MEM Lecture 8

Biresh Sahoo, Ph.D

Professor, XIM, Bhubaneswar
Price elasticity of demand
Consumers responsiveness to a change in price
31 August 2014 2
,
/
/
x
x
x p
x x x
p x x x
p p x p
c
A A
= =
A A
,
If 1, good is
x
x p
x elastic c >
,
If 1, good is
x
x p
x unitarily elastic c =
,
If 1, good is
x
x p
x inelastic c <
( )
,
x
x p
c
Defined as percentage change in quantity demanded
of a good over the percentage change in its price.
Determinants of
price elasticity of demand
Availability of close substitutes
Necessities versus luxuries
Time horizon
Definition of market

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|c
x,px
| =(p/x)-(Ax/Ap)
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Price elasticity, total revenue (TR) and
marginal revenue (MR)
p x
c
p
TR MR
6 0 0 ---
5 100 5 500 5
4 200 2 800 3
3 300 1 900 1
2 400 0.5 800 -1
1 500 0.2 500 -3
0 600 0 0 -5
Firms Strategy:
When a good is inelastic,
increasing price leads to
increased revenue; and when it
is elastic, decreasing prices
leads to increased revenue.
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Demand Curve:
x = f(p) = 600-100p
| |
x p x,
1 x
dp
d(TR)
=
Learning and applying price elasticity
Business around the globe use the total revenue test
to help manage cash flows. In the mid 2000s, for
instance, Indian Airlines faced a dilemma regarding
its pricing strategy for its New Delhi and Tokyo
Routes: Should it increase fares to boost cash flows,
or adopt a cut price and make it up in volume
strategy?
Based on a careful analysis of its demand, the airline
decided to adopt the latter strategy and reduced
prices in order to increase revenues. (Why?)
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To see why, suppose the research department of the airline
estimates that the price elasticity of demand for this
particular route is -1.5. If the airline cuts fares by 5% (say),
will the ticket sales increase enough to increase overall
revenues?
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c
x, px
= (Ax/x) /(Ap/p)
-1.5 = (Ax/x) /-5
(Ax/x) = -1.5*(-5)
= 7.5
Therefore, the quantity of ticket sold will increase by 7.5%.
Income elasticity of demand
If c
x,m
> 0, good x is normal good.
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Income elasticity of demand (c
x,m
) is defined as the
percentage change in the demand of a good (x) over
the percentage change in income (m).
c
x,m
= (Ax/x) /(Am/m) = (m/x)-(Ax/Am)
If c
x,m
< 0, good x is inferior good.
If c
x,m
> 1, good x is luxury good.
If 0 < c
x,m
< 1, good x is necessary good.
Learning and applying income elasticity
Your firms research department has estimated the income
elasticity of demand for nonfed ground beef to be -1.89.
You have just read in The Economic Times that due to an
upturn in the economy, consumer incomes are expected to
rise by 10% over the next three years. As a manager of a
meat-processing plant, how will this forecast affect your
purchases of non-fed cattle?
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c
x,m
= (Ax/x) /(Am/m)
-1.89 = (Ax/x) /10
(Ax/x) = -1.89*10 = -18.9
You can expect to sell 18.9% less nonfed ground beef over the
next three years, and therefore, you should decrease your
purchases of nonfed cattle by 18.9%, unless something else
changes.
Cross-price elasticity of demand
x and y are said to be compliments
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Cross-price elasticity of demand (c
x,py
) is defined as
the percentage change in demand of a good (x) over the
percentage change in the price of a good (y)
c
x,py
= (Ax/x) /(Ap
y
/p
y
) = (p
y
/x)-(Ax/Ap
y
)
If c
x,py
> 0,
If c
x,py
< 0,
x and y are said to be substitutes
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Learning and applying c
xy


You have just opened a new grocery store. Every item you carry
is generic (generic beer, generic bread, generic chicken, etc.).
You recently read an article in The Economic Times reporting
that the price of recreation is expected to increase by 10%. How
will this affect your stores sales of generic food products? You
have also read in the same article that some consulting
company has estimated that the cross-price elasticity of demand
for food and recreation is 0.175.
c
x,py
= (Ax/x) /(Ap
y
/p
y
)
0.175 = (Ax/x) /10
(Ax/x) = 0.175 *10 =1.75
Therefore, you can expect the demand for generic food
products to increase by 1.75%.
Learning and applying c
xy
:
The case of pricing decision of a firm selling multiple products

Suppose a restaurant manager earns Rs.4000 per
week from hamburger sales (x) and Rs.2000 per
week from soda sales (y). Thus R
x
= 4000, R
y
=
2000. If price elasticity of demand is |c
x,px
|=1.5
and cross-price elasticity of demand c
y,px
= -4.0,
what would happen to firms total revenue if it
reduced the price of x by 1%.
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y x
R R R + =
y p x p
y x
. . + =
y y x x
p y y p p x x p R A + A + A + A = A . . . .
|
|
.
|

\
| A
+
|
|
.
|

\
|
A
A
+ A =
y
y
y p
p
x
p x p
y
x
x x
.
|
|
.
|

\
| A
+
(

|
|
.
|

\
|
A
A
+ A =
y
y
R
p
x
x
p
p
x p
p
y
x
x
x
x
x
1
.
( ) | |
x
x
x
x
y px x x
x
x
P
P
P
y
y
P
R R
p
p A
|
|
.
|

\
|
A
A
+
A
= . . 1
,
c
( ) | |
x
x
px y y px x x
P
P
R R
A
+ = . . 1
, ,
c c
AR = [4000(1-1.5) + 2000*(-4.0)](-0.01)
= 20 + 80 = Rs.100
Market Supply Curve
The supply curve shows the amount of a good that
will be produced at alternative prices.
Law of Supply
The supply curve is upward sloping
Price (p)
Quantity (x)
S
0

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p
0
p
1
x
0
x
1
o

Determinants of Supply
Input prices
Technology or
government
regulations
Number of firms
Substitutes in
production
Taxes
Producer expectations
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