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Managerial Economics (MBA ZC416)

Session 03: Elasticity of Demand


Instructor
Monika Gupta
Assistant Professor
Economics and Finance Department
monika.gupta@pilani.bits-pilani.ac.in
A Quick Recap
• TR, AR and MR: An excel exercise and example
• Consumer behavior
• Law of diminishing Marginal Utility
• Indifference Curve
• Marginal Rate of Substitution
• Experiential learning component – Economic Modeling of Indifference
curve
• Demand and Law of Demand
• Demand Curve and Supply Curve and Market Equilibrium
• Determinants of demand
• Graphical exercise and numerical example
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Session Plan
• Demand Curve and Supply Curve and Market Equilibrium and
Determinants of demand
• Graphical exercise and numerical example
• Elasticity of demand
• Price/own price elasticity of demand
• Income elasticity of demand
• Cross price elasticity of demand
• Elasticity of Supply
• Few problems/examples
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A graphical example
Question. Show in a diagram the effect (shift) on the demand curve,
the supply curve, the equilibrium price, and the equilibrium quantity of
each of the following events.

a) The market for newspapers in your town


Case 1: The salaries of journalists go up.
Case 2: There is a big news event in your town, which is reported in the
newspaper.

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Solution
Case 1: Journalists are an input in the production of newspapers; an increase in
their salaries will cause newspaper publishers to reduce the quantity supplied at
any given price. This represents a leftward shift of the supply curve from S1 to S2
and results in a rise in the equilibrium price and a fall in the equilibrium quantity as
the equilibrium changes from E1 to E2.

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Solution
Case 2: Townspeople will wish to purchase more newspapers at any given price.
This represents a rightward shift of the demand curve from D1 to D2 and leads to a
rise in both the equilibrium price and quantity as the equilibrium changes from E1
to E2.

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A graphical example
Question. Show in a diagram the effect (shift) on the demand curve,
the supply curve, the equilibrium price, and the equilibrium quantity of
each of the following events.

b) The market for the Truett and Truett economics textbook


Case 1: Your professor makes it required reading for all of his or her
students.
Case 2: Printing costs for textbooks are lowered by the use of synthetic
paper.

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How to determine equilibrium price?
A mathematical example

• Suppose the demand curve for a product is given by Q = 300 – 2P + 4I,


where I is average income measured in thousands of rupees.
• Supply curve is Q = 3P – 50.

Find out the equilibrium price and demand in following case –


a. If I = 25, find the market-clearing price and quantity of the product.
b. Draw a graph to illustrate your answers.
c. Find out TR, AR and MR

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How to determine equilibrium price?
A mathematical example: Solution

a. P=90, Q=220,
c. If I = 25
Dd Function => Q= 400-2P
Inverse Demand Function => P=200 - .50Q
AR = P = 200 – 0.50 Q
TR= PQ = 200 Q- 0.50 Q2
MR = d (TR)/dQ = 200 - Q

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Elasticity of demand
What is Elasticity?
• The responsiveness or flexibility with respect to change in other
variable
• Percentage change in one variable with respect to percentage
change in another variable

• Why to study Elasticity of demand?

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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
year’s 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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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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Own Price Elasticity of Demand
• A measure of responsiveness or proportional change in quantity
demand with respect to propositional change in price
Percentage change in quatity demanded
Price elasticity of demand 
Percentage change in price

• Elasticity is a pure number and is unit free!


• Note that elasticity of a curve, like slope or curvature, could vary from
point to point.

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Example (Point elasticity)
• If the price of an ice cream cone increases from $2.00 to $2.20 and
the amount you buy falls from 10 to 8 cones then your elasticity of
demand would be calculated as:

(8  10)
100
10  20 percent
  2
(2.20  2.00)
100 10 percent
2.00

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Arc Elasticity of Elasticity or Mid-point formula
• The elasticity of one variable with respect to another between two
given points.
(Q 2  Q1 )/[(Q 2  Q1 )/2]
Price Elasticity of Demand =
(P2  P1 )/[(P2  P1 )/2]
• In the previous example, elasticity of demand, using the midpoint
formula, would be calculated as:
(8  10)
(10  8) / 2  22 percent
  2.32
( 2.20  2.00) 9.5 percent
( 2.00  2.20) / 2

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Cross-Price Elasticity of Demand
• Proportional change in quantity demand with respect to propositional
change in related good QX / QX QX PY
E XY   
PY / PY PY QX
• Substitutes - Two goods for which an increase in the price of one leads to
an increase in the quantity demanded of the other. Ex: Tea/Coffee,
Rice/Wheat, Chicken/Mutton
• Complements -Two goods for which an increase in the price of one leads to
a decrease in the quantity demanded of the other Ex: Milk/Sugar,
Rice/Vegetables, Car/Petrol
Substitutes Complements
EXY  0 EXY  0
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Income Elasticity of Demand
• Definition of Income Elasticity: proportional change in quantity
demand with respect to propositional change in income
Q / Q Q I
EI   
I / I I Q
• Point to Remember: Income elasticities could be both positive and
negative, depending up on the nature of the commodity.
Normal Good Inferior Good
EI  0 EI  0

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Elasticity of Supply
• The price elasticity of supply measures the relationship between change in
quantity supplied and a change in price and
• Defined as the percentage change in quantity supplied divided by the
percentage change in price.
• Sign: Positive.
• Determinants of elasticity of supply
• Time to produce, Storage capacity, etc.
• How costs respond to output changes?

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A Numerical Example
Amazon.com, the online bookseller, wants to increase its total revenue. One
strategy is to offer a 10% discount on every book it sells. Amazon.com knows that
its customers can be divided into two distinct groups according to their likely
responses to the discount. The accompanying table shows how the two groups
respond to the discount.

Cases Group A (sales per Group B (sales per


week) week)
Volume of sales before the 10% discount 1.55 million 1.50 million

Volume of sales after the 10% discount 1.65 million 1.70 million

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A Numerical Example
A) Using the midpoint method, calculate the price elasticities of
demand for group A and group B.
B) Explain how the discount will affect total revenue from each group.
C) Suppose Amazon.com knows which group each customer belongs
to when he logs on and can choose whether or not to offer the 10%
discount. If Amazon.com wants to increase its total revenue, should
discounts be offered to group A or to group B, to neither group, or
to both groups?

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Solution - A
• Using the midpoint method, the percent change in the quantity demanded by
group A is

• Since the change in price is 10%, the price elasticity of demand for group A is

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Solution – B and C
• For group A, since the price elasticity of demand is 0.625 (demand is
inelastic), total revenue will decrease as a result of the discount. For
group B, since the price elasticity of demand is 1.25 (demand is
elastic), total revenue will increase as a result of the discount.
• If Amazon.com wants to increase total revenue, it should definitely
not offer the discount to group A and it should definitely offer the
discount to group B.

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Relationship between Price Elasticity, TR and MR
• Elastic
• Increase (a decrease) in price leads to a decrease (an increase) in total
revenue.
• Inelastic
• Increase (a decrease) in price leads to an increase (a decrease) in total
revenue.
• Unitary
• Total revenue is maximized at the point where demand is unitary elastic.
• MR can be derived if you know the elasticity -
 1 
MR  P 1  
 EP 
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Elasticity, Total Revenue and Linear Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q

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Elasticity, Total Revenue and Linear Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

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Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

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Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

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Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

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Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
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Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
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Elasticity, Total Revenue and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
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Demand, Marginal Revenue (MR) and Elasticity

P • For a linear inverse


100
Elastic
demand function,
80 Unit elastic MR(Q) = a + 2bQ,
60
where b < 0.
Inelastic • When
40
• MR > 0, demand is
20 elastic;
• MR = 0, demand is unit
elastic;
0 10 20 40 50 Q • MR < 0, demand is
inelastic.
MR

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Annexure
• Keywords – Law of Demand, Elasticities of Demand, Price, Income and Cross Price
Elasticity of Demand, Relationship between Revenue and Elasticity of Demand
• Readings - Chapter 2 from the prescribed text book.
• Please reply prerecorded videos from 3.1 to 3.8 for detailed understanding of
Demand Analysis, 3.8 to 3.10 for Elasticities of demand and 3.11 and 3.12 for
Consumer Theory and Indifference Curve

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Announcements
• Try to solve numerical exercises given at the end of the chapter
• To understand the Utility concept and Indifference Curve, please read appendix
of Chapter 2 and listen pre-recorded video 3.11 and 3.12
• There would be no class tomorrow, rescheduling of the same would be
announced late
• Please listen the pre-recorded video regularly before every live class

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Plan for the Next Session
• Topics
• Demand Estimation, Demand Forecasting
• Please replay pre-recorded video 4.1 for next session
• The next session be based on excel demonstration of demand
estimation
• Readings - Chapter 3 and 4 from the prescribed text book (Truett and
Truett, Managerial Economics)

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Acknowledgements
• All slides in this presentation have been prepared by the instructor
herself. Assistance is taken from the text book. Any omission of
references is unintentional. I acknowledge the assistance of my guide
Prof. Sanjay K. Singh.

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Thank you

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Back up slides…

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Different types of Price Elasticity of Demand
• Perfectly inelastic demand (0) – vertical
• Unit Elasticity (1)
• High Elasticity of demand (>1) - The flatter the demand curve
• Less elasticity of Demand (<1) - The steeper the demand curve
• Perfectly elastic demand (∞)– horizontal

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Perfectly Inelastic Demand- Elasticity equals 0
Price Demand
Example??

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
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Inelastic Demand- Elasticity is less than 1
Price
Example??

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
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Unit Elastic Demand- Elasticity equals 1
Price
Example??

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
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Elastic Demand- Elasticity is greater than 1
Price
Example??

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
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Perfectly Elastic Demand- Elasticity equals infinity
Price
1. At any price Example??
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity


quantity demanded is infinite.
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Diagrammatic Representation
Elasticity along
Ed =  (perfectly elastic) demand curve as one
$10 moves toward the
9 quantity axis
8 Ed > 1 (elastic)
7
6
Price

5 Ed = 1 (unitary elastic)
4
3 Ed < 1 (inelastic)
2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10
Quantity (perfectly inelastic)
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