Elasticity

Objectives
To outline the importance of demand
sensitivity analysis to the behavior of the
organization
To consider the factors that affect the price
elasticity of demand
To consider the relationship between price,
demand, marginal and total revenue
To develop the concepts of supply elasticity,
advertising,
cross-price,
and
income
elasticity to the behavior of the organization
To understand the direction of economic
impact of government policy
2

the degree of
responsiveness of quantity demanded
to a change in price.

Elasticity of

demand

Percentage change in the Qty.

Ed =
demanded of Good x
Percentage change in the price
of Good x
= % Qdx
Q1 = Qd before P
% Px
Q2 = Qd after P
P1 = P before P

P2 = P after P
3

= (Q2 Q1 / Q1)
(P2 P1 / P1)
Illustration Q1=2,000, Q2=2,500
P1= 10, P2= 9 then
2500 2000 / 2000 = - 2.5
910 / 10
4

The use of proportionate or % measures

It allows comparison of changes in
two qualitatively different things
measured in two different types of
units.
It avoids the problem of what size
units to use
It is the only sensible way of deciding
how big a change in price or quantity
is.
The sign (+ or -)
5

Point elasticity
the measurement of elasticity at a
point on a curve
E = Q . P
P Q
In terms of calculus
e = dq . P
dp q
dq/dp is the reciprocal of the slope of
demand curve i.e. dp/dq which is
constant therefore Ed depend on P/Q
6

Arc elasticity
the
measurement
of
elasticity
between two points on a curve
E = Q . (P1 + P2)
P (Q1 + Q2)
Relative responsiveness of quantity
demanded to a discrete change in
price, and its intention is to provide a
measure of the elasticity of demand
over a range of prices.
7

Exercise
If P1=5, P2=4, Q1=200, Q2=260 then
measure point elasticity and arc
elasticity.

Types of price elasticity

Perfectly elastic
Perfectly inelastic
Unity elastic
Relatively elastic
Relatively inelastic

E = -1 At midpoint on demand curve

Qdx = A + BPx
if Q = 0 then P = - A/B
or if P = 0 then Q = A

Slope of linear demand curve = P

Q
B Is reciprocal of the slope of demand curve
Qdx = A + Qdx . Px
Px
As E = Qdx . Px
Px
Qx
Then
Qdx = A + E.Qx
Dividing both sides by Qx
1=A + E
Qx
Solving for E
E = (Qx A) / Qx
10

P
-A / B E = -
- > E > -1
E = -1
-1 > E > 0
O

A/ 2

E=0 Q
A

Mid point on D is at A/2, substituting

this in above equation gives E = -1
Q < A/2 E > -1
Q > A/2 E < -1
11

Total revenue and elasticity (QdX = 80 2Px)

Price of
Software
(Px)

Quantity of Own Price

Total
Software
Elasticity Revenue
Sold (Qx)
(EQxPx)
(PXQX)

80

0.00

70

-0.14

350

10

60

-0.33

600

15

50

-0.60

750

20

40

-1.00

800

25

30

-1.66

750

30

20

-3.00

600

35

10

-7.00

350

40

12

Elasticity and revenue

Total revenue test if demand is elastic,
an increase (decrease) in price will lead
to a decrease (increase) in TR. If demand
is inelastic, an increase (decrease) in
price will lead to a increase (decrease) in
total revenue. Finally, TR is maximized at
the point where demand is unitary
elastic.
Various types of revenues
TR, AR, MR, incremental revenue

13

Demand, elasticity and total

revenue

14

P
-A / B E = -
- > E > -1
E = -1
-1 > E > 0
O

A/ 2

E=0 Q
A

TR

TR

15

Relationship between ed, MR and TR

when ed>1, MR is positive and TR
rises as price falls
when ed=1, MR=0, TR=max
when ed<1, MR is negative and TR
falls as price falls
Relationship between ed and TR
elasticity

price
increases

price
decreases

e>1

TR falls

TR rises

e=1

TR constant

TR constant

e<1

TR rises

TR falls
16

TR, MR, AR AND E

MR = d(TR) = d(PQ) = P + Q dP
dQ
dQ
dQ
MR = P (1 + Q dP )
P dQ
Since Q . dP = 1
P dQ
E
MR = P (1 + 1 )
E
MR = f (E), If E = -1 Then
MR = P (1 + 1 ) = 0
-1
17

Using price elasticity of demand:

Application to Phillip Morris
In 1993, Phillip Morris cut cigarette
prices by 18%, Others including R J
Raynolds matched it
In 1994, demand increased by 12.5%
but profit declined by 25% due to bad
pricing strategy
All this happened because price was
cut when demand was inelastic (0.694)
18

Exercise
Cut price and make it up in volume
E = -1.7
e = % Q
Price cut = 5%
% P
Will sale increase enough to increase
TR due to price cut?

19

Gasoline price and consumer response in

US
Year

Avg. Price
Avg.
of
Miles per
gasoline
gallon

Avg. Miles
driven per
vehicle per
Year

Avg. Fuel
consumption
(gallons)

1973

$ 0.40

13.3

9,800

736

1975

0.57

13.7

9,400

685

1977

0.62

14.1

9,600

1979

0.86

14.5

9,300

638

1981

1.31

15.7

8,700

555

25%

7%

680

21

Estimates of price elasticity (US 1975)

Good or service
Electricity
Electricity
Water
Motion pictures
Gasoline
Gasoline
Foreign travel

Estimated price
elasticity
-0.13
SR
-1.89
LR
-0.14
LR
-3.69
LR
-0.15
SR
-0.78
LR
-4.10
LR
22

Income expenditure tree and

elasticity

23

Determinants of price elasticity

Nature of the commodity (less elastic
for broadly defined products)
Range of substitutes
Proportion of income spent
Time period
Durability of a commodity
Extent of use
Income level
Urgency of demand
24

Income elasticity of demand

the responsiveness
consumers income

of

demand

to

change

in

Point Ey = %Q
= Q . Y
% Y
Y Q
Arc
Ey = Q2-Q1 - Y2 + Y1
Y2-Y1
Q2+Q1
Example
Demand for auto = f(per capita Y)
Q=50,000+5(Y)
Y1=10,000
then
Q1=100,000,
Y2=11,000
then
Q2=105,000
Ey(Arc)= 105,000-100,000 11,000+10,000 = =0.512
11,000-10,000
105,000+100,00
Ey(Point) = 5. 10,000 = 0.5 (dq = 5)
25
100,000
dy

Income elasticity
making

and

decision

Inferior
goods(Ey<0),
normal
goods(1>Ey>0), superior goods(Ey>1)
In different stages of business cycle
International trade
Engels law and the plight of the farmer
(1940 US farmer to feed 11 people, now
he feeds 80 people)
26

Income elasticity of demand, selected commodities, global

Good

Elasticity

Grain(China)

-0.12 to 0.15

Potatoes(UK)

Good

Elasticity

Cream (US)

1.72

-0.32

Eggs (UK)

-0.21

Potatoes(US)

0.15

Eggs (US)

0.57

Oranges (US)

0.83

Break (UK)

-0.17

Apples (US)

1.32

Other cereal
products (UK)

0.18

Lettuce (US)

0.88

Domestic cars
(US)

1.62

Meat (China)

0.1 to1.2

European cars
(US)

1.93

Milk (UK)

0.05

Asian cars (US)

1.65

Milk (US)

0.50
27

Income elasticity of selected commodities

in India 1960 -76
Commodity
Minor cereals
Major cereals
Handloom cloth
Mill made cloth
Bidi tobacco
Cigarette tobacco
NCAER, 1964

Rural
-0.83
0.55
-0.12
0.66
0.64
1.51

Urban
-1.32
0.12
0.21
0.70
-0.19
1.17
28

Cross-price elasticity of demand

The responsiveness of demand for one good to a change in
the price of another. Cross elasticity provides a measure of
substitution and complementarities between two products
Exy = %Qx
%Py
Exy = Qx . Py
Py

Qx

Qx = 100+0.5Py , at Py = 20 and Qx = 110

Exy = 0.5 . 20/110 = 0.09
ARC

Exy = Qx2- Qx1 . Py1 + Py2

Py2 - Py1 Qx1 + Qx2

= 150-125 . 100+50 = 0.27

100-50 150+125
Exy >0 for substitutes and Exy<0 for complementary products
Exy may not be symmetrical

Usefulness
industries

pricing

strategy,

boundaries

between
29

Advertisement and its effect on demand

1. Shift DD to right
2. Make it less price
elastic
Elasticity of advertisement responsiveness
of sales to changes in advertising
expenditures
EA = %Q sales
%adv.exp.
= Qx . Ax
Ax Qx
ARC EA = Qx2- Qx1 . Ax1 + Ax2
Ax2 - Ax1 Qx1 + Qx2
33

The objectives of an advertising

!
!

Create awareness
Inform customers
Create the desired perception
Create a preference
Persuade customer to purchase

Advertisement response curve

Factors determining ea
Type of commodity
Market share
Rivals reactions
State of economy
34

Price elasticity of supply

The responsiveness of supply to a
change in the price
ES = % QS
% P
Determinants of ES
- Es>1 when less additional cost,
spare capacity, easy supply of raw
material, ready transformation
- Time period
35

Degrees of elasticity of
supply
Perfectly elastic- Es =
infinity

Perfectly inelastic- Es = 0

Unity elastic- Es = 1

Relatively elastic- Es > 1

Relatively inelastic- Es < 1

36

Unit elastic supply curve

b

S1

S2

S3

1
0

37

Elasticity of supply for selfconsumption of own product

Hicks in Value and Capital explained
that
supply
becomes
backward
bending due to self consumption
(Ref.: Kothari, V N, 1999, Elasticity of
demand for self-consumption of own
product, Indian Economic Journal,
46(2), pp 140-142)
38