Price, Income

and Cross Elasticity

Consider the following cases:

Making Sales Targets

A Public Transportation Problem:
Can the daily ridership fluctuations be controlled
through a pricing strategy?

The Airliners Pricing Problem:
How can an airliner fill its plains while
maximizing its profit?



Elasticity the concept
The responsiveness of one variable to changes
in another
When price rises, what happens
to demand?
Demand falls
BUT!
How much does demand fall?

Elasticity the concept
If price rises by 10% - what happens to
demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which
demand will change

Elasticity
4 basic types used:
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity

Elasticity
Price Elasticity of Demand
The responsiveness of demand
to changes in price
Where % change in demand
is greater than % change in price elastic
Where % change in demand is less than % change
in price - inelastic
Elasticity
The Formula:
Ped =
% Change in Quantity Demanded
___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)
Elasticity
Price ()
Quantity Demanded
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.
Elasticity
Price
Quantity Demanded (000s)
D
The importance of elasticity
is the information it
provides on the effect on
total revenue of changes in
price.
5
100
Total revenue is price x
quantity sold. In this
example, TR = 5 x 100,000
= 500,000.
This value is represented by
the shaded rectangle.
Total Revenue
Elasticity
Price
Quantity Demanded (000s)
D
If the firm decides to
decrease price to (say) 3,
the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue. 5
100
3
140
Total Revenue






















220

TR
0
= 220 x 120 = 26,400

TR
1
= 180 x 140 = 25,200

TR
2
= 180 x 200 = 36,000

120
180
0
Q
D
2
D
1
140 200
Elasticity
Price ()
Quantity Demanded
10
D
5
5
6
% Price = -50%
% Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
Producer decides to lower price to attract sales
Not a good move!
Elasticity
Price ()
Quantity Demanded
D
10
5
20
Producer decides to reduce price to increase sales
7
% in Price = - 30%
% in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
Good Move!
Elasticity
If demand is price
elastic:
Increasing price would
reduce TR (% Qd >
% P)
Reducing price would
increase TR
(% Qd > % P)
If demand is price
inelastic:
Increasing price would
increase TR
(% Qd < % P)
Reducing price would
reduce TR (% Qd <
% P)
Elasticity
Income Elasticity of Demand:
The responsiveness of demand
to changes in incomes
Normal Good demand rises
as income rises and vice versa
Inferior Good demand falls
as income rises and vice versa
Elasticity
Income Elasticity of Demand:

A positive sign denotes a normal good
A negative sign denotes an inferior good

Elasticity
For example:
Yed = - 0.6: Good is an inferior good but inelastic a rise in
income of 3% would lead to demand falling
by 1.8%
Yed = + 0.4: Good is a normal good but inelastic
a rise in incomes of 3% would lead to demand rising
by 1.2%
Yed = + 1.6: Good is a normal good and elastic
a rise in incomes of 3% would lead to demand rising
by 4.8%
Yed = - 2.1: Good is an inferior good and elastic
a rise in incomes of 3% would lead to a fall in demand of
6.3%

Elasticity
Cross Elasticity:
The responsiveness of demand
of one good to changes in the price of a
related good either
a substitute or a complement
Xed =
% Qd of good t
__________________
% Price of good y
Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse
relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive
relationship between the two)
Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes
in price
If Pes is inelastic - it will be difficult for suppliers to react
swiftly to changes in price
If Pes is elastic supply can react quickly to changes in
price
Pes =
% Quantity Supplied
____________________
% Price
Determinants of Elasticity
Time period the longer the time under consideration the
more elastic a good is likely to be
Number and closeness of substitutes
the greater the number of substitutes,
the more elastic
The proportion of income taken up by the product the
smaller the proportion the more inelastic
Luxury or Necessity - for example,
addictive drugs
Importance of Elasticity
Relationship between changes
in price and total revenue
Importance in determining
what goods to tax (tax revenue)
Importance in analysing time lags in
production
Influences the behaviour of a firm


Measuring elasticity of demand
Total expenditure method
If total expenditure remains same on increase or
decrease in price of a commodity, e = 1.
If total expenditure moves in a direction opposite
to the change in price, e > 1.
If total expenditure moves in the same direction
as change in price, e < 1.
Measuring e (cont.)
Percentage method
Point e
Arc e = - ((Q1 Q) / (Q1 + Q)) X ((P1 + P) / (P1 P))
Revenue method = A / (A-M)
Point e = Lower portion of curve / Upper
portion of curve