PAN African e-Network Project

Diploma in Business Management

Managerial Economics
Session - 2

Ms. Tavishi
1

Supply and Demand Practice

Answers

Supply and Demand for Boomerangs

Surplus

$12

$10

$8

Price per Boomerang

Demand

$6

Supply

$4

$2

$0

Quantity of Boomerangs

10

11

Supply and Demand for Boomerangs

$12

$10

$8

Price per Boomerang

Demand

$6

Supply

$4

$2

$0

Shortag
e4
5

Quantity of Boomerangs

10

11

Supply and Demand for Boomerangs

$12

Market
Equilibrium

$10

$8

Price per Boomerang

Demand

$6

Supply

$4

$2

$0

Quantity of Boomerangs

10

11

Supply and Demand for Boomerangs

$12

$10

$8

Original Demand
Price per Boomerang

Supply

$6

New Demand

$4

$2

$0

10

Quantity of Boomerangs

12

14

16

1. The income of the Chapel Hill townies declines

Price

after an early loss during March Madness.

P1
P2
D
D1
Q2

Q1

Quantity

Price

2. Chapel Hill is named one of the most beautiful

towns in North Carolina and tourism doubles

P2
P1

D1

D
Q1

Q2

Quantity

Price

3. The price of blue ties decreases. (Blue

ties are a substitute good for purple ties)

P1
P2
D1
Q2

Q1

D
Quantity

Price

4. The Federal government has been warning the

public about the possibility of a recession and job loss
in the RDU area. (Think expectations!)

P1
P2
D1
Q2 Q1

D
Quantity

Price

5. The price of purple striped shirts decreases (Purple

striped shirts are a complement to purple ties)

P2
P1
D1
D
Q1

Q2

Quantity

6. The price of silk increases (ties are

made with silk).
Price

S1
S

P2
P1

D
Q2 Q1

Quantity

Price

7. The government adds a subsidy to

tie production.
S
S1
P1
P2
D
Q1

Q2

Quantity

Price

8. After the release of Alan Greenspans first jazz flute

album, purple tie producers are expecting a huge
increase in demand and thus an increase in the price.

S1

P1
P2
D
Q1

Q2

Quantity

9. Congress enacts new tax on the

Price

production of purple ties.

S1
S

P2
P1

D
Q2

Q1

Quantity

Price

10. As the popularity of purple ties sweeps the greater

Orange County area, new producers enter the purple
tie market.

S
S1

P1
P2
D
Q1

Q2

Quantity

Price

11. Purple ties are named by GQ magazine as a must

have for all young professionals. At the same time, a new
textile machine decreases the cost of producing purple ties.

S1

P1
D1
D
Q1

Q2

Quantity

12. The price of pink ties (a related good that most purple tie producers also
produce) rises as spring approaches. Tie consumers in Chapel Hill begin to expect
purple ties to be put on sale since spring is coming, so they put off purchasing.

Price

S1
S

P1

D1
Q2

Q1

D
Quantity

Elasticity of demand
.

Elasticity of demand
A measure of the responsiveness of
one variable (usually quantity
demanded ) to a change in another
variable.
Price elasticity of demand is given by

continued
Demand is said to be:
Relatively elastic when Ed > 1,
unit elastic when Ed = 1, and
Relatively inelastic when Ed < 1.
Perfectly inelastic when Ed = 0
Perfectly elastic when Ed = infinity.

Perfectly Elastic Demand

Perfectly inelastic demand

Elasticity on a linear
demand curve

Elasticity on a linear
demand curve

Measurement of price elasticity of

demand

Numerical
Suppose price of sugar is $ 10 per Kg
and demand is 100 Kg.
When the price of sugar increases to
$ 11 per Kg , the quantity demanded
fall to 80 Kg.
Calculate price elasticity of demand
Answer: -2

Total expenditure method

When total expenditure increases with a fall
in price and decreases with a rise in price,
elasticity is said to be greater than one.
When total expenditure remains the same ,
whether the price rises or falls, elasticity is
said to be equal to unity .
When the total expenditure decreases with a
fall in price and increases with a rise in price
, elasticity is said to be less than unit elastic.

Elasticity and TR
A reduction in price will lead to:
an increase in TR when demand is
elastic.
a decrease in TR when demand is
inelastic.
an unchanged level of total revenue
when demand is unit elastic.

Elasticity Along a Demand

Curve
Ed =
$10
9
8
7
6
5
4
3
2
1

Elasticity declines along

demand curve as we move
toward the quantity axis

Price

Ed > 1

Ed = 1
Ed < 1
Ed = 0
1

9 10 Quantity

Continued

Marginal Revenue
Marginal revenue is defined as the change in total
revenue as the number of units cold changes. In the
demand graph we have seen that in order to sell more
the price has to be lowered. So, there is a relationship
between elasticity and marginal revenue.
If price falls and demand is elastic we know TR rises so
MR is positive.
If Price falls and demand is inelastic we know TR falls
and so MR is negative.
If price fall and demand is unit elastic we know TR
does not change.

Factors affecting the price elasticity

of demand
Nature of the commodity: Necessity ,
comfort or luxury
Substitutes : Commodities having
substitutes are more elastic .Because
with change in price of one
commodity the demand for the
substitutes is immediately affected.

Factors continued
Variety of uses: the demand for
goods , having variety of uses is
more elastic,
example milk, coal etc
coal is used for cooking , heating and
power generation , in factories etc.
If the price of coal increases , there will
be a considerable decrease in
demand for less important uses.

Factors
Postponement
of
the
use:
Commodities whose consumption
can be deferred have an elastic
demand.
Example demand for constructing
houses, then demand for the building
material such as bricks, cement,
steel etc will become elastic.

Factors
Proportion of income spent on a commodity:
goods on which consumer spend very less
proportion of their income have inelastic
demand. Example newspaper, toothpaste
etc
Habits: Demand for these goods is inelastic
to which people are habitual . Like cigarette,
coffee. Despite rise in their prices , people
demand such goods more or less the same
quantity.

factors
Time factor: the shorter the time, lesser
will be the elasticity of demand. It is
because many things like discovery of
new substitutes , changes in the habits ,
consumer adjustment to the new product
is possible in the long run.
Fashion: The elasticity of demand for a
commodity which is in fashion will be
inelastic because it becomes more or less
necessary for a consumer to purchase it.

Income elasticity of demand

It is the rate at which the quantity
bought changes , as a result of
change in the income of the
consumer , other thing remaining the
same.

Income Elasticity of Demand

EI = % Qd / % Id
Measures the responsiveness of
DEMAND
to
changes
in
disposable income.

Numerical
Suppose a house hold demands 30
litres of milk per month when the
monthly income is $3000 . If the
household income increases to
$5000, his demand for milk increases
to 40 litres per month . Calculate
income elasticity of demand.
Answer: .5

Engel Curve:
Shows the relationship between
quantity demanded and
disposable income given a
constant price.

Engel Curve: Normal Good

Disposable
Income

Engel Curve for a

Normal Good
EI > 0
Qd/ut

Luxury Goods
Luxury Goods are Normal Goods
but they have an

EI >= 1
Quantity demanded is very
senstive to changes in
disposable income

Necessities
Necessities are Normal Goods
but

0 < EI < 1
Quantity demand is not very
sensitive to changes in
disposable income

Engel Curve: Inferior Good

Disposable
Income

Engel Curve for an

Inferior Good
EI < 0

Qd/ut

 Normal Goods (EI >0)

Luxury Goods (EI >= 1)
Necessitites (0 < EI < 1)

Inferior Goods (EI < 0)

Degrees of Income elasticity of

demand
Unity income elastic:
When a percentage change in demand is the
same as percentage change in come.
More than unit elastic: when percentage
change in demand is more than percentage
change in income.
Less than unit elastic : When percentage
change in demand is less than percentage
change in come.

Cross-price elasticity of
demand

Continued
cross-price elasticity is positive if and
only if the goods are substitutes
cross-price elasticity is negative if
and only if the goods are
complements.

Numerical
Suppose the price of coffee per cup
rises from 2 to 3 as result ,
consumers demand tea , an
immediate substitutes rises from 100
cups to 200 cups. Calculate cross
elasticity of demand.

Kinds of cross elasticity

Positive: with the rise or fall in price of
commodity the quantity demanded of related
commodity increases or decreases accordingly
, then cross elasticity of demand is positive.
Negative: When with the rise in the price of a
commodity , the demand for related goods
decreases , and with a fall in price of a
commodity , the demand for other related
goods increases , then cross elasticity is said
to be negative.

Kinds of cross elasticity

Zero Cross elasticity: When with a
change in the price of a commodity ,
there is no change in the demand for
the other commodity , then the cross
elasticity of demand is said to be
zero.
They are not related goods but
Independent goods. Example butter
and books.

Importance of elasticity of
demand

Determination of price under

monopoly:
A monopolist while fixing the price
for this product takes into account its
price elasticity of demand
If the demand for his product is
elastic he will earn more profit by
foxing a low price.
If the demand is inelastic, he will be

Continued
Basis of price discrimination:
When a monopolist sells his product at
different prices, it is called price
discrimination.
A monopolist can adopt the policy of price
discrimination when price elasticity of
demand for his product for different uses
and for different consumers is different.

Continued
Price determination of joint products:
The concept of price elasticity of
demand is of much use in the pricing
of joint products, like wool and
mutton, wheat and straw, cotton and
cotton-seeds; oil and oilcakes etc.
In such cases separate cost of
production of each commodity is not
known.

Continued
Determination of wages:
The concept of elasticity of demand
is important in the determination of
wages of a particular type of labor.
If the demand for labor in an industry
is elastic, strikes and other trade
union tactics will not be of any avail
in raising wages.

Continued
Advantage to Finance Minister:
The concept of price elasticity of
demand is of paramount importance to
the Finance Minister.
The Finance Minister has to find out
how he can bring more revenue to the
exchequer. For this, while imposing
new taxes, Finance Minister takes into
consideration elasticity of demand;

 Taxes on goods having elastic

demand will yield less revenue. It is
because of the fact that taxes will
raise their prices and thus bring
down their demand.
Goods having inelastic demand are
taxed at a higher rate.

Continued
Determinations of prices of public
utilities:
It helps in fixing the prices for the
services rendered by public utilities
services of mass consumption like
water, electricity, railways, post and
telegraph.
Where the demand for services is
inelastic high price is charged, while
in case of elastic demand a lower

Continued
Distribution of burden of taxations:
If the demand for a product is inelastic
the burden of indirect tax will be more
on the consumers.
Price of the product will increase due
to imposition of the tax but demand
being inelastic will not contract.
In the situation burden on the
producers will be less.

Continued
International trade:
A country will gain by increasing the
price of her export if their demand in
the importing country is inelastic.

Continued
Effect on employment:
Effect of automatic machines on employment
depend upon the price elasticity of demand for
the goods produces by these machines.
Workers often oppose the use of the automatic
machines fairing unemployment.
In some cases where machine reduce costs and
prices of products with elastic demand the
amount demanded may go up as a result
production may have to be increased and more
workers employed.

Continued
While granting production:
The
government
considers
the
elasticity of demand of the product of
those industries which apply for
grant of subsidy or protection.
Subsidy or production is given only to
those industries whose products
have an elastic demand.

Importance of income elasticity of

demand
Knowledge of nature of goods:
It helps in distinguishing between
essential and non essential goods.
Commodity
with
high
income
elasticity are luxuries.

Continued
Helpful in business research:
In recent times the concept of income sensitivity has
been evolved which is intimately related to income
elasticity.
The difference between the two is that while income
elasticity is concern with physical units of the
commodity purchased, income sensitivity tells us
about changes in money expenditure.
It helps in business forecasting. It has been found
that telephone service, automobiles have high
income sensitivity while shoes, clothing , local bus
have low income sensitivity .

Continued
Importance in production planning
In less developed countries like Africa , as
standard of living rises , demand for some
commodities is expected to go up much
faster than the demand for others. In the
earlier stages demand for food and
clothing tends to be high. Generally as
the income increases there is shortage of
food and clothing which when not
satisfied leads to inflation.

Importance of Cross elasticity of

demand
Classification of commodities:
The concept of cross elasticity of demand can be
used to classify goods into three categories viz;
Substitutes- the goods for which cross elasticity
is positive then the two goods will be substitutes
for each other
Complementary if cross elasticity is negative,
the goods, will be complementary to each other
Independent goods- in case of independent
goods, cross elasticity will be zero.

Continued
Helps to define industry:
The concept of cross elasticity helps
to define an industry. Commodities
which are close substitutes have high
cross elasticity and commodities
which are poor substitutes have low
cross elasticity.
The distinction helps to define an
industry.

Advertising Elasticity of
Demand

Advertising elasticity is defined as

the ratio of proportionate change in
sales to proportionate change in
advertising expenditure.

Exercises
For each of the following pairs of goods, which
good has the more elastic demand and why?
Potatoes ( = .3) vs. Restaurant Meals (1.6)
Cigarettes today vs. Cigarettes over the next
year
Butter vs. Eggs
Suppose for cigarettes is 4, the price of
cigarettes is $3.00 per pack and we want to
reduce smoking by 20%. What should we do?

Continued
First, recognize that we need to raise the price.
Then, figure out by how much:
4 = = (Q / Q) / (p / p) = .20 / (X/3.00) gives
4 = .2 (3.00/X)
0.6 / X = 4
0.6 = 4X
X = .15 or 15 cents.
Raise the price of cigarettes by 15 cents.
Do you think the elasticity of demand for cigarettes is 4?
Probably not if people are addicted. What would be a more
realistic elasticity of demand for cigarettes? Try a different
value, still with the goal of reducing cigarette smoking by
20%.

Questions
Do you think the price elasticity of demand for Ford sportutility vehicles (SUVs) will increase, decrease, or remain
the same when each of the following events occurs?
Explain your answer.
a. Other car manufacturers, such as General
Motors, decide to make and sell SUVs.
b. SUVs produced in foreign countries are banned
from the American market.
c. Due to ad campaigns, Americans believe that
SUVs are much safer than ordinary passenger cars.
d. The time period over which you measure the
elasticity lengthens. During that longer time, new
models such as four-wheel-drive cargo vans appear.

Answers
Answer to Question:
a. The price elasticity of demand for Ford SUVs will
increase because more substitutes are available.
b. The price elasticity of demand for Ford SUVs will
decrease because fewer substitutes are available.
c. The price elasticity of demand for Ford SUVs will
decrease because other cars are viewed as less of
a substitute.
d. The price elasticity of demand for Ford SUVs will
increase over time because more substitutes (such
as four-wheel-drive cargo vans) become available.

Questions
Goods

Cross Elasticity

Air-conditioning units and

kilowatts of electricity

-.034

Coke and Pepsi

+0.63

High-fuel-consuming sport-utility
vehicles (SUVs) and gasoline

-0.28

McDonalds burgers and Burger

King burgers

+0.82

Butter and margarine

+1.54

Answers
A negative cross-price elasticity of demand
implies that the two goods are gross
complements. So air-conditioning units and
kilowatts
of
electricity
are
gross
complements, as are sport-utility vehicles
and gasoline. A positive cross-price elasticity
of demand implies that the two goods are
gross substitutes. So Coke and Pepsi are
gross substitutes, as are McDonalds and
Burger King burgers as well as butter and
margarine.

 The larger (and positive) the cross-price

elasticity of demand is, the more closely
the two goods are gross substitutes. Since
the cross-price elasticity of butter and
margarine is larger than the cross-price
elasticity of McDonalds burgers and
Burger King burgers, butter and margarine
are closer gross substitutes than are
McDonalds and Burger King burgers.
Similarly, the greater (and negative) the
cross-price elasticity of demand is, the
more strongly the two goods are gross

Answers
C. A cross-price elasticity of 0.63
implies that a 1% increase in the
price of Pepsi would increase the
quantity of Coke demanded by
0.63%. Therefore, a 5% increase in
the price of Pepsi would increase the
quantity of Coke demanded by five
times as much, that is, by 5 0.63%
= 3.15%.

 d. A cross-price elasticity of 0.28

implies that a 1% fall in the price of
gasoline would increase the quantity
of SUVs demanded by 0.28%.
Therefore, a 10% fall in the price of
gasoline would increase the quantity
of SUVs demanded by 10 times as
much, that is, by 10 0.28% =
2.8%.

Questions
What can you conclude about the price elasticity of demand
in each of the following statements?
a. The pizza delivery business in this town is very
competitive. Id lose half my customers if I raised the price
by as little as 10%.
b. I owned both of the two Jerry Garcia autographed
lithographs in existence. I sold one on eBay for a high price.
But when I sold the second one, the price dropped by 80%.
c. My economics professor has chosen to use the
Krugman/Wells textbook for this class. I have no choice but
to buy this book.
d. I always spend a total of exactly $10 per week on
coffee.

Answers
a. This statement says that a 10% increase in price reduces the
quantity demanded by 50%. That is, the price elasticity of
demand is
-50%/10% = -5
So demand is elastic.
b. The fact that it was necessary for price to drop by 80% in
order to sell one more unit (an increase in quantity of 67%, using
the midpoint method) indicates that the demand for Jerry Garcia
autographed lithographs is inelastic.
c. There is no substitute available, so demand is inelastic.
(Although, over time, as more used Krugman/Wells textbooks
become available, the price elasticity of demand will increase.)
d. Demand is unit-elastic: no matter what the price of coffee is,
the total revenue to the producer (which is my total expenditure
on coffee) remains the same.

Question
Taiwan is a major world supplier of semiconductor
chips. A recent earthquake severely damaged the
production facilities of Taiwanese chip-producing
companies, sharply reducing the amount of chips
they could produce.
a. Assume that the total revenue of a typical nonTaiwanese chip manufacturer rises due to these
events. In terms of an elasticity, what must be true
for this to happen? Illustrate the change in total
revenue with a diagram, indicating the price effect
and the quantity effect of the Taiwan earthquake on
this companys total revenue.

Question
b. Now assume that the total revenue of a
typical non-Taiwanese chip manufacturer
falls due to these events. In terms of an
elasticity, what must be true for this to
happen? Illustrate the change in total
revenue with a diagram, indicating the
price effect and the quantity effect of the
Taiwan earthquake on this companys total
revenue.

Answer
a. If the increase in price results in an
increase in total revenue, then the price
effect (which tends to increase total
revenue) must outweigh the quantity effect
(which tends to reduce total revenue). That
is, demand must have been inelastic. In the
accompanying diagram, as supply shifted
leftward from S1 to S2, the fall in total
revenue due to the quantity effect (area A)
is outweighed by the gain in total revenue
due to the price effect (area B).

Answer
b. If the increase in price results
in a fall in total revenue, then
the quantity effect (which tends
to reduce total revenue) must
outweigh the price effect (which
tends to increase total revenue).
That is, demand must have been
elastic.

 In the accompanying diagram, as

supply shifted leftward from S1 to S2,
total revenue falls by the amount of
the quantity effect (area A) but rises
by the amount of the price effect
(area B). The quantity effect (area A)
is larger than the price effect (area
B) so total revenue declines.

Answer

Questions
There is a debate about whether sterile hypodermic needles should
be passed out free of charge in cities with high drug use. Proponents
argue that doing so will reduce the incidence of diseases, such as
HIV/AIDS, that are often spread by needle sharing among drug users.
Opponents believe that doing so will encourage more drug use by
reducing the risks of this behavior. As an economist asked to assess
the policy, you must know the following: (i) how responsive the
spread of diseases like HIV/AIDS is to the price of sterile needles and
(ii) how responsive drug use is to the price of sterile needles.
Assuming that you know these two things, use the concepts of price
elasticity of demand for sterile needles and the cross-price elasticity
between drugs and sterile needles to answer the following questions.
a. In what circumstances do you believe this is a beneficial
policy?
b. In what circumstances do you believe this is a bad policy?

Answers
a. Handing out free needles lowers the price of needles to zero. First consider the
demand for needles. The higher the price elasticity of demand for sterile needles,
the greater the increase in the quantity of sterile needles demanded in response
to a decrease in the price. And the greater the increase in the quantity of sterile
needles demanded, the lower the spread of diseases like HIV/AIDS. Now consider
the demand for drugs. Drugs and sterile needles are gross complements: as the
price of sterile needles falls, the demand for drugs increases. This implies that
the cross-price elasticity of demand between drugs and sterile needles is
negative. The less negative (the closer to zero) the cross-price elasticity of
demand between drugs and sterile needles, the less
responsive is the demand for drugs to the price of sterile needles. So the policy
would be beneficial if the price elasticity of demand for sterile needles is high
(elastic) and the cross-price elasticity of demand between drugs and sterile
needles is negative and low (close to zero, that is, weakly complementary).
b. Similar reasoning as in part a implies that the policy would be a bad idea if the
price elasticity of demand for sterile needles is low (inelastic) and the cross-price
elasticity of demand between drugs and sterile needles is high and negative
(strongly complementary).

Question
Worldwide, the average coffee grower has
increased the amount of acreage under cultivation over the past few years. The result has
been that the average coffee plantation produces
significantly more coffee than it did 10 to 20 years
ago. Unfortunately for the growers, however, this
has also been a period in which their total
revenues have plunged. In terms of an elasticity,
what must be true for these events to have
occurred? Illustrate these events with a diagram,
indicating the quantity effect and the price effect
that gave rise to these events.

Answer
An increase in the amount of acreage that is cultivated
results in a rightward shift in the supply of coffee. This
reduces the price of coffee and increases the quantity
demanded. If total revenue from coffee sales have
decreased, this means that the price effect (which tends to
lower total revenue) must have outweighed the quantity
effect (which tends to increase total revenue). This implies
that demand must be inelastic. As shown in the
accompanying diagram, the price effect results in a loss of
total revenue equal to the size of area A. The quantity
effect (the quantity demanded increases as a result of the
price fall) results in an increase in total revenue equal to
the size of area B. Area A exceeds area B, so total revenue
falls.

Answer

Question
The U.S. government is considering reducing the amount
of carbon dioxide that firms are allowed to produce by
issuing a limited number of tradable allowances for carbon
dioxide (CO2) emissions. In an April 25, 2007, report, the
U.S. Congressional Budget Office (CBO) argues that most
of the cost of meeting a cap on CO2 emissions would be
borne by consumers, who would face persistently higher
prices for products such as electricity and gasoline . . .
poorer households would bear a larger burden relative to
their income than wealthier households would. What
assumption about one of the elasticity you learned about
in this chapter has to be true for poorer households to be
disproportionately affected?

Answer
For poorer households to be disproportionately affected
by an increase in energy prices, it is necessary that
those households spend a larger share of their income
on energy products than wealthier households. In other
words, as income rises, the quantity of energy products.
demanded has to increase less than proportionately. So
the CBO must think that the income elasticity of
demand for energy products, although positive, is less
than 1: energy products are income-inelastic. In fact,
this is just what the CBO report says: lower-income
households tend to spend a larger fraction of their
income than wealthier households do and . . . energy
products account for a bigger share of their spending.

Elasticity of Supply
It is defined as the percentage
change in quantity supplied divided
by the percentage change in price of
that brought it about.
Or its a measure of responsiveness
of quantity supplied to changes in
the product's own price.

Kinds of elasticity of supply

Perfectly inelastic
Perfectly elastic
Unit elastic
Relatively elastic
Relatively inelastic

Numerical
Suppose the price of the product is $
10 and a producer supplies 100 kg of
this product in the market.
Now the price of the product
increases to 15 and producer
increases the supply by 100 units .
Calculate the price elasticity of
supply.

Answer
First find out percentage change in
quantity demanded
Then find out percentage change in
price.
Now divide the former by the latter
to arrive at price elasticity of supply.

Numerical
Demand for advanced economic theory by
Michael Douglas is given by
Q= 20,000 60 P
a) compute the point price elasticity.
B) If the objective is to increase Total
Revenue from the sales of the book should
the price be increased or reduced?

Numerical
The following demand function of
ready made trousers has been
estimated:
Q= 2000 + 15 Y 5.5 P
Where Y = income, P is price, Q=
Quantity
A) when P = 150, and y= 15,000
calculate price elasticity of demand
and income elasticity of demand.

Answer
Price elasticity = -0.59
Income elasticity = 0.16

Thank you
For Queries mail at
tavishie@amity.edu