Managerial Economics3

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Managerial Economics3

© All Rights Reserved

- finance
- Micro Economics
- Managerial Economics
- EFM College Notes
- Elasticity and Its Applications
- Daily Test Economics
- Demand Analysis
- Price Elasticity
- 5803 BEC1034 Lec02b-Examples
- becker-stigler_de_gustibus_non_est_disputandum
- Price Elasticity
- Elasticity Economics
- Chapter 6 Studyguide
- Tutorial 4-Chapter 4-Elasticity of Dd & Ss
- Princ Ch05 Presentation
- Unit 1 ME.docx
- 4 Microeconomics
- Economics For Managers GTU MBA sem 1 Chapter 4 Elasticity
- 1
- Elasticity Final 2

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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

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

Percentage change in Qd

=

Percentage change in P

how much Qd responds to a change in P.

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

Standard method

of computing the

percentage (%) change:

Calculate

Price

Elasticity of

Demand

x 100%

start value

$250

$200

D

8

12

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

x 100%

midpoint

the start & end values, also the average of

those values.

start and which as the end you get the

same answer either way!

What is PED using midpoint method?

in P equals

$250 $200

x 100% = 22.2%

$225

8 12

x 100% = - 40.0%

10

- 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

% 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

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.

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

Demand

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:

Demand

Point Elasticity: Elasticity at a particular point (price)

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

Demand

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

EXAMPLE 1:

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.

substitutes are available.

EXAMPLE 2:

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).

broadly defined goods.

(Can you think of a substitute for clothing,

other than living in a nudist colony?)

defined goods than broadly defined ones.

EXAMPLE 3:

For which good does Qd drop the most? Why?

necessity.

A rise in its price would cause little or no

decrease in demand.

some people will forego it.

Lesson: Price elasticity is higher for luxuries

than for necessities.

EXAMPLE 4:

Long Run

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

short run, other than ride the bus or carpool.

or live closer to where they work.

Lesson: Price elasticity is higher in the

long run than the short run.

A Summary

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.

according to their elasticity.

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.

classifications, from least to most elastic.

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%

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%

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 %

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.

from $200 to $250, would your revenue rise or fall?

Revenue = P x Q

Higher P means more revenue on each unit

you sell.

But you sell fewer units (lower Q), due to

Law of Demand.

It depends on the price elasticity of demand.

Price elasticity

=

of demand

Percentage change in Q

Percentage change in P

Revenue = P x Q

price elast. of demand > 1

% change in Q > % change in P

than the increase in revenue from higher P,

so revenue falls.

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

=

of demand

Percentage change in Q

Percentage change in P

price elast. of demand < 1

% change in Q < % change in P

than the increase in revenue from higher P,

so revenue rises.

(instead of 8) when you raise your price to

$250.

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.

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

Does luxury cruise companies total revenue

rise or fall?

Revenue = P x Q

but Q increases, which increases revenue.

Which effect is bigger?

Since demand is elastic, Q will increase more

than 20%, so revenue rises.

37

response of Qd to a change in consumer income.

Percent change in Qd

Income elasticity

=

of demand

Percent change in income

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

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

= 5 x (10500 / 102500)

E = 0.512

luxuries

Elasticity measurement as:

E<0

E>1

: Luxuries

demand for a normal good and luxuries.

demand for inferior goods.

response of demand for one good to changes in the

price of another good.

Cross-price elast.

=

of demand

% change in price of good 2

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

increase in demand for chicken.

(Negative)

E.g., an increase in price of computers causes

decrease in demand for software.

Demand

Arc Elasticity,

DQ

%DQ

DQ po

Q

po

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

Percentage change in Qs

=

Percentage change in P

how much Qs responds to a change in

P.

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

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.

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%

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 %

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

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

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

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