of Needs theory explains that people prioritize needs, satisfying the
most crucial ones first. Motivation drives action, influenced by perception and learning.
Perception involves selecting, organizing, and interpreting information, while learning
leads to behavioral changes based on experiences. Beliefs and attitudes, shaped by
perception and learning, play a crucial role in buying behavior. Ultimately, a consumer
chooses a product if they perceive it as offering the best value or utility within their
budget, aligning with their beliefs and attitudes.

Figure 25: Maslow’s Hierarchy of Needs

The Utility Function

A utility function is a concept used in economics and decision theory to represent

an individual’s preferences or satisfaction from consuming goods and services. It is a
way to quantify how much an individual values different outcomes or choices.

The utility function assigns a numerical value to each possible outcome or set of
outcomes. It does not necessarily measure in absolute terms but rather in terms of
preferences and relative satisfaction. It helps in decision-making by allowing
comparisons between different choices.
For instance, suppose you are deciding between buying a new phone or going on a
vacation. Your utility function could assign values to each option based on your
preferences and satisfaction you would derive from each choice.
If you value communication and technology highly, the phone might have a higher
utility value for you. However, if relaxation and travel are more important, the vacation
might yield higher utility.
The concept is essential in understanding how individuals make choices and how
these choices can change based on personal preferences and circumstances.
Economists and decision-makers often use utility functions to model and predict
behavior in various scenarios, especially in the realm of consumer choice, investment
decisions, and more.

Table 9
Utility Schedule

• When no units consumed (Quantity = 0), total utility is zero as no satisfaction is

derived.

• As consumption increases, total utility rises, but the rate of increase gradually
diminishes.
• Marginal utility decreases as more units are consumed. At first, each new unit
adds a relatively high amount to totality (e.g., the jump from to 1 unit yields to 10
units of utility), but as consumption grows, the additional utility from each unit
decreases.

Understanding these relationships through a utility schedule helps economists

and individuals analyze consumer behavior, make decisions regarding resource
allocation, and comprehend how preferences change with varying levels of
consumption.

Figure 26: THE UTILITY CURVES

 • The horizontal axis represents the quantity of the good or service consumed.
• The vertical axis represents utility (measured in arbitrary units)
• The total utility curves slope upwards but at a decreasing rate, showing how total
satisfaction increases with more consumption but at a diminishing pace.
• The marginal utility curves slope downwards, depicting the declining additional
satisfaction gained from consuming each extra unit.

Understanding these curves helps explain economic concepts like the law of
diminishing marginal utility, which states that as a person consumes more units of a
good, the additional satisfaction from each units tends to decrease. This information is
crucial in determining consumer behavior and preferences in economics.

Law of Diminishing Marginal Utility in Calvin’ mind:

In Calvin’s universe, the law of diminishing marginal utility could be understood

as the principle that the more he engages in a particular activity, the less enjoyment or
satisfaction he derives from it. For instance, the first time he explores a new adventure,
it is exhilarating and thrilling. However, with each subsequent attempt, the novelty wears
off, and the excitement gradually diminishes. Calvin might find himself constantly
seeking new and more outlandish experiences because, in his mind, the diminishing
returns mean that the initial joy of any escapade fades over time, pushing him to chase
after the next big adventure.

CONSUMPTION

The Indifference Curve

An indifference curve is a graphical representation showing combinations of two

goods that provide a consumer with equal satisfaction or utility. Each curve represents
different levels of satisfaction, with higher curves indicating higher utility. These curves
are downward sloping, suggesting that as the quantity of one good increases, the
quantity of the other good must decrease to maintain the same level of satisfaction.
Indifference curves never intersect, as they imply that each point on a curve provides
the same level of satisfaction, and a curve closer to the origin represents lower
satisfaction compared to a curve farther from it. Indifference curves help illustrate
consumer preferences and are a fundamental concept in understanding consumer
choice and decision-making.

Table 10
Indifference Schedule
 Figure 27: Indifference Curve

The Law of Diminishing Marginal Utility and the Shape of the Curve

The Law of Diminishing Marginal Utility asserts that as an individual consumes

more of a specific good or service, the additional satisfaction or utility gained from each
extra unit decreases. This principle implies that the more you possess of something, the
less each new unit adds to your overall happiness or satisfaction. The curve illustrating
this concept is typically downward-sloping, signifying that to maintain a constant level of
total satisfaction, a consumer must give up increasing amounts of one good to obtain
additional units of another. The curve's convex shape demonstrates that as consumption
increases, the willingness to exchange one good for another diminishes at a decreasing
rate, reflecting the declining marginal utility of each successive unit. Essentially, it
visualizes the trade-offs consumers make between goods as they aim to maximize their
overall satisfaction.

Hierarchy of Indifference Curve

The hierarchy of indifference curves represents various levels of satisfaction or

utility for a consumer. Each curve represents a higher level of satisfaction than the one
before it, with curves farther from the origin indicating greater utility. These curves never
intersect, illustrating that each point on a curve provides the same level of satisfaction,
and higher curves imply greater satisfaction. A consumer prefers points on higher
indifference curves as they represent combinations of goods that yield higher utility. The
downward-sloping nature of these curves showcases the trade-offs consumers are
willing to make between goods to maintain their preferred level of satisfaction.

The Budget Line and the Optimum Combination

The budget line represents the combinations of two goods that a consumer can
afford given their income and the prices of the goods. It shows the maximum quantities
of one good that can be obtained in exchange for a certain quantity of the other, given
the budget constraint. The point where the budget line intersects with the highest
possible indifference curve represents the optimum combination of goods. At this point,
the consumer maximizes utility by allocating their entire budget while reaching the
highest possible satisfaction level based on their preferences and the prices of the
goods. Any point beyond the budget line is unaffordable, while points below it indicate
that the consumer isn’t fully utilizing their budget to achieve the highest satisfaction level
possible.
The Budget Line

The budget line illustrates the various combinations of two goods a consumer can
purchase given a fixed income and the prices of the goods. It's a
boundary that separates affordable and unaffordable combinations. The slope of
the line is determined by the relative prices of the goods, reflecting the rate at which one
good can be exchanged for another. Changes in income or prices can shift or rotate the
budget line. The points on or inside the line represent affordable combinations, while
points beyond the line are unattainable with the given income.

The Optimum Combination

The optimum combination represents the point where a consumer achieves the highest
possible satisfaction or utility given their budget constraint and preferences. It occurs at
the intersection of the highest attainable indifference curve and the budget line. At this
point, the consumer allocates their entire budget to purchase a combination of goods
that maximizes their satisfaction, considering the prices of the goods and their
preferences. Any deviation from this point would either leave the consumer unable to
afford that combination or not fully utilize their budget, resulting in a lower level of
satisfaction. Achieving the optimum combination involves balancing preferences,
available budget, and the prices of goods to maximize overall utility.

DYNAMICS

The world is not static and so is consumption which can change due to the consumer or
the goods themselves. Prices can change to make goods relatively cheap or costly.
Figure 31 shows that the budget line B2 is relatively steep as the same budget can now
buy more of cheaper food, but less of more costly clothing (higher marginal rate of
substitution or MRS) from the initial consumption mix at point A along budget line B1.
The consumer then adjusts to point B to maximize satisfaction by buying what is
cheaper in exchange for what is more costly. Originally consuming less food and more
clothing at point A I1 now beyond the budget B2. The consumer is worse off as the
same budget can only buy less of more costly clothes if only to maintain the food
consumption at point A. Relative reference can also change the consumption mix as
figure 32 illustrates indifference curve I2 is now steep relative to I1, as the consumer
shifts preferences from food to clothing. The foregoing shows that a consumer can
attain a combination in consumption that yields the highest level of satisfaction possible
from a given or fixed income, assuming market prices are constant buy what spending
process conceptually attains this objective?
The ultimate result is a condition of equality and maximum satisfaction where the utility
gained or marginal utility from the last peso spent on one commodity is the same as is
any other commodity. This can be restated quantitative as follows.

MU of Commodity Y = MU of Commodity X

Price of Commodity Y Price of Commodity X

This is the optimum condition at the equilibrium point of the indifference curve and the
budget line where their marginal rates of substitution (MRS) are equal. Along a budget
line, how much the consumer additionally spend on one good is alternatively spends on
one good is alternatively the same as the other, given a fixed budget. Along an
indifference curve, the utility gained by consuming more of the other. The additional
peso spent on one yields the same utility as the other.

INCOME AND SUBSTITUTION EFFECTS

How does consumer equilibrium change with the price of a commodity item? Assume
with the substitutes such as Coke and Pepsi where the price of the latter in assumed to
decrease. With the change in price, Coke shares in the potential increase in the
consumption of Pepsi. The potential increase in the consumption of both commodities, if
realized, is called income effort. However, the consumer is not only content to realize
this effect as the new condition allows optimization by substituting more Pepsi for Coke,
this potential substitution, if realized, is called substitution effect.

The substitute effect results in net satisfaction since an additional peso is better spent
on cheaper and more units of Pepsi instead of the more costly units of Coke. A
decrease in the price of Pepsi means more consumption, hence more satisfaction from
every peso spent in Pepsi. In effect, the marginal utility vantage of consuming more
Pepsi instead of Coke leads the consumers to substitute the former for latter until the
equi-marginal condition is fully met.

Consumer surplus is an indicator of social welfare and can help make correct social
decisions. For example, a substantial decrease in this surplus indicates the negative
impact of an increase in price on consumers' welfare. This price increase leaves the
consumer with more expenditure for the product, and consequently less surplus
spending for other products. A change in consumer surplus is a change in well-being
and is the income effect discussed in the previous section. Take the extreme case of a
perfectly inelastic demand due to the absence of substitutes. At a higher price, the
surplus would be non-existent as compared with a bigger surplus when demand is
downward sloping with certain substitutes. Consumers cannot shift to cheaper
substitutes as there are none and therefore bear the full weight of the loss of purchasing
power. But at the other extreme, there is no loss at all, even of satisfaction or well-being
where demand is perfectly elastic. Consumers can easily shift to cheaper goods as
perfect substitutes to avoid higher price. Thus, the more substitutable are its
alternatives, the more consumers avoid the higher price of a good and its income effect
on consumption.

UTILITY AND DEMAND

Derivation of the Demand Curve  There is a potential consumption for a certain

commodity item given its market price and the income of its potential consumers. This
potential consumption is also called demand which is the quantity that the consumers
are willing to buy.  Demand is a consumer's desire for a particular product or service.
Utility is the satisfaction a consumer receives from a good or service. The amount of
money a consumer can spend on a product or service is combined with the utility
function to determine the demand function.  The potential demand for a product at
varying price levels and a certain degree of influence of the non – price factors
determine its demand curve.
FIGURE 34 ILLUSTRATION THE DERIVATION OF THE DEMAND
CURVE

The varying effects of the non-price factors on consumption and demand. A change in
taste or preference can change demand through a change in the quantity combination
of items, with the same budget size.  For product B can create instead a steeper
indifference curve where there is more consumption of product A foregone in order to
consume an additional unit of product B.  This results in more consumption of product
B at very given price level, thus shifting the demand curve to the right.  On the other
hand, price speculation can change demand through a change in the budget size. An
increase in population requires a bigger budget and shifts the budget line upward, thus
increasing consumption at every price level and shifting the demand curve to the right.

CASE STUDY

Demand for the Big Mac on the Rise (NYSE: MCD) McDonald's (NYSE: MCD) has
bucked the global recession in February as both global and U.S. same store sales rose.
The company, which operates more than 32,000 McDonald's restaurants in over 100
countries, reported February comparable sales results on March 9 that showed global
sales rising1.4% year over year even as Feb. Based on the theory, a person will try to
satisfy the most important needs first. When a person succeeds in satisfying an
important need, he will be motivated to satisfy the next most important need.
A motivated person is ready to act. How the motivated person acts are influenced by his
perception and learning of the situation. Two people may act quite differently because
their perception and learning of a situation may be different. Perception can be defined
as the process by which an individual selects, organizes, and interprets information to
create meaningful picture of the world. Learning, on the other hand, describes changes
in an individual’s behavior arising from experience. Through perception and learning,
people acquire their beliefs and attitudes. These, in turn, influence their buying behavior.
If a consumer perceives and believes that Coke is the best soft drink, he will buy Coke.
A belief is a descriptive thought that a person holds about something, while an attitude
describes a person’s enduring favorable and unfavorable cognitive evaluations,
emotional feelings, and action tendencies toward some object or ideas. To sum up, a
consumer will buy a particular product, given an optimum budget, if he thinks and
believes that this product will give him the best value or utility.