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Introduction

The Elasticity Concept

The term elasticity was developed by Alfred Marshall, and is used to measure the relationship
between price and quantity demanded. The concept of elasticity simply involves the
percentage change in one variable associated with a given percentage change in another
variable. In addition to being used in demand analysis, the concept is used in finance, where
the impact of changes in sales on earnings under different production levels (operating
leverage) and different financial structures (financial leverage) are measured by an elasticity
factor. Elasticities are also used in production and cost analysis to evaluate the effects of
changes in input on output as well as the effects of output changes on costs.

One measure of responsiveness employed not only in demand analysis but throughout
managerial decision making is elasticity, defined as the percentage change in a dependent
variable,Y, resulting from a 1 percent change in the value of an independent variable, X.
Elasticities are tools you can use to quantify the impact of changes in prices, income, and
advertising on sales and revenues.

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Demand

Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a
commodity does not become demand. A person wishing to have a commodity should be
willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it
is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated
with reference to a price. Decisions regarding what to produce, how to produce and for whom
to produce are taken on the basis of price signals coming from the market. The law of
demand explains inverse relationship between price and quantity demanded. When price falls
quantity demanded of that commodity will increase. The deficiency of law of demand is
removed by the concept of elasticity of demand.

Law of Demand

According to Paul Samuelson, when the price of a good is raised (at the same time that all
other things are held constant), less of it is demanded”. In brief, the law of demand states that
the other things being equal, at a higher price consumers will buy less of a commodity and at
a lower price, consumers will buy more of it. As the price of the good rises so does the
opportunity cost of purchasing the good increase, therefore either the consumers will have to
forego buying other goods or purchase lesser quantity of the good whose price has increased.

In an economic point of view, the law of demand is normally depicted as an inverse relation
of quantity demanded and price: the higher the price of the product, the less the consumer
will demand, ceteris paribus ("all other things being equal").

Refer to APPENDIX 1

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Price elasticity of demand (Ped)

Price elasticity of demand is the economist’s way of talking about how responsive consumers
are to price changes. Elasticity varies among products because some products may be more
essential to the consumer. Products that are necessities are more insensitive to price changes
because consumers would continue buying these products despite price increases.

Conversely, a price increase of a good or service that is considered less of a necessity will
deter more consumers because the opportunity cost of buying the product will become too
high. It is the degree to which changes in price effect in changes in demand. One typical
application of the concept of elasticity is to consider what happens to consumer demand for a
good (for example, apples) when prices increase. As the price of a good rises, consumers will
usually demand a lower quantity of that good, perhaps by consuming less, substituting other
goods, and so on. The greater the extent to which demand falls as price rises, the greater the
price elasticity of demand. Conversely, as the price of a good falls, consumers will usually
demand a greater quantity of that good, by consuming more, dropping substitutes, and so
forth.

However, there may be some goods that consumers require, cannot consume less of, and
cannot find substitutes for even if prices rise (for example, certain prescription drugs).
Another example is oil and its derivatives such as gasoline.

The term price elasticity of demand is used to measure the responsiveness of demand to a
change in the price of that product.

The value of the price elasticity of demand can be calculated by using the following formula.

Refer to APPENDIX 2

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Classifications of demand curves

Since the responsiveness of quantity demanded varies from commodity to commodity and
from market to market, it is important to study the degrees of price elasticity. We can identify
five degrees of elasticity. They are: -
1. Perfectly elastic demand
2. Relatively elastic demand
3. Unitary elastic demand
4. Relatively inelastic demand
5. Perfectly inelastic demand
Refer to APPENDIX 3

Relatively elastic demand

As price rises so quantity demanded falls, and vice versa. When demand is elastic, quantity
demanded changes proportionately more than price. Thus the change in quantity has a bigger
effect on total consumer expenditure than does the change in price. For example, when the
price rises, there will be such a large fall in consumer demand that less will be spent than
before. Note that TE stands for Total consumer Expenditure, which is simply price times
quantity purchased (TE = P x Q).
This can be summarised as follows:
• P rises; Q falls proportionately more; thus TE falls.
• P falls; Q rises proportionately more; thus TE rises.

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When demand is elastic, then, a rise in price will cause a fall in total consumer expenditure
and thus a fall in the total revenue that firms selling the product receive. A reduction in price,
however, will result in consumers spending more, and hence firms earning more.

Relatively inelastic demand

When demand is inelastic, it is the other way around. Price changes proportionately more
than quantity. Thus the change in price has a bigger effect on total consumer expenditure than
does the change in quantity. Note that TE stands for Total consumer Expenditure, which is
simply price times quantity purchased (TE = P x Q).
To summarise the effects:
• P rises; Q falls proportionately less; TE rises.
• P falls; Q rises proportionately less; TE falls.

In other words, total consumer expenditure changes in the same direction as price.
In this case, firms’ revenue will increase if there is a rise in price and fall if there is a fall in
price.

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Perfectly inelastic demand

This is shown by a vertical straight line. No matter what happens to price, quantity demanded
remains the same. It is obvious that the more the price rises, the bigger will be the level of
consumer expenditure. Perfectly inelastic means that quantity demanded is unaffected by any
change in price. The quantity is essentially fixed. It does not matter how much price changes,
quantity does not budge.

Perfectly elastic demand

This is shown by a horizontal straight line. Perfectly elastic means an infinitesimally small
change in price results in an infinitely large change in quantity demanded.

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Unitary elastic demand

This is where price and quantity change in exactly the same proportion. Any rise in price will
be exactly offset by a fall in quantity, leaving total consumer expenditure unchanged.
This might give the impression that a demand curve with unit elasticity would be a straight
line at 45° to the axes. Instead it is a curve called a rectangular hyperbola. The reason for its
shape is that the proportionate rise in quantity must equal the proportionate fall in price (and
vice versa). As we move down the demand curve, in order for the proportionate change in
both price and quantity to remain constant there must be a bigger and bigger absolute rise in
quantity and a smaller and smaller absolute fall in price. For example, a rise in quantity from
200 to 400 is the same proportionate change as a rise from 100 to 200, but its absolute size is
double. A fall in price from £5 to £2.50 is the same percentage as a fall from £10 to £5, but its
absolute size is only half.

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Income elasticity of demand (Yed)

For many goods, income is another important determinant of demand. Income is frequently
as important as price, advertising expenditures, credit terms, or any other variable in the
demand function. This is particularly true of luxury items such as big screen televisions,
country club memberships, elegant homes, and so on. In contrast, the demand for such basic
commodities as salt, bread, and milk is not very responsive to income changes. These goods
are bought in fairly constant amounts regardless of changes in income. Of course, income can
be measured in many ways—for example, on a per capita, per household, or aggregate basis.
Gross National Product (GDP), national income, personal income, and disposable personal
income have all served as income measures in demand studies.
Income elasticity of demand measures the relationship between a change in quantity
demanded for good X and a change in real income.

The formula for calculating income elasticity is:

Normal Goods

Normal goods have a positive income elasticity of demand so as consumers’ income rises,
so more is demanded at each price level i.e. there is an outward shift of the demand curve
1. Normal necessities have an income elasticity of demand of between 0 and +1 for example,
if income increases by 10% and the demand for fresh fruit increases by 4% then the income
elasticity is +0.4. Demand is rising less than proportionately to income.

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2. Luxuries have an income elasticity of demand > +1 i.e. the demand rises more than
proportionate to a change in income – for example a 8% increase in income might lead to a
16% rise in the demand for restaurant meals. The income elasticity of demand in this example
is +2.0. Demand is highly sensitive to (increases or decreases in) income.

Inferior Goods

Inferior goods have a negative income elasticity of demand. Demand falls as income rises.
Typically inferior goods or services tend to be products where there are superior goods
available if the consumer has the money to be able to buy it. Examples include the demand
for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned
properties.

The income elasticity of demand is usually strongly positive for


• Wines and spirits
• Consumer durables - audio visual equipment, 3rd generation mobile phones and new
kitchens
• Sports and leisure facilities (including gym membership and sports clubs)

In contrast, income elasticity of demand is lower (but still positive) for


• Staple products such as bread, vegetables and frozen foods
• Mass transport (bus and rail)
• Beer and takeaway pizza

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Product ranges: However the income elasticity of demand varies within a product range. For
example the Yed for own-label foods in supermarkets is probably less for the high-value
“finest” food ranges that most major supermarkets now offer. You would also expect income
elasticity of demand to vary across the vast range of vehicles for sale in the car industry and
also in the holiday industry.

Long-term changes: There is a general downward trend in the income elasticity of demand
for many products, particularly foodstuffs. One reason for this is that as a society becomes
richer, there are changes in consumer perceptions about different goods and services together
with changes in consumer tastes and preferences. What might have been considered a luxury
good several years ago might now be regarded as a necessity (with a lower income elasticity
of demand). Consider the market for foreign travel. A few decades ago, long-distance foreign
travel was regarded as a luxury out of the reach of the majority of households. Now as real
price levels have come down and incomes have grown, so millions of consumers are able to
fly overseas on short and longer breaks. For many an annual holiday overseas has become a
necessity and not a discretionary item of spending!

Knowledge of income elasticity of demand is useful in predicting future demand in the


leisure and tourism sector. For example, Song et al. (2000) undertook an empirical study of
outbound tourism demand in the UK. Their results show that the long-run income elasticities
for the destinations studied range from 1.70 to 3.90 with an average of 2.367. These estimates
of income elasticities imply that overseas holidays are highly income elastic. In other words,
demand for outbound tourism should continue to grow with economic growth. The study also
considered own-price elasticities and found that the demand for UK outbound tourism is
relatively own-price inelastic.

Knowledge of income elasticity of demand also helps to explain some merger and take-over
activity as organizations in industries with low or negative income elasticity of demand
attempt to benefit from economic growth by expanding into industries with high-positive
income elasticity of demand. Such industries show market growth as the economy expands.

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Cross Price Elasticity of Demand (CPed)

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a
change in the price of good Y (a related good). We are mainly concerned here with the effect
that changes in relative prices within a market have on the pattern of demand.
The formula to calculate cross-price elasticity of Demand (CPed) is as follows:

With cross price elasticity we make an important distinction between substitute products
and complementary goods and services.

Substitutes: If goods are substitutes then the value of CPed will be positive, that is greater
than zero. Coffee and tea are examples of substitutes, as are margarine and butter. If the price
of coffee falls sharply then demand for tea is likely to fall as a result. Whether goods are
substitutes or complements will influence the pricing policy adopted by a business.

Like income elasticity, cross-price elasticity can be either positive or negative. A positive
cross-price elasticity indicates that an increase in the price of X causes the demand for Y to
rise. This implies that the goods are substitutes. For McDonald's, Big Macs and Chicken
McNuggets are substitutes with a positive cross-price elasticity. In our earlier example, as
McDonald's lowered the price of Big Macs, it saw a decline in the quantity of McNuggets
sold as consumers substituted between the two meals. If cross-price elasticity turns out to be
negative, an increase in the price of X causes a decrease in the demand for Y. This implies
that the goods are complements. Hot dogs and football games are complements with a
negative cross-price elasticity.

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As we have already seen, knowing the cross-price elasticity can be a very important part of a
company's business strategy. Sony and Toshiba recently competed in the market for high
definition DVD players: Sony's Blu-ray versus Toshiba's HD DVD. Both firms recognized
that an important driver of a customer's choice of a DVD player is movie price and
availability. No one wants a new high-definition player if there is nothing to watch on it or if
the price of movies is expensive. Inexpensive and available movies are a key complement to
new DVD players. The cross-price elasticity of movies and high-definition DVD players is
strong and negative. Sony won, and some observers think that Sony ownership of a movie
studio gave it an important advantage.

Complements: If goods are complements, for example CD player and CDs, or cars and
petrol, then the cross elasticity of demand (CPed) will be negative. This means that if the
price of cars increases, for example, demand for petrol will fall. Of course, the percentage
amount of the price increase is important in terms of its impact on the complementary
product – if car prices rise by 0.5 per cent this is not likely to have a big impact on demand
for petrol.

The stronger the relationship between two products, the higher is the co-efficient of
cross-price elasticity of demand. For example with two very close substitutes, the cross-
price elasticity will be strongly positive. Likewise when there is a strong complementary
relationship between two products, the cross-price elasticity will be highly negative.
Unrelated products have a zero CPed.

Canina et al. (2003) undertook a study to quantify the effects of gasoline price increases on
hotel room demand in the US. Their analysis was based on data from 1988 to 2000. They
found that each 1 per cent increase in gasoline prices is associated with a 1.74 per cent
decrease in lodging demand. In other words, there is a negative cross-price elasticity of

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demand between gasoline prices and lodging demand which can therefore be seen as
complementary items. However, they noted that changes in gasoline price changes do not
affect all industry segments equally. The segments that feel the greatest effects of gasoline
price increases are full-service mid market properties and highway and suburban hotels.
High-end hotels seem to be immune to the negative effects of fuel price increases.

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Supply

Supply refers to the quantity of a good or service that producers are willing and able to sell
during a certain period under a given set of conditions. Factors that must be specified include
the price of the good in question, prices of related goods, the current state of technology,
levels of input prices, weather, and so on. The amount of product that producers bring to the
• Market - the supply of the product depends on all these influences.

So far, we have focused on the consumer part of the market. But elasticity also matters on the
producer's side. Elasticity of supply, which measures the response of quantity of a good
supplied to a change in price of that good, is defined as

In output markets, the elasticity of supply is likely to be a positive number—that is, a higher
price leads to an increase in the quantity supplied, ceteris paribus. The elasticity of supply is
a measure of how easily producers can adapt to a price increase and bring increased
quantities to market. In some industries, it is relatively easy for firms to increase their output.
Ballpoint pens fall into this category, as does most software that has already been developed.
For these products, the elasticity of supply is very high. In the oil industry, supply is inelastic,
much like demand.

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The supply of a product is the quantity of the product that firms are willing and able to put
onto the market at a particular price over a particular period of time. We will assume that the
prime motive for supplying a product is to make a profit and that supply is the market supply
rather than an individual firm’s supply.
The factors which influence the quantity supplied are:

a) the price of product;


b) the price of all the other products in the economy;
c) the price of the factors of production;
d) the state of technology;
e) all the other factors which might influence the quantity supplied.

Law of Supply

Law of supply is different from law of demand. Law of supply explains the relationship
between price of a commodity and its quantity supplied. Price and supply are directly related.
A rise in price induces producers to supply more quantity or the commodity and a fall Prices,
makes them reduce the supply. The higher is the price of the commodity the larger is the
profit that can be earned, and, thus the greater is the incentive to the producer' to produce
more of the commodity and offer It in the Market. Likewise at lower prices, profit margin
shrinks and hence producers reduce the sale.

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Revenue Maximization

An important piece of information for the management of a firm is knowledge of the shape of
its demand curve for its product and the responsiveness, or elasticity, of the quantity
demanded to changes in key economic determinants of demand, such as price or income. The
slope of the demand curve ∆Qx/Px, for example, tells managers how many extra units the
firm will sell in response to any change in the price of the good. If the firm is interested in
nothing more than predicting the number of additional units that can be sold by changing
price, then the slope of the demand curve ∆Qx/Px will suffice. However, if the firm is
concerned about the additional revenue generated by lowering the price, then the slope of the
demand curve alone is an inadequate indicator; this is because the slope of a linear demand
curve never changes and is always constant. However, total revenue varies from one point to
another along the demand curve. Even if the slope of the demand curve does change, because
it is non-linear, the simple slope still fails to convey information about how the revenue of the
firm changes, consequent to a price change.

Consider the oil-producing countries, which have had some success keeping oil prices high
by controlling supply. To some extent, reducing supply and driving up prices has increased
the total oil revenues to the producing countries. As a result, we might expect this strategy to
work for everyone. If the organization of banana-exporting countries (OBEC) had done the
same thing, however, the strategy would not have worked.

Why? Suppose OBEC decides to cut production by 30 percent to drive up the world price of
bananas. At first, when the quantity of bananas supplied declines, the quantity demanded is
greater than the quantity supplied and the world price rises. The issue for OBEC, however, is
how much the world price will rise. That is, how much will people be willing to pay to
continue consuming bananas? Unless the percentage increase in price is greater than the
percentage decrease in output, the OBEC countries will lose revenues.

A little research shows us that the prospects are not good for OBEC. There are many
reasonable substitutes for bananas. As the price of bananas rises, people simply eat fewer
bananas as they switch to eating more pineapples or oranges. Many people are simply not
willing to pay a higher price for bananas. The quantity of bananas demanded declines 30

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percent—to the new quantity supplied—after only a modest price rise, and OBEC fails in its
mission; its revenues decrease instead of increase.

We have seen that oil-producing countries often can increase their revenues by restricting
supply and pushing up the market price of crude oil. We also argued that a similar strategy by
banana-producing countries would probably fail. Why? The quantity of oil demanded is not
as responsive to a change in price as is the quantity of bananas demanded. In other words, the
demand for oil is more inelastic than is the demand for bananas. One of the very useful
features of elasticity is that knowing the value of price elasticity allows us to quickly see what
happens to a firm's revenue as it raises and cuts its prices. When demand is inelastic, raising
prices will raise revenues; when (as in the banana case) demand is elastic, price increases
reduce revenues.

We can now use the more formal definition of elasticity to make more precise our argument
of why oil producers would succeed and banana producers would fail as they raise prices. In
any market, P x Q is total revenue (TR) received by producers:

The oil producers' total revenue is the price per barrel of oil (P) times the number of barrels
its participant countries sell (Q). To banana producers, total revenue is the price per bunch
times the number of bunches sold.

When price increases in a market, quantity demanded declines. As we have seen, when price
(P) declines, quantity demanded (QD) increases. This is true in all markets. The two factors, P
and QD move in opposite directions:

Because total revenue is the product of P and Q, whether TR rises or falls in response to a
price increase depends on which is bigger: the percentage increase in price or the percentage
decrease in quantity demanded. If the percentage decrease in quantity demanded is smaller
than the percentage increase in price, total revenue will rise. This occurs when demand is

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inelastic. In this case, the percentage price rise simply outweighs the percentage quantity
decline and P x Q = (TR) rises:

If, however, the percentage decline in quantity demanded following a price increase is larger
than the percentage increase in price, total revenue will fall. This occurs when demand is
elastic. The percentage price increase is outweighed by the percentage quantity decline:

The opposite is true for a price cut. When demand is elastic, a cut in price increases total
revenues:

When demand is inelastic, a cut in price reduces total revenues:

Review the logic of these equations to make sure you thoroughly understand the reasoning.
Having a responsive (or elastic) market is good when we are lowering price because it means
that we are dramatically increasing our units sold. But that same responsiveness is
unattractive as we contemplate raising prices because now it means that we are losing
customers. And, of course, the reverse logic works in the inelastic market. Note that if there is
unitary elasticity, total revenue is unchanged if the price changes.

With this knowledge, we can now see why reducing supply by the oil-producing countries
was so effective. The demand for oil is inelastic. Restricting the quantity of oil available led
to a huge increase in the price of oil—the percentage increase was larger in absolute value
than the percentage decrease in the quantity of oil demanded. Hence, oil producers' total

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revenues went up. In contrast, a banana cartel would not be effective because the demand for
bananas is elastic. A small increase in the price of bananas results in a large decrease in the
quantity of bananas demanded and thus causes total revenues to fall.

As can be seen in Figure a, as the price falls from P1 to P2 the total revenue rises since the
loss in revenue (-) from selling the original quantity at a now lower price is outweighed by
the gain in revenue (+) from selling extra units at this lower price. This arises because
demand is elastic. Note that the shaded area is ‘common’ to the revenue situation both before
and after the price fall.
In Figure b a reduction in the price from P3 to P4 leaves total revenue unchanged as the
revenue lost (-) is equal to the revenue gained (+). In this situation we have unit elasticity of
demand.
In Figure c a reduction in the price from P5 to P6 leads to a fall in total revenue with the loss
(-) being greater than the gain (+). In this situation we have inelastic demand.

Elasticity can be considered by referring to total revenue. If, following a price reduction,
there is a rise in total revenue as in (a), then demand is elastic. On the other hand, if,
following a price reduction, there is a fall in total revenue as in (c), then demand is inelastic.
If total revenue is constant after a price reduction then demand is unit-elastic as in (b).

The practical usefulness of marginal analysis is easily demonstrated with simple examples
that show how managers actually use the technique. Common applications are to maximize
profits or revenue, or to identify the average-cost minimizing level of output.

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Knowing the price elasticity of demand for a product alone does not, in general, provide
sufficient information to determine the optimal price a firm should charge. A firm must also
consider its costs of producing the good. However, because of the relation between price
elasticity of demand and total revenue, knowing the price elasticity does provide useful
information for price-setting decisions.

To see why, start by considering a firm's total revenue. For a firm that charges all consumers
the same price for its product, the firm's total revenue equals the price (P) it charges t the
number of units (Q) it sells. That is,

A firm's marginal revenue measures the change in its total revenue from selling an additional
unit of its product. To find marginal revenue, take the derivative of total revenue with respect
to quantity Q. That is,

This is expressed as the derivative of total revenue with respect to quantity. For a review of
derivatives, click on the following link.

For perfectly competitive firms that often have no control over the price they can charge (that
is, they must simply accept the existing market price), marginal revenue is constant and equal
to the market price. The additional revenue a firm earns by increasing the quantity it produces
by one unit (marginal revenue) is simply the market price.

Firms in competitive markets, then, must decide only how many units to produce and sell.
Note, however, that many producers acting together can influence the market price even in
competitive markets.

The OPEC illustration described earlier provides one such example. Understanding the
relation between the price elasticity of demand and total producer revenue helps OPEC
determine the quantity of oil that each of its member countries should produce in order to
maximise total OPEC revenue.
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A firm that has some degree of market power (that is, a firm that can choose the price of its
product) must consider both the price to charge and the number of units to sell. This is where
price elasticity of demand becomes important, as it determines the optimal markup over cost
a firm can charge to maximise its profits.

The key is to understand what happens to a firm's total revenue if price is changed by a small
amount. The example below should help clarify this concept.

Example: Price Elasticity of Demand and Total Revenue

Suppose the coffee shop in the example above lowers the price of a cup of coffee by a small
amount (from, say, $4 per cup to $3.50 per cup). What would you expect to happen to the
firm's total revenue from its coffee sales?

The linear demand curve used in the coffee shop example is

Consumers would purchase 20 cups of coffee at $4 per cup.

Therefore, total revenue would be

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If the shop decreased its price to $3.50 per cup, quantity demanded would increase to 25 cups
per day.

Therefore, total revenue would be

In this case, the firm's total revenue from coffee sales increased when it decreased the price of
its coffee. There are two opposing effects on total revenue when there is a decrease in price.
The first effect comes from the firm charging a lower price on each unit it sells. This first
effect decreases total revenue. However, we know from the law of demand that as price falls,
the quantity of a good that consumers will be willing to purchase rises. This second effect of
a price decrease tends to increase total revenue because quantity sold increases.

The net effect of a price decrease on total revenue depends on what effect dominates, which
is exactly what the price elasticity of demand tells us. The fact that total revenue increased
when price decreased from $4 to $3.50 is consistent with the fact that demand was found to
be elastic at a price of $4. For an elastic demand, the percentage change in quantity demanded
is larger than the percentage change in price.

To summarise:

• If demand is elastic at the current price, then total revenue will increase (implying
positive marginal revenue of output) when price is decreased. The additional revenue
generated by increasing quantity will be positive. This means that the percent change
in price will be smaller than the percent change in quantity demanded, causing total
revenue to increase.

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• If demand is unit elastic, then total revenue will not change. The additional revenue
generated by increasing quantity is zero. Thus, price and quantity demanded change
by the same percent, leaving total revenue unchanged.
• If demand for the product is inelastic at the current price, then total revenue
will decrease (implying negative marginal revenue of output) when the price is
decreased. The additional revenue generated by increasing quantity will be negative.
This means that the percent change in price will be larger than the percent change in
quantity demanded, causing total revenue to decrease.

The implications of this analysis for a firm's price-setting decision are important. In general, a
firm with some market power will not maximise profits by setting a price at which demand is
inelastic. When demand is inelastic, a firm could increase revenue and decrease costs
(because it sells fewer units) by raising price.

This is because the percentage change in quantity sold increases but the percentage change in
price decreases, as one moves upwards along the demand curve towards higher prices.

The logical conclusion of the analysis thus far is that, for a linear demand, the price that will
maximise a firm's total revenue will be the price at which demand is unit elastic. The example
on page 24 illustrates this result.

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Example: Revenue-maximising prices and price elasticity

For consistency, return to the coffee shop example, where daily demand for cups of coffee is
given by

What price per cup should the coffee shop charge to maximise total revenue?

Because a firm's total revenue is maximised where demand is unit elastic, you need to find
the unit elastic price and quantity combination for this linear demand curve. To find the price-
quantity pair, begin with the point-slope formula for price elasticity of demand.

Set the elasticity equal to -1 and substitute the appropriate slope and expression for price
(taken from the demand function).

Then solve for Qd.

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The result indicates that demand is unit elastic at a quantity of 30 cups. To find the
corresponding price, substitute the value for Qd into the demand function.

The demand for coffee at the shop is unit elastic at a price of $3, which corresponds to a
quantity sold of 30 cups per day. Therefore, a price of $3 maximises total daily revenue.
Total daily revenue would be $90.

It is also true that the firm's marginal revenue is zero at Q = 30 units, which you can
demonstrate using calculus.

A firm's total revenue is price times quantity. From the demand function, you know the
relation between price and the number of cups that will be sold.

Therefore,

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The firm's marginal revenue is the derivative of total revenue with respect to quantity.

Notice that if you set marginal revenue equal to zero and solve for Q, you find that Q = 30.

Marginal revenue is positive for all units up to 30 and is negative for all units after 30. The
graph below illustrates this result. Notice that at 30 units of output, where demand is unit
elastic, P = $3 and total revenue is maximised at $90.

Does this mean that firms should set price where demand is unit elastic? Again, the answer is
generally no. Firms are interested in maximising profits, not total revenue. The only time the
two will coincide is when it costs the firm nothing to produce additional units of its product
(that is, when the firm's marginal cost of output is zero).

Unlike profit maximization, cost relations are not considered at all. Relative to profit
maximization, revenue maximization increases both unit sales and total revenue but
substantially decreases short-run profitability. These effects are typical and a direct result of
the lower prices that accompany a revenue maximization strategy. Because revenue
maximization involves setting MR = 0, whereas profit maximization involves setting MR =
MC, the two strategies will only lead to identical activity levels in the unlikely event that MC
= 0. Although marginal cost sometimes equals zero when services are provided, such as
allowing a few more fans to watch a scarcely attended baseball game, such instances are rare.
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Most goods and services involve at least some variable production and distribution costs, and
hence marginal costs typically will be positive. Thus, revenue maximization typically
involves moving down along the demand and marginal revenue curves to lower prices and
greater unit sales levels than would be indicated for profit maximization. Of course, for this
strategy to be optimal, the long run benefits derived from greater market penetration and
scale advantages must be sufficient to overcome the short-run disadvantage of lost profits.

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Conclusion

In the project regarding the concepts elasticity, we have discussed different types and
measurement of elasticity. Applying the theory of elasticity we have to increase revenue. So
we must take some strategic decisions to make full use of our managerial skills to thereby
increase profit as well as revenue and increase in demand and also we have to reduce the cost
of production.

Although most businessmen are very much aware of the elasticity of demand of the goods
they make, the use of precise estimates of elasticity of demand will add precision to their
business decision, that is the theory of elasticity of demand is very useful at the time of taking
tactical decisions by the top management. So this project is much useful to us to know how
elasticity influences the working of business and even in our day to day life.

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APPENDIX 1

Factors Determining Elasticity of Demand

Product Characteristics Elastic Demand Inelastic Demand

Number of substitutes Many Few or none


% of purchaser's budget High Low
Type of good Luxury Necessity, Emergency
Time until purchase No hurry Required quickly
Examples Steak, Vacations Salt, Bread

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APPENDIX 2

Graphing and Interpreting price elasticity of demand

A demand schedule has more than one elasticity of demand.


Demand Schedule
Price 2 3 4 5 6 7 8 9
Quantity 9 8 7 6 5 4 3 2
Total 18 24 28 30 30 28 24 1
Revenue

P goes from 4 to 5 and Q P goes from 5 to 6 and Q P goes from 6 to 7 and Q


from 7 to 6. from 6 to 5. from 5 to 4.

Note: A down sloping


demand curve is yields a
negative ED.
Its sign is often ignored.

Interpreting Elasticity of demand

Relative Change in Quantity Terminology ED Parameters


None, will pay anything, numerator Perfectly Inelastic ED = 0
is zero.
Small Inelastic 0 < ED < 1
Q demanded and P change same Unitary Elasticity ED = 1
percentage
Large Elastic 1 < ED <
Infinitely Large, price doesn't Perfectly Elastic ED is undefined, can't divide
change, denominator is zero by zero.

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APPENDIX 3

Summary Elasticity of Demand and Total Revenue


When Price Increases Total Revenue
ED >1 Somewhat Quantity Changing a Lot so decreases
Elastic you could lose lots of money.
ED = 1 Unitary Quantity/Price Changing Same no change
Elasticity %
ED <1 Somewhat Inelastic Quantity Doesn't Change increases
Much, so you could make lots
of money
The following matrix is useful in analyzing problems that consider the responsiveness of
consumers to price changes. It also reminds one that elasticity does not defy the law of
demand; it measures the direction of change of total revenue or expenditure in response to
changes in price.

Price Quantity Total Revenue Elasticity


Demanded

UP ↑ DOWN ↓ UP ↑ INELASTIC

UP ↑ DOWN ↓ DOWN ↓ ELASTIC

UP ↑ DOWN ↓ no change Unit Elastic

DOWN ↓ UP ↑ UP ↑ ELASTIC

DOWN ↓ UP ↑ DOWN ↓ INELASTIC

DOWN ↓ UP ↑ no change Unit Elastic

• The arrows indicate the direction of change for price, quantity demanded, and total
revenue or expenditure.
• The change in price and quantity always goes in opposite directions (the law of
demand).
• When the change in price and total revenue goes in the same direction, the demand is
inelastic.
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• If the change in price and total revenue goes in opposite directions, the demand is
elastic.
• If the price changes and there is no change in total revenue, the demand is unit elastic.

The rationale for the above table is straightforward, and with all concepts in economics, it
always helps to think of a sentence that explains each possible scenario.

For example: If the price of Ipods goes and Apple still makes more money, then obviously
demand for Ipods is inelastic, since the increase in price apparently didn't scare away many
consumers!

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Table of Contents
Example: Price Elasticity of Demand and Total Revenue.......................................................21

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