Difficulty: Introductory | Prerequisites: Familiarity with demand and supply (see Part 1 notes)
Source: Module 1 Glossary, Microeconomics, University of Illinois at Urbana-Champaign
Tags: price elasticity, income elasticity, cross-price elasticity, elastic, inelastic, unit elastic, normal good, inferior good, cardinal utility, ordinal utility, marginal utility, diminishing marginal utility, consumer equilibrium, ECON 101
Part 1 introduced the shapes of demand and supply curves. This section asks a more precise question: how responsive are buyers and sellers to changes in price, income, or the price of related goods? That responsiveness is called elasticity, and it determines everything from tax incidence to how much revenue a firm gains or loses when it changes its price. The utility section then goes deeper into why consumers buy what they buy, introducing the idea that people allocate their budgets to maximise satisfaction. These two threads (elasticity and utility) together explain the demand side of the market at a level beyond the basic supply-and-demand diagram.
Elasticity measures how sensitive quantity demanded or supplied is to changes in price, income, or the price of other goods. Utility is the satisfaction a consumer gets from consuming goods. Consumers maximise utility by equalising the marginal utility per pound (or dollar) spent across all goods. Diminishing marginal utility explains why demand curves slope downward.
Price elasticity of demand
Measured as the percentage change in quantity demanded divided by the percentage change in price.
In simple terms, this means: how much does the quantity people buy change when the price changes? A large number means very responsive (elastic); a small number means not very responsive (inelastic).
Elastic demand
Demand is elastic if the price elasticity is greater than one (in absolute value).
Think of it as: a small price increase causes a large drop in quantity demanded. Luxury goods and goods with many substitutes tend to have elastic demand.
Inelastic demand
Demand is inelastic if the price elasticity is between zero and one (in absolute value).
Think of it as: even a large price increase does not reduce quantity demanded by much. Necessities and goods with few substitutes tend to have inelastic demand.
Unit elastic demand
Demand is unit elastic if the price elasticity is exactly one.
In simple terms, this means: the percentage change in quantity demanded is exactly equal to the percentage change in price. Total revenue does not change when price changes.
Point elasticity of demand
The elasticity computed at a particular point on the demand curve.
Think of it as: elasticity measured at one specific price-quantity combination, rather than over a range.
Cross-price elasticity of demand
The percentage change in the quantity demanded of a product divided by the percentage change in the price of another product.
In simple terms, this means: how does the demand for good A respond when the price of good B changes? Positive cross-price elasticity means the goods are substitutes. Negative means they are complements.
Income elasticity of demand
The percentage change in quantity demanded divided by a percentage change in income.
Think of it as: how does demand respond when consumers get richer or poorer? Positive income elasticity means a normal good. Negative means an inferior good.
Normal good
A good whose demand increases in response to higher incomes.
In simple terms, this means: as people earn more, they buy more of it. Most goods are normal goods.
Inferior good
A good whose demand falls in response to higher incomes. Inferior goods have a negative income elasticity.
Think of it as: as people earn more, they buy less of it and switch to something better. Instant noodles are the classic textbook example.
Elasticity of supply
The percentage change in quantity supplied divided by the percentage change in price.
In simple terms, this means: how responsive are sellers to a price change? If supply is elastic, firms can ramp up production quickly. If inelastic, they cannot.
Cardinal utility
A measurable concept of satisfaction.
Think of it as: utility expressed as a number ("this apple gives me 10 utils"). Useful for calculation, though in practice we cannot measure satisfaction this precisely.
Ordinal utility
Assumes that individuals can rank commodity bundles in accordance with the level of satisfaction associated with each bundle.
In simple terms, this means: you do not need to say how much you like something, only whether you prefer bundle A to bundle B. This is a weaker, more realistic assumption than cardinal utility.
Total utility
A measure of the total satisfaction derived from consuming a given amount of goods and services.
Think of it as: the cumulative happiness from everything you have consumed so far.
Marginal utility
The addition to total utility created when one more unit of a good or service is consumed.
In simple terms, this means: how much extra satisfaction does the next unit give you?
Diminishing marginal utility
The addition to total utility from each extra unit of a good or service consumed is declining.
Think of it as: the first slice of pizza is brilliant, the second is good, the fifth is a chore. Each additional unit adds less satisfaction than the one before.
Consumer equilibrium
Occurs when marginal utility per dollar spent on the last unit of each good is equal.
In simple terms, this means: the consumer has allocated their budget so that the last pound spent on any good gives the same extra satisfaction. If it did not, they could rearrange spending and be happier.
Formula: % change in quantity demanded / % change in price.
The result is typically negative (law of demand), but by convention we often use the absolute value.
Elastic (> 1): quantity responds more than proportionally to a price change. A 10% price increase causes more than a 10% drop in quantity.
Inelastic (< 1): quantity responds less than proportionally. A 10% price increase causes less than a 10% drop in quantity.
Unit elastic (= 1): proportional response. Total revenue is unchanged when price changes.
If demand is elastic, a price increase reduces total revenue (the quantity effect dominates the price effect).
If demand is inelastic, a price increase raises total revenue (the price effect dominates).
If demand is unit elastic, total revenue stays the same.
This relationship is one of the most tested ideas in introductory economics.
Positive cross-price elasticity: the goods are substitutes (price of A up, demand for B up).
Negative cross-price elasticity: the goods are complements (price of A up, demand for B down).
Zero or near-zero: the goods are unrelated.
Positive income elasticity: the good is a normal good (income up, demand up).
Negative income elasticity: the good is an inferior good (income up, demand down).
Income elasticity greater than 1: the good is a luxury (demand rises faster than income).
Income elasticity between 0 and 1: the good is a necessity (demand rises, but more slowly than income).
Formula: % change in quantity supplied / % change in price.
Supply tends to be more elastic in the long run than in the short run, because firms have more time to adjust production capacity.
Total utility is the cumulative satisfaction from all units consumed.
Marginal utility is the extra satisfaction from consuming one more unit.
Diminishing marginal utility means each additional unit adds less satisfaction than the previous one. This is why consumers are willing to pay less for additional units, which gives the demand curve its downward slope.
Cardinal utility assigns numerical values to satisfaction (10 utils, 20 utils). It allows direct comparison of the size of preferences.
Ordinal utility only ranks bundles (I prefer A to B to C). No claim about how much more A is preferred.
Modern consumer theory mostly uses ordinal utility, but cardinal utility is still used in introductory courses for its simplicity.
The consumer is in equilibrium when: MU of good A / price of A = MU of good B / price of B = ... for all goods.
In plain language: the last pound spent on every good delivers the same marginal utility.
If this condition does not hold, the consumer can increase total utility by reallocating spending from the good with lower MU per pound to the one with higher MU per pound.
Firms use price elasticity to set prices: if demand is inelastic, raising prices increases revenue. This is why petrol prices can rise without a large drop in sales.
Governments use elasticity to predict tax revenue and understand who bears the burden of a tax. Taxing goods with inelastic demand generates more revenue and falls more heavily on consumers.
The concept of diminishing marginal utility explains why people diversify their consumption rather than spending everything on a single good.
Students often think a steep demand curve means inelastic demand. Slope and elasticity are related but not the same thing. Elasticity changes along a straight-line demand curve (elastic at the top, inelastic at the bottom).
Many students confuse "inferior good" with "bad good." An inferior good is not low quality by definition. It is simply one that people buy less of as their income rises (e.g. bus travel when you can afford a car).
Students sometimes assume that diminishing marginal utility means total utility is falling. It does not. Total utility is still rising; it is just rising more slowly.
The condition for consumer equilibrium (MU/P equal across all goods) is often misremembered as "buy the good with the highest marginal utility." That is wrong. It is the marginal utility per unit of currency that must be equalised.
The elasticity-total revenue relationship (elastic: price up, revenue down; inelastic: price up, revenue up) is tested in virtually every introductory exam.
Expect at least one question requiring you to classify goods as complements or substitutes using cross-price elasticity (positive = substitutes, negative = complements).
Income elasticity questions often ask you to classify a good as normal, inferior, luxury, or necessity based on the sign and magnitude of the elasticity.
The consumer equilibrium condition (MU per dollar equal across goods) is a staple calculation question. Be ready to show that reallocating spending increases total utility.
True or false: If demand is inelastic, raising the price will increase total revenue.
True.
Fill in the blank: A good with a negative income elasticity of demand is called a(n) ________ good.
Inferior.
True or false: A positive cross-price elasticity of demand means the two goods are complements.
False. Positive cross-price elasticity means they are substitutes.
Fill in the blank: Diminishing marginal utility means that total utility is ________ at a decreasing rate.
Increasing.
True or false: Consumer equilibrium requires that the marginal utility of every good consumed is equal.
False. It requires that the marginal utility per unit of currency spent is equal across all goods.
Q: The price of cinema tickets rises by 10% and the quantity demanded falls by 15%. Calculate the price elasticity of demand and state whether demand is elastic or inelastic.
A: Price elasticity = 15% / 10% = 1.5. Because 1.5 > 1, demand is elastic.
Q: A consumer spends their entire budget on goods A and B. The marginal utility of the last unit of A is 20 and its price is $4. The marginal utility of the last unit of B is 10 and its price is $2. Is the consumer in equilibrium? Explain.
A: MU per dollar for A = 20 / 4 = 5. MU per dollar for B = 10 / 2 = 5. Yes, the consumer is in equilibrium because MU/P is equal for both goods.
Q: When income rises by 5%, demand for good X falls by 3%. Calculate the income elasticity and classify the good.
A: Income elasticity = -3% / 5% = -0.6. The negative sign means good X is an inferior good.
Q: The cross-price elasticity of demand between goods A and B is +2.5. Are these goods substitutes or complements? Explain what would happen to the demand for B if the price of A rises.
A: They are substitutes (positive cross-price elasticity). If the price of A rises, consumers switch to B, so the demand for B increases.
Q: Explain why a rational consumer does not simply buy the good with the highest marginal utility.
A: Because goods have different prices. A consumer maximises satisfaction by equalising marginal utility per unit of currency spent, not marginal utility alone. A good with high marginal utility but a very high price may deliver less satisfaction per pound than a good with lower marginal utility but a much lower price.
Elasticity ties directly to the demand and supply material in Part 1: the steepness of the curves reflects how elastic or inelastic they are, and that determines the outcome of comparative static analysis, price controls, and tax incidence. Consumer equilibrium connects to the demand curve itself: the downward slope comes from diminishing marginal utility. Later in the course, elasticity reappears in the study of monopoly pricing (a monopolist raises prices in the elastic portion of demand) and in welfare economics (deadweight loss depends on elasticities).
price elasticity, elastic demand, inelastic demand, unit elastic, perfectly elastic, perfectly inelastic, total revenue test, cross-price elasticity, income elasticity, normal good, inferior good, luxury good, necessity, elasticity of supply, cardinal utility, ordinal utility, utils, total utility, marginal utility, diminishing marginal utility, law of diminishing marginal utility, consumer equilibrium, equimarginal principle, MU per dollar, MU per pound, budget allocation, consumer choice, ECON 101, introductory microeconomics, Module 1