Vous êtes sur la page 1sur 28

DEMAND ELASTICITY

Introduction
The successful manager is interested in providing detailed quantitative answers to questions like : How much do we have to cut our price to achieve 3.2 percent sales growth?

If we cut prices by 6.5 percent, how many more units will we sell? How much will our revenues and cash flows change as a result of this price cut?

How much will our sales change if rivals cut their prices by 2 percent or a recession hits and household incomes decline by 2.5 percent?

Suppose some variable, such as the price of a product, increased by 10 percent. What would happen to the quantity demanded of the good? Based the law of demand, we know that the quantity demanded would fall. It would be useful for a manager to know whether the quantity demanded would fall by 5 percent, 10 percent, or some other amount. Demand elasticity is a useful tool for answering such important questions.
An elasticity measures the responsiveness of one variable to changes in another variable. E.g. Responsiveness of quantity demanded of a commodity to change in its own price, substitute price, complement price, income, advertisement expenditure etc. Two aspects of an elasticity are important: (1) Whether it is positive or negative (2) Whether it is greater than 1 or less than 1 in absolute value.

The sign of the elasticity determines the relationship between the two variables under consideration. If the elasticity is positive, an increase in one variable leads to an increase in the other variable. If the elasticity is negative, an increase in one variable leads to a decrease in the other variable.
Whether the absolute value of the elasticity is greater or less than 1 determines how responsive one variable is to changes in the other variable. If the absolute value of the elasticity is greater than 1, the numerator is larger than the denominator in the elasticity formula which indicates that a small percentage change in variable X will lead to a relatively large percentage change in variable Y.

If the absolute value of the elasticity is less than 1, the numerator is smaller than the denominator in the elasticity formula. In this instance, a given percentage change in variable X will lead to a relatively small percentage change in variable Y.

Types of Elasticities
It is not conceptually possible to measure elasticity of demand with respect to each of the demand determinants as it is difficult to quantify certain variables. For example a scientific quantitative measure of tastes and preferences does not exist so its not possible to measure the elasticity of these determinants.

The following elasticity measures can be considered 1. Price elasticity of demand 2. Income elasticity of demand 3. Cross elasticity of demand 4. Promotional elasticity of demand 5. Expectation elasticity of demand

The Elasticity of Demand


The demand curve and demand function show only the directional relationship between demand and its determinants. For the manager the knowledge about the direction of change isnt enough. They also need to know the magnitude of the impact of changes in these determinants on the demand. The elasticity of demand is defined as the percentage change in quantity demanded caused by one percent change in the demand determinant under consideration, while other determinants are held constant. The general equation for the measurement of elasticity of demand is, E = % change in quantity demanded of good X % change in the determinant Symbolically it may be stated as , E = Q x Z Z Q

Point Price elasticity of Demand


The price elasticity of demand (Ep) is given by the percentage change in quantity demanded of the commodity divided by the percentage change in its price, holding constant all the other variables of the demand function. Ep = Q x P P Q Point elasticity of demand refers to the elasticity at a particular point on the demand curve the formula of elasticity for point is the same as shown above. Suppose, P1 = Rs.10 P2 = Rs.8 Q1 = 4 units Q2 = 6 units The demand elasticity is -2.5 This means that the quantity demanded increases by 2.5 percent if there is a one percent decrease in price, while holding all the other variables in the demand function constant.

Arc Price elasticity of demand


In the real world, the price elasticity of demand between two points on the demand curve is more important than the elasticity at a particular point. Arc price elasticity of demand is the average elasticity over a segment of the demand curve. Arc price elasticity is the midpoint of the chords that connects the initial and the new point on the demand curve

The formula for arc price elasticity is as follows Ep = Q x P1 + P2 P Q1+Q2 The arc price elasticity for the previous example would be -1.8

The higher the elasticity of demand, the greater will be the percentage change in quantity demanded for every percentage change in demand. For example is Ep is 2 then it means that 1% change in price will change the quantity demanded by 2% and if Ep is 0.5, it implies that the quantity demanded will change by 0.5 % when the price of the commodity changes by 1%.
Suppose a manager has to take a decision about price change of her product. What would she do if the price elasticity of demand is 2 and what would she do if the price elasticity is 0.5? In the first case where the Ep is 2, she would reduce the price as this will increase the quantity demanded by twice the amount. In the second case where Ep is 0.5, she would increase the price as this will reduce the quantity demanded by only 0.5%.

Types of Price Elasticity


The price elasticity of demand depends upon the nature of the commodity under consideration. For example, the increase in the price of necessary commodities has very less impact on the quantity demanded. Thus, different kinds of commodities have different price elasticities. Price elasticities of demand can be classified into the following categories. 1. Perfectly elastic demand : Ep = A situation where the quantity demanded will increase or decrease even is there is no change in the price 2. Perfectly inelastic demand : Ep = 0 A situation where the quantity demanded will not change even is there is a large increase in the price Usually the demand for necessary commodities is inelastic.

3. Unitary elastic demand : Ep = 1 When a given change in price causes an equally proportionate change in quantity demanded, the demand is said to be unitary elastic. 4. Relatively elastic demand : Ep > 1 When a given change in price causes a more than proportionate change in quantity demanded, the demand is said to be relatively elastic
5. Relatively inelastic demand : Ep < 1 When a given change in price causes a less than proportionate change in quantity demanded, the demand is said to be relatively inelastic Perfectly elastic and perfectly inelastic demands are very rare in real life. Usually changes in price do cause changes in quantity demanded. The magnitude of such changes may be different for different products.

Price Elasticity, Total Revenue and Marginal Revenue


There is a very important relationship between the price elasticity of the demand and the firms total revenue and marginal revenue. Total revenue = P x Q Marginal revenue = TR Q The total revenue increases, when the price declines, if the demand is elastic i.e. if Ep > 1 The total revenue remains unchanged when the price declines, if the demand is unitary elastic i.e. if Ep = 1 The total revenue declines when the price declines, if the demand is inelastic i.e. if Ep < 1 If we consider an increase in price, the total revenue will reduce in the first scenario, will remain unchanged in the second scenario and will increase in the third scenario.

When demand is elastic, a decline in price leads to a proportionately larger increase in quantity demanded, therefore total revenue increases. When the demand is unitary elastic, a decline in price leads to an equally proportionate increase in quantity demanded, therefore total revenue remains unchanged. When demand is elastic, a decline in price leads to a proportionately smaller increase in quantity demanded, therefore total revenue declines. To understand the relationship between Price elasticity, Total Revenue and Marginal Revenue., lets have a look at the market demand curve of a monopolist firm for commodity X. The price elasticity, total revenue and marginal revenue are given in column 3, 4 and 5 respectively.

From the demand schedule, we can notice that TR increases as long as Ep >1, TR is maximum when Ep = 1 and TR declines when Ep < 1
MR is positive as long as TR increases (i.e. as long as demand is elastic), and MR is negative when TR declines (i.e. when demand is inelastic) and MR is zero when TR is maximum (i.e. when demand is unitary elastic) If we plot the demand schedule on a graph, well be able to see this relationship more clearly. From the figure, we can see that as long as demand is price elastic, up to 300 units of output, a reduction in price increases the total revenue and marginal revenue is positive. At Q = 300, demand is unitary price elastic, TR is maximum and MR = 0. When demand is price inelastic at output levels greater than 300, the price reduction reduces the total revenue and MR is negative.

There is an important often used relationship among marginal revenue, price and price elasticity. This relationship can be expressed by the following equation :
MR = P (1 + 1 ) Ep For example, when P = $ 4 and Ep = -2, substituting these values in the formula we get, MR = 2. When P = $ 3 and Ep = -1, MR = 0.

Factors affecting the price elasticity of demand


The closeness of the substitutes The higher the number of close substitutes, available of a commodity the more elastic the demand. Demand for sugar is more elastic than demand for salt. The share of the commodity in the buyers budget. If the proportion of the consumers income spent on the commodity is very small, demand tends to be inelastic. E.g. salt, matchboxes Nature of the commodity Generally, the demand for necessities is inelastic and the demand for luxuries is elastic. Habit forming commodities Demand for such commodities is inelastic. i.e. tobacco and alcohol

Time period Demand is more elastic in the long run then in the short run Narrow definition of a commodity. The more narrowly a commodity is defined, the greater is the price elasticity of the commodity. e.g. Coke, Soft drinks, Non alcoholic beverages

Income Elasticity of Demand


The income elasticity of demand (EI) is given by the percentage change in the demand of the commodity divided by the percentage change in income, holding constant all the other variables of the demand function, including price. EI = Q x I I Q Point income elasticities give different results depending on whether income rises or falls. To avoid this, arc income elasticity is used. By doing so, we get the same result whether income rises or falls EI = Q x I1 + I2 I Q1+Q2

For most commodities, an increase in income leads to an increase in demand for the commodity so that EI is positive. These commodities are called normal goods. In real world, food, clothing, housing, healthcare, education, recreation are normal goods. For the first three (Necessities) EI is positive but low, for the last three (luxuries) EI is well above 1. There are some narrowly defined goods of which consumer purchases less as income rises. These are called inferior goods. For these goods, income elasticity will be negative. Income elasticity is not as clear cut and precise measure as the demand elasticity for the following reasons: 1. 2. Different concepts of income such as GNP, national income, personal income, personal disposable income etc can be used in its measurement. A commodity may be normal for some people and at some income level and inferior for other people and other income levels.

An important use of demand elasticity is in forecasting the change in the demand for a commodity under different economic conditions. The demand for a commodity with a low income elasticity will not fluctuate very much during boom or recession. On the other hand the demand for luxury items such as vacations will increase sharply when the economy is booming and will fall sharply during recession.

Cross Price Elasticity of Demand


The cross price elasticity of demand (EI) is given by the percentage change in the demand for commodity X divided by the percentage change in price of commodity Y, holding constant all the other variables of the demand function, including income and the price of commodity X. Exy = Qx x Py Py Qx The above formula is for point cross price elasticity. The following formula is used for arc price elasticity

Exy = Q x x Py1 + Py2 Py Qx1 + Qx2

If the value of Exy is positive , commodities X and Y are substitutes as increase in Py leads to an increase in Qx. For example, tea and coffee, coke and pepsi.
On the other hand if Exy is negative, commodities X and Y are complements as an increase in Py leads to a decrease in Qx. For example coffee and sugar, coffee and cream, car and petrol The absolute value of Exy measures the degree of substitutability and complementarity between X and Y. If the cross price elasticity of demand between tea and coffee is greater than that between coffee and coco, it means that tea is a better substitute for coffee than cocoa. If Exy is close to zero then it means that X and Y are independent commodities. For example car and candy, potato and pencil. A high positive cross price elasticity means that the various commodities belong to the same industry. For exmaple elasticity between SX4 and Ertiga

Using Elasticities in Managerial Decision-making


Some of the forces (Determinants) that affect the demand are under the control of the firm while others are not.

The price of the commodity and the level of expenditure on advertising, product quality and customer service are under the control of the firm while growth of consumers income, consumers price expectations, competitors pricing decisions and their expenditure are not under the firms control.
The firm needs elasticity estimates with respect to all the factors that affect the demand for their commodity to determine the optimal operational policies, and to determine the most effective response to the policies of the competing firms. Therefore the firm should identify all the important variables that affect the demand of its products and should obtain estimates about what happens to the demand if theres a change in any of the identified variables.

Suppose a company called Coffee corporation ltd. estimated the following regression equation of the demand for its coffee brand.
Qx = 1.5 3.0Px + 0.8I + 2.0Py 0.6Ps + 1.2A Qx = sales of coffee brand X in India, in millions of pounds per year Px = price of coffee brand X, in dollars per pound I = personal disposable income in trillions of dollars per year Py = price of competitor brand , in dollars per pound Ps = price of sugar A = advertising expenditure Suppose that this year Px = $2, I = $2.5, Py = $1.8, Ps = $0.50, A = $1. Putting this values in the equation, what answer do you get?

We can say that this year the firm would sell 2 million pounds of coffee brand X. This information can be used by the firm to find the elasticity of demand for coffee brand X with respect to different variables.
Qx = 1.5 3(2) + 0.8(2.5) + 2(1.8) 0.6(0.5) + 1.2(1) = 2 Forecast for sales of coffee brand X this year = 2 million pounds
EP = -3(2/2) EI = 0.8(2.5/2) Exy = 2(1.8/2) Exs = -0.6(0.5/2) EA = 1.2(1/2)

EP = -3
EI = 1 Exy = 1.8 Exs = -0.15 EA = 0.6 If the firms has forecasts about value all the determinants of the coffee brand X for next year, the firm can use it to determine the sales of its coffee brand next year. Thus elasticity is a very important tool for making important managerial decision such as pricing, advertising expenditure, quality control, diversification etc.

Vous aimerez peut-être aussi