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You are on page 1of 35

Time: 90 Minutes

Slides: 35

Elasticity

Session 03

Elasticity: Concepts and Applications

18 June, 2017; Sunday

Plan of the Presentation

_____________________________________________________________

Part Topic

Part I: Motivation

Part II: Elasticity - Definitions and Concepts

Arc versus Point Elasticity

Exact Formula of Elasticity at a Point on a Curve

Taxonomy and Terminologies

Elasticities of Individual Items and Item Groups

Short-run versus Long-run Elasticity

Part III: A Very Brief Case Study

Part IV: Illustrative Questions

Part I: Motivation

Motivation of Elasticity: Academic Perspective

with respect to a few variables of interest (typically,

prices or income)?

features of the demand curve or supply curve.

Typical features:

Slope

Curvature

depend on the units of measurement!

12/16/2017 3:18 AM KB: ME, Session 03, Term I 3 of 35

3

An Illustration of Dependence of Slope on the Unit

of Measurement

Demand Curve for Oil under Two Different Sets of Measurement

A Dimensionless Measure of Responsiveness

Basic Idea: Replace percentage change in place of

absolute change

interest (e.g., Y Demand, X Price)

Then, a possible measure: (Y/Y) / (X/X)

Interpretation: Percentage change in Y under a unit percentage

increase in X.

Since both the numerator and the denominators would be

free from choice of units, the measure itself would be free

from choice of units.

different commodities could be compared.

Motivation of Elasticity: Business Perspective

By what percentage will your sales decrease if you raise your price

5.0 per cent?

Your competitor has initiated a price war by a 10.0 per cent price-

cut. How will the demand for your product be affected?

Per-capita income in the Indian economy is growing approximately

at 8.0 per cent per annum. By what percentage is demand for air-

conditioners likely to change after five years? How shall it change if

the government reduces indirect tax on AC in this years budget by

5.0 percent?

Other Examples

By what percentage will my sales change if I increase my

advertising expenditure in television by 10.0 per cent?

Murder and the probability of capital punishment (Reference: A

study by Ehlrich in American Economic Review, June 1975)

Part II: Elasticity Definitions and Concepts

Definition of Elasticity

percent increase in another variable.

Percentage change in quantity demanded of a commodity

resulting from a 1-percent increase in its price.

Computation of Elasticity from Two Points on a

Curve: A Practical Problem

Note: In one case, elasticity measure

is -3, and the other case, the same

A measure is (1/3)

What happens

when B

approaches A or

vice versa?

Empirical Formula of Arc Elasticity

For any two points (p1,q1) and (p2,q2),

elasticity of q with respect to p may be

written as:

(q/p)(p/q)

The best approximation to the correct

measure is obtained by defining p and q as

the average of the prices and quantities at

the two points on the curve, e.g.,

[(q2 q1)/(p2-p1)][(p1+p2/(q1+q2)]

Study (To be presented before you soon!)

Definition of Elasticity at a Point on a Curve

Recall: Elasticity of a variable Y=f(X) with respect to X

= (%change in Y)/(%change in X)

Precise mathematical definition of elasticity at a point (X,Y)

= (X/Y) (dY/dX) = d{ln(Y)}/d{ln(X)}

Interpretation

Linear

Quadratic

vary from point to point.

12/16/2017 3:18 AM KB: ME, Session 03, Term I 10 of 35

A Taxonomy of Elasticity

Price elasticity

Demand (Price elasticity of demand)

Own price (Own price elasticity of demand)

Cross price (Cross price elasticity of demand)

Substitutes

Complements

Supply

Own price

Income elasticity

Demand (Income elasticity of demand)

Price Elasticity of Demand

What kind of signs do we expect?

Cross Price Elasticity of Demand

Substitutes (+)

Complements (-)

terms of the absolute values.

Extreme Cases:

[a] (Minus) Infinite Elasticity

For a horizontal demand practical example to

curve, Q/P is infinite. illustrate this case?

Because a tiny change

in price leads to an

enormous change in

demand, the elasticity of

demand is infinite.

Infinitely Elastic Demand: Principle that consumers will buy as much of a good

as they can get at a single price, but for any higher price the quantity demanded

drops to zero, while for any lower price the quantity demanded increases without

limit.

12/16/2017 3:18 AM KB: ME, Session 03, Term I 13 of 35

Extreme Cases:

[b] Zero Elasticity (Completely Inelastic)

Q/P is zero. Because the

quantity demanded is the

same no matter what the

price, the elasticity of demand

is zero.

Completely Inelastic

Demand: Principle that

consumers will buy a fixed

quantity of a good

regardless of its price.

Income Elasticity of Demand

definition with income as the X variable!

positive and negative, depending up on the nature of the

commodity.

and income.

expenditure due to severe data limitations!

Elasticity of Supply

with supply as the Y variable.

Sign: Positive.

Interpretation

Determinants of elasticity of supply

How easily can producers shift to other

products?

How costs respond to output changes?

Terminologies

Price Elasticity of Demand / Supply (Ignoring Sign!)

Completely inelastic =0

Inelastic 0<<1

Unit elasticity =1

Elastic 1< <

Infinitely elastic =

Income Elasticity of Demand

Inferior good <0

Normal good

Income inelastic 0<<1

Income elastic >1

Substitute: >0

Complement: <0

Elasticities of Individual Items and Item Groups

an elastic demand, one with no close

substitutes tends to have an inelastic demand.

Examples:

Food

A Product with a high brand value

tend to have an elastic demand, even though

the demand for the group as a whole may be

inelastic!

Short-Run versus Long-Run Elasticities

Curves

What happens in

In the short run, an increase in price case of automobile

has only a small effect on the

demand?

quantity of gasoline demanded.

Motorists may drive less, but they

will not change the kinds of cars

they are driving overnight. In the

longer run, however, because they

will shift to smaller and more fuel-

efficient cars, the effect of the price

increase will be larger.

elastic in the long run than in the

short run, because of more

flexibility over time.

Part III: A Brief Case Study

Keeping up with The Times

In September 1993, The Times unilaterally lowered its price

Pre- 09-93 Post-09-93 Pre-09-93 Post-09-93

Times 45 30 376836 448962

Guardian 45 45 420154 401705

Telegraph 45 45 1037375 1017326

Independent 50 50 362099 311046

___________________________

2196464 2179039

mentioned in the slide) remained constant at about 2.5 million at both

pre and post Sep-93.

Can you compute (i) the own-price elasticity of demand for Times, (ii)

relevant cross-price elasticities of demand for Guardian, Telegraph and

Independent?

How do you ensure that the ceteris paribus assumption has been met

here, although approximately?

Consequence

A 40 per cent price reduction of The Times led to a 17.5 per

cent increase in its sales.

Price elasticity of demand for The Times: -0.44

Note: The revenue earned by The Times fell from

169,576 to 134,689!

Independent suffered most, with a 15.2 per cent loss of sales,

indicating a cross-price elasticity of 0.38

Cross-price elasticity for the Guardian was 0.11 and that for

the Daily Telegraph was 0.05.

Implications?

What do you expect would happen to the sales of The Financial

Times?

Why did The Times adopt a strategy of price cut?

An Imaginary Travel in Rajdhani Express

(INR) unilaterally lowered the AC I class passenger fare of the

Mumbai-Delhi Rajdhani Express!

Pre- 09-03 Post-09-03 Pre-09-03 Post-09-03

INR 45 30 376836 448962

AIR 90 90 1037375 1207326

______________________________________________________

groups, do you think that a computation of the own-price

elasticity of demand for Mumbai-Delhi travel by Rajdhani

Express as in the earlier case will yield the correct measure?

Part IV: Illustrative Questions

Question 1

are given by the equations

(1) Qd = 4 - P

(2) Qs = -2+P

point of equilibrium?

b) What is the price elasticity of the supply curve at the

point of equilibrium?

Question 2

are given by the equations

(1) Qd = 4 - P

(2) Qs = -2+P

(a) What are the price elasticities of the demand curve and

the supply curves at the points P = 1, 2, 3

Suppose for commodity X, price elasticity of demand is

constant throughout the curve. What can you say about

the functional form of the demand curve?

Question 3: Elasticity at two points of a line

demand at points A and B?

What happens

when B

approaches A or

vice versa?

Question 4

20 litres of petrol and B says I want Rs. 20/-

worth of petrol. What can you say about A and

Bs price elasticity of demand on petrol?

Question 5

income on clothing. What is Emilys income

elasticity of demand? What is her price-

elasticity of demand?

Question 6

Emilys taste as reported in the previous

question - has now changed. She now realizes

the importance of savings and spends only one

tenth of her income on clothing. What are her

new income and price elasticities of demand for

clothing?

After solving questions 3 and question 4, what do you

think would be the relationship between price elasticity

and the change in total amount spent by consumers on

a product after a price increase?

What are the business implications?

Question 7

of demand and revenue earned by firms?

per cent and observed that its revenue

increased by 3.0 per cent. Enthused by this

fact, it again raised price by another 5.0 per

cent. This time revenue fell by 8.0 per cent.

explain this be explained?

Question 8

demand for food for the Indian States. For

which State would you expect to have the

highest value and which State the lowest?

Earlier estimates reveal that income elasticity of food

in India is generally in the range of 0.7 0.9. Wide

regional variations are also reported.

The corresponding figures are: 0.65 for Peru, 0.5 for

Israel, 0.2 in the UK and 0.15 in the US.

Question 9

In a growing economy like India, do you think

income elasticity of demand for food should be

stable? If so, why? If not, what type of

behavior do you expect?

Annexure

Keywords, Important Concepts and Additional

References

Elasticity, Use of elasticity in business, arc vis--vis point elasticity,

taxonomy of elasticity, elasticity of individual items vis--vis group

items, short-run vis--vis long-run elasticity, extreme cases

Additional References:

Craig A. Gallet and John A. List, 1998: Elasticities of Beer Demand

Revisited, Economics Letters, 61, 6771.

Other references as cited in text.

Plan for the Next Session

Read:

Chapters 3 and 4 of Pindyck and Rubinfeld.

Be familiar with concepts like marginal and

diminishing / increasing marginal

Acknowledgements

same in Microeconomics: Theory and Applications by FD

Glahe and DR Lee. Textbox etc. are added by the

instructor.

Parts of a few slides (especially graphs, formulas etc.) in

this presentation have been copied from Pindyck,

Rubinfeld and Mehta.

The Times case study is available in Economics by RG

Lipsey and KA Chrystal.

All other slides have been prepared by the instructor

himself with the help of the textbooks. Any omission of

references is unintentional.

Dedication

When you share your wealth with others, your own wealth shrinks.

When you share your knowledge with others, your own knowledge increases.

~ Chanaky

free to use it and to distribute it to any student

of economics; but for heavens sake, though you

all are students of a business school, do not

make any business out of it!

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