Elasticity and Demand

Dr Prabha Bhola, IIT KGP, Managerial

Elasticity of Demand
A

general definition: Elasticity is a (standard) measure of the degree of sensitivity ( or responsiveness) of one variable to changes in another variable percentage changes - unit free demand elasticities

Uses Four

price, income, cross, promotional

Dr Prabha Bhola, IIT KGP, Managerial

Price Elasticity of Demand (E)

The

% change in quantity demanded, divided by the % change Qprice. in % E= %P

& Q are inversely related by the law of demand so E is always negative

The larger the absolute value of E, the more sensitive buyers are to a change in price

Dr Prabha Bhola, IIT KGP, Managerial

Demand Elasticity
Elastic Unit

Demand When % Change in Quantity Demanded > % Change in Price Elastic Demand When % Change in Quantity Demanded = % Change in Price Demand When % Change in Quantity Demanded < % Change in Price Elastic Demand When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price Inelastic Demand When the Quantity Demanded remains constant as Price changes

Inelastic

Perfectly

Perfectly

Dr Prabha Bhola, IIT KGP, Managerial

Perfectly Elastic Demand Curve

14 12 10 8 6 4 2 D

10

15

20 25 Quantity

30

The

elasticity of perfectly elastic demand curve is infinity

Dr Prabha Bhola, IIT KGP, Managerial

Perfectly Inelastic Demand Curve

D 3 0 2 5 2 0 1 5 1 0 5

1 0

1 5

2 0

2 5

Q a tity un

The

elasticity of perfectly inelastic demand curve is zero

Dr Prabha Bhola, IIT KGP, Managerial

Price Elasticity of Demand (E)

Elasticity Responsiveness

Elastic
Unitary Elastic

Q> P E> 1 % % Q= P E= 1 % % Q< P E< 1 % %

Inelastic

Dr Prabha Bhola, IIT KGP, Managerial

Percentage

change in quantity demanded can be predicted for a given percentage change in price as:

Price Elasticity of Demand (E)

%Qd = %P x E
Percentage

change in price required for a given change in quantity demanded can be predicted as:

%P = %Qd E
Dr Prabha Bhola, IIT KGP, Managerial

Price Elasticity and Changes in Total Revenue (TR)

The The

Price Elasticity and Total Revenue

effect on TR of changing price, holding output constant, is called the price effect effect on TR of changing output, holding price constant, is called the Elastic Unitary elastic Inelastic quantity effect
Q> P Q= P Q< P % % % % % %
Q-effect dominates No dominant effect P-effect dominates

Price rises Price falls

TR falls TR rises

No change in TR No change in TR

TR rises TR falls

Dr Prabha Bhola, IIT KGP, Managerial

Significance of Price Elasticity of Demand

Profit

maximization requires that business set a price that will maximize the firms profit tells the firm how much control it has over using price to raise profit

Elasticity

Dr Prabha Bhola, IIT KGP, Managerial

Factors Affecting Price Elasticity of Demand

Availability

of substitutes

The better & more numerous the substitutes for a good, the more elastic is demand
Percentage

of consumers budget

The greater the percentage of the consumers budget spent on the good, the more elastic is demand
Time

period of adjustment

The longer the time period consumers have to adjust to price changes, the more elastic is demand Dr Prabha Bhola, IIT KGP, Managerial

Calculating Price Elasticity of Demand

Price

elasticity can be calculated by multiplying the slope of demand (Q/P) times the ratio of price to quantity (P/Q) Q 100 Q P Q %Q = = E= P P Q %P 100 P

Dr Prabha Bhola, IIT KGP, Managerial

Price elasticity can be measured either:

Interval

Calculating Price Elasticity of Demand

(or arc) elasticity: calculated over an interval (or arc) of a demand curve.
Q Average P E= P Average Q

Point

elasticity: calculated at a specific point on the demand curve rather than over an interval.
Multiply the slope of demand (Q/P), computed at the point of measure, times the ratio P/Q, using the values of P and Q at the point of measure.

Method of measuring point elasticity depends Dr Prabha Bhola, IIT KGP, Managerial linear or curvilinear. on whether demand is

Calculating Price Elasticity of Demand

Point Elasticity when Demand is Linear Given Q = a + bP + cM + dPR , let income &
price of the related good take specific

values M and PR , respectively

Then express demand as Q = a' + bP , where = a + cM + dP and the slope parameter a' R

is b = Q P

Dr Prabha Bhola, IIT KGP, Managerial

Calculating Price Elasticity of Demand

Point Elasticity when Demand is Linear
Compute

elasticity using either of the two formulas below which give the same value for E

P E =b Q

P or E = PA

Where P and Q are values of price and quantity demanded at the point of measure along demand, and A ( = a'/ b ) is the price-intercept of demand

Dr Prabha Bhola, IIT KGP, Managerial

Point elasticity when Demand is Curvilinear Compute elasticity using either of two
equivalent formulas below

Calculating Price Elasticity of Demand

Q P P E= = P Q P A
Where Q P is the slope of the curved demand at the point of measure, P and Q are values of price and quantity demanded at the point of measur e, and A is the price-intercept of the tangent line extende d to cross the price-axis
Dr Prabha Bhola, IIT KGP, Managerial

Calculating Price Elasticity of Demand

If

the price change is relatively small, a point calculation is suitable

If

the price change spans a sizable arc along the demand curve, the interval calculation provides a better measure

Dr Prabha Bhola, IIT KGP, Managerial

Elasticity (Generally) Varies Along a Demand Curve

For

linear demand, price and vary E directly

The higher the price, the more elastic is demand The lower the price, the less elastic is demand

case of Q =b which has a constant aP For curvilinear demand, no general price elasticity (equal to b) for all prices

Special

rule about the relation between price and quantity

Dr Prabha Bhola, IIT KGP, Managerial

Elasticity of Straight Line Demand Curve

11 Ve e stic ry la 1 0 9 8 7 6 5 4 3 2 1 0 e =.2 9 Ve ry in la e stic U it e stic n la e =1 .0 S h in la lig tly e stic e =6 3 .3

Slope
S h e stic lig tly la

of

D 0 1 2 3 4 5 6 7 8 9 1 0 1 1

the linear demand curve is constan t but elasticit y varies

Q a tity un

Dr Prabha Bhola, IIT KGP, Managerial

Constant Elasticity of Demand

Demand EU

Function: Q = aPb

= P / (P - A) = 20 / (2033.33) = -1.5 = P / (P - A) = 40 / (4066.67) = -1.5

EV

Dr Prabha Bhola, IIT KGP, Managerial

Marginal Revenue, Demand & Price Elasticity

Marginal

revenue (MR) is the change in total revenue per unit change in output MR measures the rate of change in total revenue as quantity changes, MR is the slope of the total TR MR = revenue (TR) curve Q

Since

Dr Prabha Bhola, IIT KGP, Managerial

Marginal Revenue and Demand

Unit sales (Q) 0 1 2 3 4 5 6 7
MR

Price $4.50 4.00 3.50 3.10 2.80 2.40 2.00 1.50

TR = P Q MR = TR/ Q $0 4.00 7.00 9.30 11.20 12.00 12.00 10.50 -$ 4.00 3.00 2.30 1.90 0.80 0 -1.50

MR

< P for all but the 1st unit sold because price must be lowered inorder to sell more units. units: units of output that could have been sold at a higher price had a firm not

Inframarginal

= Price Revenue lost by lowering price on the inframarginal units

Dr Prabha Bhola, IIT KGP, Managerial

Demand, MR and TR

Panel A
Dr Prabha Bhola, IIT KGP, Managerial

Panel B

Demand and Marginal Revenue

When

A + BQ

inverse demand is linear, P =

Marginal revenue is also linear, intersects the vertical (price) axis at the same point as demand, & is twice as steep as the inverse demand function. The equation of the linear marginal curve is:
Dr Prabha Bhola, IIT KGP, Managerial

MR = A + 2BQ

= 120 2P

Linear Demand, MR, & Elasticity

Dr Prabha Bhola, IIT KGP, Managerial

MR, TR & Price Elasticity of Demand

Marginal revenue Total revenue Price elasticity of demand

Elastic E MR > 0 TR increases as Q Elastic ( > 1) increases ( > 1) E MR = 0 TR is maximized Unit elastic ( = Unit ElasticE 1) ( = 1) E E MR < 0 TR decreases as Q Inelastic ( < 1) Inelastic increases ( < 1) E

Dr Prabha Bhola, IIT KGP, Managerial

Marginal Revenue & Price Elasticity

For

all demand & marginal revenue curves, the relation between marginal revenue, price, & elasticity can be expressed as:

1 MR = P 1 + E

Dr Prabha Bhola, IIT KGP, Managerial

Income Elasticity
Income

elasticity (EM): A measure of the responsiveness of quantity demanded to changes in income, holding all other variables in the generalized function constant.
Positive for a normal good Negative for an inferior good

EM

%Qd Qd M = = %M M Qd

Dr Prabha Bhola, IIT KGP, Managerial

Cross-Price Elasticity
Cross-price

elasticity (EXR): A measure of the responsiveness of quantity demanded (of good X) to changes in the price of related good (R), when all other variables in the generalized demand function remain constant.
Positive when the two goods are substitutes Negative when the two goods are % QX PY complements Q X

E XY =

%PY

PY

QX

Dr Prabha Bhola, IIT KGP, Managerial

Interval Elasticity Measures

To

calculate interval measures of income & cross-price elasticities, the following formulas can be employed

EM

Q Average M = M Average Q Q Average PR = PR Average Q

E XR

Dr Prabha Bhola, IIT KGP, Managerial

Point Elasticity Measures

For the linear demand function Q X =a +bPX+ cM dPY , + point measures of income & cross-price elasticities can be calculated as

EM E XR

M =c Q PR =d Q

Dr Prabha Bhola, IIT KGP, Managerial

Promotional Elasticity of Demand

Purpose

Product Differentiation (Branding) To make the demand for a Itproduct greater measures the responsiveness of

demand to the advertisement expenditure of the firm

E

= % change in the demand for X % change in the ad. exp. on X

Dr Prabha Bhola, IIT KGP, Managerial

Importance of Elasticity
Determining

the level of output

and prices Helpful in price discrimination Fixation of rewards for factors of production Determining Govt. policies Helpful in international trade Helps in demand forecasting
Dr Prabha Bhola, IIT KGP, Managerial