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Slides: Teaching

Time: 90 Minutes
Slides: 35
Elasticity

Session 03
Elasticity: Concepts and Applications

Indian Institute of Management Lucknow


18 June, 2017; Sunday
Plan of the Presentation
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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

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Part I: Motivation
Motivation of Elasticity: Academic Perspective

How to measure responsiveness of demand or supply


with respect to a few variables of interest (typically,
prices or income)?

Clearly, the responsiveness would depend up on some


features of the demand curve or supply curve.

Typical features:
Slope
Curvature

Problem: Measures like slope or curvature of a curve


depend on the units of measurement!
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3
An Illustration of Dependence of Slope on the Unit
of Measurement
Demand Curve for Oil under Two Different Sets of Measurement

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A Dimensionless Measure of Responsiveness
Basic Idea: Replace percentage change in place of
absolute change

Suppose, Y = f(X), where X and Y are the variables of


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.

Advantage: Responsiveness of demand or supply curves for


different commodities could be compared.

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Motivation of Elasticity: Business Perspective

Examples involving Price and Income


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)

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Part II: Elasticity Definitions and Concepts
Definition of Elasticity

Elasticity: Percentage change in one variable resulting from a 1-


percent increase in another variable.

Illustration: Price Elasticity of Demand


Percentage change in quantity demanded of a commodity
resulting from a 1-percent increase in its price.

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Computation of Elasticity from Two Points on a
Curve: A Practical Problem

Which one is the initial price? A or B?


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?

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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)]

Illustrative Example: A Very Brief Case


Study (To be presented before you soon!)

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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

Elasticity is a pure number and is unit free!

A few special cases


Linear
Quadratic

Note that elasticity of a curve, like slope or curvature, could


vary from point to point.
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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)

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Price Elasticity of Demand

(Own) Price Elasticity of Demand


What kind of signs do we expect?
Cross Price Elasticity of Demand
Substitutes (+)
Complements (-)

Note: In many cases, price elasticities are compared in


terms of the absolute values.

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Extreme Cases:
[a] (Minus) Infinite Elasticity

Can you think of any


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.
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Extreme Cases:
[b] Zero Elasticity (Completely Inelastic)

For a vertical demand curve,


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.

Can you think of any practical example to illustrate this case?

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Income Elasticity of Demand

Definition of Income Elasticity: Just apply the general


definition with income as the X variable!

Point to Remember: Income elasticities could be both


positive and negative, depending up on the nature of the
commodity.

Engel curve: Relationship depicting quantity demanded


and income.

Practical Problem: Often income is replaced by total


expenditure due to severe data limitations!

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Elasticity of Supply

Definition: Just apply the common definition


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?

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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

Cross-Price Elasticity of Demand


Substitute: >0
Complement: <0

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Elasticities of Individual Items and Item Groups

A product with close substitutes tends to have


an elastic demand, one with no close
substitutes tends to have an inelastic demand.

Examples:
Food
A Product with a high brand value

Any one of a group of related products will


tend to have an elastic demand, even though
the demand for the group as a whole may be
inelastic!

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Short-Run versus Long-Run Elasticities

Gasoline: Short-Run and Long-Run Demand


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.

Demand, therefore, is more


elastic in the long run than in the
short run, because of more
flexibility over time.

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Part III: A Brief Case Study
Keeping up with The Times
In September 1993, The Times unilaterally lowered its price

Price Average Daily Sale


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

Total daily newspaper sales (including a few other newspapers not


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?

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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!

Competing papers suffered!


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?

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An Imaginary Travel in Rajdhani Express

Suppose on 30 September 2003, the Indian National Railways


(INR) unilaterally lowered the AC I class passenger fare of the
Mumbai-Delhi Rajdhani Express!

Fare (per 100 KM) Average Daily Sale (Rs.)


Pre- 09-03 Post-09-03 Pre-09-03 Post-09-03
INR 45 30 376836 448962
AIR 90 90 1037375 1207326
______________________________________________________

Assuming travel by AIR as the only alternative for high-income


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?

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Part IV: Illustrative Questions
Question 1

Suppose for a commodity X, demand and supply curves


are given by the equations
(1) Qd = 4 - P
(2) Qs = -2+P

a) What is the price elasticity of the demand curve at the


point of equilibrium?
b) What is the price elasticity of the supply curve at the
point of equilibrium?

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Question 2

Suppose for a commodity X, demand and supply curves


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

(b) A Tough Question:


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?

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Question 3: Elasticity at two points of a line

What are the price elasticities of


demand at points A and B?

What happens
when B
approaches A or
vice versa?

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Question 4

A and B drive to a petrol pump. A says I want


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?

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Question 5

Emily has decided to spend one third of her


income on clothing. What is Emilys income
elasticity of demand? What is her price-
elasticity of demand?

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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?

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Question 7

What is the relationship between price elasticity


of demand and revenue earned by firms?

A firm increased the price of its product by 5.0


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.

How can one use the concept of elasticity to


explain this be explained?

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Question 8

Suppose you are comparing income elasticity of


demand for food for the Indian States. For
which State would you expect to have the
highest value and which State the lowest?

Some related facts:


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.

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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?

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Annexure
Keywords, Important Concepts and Additional
References

Keywords and Important Concepts:


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.

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Plan for the Next Session

Theory of Consumer Behavior

Read:
Chapters 3 and 4 of Pindyck and Rubinfeld.
Be familiar with concepts like marginal and
diminishing / increasing marginal

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Acknowledgements

Graphs in slides 4, 8 and 25 are scanned copies of the


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.

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Dedication

When you share your wealth with others, your own wealth shrinks.
When you share your knowledge with others, your own knowledge increases.
~ Chanaky

These slides are dedicated to you all. You are


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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