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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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 2

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 3

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.

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.

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.

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.

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.

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.

How to determine equilibrium price?

A mathematical example

where I is average income measured in thousands of rupees.

• Supply curve is Q = 3P – 50.

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

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

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

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)

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”)

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

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

point to point.

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

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

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 16

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

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?

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.

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

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?

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

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.

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 23

Elasticity, Total Revenue and Linear Demand

P

TR

100

0 10 20 30 40 50 Q 0 Q

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

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

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

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

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 29

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 30

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

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 31

Demand, Marginal Revenue (MR) and Elasticity

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

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

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

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)

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.

Thank you

Back up slides…

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

Perfectly Inelastic Demand- Elasticity equals 0

Price Demand

Example??

1. An $5

increase

in price... 4

100 Quantity

2. ...leaves the quantity demanded unchanged.

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 40

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.

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 41

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.

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 42

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.

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 43

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.

quantity demanded is infinite.

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 44

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)

2/26/2018 MBA ZC416, Managerial Economics, Monika Gupta 45

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