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Managerial Economics

Executive MBA Program


Session 3: Elasticity and its
Application
Instructor
Sandeep Basnyat
9841892281
Sandeep_basnyat@yahoo.com

A scenario
You design websites for local businesses.
You charge $200 per website, and currently
sell 12 websites per month.
Your costs are rising (including the opp.
cost of your time), so youre thinking of
raising the price to $250.
The law of demand says that you wont sell
as many websites if you raise your price.
How many fewer websites? How much will
your revenue fall, or might it increase?

Elasticity

Basic idea: Elasticity measures how much


one variable responds to changes in
another variable.
One type of elasticity measures how much
demand for your websites will fall if you raise
your price.

Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
Elastic and Inelastic demand and supply.

Price Elasticity of Demand


Price elasticity
of demand

Percentage change in Qd
=

Percentage change in P

Price elasticity of demand measures


how much Qd responds to a change in P.

Price Elasticity of Demand


Price elasticity
of demand

Example:
Price
elasticity
of demand
equals
15%
= 1.5
10%

Percentage change in Qd
=

Percentage change in P
P

P rises
P2
by 10%
P1
D
Q2

Q falls
by 15%
What does elasticity = 1.5 mean?

Q1

Calculating Percentage Changes


Standard method
of computing the
percentage (%) change:

Calculate
Price
Elasticity of
Demand

end value start value


x 100%
start value

$250

$200

D
8

12

Calculating Percentage Changes


Demand for
your websites

Problem:
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = -1.33

$250

$200

D
8

12

From B to A,
P falls 20%, Q rises 50%,
elasticity = 50/20 = - 2.50

How to solve this confusion?

Calculating Percentage Changes

So, we instead use the midpoint method:

end value start value


x 100%
midpoint

The midpoint is the number halfway between


the start & end values, also the average of
those values.

It doesnt matter which value you use as the


start and which as the end you get the
same answer either way!
What is PED using midpoint method?

Calculating Percentage Changes

Using the midpoint method, the % change


in P equals

$250 $200
x 100% = 22.2%
$225

The % change in Q equals


8 12
x 100% = - 40.0%
10

The price elasticity of demand equals


- 40/22.2 = -1.8

ACTIVE LEARNING

1:

Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms using
midpoint method:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

10

ACTIVE LEARNING

1:

Answers

Use midpoint method to calculate


% change in Qd
(5000 3000)/4000 = 50%
% change in P
($70 $90)/$80 = - 25%
The price elasticity of demand equals
50%
= - 2.0
- 25%
11

Calculating Price Elasticity of


Demand
Two Ways: Arc elasticity Calculation and Point
Elasticity Calculation

Arc Elasticity:

DQ
%DQ Q
DQ p
e

%Dp Dp Dp Q
p
where D indicates change.

Important Note:
Along a D curve, P
and Q move in
opposite directions,
which would make
price elasticity
negative most of the
cases. (E <0)

Example
If a 1% increase in price results in a 3% decrease in
quantity demanded, the elasticity of demand is e = 3%/1% = -3.

Numerical example
Consider a competitive market for which the
quantities demanded and supplied (per
year) at various prices are given as follows:
Price($) Demand (millions) Supply
(millions)
60
22
14
80
20
16
100
18
18
120
16
20
Calculate the price elasticity of demand when
the price is $80. When the price is $100.

Solution to Numerical example


DQ D
QD
P DQ D
ED

.
DP
Q D DP
P
From the above question, with each price increase of $20, the quantity
demanded decreases by 2. Therefore,

DQD 2 0.1.
DP 20
At P = 80, quantity demanded equals 20 and

80

ED
0.1 0.40.
20
Similarly, at P = 100, quantity demanded equals 18 and

100

ED
0.1 0.56.
18

Calculating Price Elasticity of


Demand

The estimated linear demand function for pork


is:
Q = 286 -20p
where Q is the quantity of pork demanded in million
kg per year and p is the price of pork in $ per year.
At the equilibrium point of p = $3.30 and Q = 220
Find the elasticity of demand for pork:

Calculating Price Elasticity of


Demand
Point Elasticity: Elasticity at a particular point (price)

Use of derivative: dQ/dP : denotes rate at which


quantity changes with respect to Price: D
similar
Q to:

Dp
So, replace by dQ /dP in the Arc elasticity formula,
So the elasticity of demand is:

DQ p
p
e
(dQ / dP)
Dp Q
Q

Calculating Price Elasticity of


Demand

The estimated linear demand function for pork


is:
Q = 286 -20p
where Q is the quantity of pork demanded in million
kg per year and p is the price of pork in $ per year.
At the equilibrium point of p = $3.30 and Q = 220 the
elasticity of demand for pork:

p
3.30
e (dQ / dP) 20
0.3
Q
220

Numerical Problems
Consider a market with Demand curve q = 16 10p and Supply curve
q = 8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)
(a) Determine the market equilibrium price and quantity and the total
revenue in this market.
(b) Calculate the price elasticity of demand and the price elasticity of
supply at the market equilibrium.
Answer (a):
P = $0.8/kg

Answer (b):
PED = -1
PES = 2

q = 8 million kgs.

TR = $6.4 millions

What determines the Elasticity of Demand?


EXAMPLE 1:

Wai Wai vs. Yogurt or curd


The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
Wai Wai has lots of close substitutes
(e.g., Rum Pum, Mayoz etc.),
so buyers can easily switch if the price rises.
Yogurt has no close substitutes,
so consumers would probably not
buy much less if its price rises.

Lesson: Price elasticity is higher when close


substitutes are available.

EXAMPLE 2:

Blue Jeans vs. Clothing

The prices of both goods rise by 20%.


For which good does Qd drop the most? Why?
For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos, or even cotton
pant).

There are fewer substitutes available for


broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)

Lesson: Price elasticity is higher for narrowly


defined goods than broadly defined ones.

EXAMPLE 3:

Insulin vs. Caribbean Cruises

The prices of both of these goods rise by 20%.


For which good does Qd drop the most? Why?

To millions of diabetics, insulin is a


necessity.
A rise in its price would cause little or no
decrease in demand.

A cruise is a luxury. If the price rises,


some people will forego it.
Lesson: Price elasticity is higher for luxuries
than for necessities.

EXAMPLE 4:

Gasoline in the Short Run vs. Gasoline in the


Long Run

The price of gasoline rises 20%. Does Qd drop


more in the short run or the long run? Why?

Theres not much people can do in the


short run, other than ride the bus or carpool.

In the long run, people can buy smaller cars


or live closer to where they work.
Lesson: Price elasticity is higher in the
long run than the short run.

The Determinants of Price Elasticity:


A Summary

The price elasticity of demand depends


on:
the extent to which close substitutes are
available
whether the good is a necessity or a luxury
how broadly or narrowly the good is defined
the time horizon: elasticity is higher in the
long run than the short run.

The Variety of Demand Curves

Economists classify demand curves


according to their elasticity.

The price elasticity of demand is closely


related to the slope of the demand curve.

Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the
elasticity.

The next 5 slides present the different


classifications, from least to most elastic.

Perfectly inelastic demand (one extreme case)


0%
% change in Q
Price elasticity
=
=
of demand
% change in P 10%
P

D curve:
vertical

P1

Consumers
price sensitivity:
0
Elasticity:
0

=0

P2

P falls
by 10%

Q1
Q changes
by 0%

Inelastic demand
% change in Q < 10%
Price elasticity
=
=
of demand
% change in P 10%
P

D curve:
relatively steep
P1

Consumers
price sensitivity:
relatively low
Elasticity:
<1

<1

P2
D

P falls
by 10%

Q1 Q2

Q rises less
than 10%

Unit elastic demand


10%
% change in Q
Price elasticity
=
=
of demand
10%
% change in P
P

D curve:
intermediate slope
P1

Consumers
price sensitivity:
intermediate
Elasticity:
1

=1

P2

P falls
by 10%

D
Q1

Q2

Q rises by 10%

Elastic demand
% change in Q > 10%
Price elasticity
=
=
of demand
10%
% change in P
P

D curve:
relatively flat
P1

Consumers
price sensitivity:
relatively high
Elasticity:
>1

>1

P2

P falls
by 10%

Q1

Q2

Q rises more
than 10%

Perfectly elastic demand (the other extreme)


any %
% change in Q
Price elasticity
=
=
of demand
0%
% change in P
P

D curve:
horizontal
Consumers
price sensitivity:
extreme
Elasticity:
infinity

= infinity

P2 = P1

P changes
by 0%

Q1

Q2

Q changes
by any %

Elasticity of a Linear Demand Curve


P

200%
E =
= 5.0
40%

$30

67%
E =
= 1.0
67%

20

40%
E =
= 0.2
200%

10
$0

20

40

60

The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.

Price Elasticity and Total Revenue

Continuing our scenario, if you raise your price


from $200 to $250, would your revenue rise or fall?
Revenue = P x Q

A price increase has two effects on revenue:


Higher P means more revenue on each unit
you sell.
But you sell fewer units (lower Q), due to
Law of Demand.

Which of these two effects is bigger?


It depends on the price elasticity of demand.

Price Elasticity and Total Revenue


Price elasticity
=
of demand

Percentage change in Q
Percentage change in P

Revenue = P x Q

If demand is elastic, then


price elast. of demand > 1
% change in Q > % change in P

The fall in revenue from lower Q is greater


than the increase in revenue from higher P,
so revenue falls.

Price Elasticity and Total Revenue


Elastic demand
(elasticity = 1.8)
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 8 and
revenue = $2000.

increased
revenue due
to higher P

$250

Demand for
your websites
lost
revenue
due to
lower Q

$200

When D is elastic,
a price increase
causes revenue to fall.

12

Price Elasticity and Total Revenue


Price elasticity
=
of demand

Percentage change in Q

Percentage change in P

If demand is inelastic, then Revenue = P x Q


price elast. of demand < 1
% change in Q < % change in P

The fall in revenue from lower Q is smaller


than the increase in revenue from higher P,
so revenue rises.

In our example, suppose that Q only falls to 10


(instead of 8) when you raise your price to
$250.

Price Elasticity and Total Revenue


Now, demand is
inelastic:
elasticity = 0.82
If P = $200,
Q = 12 and
revenue = $2400.

If P = $250,
Q = 10 and
revenue = $2500.

$250

increased
Demand for
revenue
due
your websites
lost
to higher P
revenue
due to
lower Q

$200

When D is inelastic,
a price increase
causes revenue to rise.

10

12

ACTIVE LEARNING

2:

Answers
A.

Pharmacies raise the price of insulin by


10%. Does total expenditure on insulin
rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

36

ACTIVE LEARNING

2:

Answers
B. As a result of a fare war, the price of a luxury

cruise falls 20%.


Does luxury cruise companies total revenue
rise or fall?
Revenue = P x Q

The fall in P reduces revenue,


but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
37

Income Elasticity of Demand

The income elasticity of demand measures the


response of Qd to a change in consumer income.
Percent change in Qd

Income elasticity
=
of demand
Percent change in income

Calculating Income Elasticity of Demand

Arc Elasticity:

DQ
%DQ Q
DQ Y
x

%DY DY DY Q
Y
where Y stands for income.

Example
If a 1% increase in income results in a 3% decrease in
quantity demanded, the income elasticity of demand is x
= -3%/1% = -3.

Numerical Example
a) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand when per capita
income increases from $10,000 to $11,000? (Using midpoint
method)

Numerical Example
a) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand when per capita
income increases from $10,000 to $11,000? (Using midpoint
method)
Solution:
When I1 = 10,000 Q1 = 100,000
When I2 = 11,000, Q2 = 105,000
Percentage Change in Q = 4.88
Percentage Change in I = 9.52
Income Elasticity of Demand = 4.88 / 9.52 = 0.512

Numerical Example-Point Income Elasticity


b) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand at the income level
of $10,500?

Numerical Example
b) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand at the income level
of $10,500?
Solution:
When I = 10,500;
Q = 102,500
dQ / dI = 5

Income Elasticity of Demand = b x (P/Q)


= 5 x (10500 / 102500)
E = 0.512

Necessities, Inferior goods and


luxuries
Elasticity measurement as:

E<0

: Inferior goods (negative)

0 < E 1 : Normal goods or necessities


E>1

: Luxuries

An increase in income causes an increase in


demand for a normal good and luxuries.

An increase in income causes a decrease in


demand for inferior goods.

Cross Price Elasticity of Demand

The cross-price elasticity of demand measures the


response of demand for one good to changes in the
price of another good.

% change in Qd for good 1

Cross-price elast.
=
of demand
% change in price of good 2

For substitutes, cross-price elasticity > 0 (positive)


E.g., an increase in price of goat meat causes an
increase in demand for chicken.

For complements, cross-price elasticity < 0


(Negative)
E.g., an increase in price of computers causes
decrease in demand for software.

Calculating Cross Price Elasticity of


Demand

Arc Elasticity,

DQ
%DQ
DQ po
Q

%Dpo Dpo Dpo Q


po

where Po stands for price of another good.

Example
If a 1% increase in the price of a related good results in a
3% decrease in quantity demanded, the cross-price
elasticity of demand is = -3%/1% = -3.

Numerical Example
Demand for a publishers book is given as:
Qx = 12,000 5,000Px + 5I + 500Pc
Px = Price of the book = $5
I
= Income per capita = $10,000
Pc = Price of the books from competing
publishers = $6

Numerical Example
1) a) Find Price elasticity of demand for the book.
b) What effect a price increase would have on total
revenues?
Solution:
a) Substituting the values of I and Pc
Qx = 12,000 5,000Px + 5(10000) + 500(6)
Or, Qx = 65,000 5,000Px
When Px = $5 (given), Qx = 40,000
Now, dQx/dPx = - 5000
Therefore, E p = -5000 x (5 / 40000) = - 0.625
b) Since, the demand for the book is inelastic, an
increase in the price of the book would increase
total revenue.

Numerical Example
2) a) Find income elasticity of demand for the book.
b) Find if the book is inferior good, normal good or luxury.

Solution:
a) Substituting the values of Px and Pc
Qx = 12,000 5,000(5) + 5I + 500(6)
Or, Qx = - 10,000 + 5I
When I = $10000 (given), Qx = 40,000
Now, dQx/dI = b = 5
Therefore, E I = 5 x (10000 / 40000) = 1.25
b) Since, the E I > 1 for the book, the book is luxury.

Numerical Example
3) a) Assess the probable impact on demand for the book
if competing publishers raise their prices.
b) Are the books substitute for each other or
Solution:
complements
a) Substituting the values of Px and I
Qx = 12,000 5,000(5) + 5(10000) + 500Pc
Or, Qx = 37,000 + 500Pc
When Pc = $6 (given), Qx = 40,000
Now, dQx/dPc = b = 500
Therefore, Cross price elasticity of demand for the book
E c = 500 x (6 / 40000) = 0.075
1% increase in competitors book price will increase the
demand for the book by 0.075%
b) Since, the E C > 0 for the book, the book is substitute to
competing producers book.

Price Elasticity of Supply


Price elasticity
of supply

Percentage change in Qs
=

Percentage change in P

Price elasticity of supply measures


how much Qs responds to a change in
P.

Price Elasticity of Supply


Price elasticity
of supply

Example:
Price
elasticity
of supply
equals
16%
= 2.0
8%

Percentage change in Qs
=

Percentage change in P
P

P rises
P2
by 8%
P1

Q1
Q rises
by 16%

Q2

The Variety of Supply Curves


Economists classify supply curves
according to their elasticity.
The slope of the supply curve is closely
related to price elasticity of supply.
Rule of thumb:
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
The next 5 slides present the different
classifications, from least to most elastic.

Perfectly inelastic (one extreme)


0%
% change in Q
Price elasticity
=
=
of supply
10%
% change in P
P

S curve:
vertical

P2

Sellers
price sensitivity:
0
Elasticity:
0

=0

P1
P rises
by 10%

Q1
Q changes
by 0%

Inelastic
< 10%
% change in Q
Price elasticity
=
=
of supply
10%
% change in P
P

S curve:
relatively steep

S
P2

Sellers
price sensitivity:
relatively low
Elasticity:
<1

<1

P1
P rises
by 10%

Q1 Q2
Q rises less
than 10%

Unit elastic
% change in Q
Price elasticity
=
=
of supply
% change in P

=1

10%

S curve:
intermediate slope

S
P2

Sellers
price sensitivity:
intermediate
Elasticity:
=1

10%

P1
P rises
by 10%

Q1

Q2

Q rises
by 10%

Elastic
> 10%
% change in Q
Price elasticity
>1
=
=
of supply
10%
% change in P
P

S curve:
relatively flat

S
P2

Sellers
price sensitivity:
relatively high
Elasticity:
>1

P1
P rises
by 10%

Q1

Q2

Q rises more
than 10%

Perfectly elastic (the other extreme)


any %
% change in Q
Price elasticity
= infinity
=
=
of supply
0%
% change in P
P

S curve:
horizontal
Sellers
price sensitivity:
extreme
Elasticity:
infinity

P2 = P1

P changes
by 0%

Q1

Q2
Q changes
by any %

The Determinants of Supply Elasticity


1) The more easily sellers can change the
quantity they produce, the greater the price
elasticity of supply.
Example: Supply of Kings Way property is
harder to vary and thus less elastic than
supply of new cars.
2) For many goods, price elasticity of supply
is greater in the long run than in the short
run,
because firms can build new factories, or
new firms may be able to enter the market.

3:
Elasticity and changes in equilibrium
ACTIVE LEARNING

The supply of beachfront property is


inelastic. The supply of new cars is
elastic.
Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
For which product will P change the
most?
For which product will Q change the
most?

60

ACTIVE LEARNING

3:

Answers

Beachfront
property (inelastic
supply):

When supply
is inelastic,
P
an increase in
D1 D2
demand has a
bigger impact
on price than P
2
on quantity.
P1

S
B
A

Q 1 Q2

Q
61

ACTIVE LEARNING

3:

Answers
When supply
is elastic,
an increase in
demand has a
bigger impact
on quantity
than on price.

New cars
(elastic supply):
P

D1 D2
S
P2
P1

B
A

Q1

Q2

Q
62

How the Price Elasticity of Supply Can Vary


P

Supply often
becomes
less elastic
as Q rises,
due to
capacity
limits.

S
elasticity
<1

$15
12

elasticity
>1
4
$3
100 200

Q
500 525

Thank you