Managerial Economics

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 Managerial Economics
Prescribed Text Books:
Managerial Economics by Thomas, C. R.Maurice, S. C. and Sarkar,
S., The McGraw-Hill Companies, 2010.
Managerial Economics: Principles and Worldwide Applications by
Salvatore, D., Adapted by Srivsatava, R., Oxford University Press,
2012.
Other Reference/Suggested Books:
Managerial Economics: Principles and Worldwide Applications by
Salvatore, D. and Siddhartha K. Rastogi, Oxford University Press, 2016.
Managerial Economics by William F. Samuelson, W. F. and Marks, S. G.,
John Wiley & Sons, Inc, 2012.
Managerial Economics: A Problem Solving Approach by Wilkinson. N.,
Cambridge University Press, 2005.
Managerial Economics: Theory and Practice by Webster. T. J., Academic
Press, 2003.
Theory and Problems of Managerial Economics by Salvatore, D., The
McGraw-Hill Companies, Schaums Outline Series.
 Introduction to Managerial
Economics: Scope and Nature
 What is Economics?
Economics is a social science that studies how
individuals, governments, firms and nations make
choices on allocating scarce resources to satisfy/
achieve their goals or objectives.
 Some Popular Definitions of Economics

1. The Wealth Definition (Adam Smith, 1776): An Inquiry into

the Nature and Causes of the Wealth of Nations. According to
him , economics deals with the main question of how wealth is
produced and distributed among the economic agents.
2. Welfare Definition (Alfred Marshall, 1890): A study of
mankind in the ordinary business of life. According to him,
economics examines that part of individual and social action
which is mostly closely connected with the attainment and the
use of material requisites of well being.
3. The Scarcity Definition (Lionel Robbins, 1932): Economics
is a science which studies human behaviour as a relationship
between ends and scarce means which have alternative uses.
According to him, economics is concerned with that aspect of
mans behaviors which arises from the scarcity of means
(resources) to achieve given ends.
 Scope of Economics
Economics

Consumption Production Exchange Distribution

Factor Income
Factors of Production
Rent
Land Ends
(Economic Wages
Labor progress and Interest
Capital Welfare)
Means Profits
Organization
 The Circular Flow of Economic Activity
Income spent Revenue earned
Product
Market
Goods demand Goods supplied

Taxes
Households Firms
Government
Taxes

Inputs supplied Inputs demand

Factor
Market
Factor Income Factor costs
 Major Areas of Economics

Microeconomics and Macroeconomics

 Major Areas of Economics
Microeconomics:
Microeconomics is the study of the economic
behaviour of individual decision-making units,
such as individual consumers, resource owners,
and business firms.
It is concerned with the interaction between
buyers (individuals and firms) and sellers
(individuals and firms) and the factors that
influence the choices made by buyers and
sellers.
In particular, microeconomics focuses on
patterns of supply and demand and the
determination of price and output in individual
market.
Subject matter of Microeconomics
Theory of Demand and Supply- Consumer
Behaviour, Demand Theory, Demand Forecasting
and Factors affecting Individual and Market
Supply- Helps in choice of commodities for
production
Theory of Production: Production Function and
Laws of Returns to Scale which gives an idea
about input and output relations, input
requirements, size of firm, technology choice of
output. Helps producer to plan production, cost
and budget.
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Subject matter of Microeconomics
Market Analysis: Helps understand degrees
of competition, pricing-output decisions,
price discrimination, monopoly power and
advertising.
Profit Analysis: Provides logical analysis of
break-even point, emergence of profits,
profit-maximising output, dealing with risk
and uncertainty.

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Subject matter of Microeconomics
Theory of Capital: Along with quantitative
techniques enables investors to calculate cost of
capital, efficiency of capital, efficient allocation
of capital, and choice of projects as per risk-
return analysis.

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 Major Areas of Economics
Macroeconomics

Macroeconomics is the study of the total or

aggregate level of output, income,
employment, consumption, investment and
prices for the economy viewed as a whole.

Macroeconomics examines economy-wide

phenomena such as determination and
changes in unemployment, national income,
national output, rate of growth, gross
domestic product, inflation and price levels.
Subject matter of Macroeconomics
Behaviour of macro economic indicators: GDP,
GNP, GDCF, GDS, HDI etc.
Business Cycles Inflation- Employment
Fiscal Policy
Monetary Policy
Foreign Trade: Imports and exports, Exchange
rate, trade policies and capital flows

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 Three Basic Economic Questions
1. WHAT GOODS AND SERVICES SHOULD BE
PRODUCED?
2. HOW ARE GOODS AND SERVICES PRODUCED?
3. FOR WHOM ARE GOODS AND SERVICES
PRODUCED?

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Other Economic Questions
1. WHERE TO PRODUCE?
2. HOW MUCH TO PRODUCE?
3. ARE RESOURCES USED OPTIMALLY?
4. ARE RESOURCES FULLY EMPLOYED?
5. IS THE ECONOMY GROWING?
6. IN WHAT PHASE OF BUSINESS CYCLE
IS THE ECONOMY?

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 Decision Sciences
Mathematical Economics
Expresses and analyzes economic models
using the tools of mathematics.
Econometrics
Employs statistical methods to estimate and
test economic models as well as forecasting
using empirical data.
 What is Managerial Economics?
Managerial Economics refers to
the use of economic theory and
decision science tools to find the
optimal solution to managerial
decision problems.
Some Popular Definitions of Managerial Economics

Managerial Economics is economics applied in decision making. It

is a special branch of economics bridging the gap between
abstract theory and managerial practice William Warren Haynes,
V.L. Mote, Samuel Paul

Integration of economic theory with business practice for the

purpose of facilitating decision-making and forward planning -
Milton H. Spencer

Application of economic principles and methodologies to the

decision-making process within the firm or organizationunder
conditions of uncertainty -- Evan Douglas
 NATURE OF MANAGERIAL ECONOMICS

BUSINESS ADMINISTRATION

MANAGERIAL DECISION
PROBLEMS
DECISION SCIENCES
ECONOMIC THEORY : TOOLS AND TECHNICS:
MICROECONOMICS AND MATHEMATICS,
MACROECONOMICS STATISTICS AND
ECONOMETRICS
MANAGERIAL ECONOMICS :
APPLICATION OF ECONOMIC
THEORY AND DECISION
SCIENCES TOOLS AND
TECHNICS TO SOLVE
MANAGERIAL DECISION
PROBLEMS

OPTIMAL SOLUTIONS TO
MANAGERIAL BUSINESS PROBLEMS
NATURE OF MANAGERIAL ECONOMICS
Some Examples of Managerial Decisions
1. Determination of Price and Output to Maximize Profit
Some Examples of Managerial Decisions
2. Market Entry and Price Wars
Some Examples of Managerial Decisions
3. Decision on Research and Development
 Some Examples of Managerial Decisions
4. BP and Oil Exploration Risks
BP (known as British Petroleum prior to 2001) is in the business of
taking risks. As the third largest energy company in the world, its
main operations involve oil exploration, refining, and sale. The risks it
faces begin with the uncertainty about where to find oil deposits
(including drilling offshore more than a mile under the ocean floor),
mastering the complex, risky methods of extracting petroleum, cost-
effectively refining that oil, and selling those refined products at
wildly fluctuating world prices. In short, the company runs the whole
gamut of risk: geological, technological, safety, regulatory, legal, and
market related. Priding itself on 17 straight years of 100 percent oil
reserve replacement, BP is an aggressive and successful oil discoverer.
But the dark side of its strategic aspirations is its troubling safety and
environmental record, culminating in the explosion of its Deepwater
Horizon drilling rig in the Gulf of Mexico in April 2010. This raises the
question: What types of decisions should oil companies like BP take to
identify, quantify, manage, and hedge against the inevitable risks
they face?
 What is Decision Making?

Decision making is defined as the process of

selecting a suitable action from among several
alternative courses of action available.

In the process one has to decide what to do first

and what to do next. Therefore, decision making
can be referred to as choosing the right option
from alternative courses of action available.
The Decision Making Process
The Decision Making Process
 Role of Managerial Economist
Plan and Control Business Operations
Cost Minimization
Profit Maximization
Managing Competition
Economic Intelligence
Market Research
Uncertainty and Risk Management
Forecasting

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 The Theory of the Firm
A firm combines and organizes scarce resources
for the purpose of producing goods and/or
services for sale.
Internalizes transactions, reducing transactions
costs.
Economic theory assumes that the primary goal
of managers is to maximize the Wealth or Value
of the firm (the price at which the firm can be
sold).
 Alternative Objectives of Firm
Profit Maximization
Sales Revenue Maximization (Baumol, W. J.,
1959)
Managerial Utility Maximization (Williamson,
O., 1963)
Growth Maximization (Marris, R., 1963)
 Value of the Firm
The present value of all expected future profits
1 2 n n
t
=
PV
(1 + r )
1
+
(1 + r ) 2
+ + =
(1 + r ) n
(1 + r )
t =1
t

n
t
TRt TCt n
of Firm
Value= =
=t 1 = (1 + r ) t
t 1 (1 + r )
t

Where,
PV = Present Value;
1 , 2 , n are firms future expected profits;
r is the appropriate discount rate;
1,2,n is time period;
TR= Total Revenue; TC= Total Cost
 Example
1. Calculate the value of a firm at a discount
rate of 10% that generates $100 of profits for
each of two years and is sold for $800 at the end
of the second year.
 Example
1. Calculate the value of a firm at a discount rate of
10% that generates $100 of profits for each of two
years and is sold for $800 at the end of the second
year.

Solution:
 Example
2. Help the managers of the XYZ Company who are
in a position to organize production Q in a way that
will generate the following two net income streams,
where i,j designates the ith production process in the
jth production period so that they can maximize the
value of the company. The time value of money is
10%.
Stream I: 1,1 (Q)=$100; 1,2 (Q)=$330
Stream II: 2,1 (Q)=$300; 2,2 (Q)=$121
 Example
2. Solution:
Stream I:

Stream II:

The computation of present values (PV) reveals that,

the second stream is preferable to the first though the
first profit stream appears to be preferable to the
second, since it yields $9 more in profit over the two
periods.
 Example
3. A firm is expected to earn $10,000, $25,000,
$48,000, and $75,000 during the next four years,
after which it will be dissolved. What is the
present value of the firm if the discount rate is
8%?
 Example
4. Determine which of the two investment projects
a manager should choose if the discount rate of the
firm is 10%. The first project promises a profit of
$1,00,000 in each of the next four years while the
second project promises a profit of $75,000 in
each of the next six years. Also, determine which
of the two investment projects the manager should
choose if the discount rate of the firm is 20%.
 Example
4. Solution
 Example
4. Solution
 The Nature and Measurement of
Economic Profit and Economic Cost
Economic Cost and Opportunity Cost
Economic Cost is the expenditure (cost) incurred
by the firm on economic resources in production
of goods and services.
Opportunity Cost: Opportunity cost of a given
economic resource is the forgone benefits from the
next best alternative use of that resource.
--Notional idea, measured in terms of opportunity
lost or sacrificed or foregone benefits/profits from
the next best alternative from a given economic
resource.
 Measuring Opportunity Cost
Firms (use two kinds Inputs)

Market-supplied Owner-supplied
resources resources

Owned and supplied by Owned and supplied

others which is hired, by the owner which is
rented, or leased by the used by the firm
firm in factor markets.

Money and Capital equipment,

Wages, Rent, Interest and Time and Labor Services and
Profits Managerial Talent
 Total Economic Cost (used in Production)
Total Economic Cost = Sum of opportunity
costs of market-supplied resources plus
opportunity cost of owner-supplied resources.
Total Economic Cost

Explicit Costs Implicit Costs

(Out-of-Pocket Costs, (Book Costs)
Accounting Costs)

Non-monetary opportunity
costs of using owner-
Monetary payments to supplied resources (firms
owners of market-supplied make no monetary payment
resources to use its own resources)
Opportunity cost of using
owner-supplied resources are
not zero.
 Examples
Explicit Cost: Cost of raw materials; wages and
salaries; power charges; rent of business or
factory premises; interest payment on capital
invested; insurance premium; taxes like property
tax, duties, license fees and other miscellaneous
business expenses like marketing and advertising
expenses, transport and distribution costs.
Implicit Cost: Wages of labor rendered by the
owner himself; interest on capital supplied by
him, rent of land and premises belonging to the
owner, managerial time and talent.
Economic Cost of Using Resources
Explicit Costs
of
Market-Supplied Resources
The monetary payments to
resource owners

+
Implicit Costs
of
Owner-Supplied Resources
The returns forgone by not taking
the owners resources to market

Total Economic Cost

= The total opportunity costs of
both kinds of resources
 Economic Profit and Accounting Profit
Economic Profit = Total Revenue Total Economic Cost
= Total Revenue (Explicit costs + Implicit costs)
==========================================
Accounting Profit (Business Profit) = Total Revenue Explicit Costs
==========================================
Accounting profit does not subtract implicit costs from total
revenue. It only subtracts explicit costs.
Since, firm owners must cover all costs (explicit and implicit
costs) of all resources used by the firmMaximizing
economic profit should be the objective of the firms owners.
 Example
1. The cost of attending a private college for one year is
$6000 for tuition, $2000 for the room, $1500 for
meals and $500 for books and supplies. The student
could also have earned $15000 by getting a job
instead of going to college and 10% interest on
expenses he or she incurs at the beginning of the
year. Calculate the explicit, implicit and total
economic costs of attending college?
1. Solution:
Explicit Costs
Tuition $6,000
Room rent $2,000
Meals $1,500
Books and Supplies $500___
Total Explicit Costs $10,000
Implicit Costs
Salary from Job $15,000
Interest foregone $1000
($10,000@10%)
Total Implicit Costs $16,000

Total Economic Costs $26,000 (Explicit + Implicit Costs)

 Example
2. A woman managing a photocopying establishment for $25000 per
year decides to open her own duplicating place. Her revenues during
the first year of operation is $1,20,000 and her expenses are as
follows:

Salaries to hired people $45,000

Supplies $15,000
Rent $10,000
Utilities $1,000
Interest on bank loan $10,000

Calculate the following: (1) The Explicit Costs, (2) The Implicit
Costs, (3) The Business profit, and (4) The Economic Profit.
2. Solution
Salaries to hired people $45,000
Supplies $15,000
Rent $10,000
Utilities $1,000
Interest on bank loan $10,000
1. Total Explicit Costs $81000
Foregone salary $25,000
2. Total Implicit Costs $25,000
3. Business (Accounting) Profit $39,000 ($1,20,000 $81,000)
(Total Profit-Explicit Costs)
4. Economic Profit $14,000 ($1,20,000 $1,06,000)
(Total Profit- (Explicit+ Implicit
Costs)
 Example
3. At the beginning of the year, a audio engineer quit his job and gave
up a salary of $1,75,000 per year in order to start his own business,
Sound Devices, Inc. The new company builds, installs and maintains
custom audio equipment for business that require high-quality audio
systems. To get started the owner of the company spent $1,00,000 of
his personal savings to pay for some of the capital equipment used in
the business. In 2016, the owner of the company could have earned a
15% return by investing in stocks of other new business with risk
levels similar to the risk level at Sound Devices. From the partial
income statement for Sound Devices, Inc., compute the following:
1. What are total explicit, total implicit and total economic costs in
2016?
2. What is accounting (business) profit in 2016?
3. What is economic profit in 2016?
4. Given your answer in question 3, evaluate the owners decision to
leave his job to start his company.
 Example
Income and Expenditure Statement of Sound Devices, Inc for the year ended-
Mar-2016
Revenues
Revenue from Sales of Product and Services $9,70,000
Operating Costs and Expenses
Cost of Products and Services Sold $3,55,000
Selling Expenses $1,55,000
Administrative Expenses $45,000
Total Operating Costs and Expenses $5,55,000

Income from Operations (PBIT) $4,15,000

Interest Expense (Bank Loan) $45,000

Legal Expenses to start business $28,000
Income Taxes $1,65,000
Net Income (PAT) $1,77,000
Solution:
1. Total Explicit Cost = $7,93,000 (= $5,55,000+ $45,000 + $28,000
+ $1,65,000);
Total Implicit Cost = $1,90,000 (= $1,75,000+[0.15$1,00,000]);
Total Economic Cost = $9,83,000 (= $7,93,000+ $1,90,000)
2. Accounting/Business Profit = $1,77,000 (= $9,70,000$7,93,000)
3. Economic Profit = $13,000 (= $9,70,000 $9,83,000)
4. The owners accounting profit is $13,000 less than what he
could have earned in salary and return on investment of his
$1,00,000, i.e., his economic profit is $13,000. Thus, he would
have made $13,000 more if he had kept his job and invested his
$1,00,000 in stocks of other businesses.
DEMAND, SUPPLY, AND MARKET EQUILIBRIUM
 Demand Analysis
Demand analysis has the following important
managerial purposes:
Forecasting and Promotion of Sales
Estimating Demand
Tracing the trend of the firms competitive
position in the market.
 Demand
Quantity Demanded (Qd)
Mere desire for a commodity is not demand.
Demand should be backed by capacity and
willingness to pay for it. That is one should have
desire to buy a commodity, he must be willing to
pay its price and he should have the capacity
(money) to be paid.
Demand is defined as the amount of a good or
service consumers are willing and able to
purchase during a given period of time at a
particular price.
 Factors Determining Demand
Controllable and Uncontrollable Factors:
 General Demand Function
Six variables that MOST influence Qd
Price of good or service (P)
Incomes of consumers (Y)
Prices of related goods and services (PR)
Taste and preferences of consumers (T)
Expected future price of product (Pe )
Number of consumers in market (N)
General Demand Function
Qd = f(P,Y,PR,T,Pe,N)
 General Demand Function
Qd = a+bP+cY+dPR +eT+f Pe +gN
b, c, d, e, f, and g are slope parameters to be estimated
Measure effect on Qd of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is related to Qd
Positive sign indicates direct relationship
Negative sign indicates inverse relationship
 General Demand Function
Variable Relation to Qd Sign of Slope Parameter

P Inverse b = Qd/P is negative

Direct for normal goods c = Qd/Y is positive

Y c = Qd/Y is negative
Inverse for inferior goods

PR Direct for substitutes d = Qd/PR is positive

Inverse for complements d = Qd/PR is negative
T
Direct e = Qd/ T is positive

Pe Direct f = Qd/Pe is positive

N Direct g = Qd/N is positive

INCOME EFFECT: The income effect asserts that as a
products price declines (increases), an individuals real
income (purchasing power) increases (decreases). The
increase in real purchasing power resulting from a fall in
prices enables the individual to consume greater
quantities of a commodity, while the opposite is true for
an increase in prices.
An increase in real purchasing power generally
(although not always) leads to increase in quantity
demanded. The goods of the types for which this
phenomenon holds are referred to as normal goods.
 The income effect does not always have the expected
positive effect on the quantity demanded of a good. In
some cases, as an individuals purchasing power
increases, the quantity demand for that good falls. Goods
of these types are called inferior goods.
 Normal Good: A good or service for which an increase
(decrease) in income causes consumers to demand more
(less) of the good or service, holding all other variables
in the general demand function constant.
Example: Cars; Laptop; Branded Shoes; Branded Shirts.
Inferior Good: A good or service for which an
increase (decrease) in income causes consumers to
demand less (more) of the good or service, holding
all other variables in the general demand function
constant.
Example: Cheaper Cars; Inter-City Bus Service,
SUBSTITUTION EFFECT: The substitution effect
states that as a products price declines, consumers will
substitute the now less expensive product for similar
goods that are more expensive and vice-versa.
 Substitutes: Goods are said to be substitutes if one good can be
used in the place of the other.
Ex: tea and coffee; peas and beans; groundnut oil and sunflower
oil; jowar and bajra; Hyundai i10 and Maruti swift.
If two goods are substitutes an increase (decrease) in the price of
one of the good causes consumers to demand more (less) of the
other good, holding all other factors constant.
Complements: Goods are said to be complements if they are
used in conjunction with each other.
Ex: Car and Petrol; pen and ink; tea and sugar; shoes and socks;
gun and bullets.
Two goods are complements if an increase (decrease) in the price
of one of the goods causes consumers to demand less (more) of the
other good, all other things held constant.
 Direct Demand Function
The direct demand function, or simply demand,
shows how quantity demanded, Qd , is related to
product price, P, when all other variables are held
constant, that is Qd = f(P).
 Direct Demand Function
Law of Demand
Statement of the Law: Other things being equal,
the higher the price of a commodity, the smaller
is the quantity demanded and lower the price,
larger is the quantity demanded.
In other words, the demand for a commodity
extends as the price falls and contracts as the price
rises, ceteris paribus.
Qd increases when P falls and Qd decreases when P
rises, all else constant.
 Graphing Demand Curves
A point on a direct demand curve shows either:
Maximum amount of a good that will be
purchased for a given price
Maximum price consumers will pay for a
specific amount of the good
A Demand Curve
 Shifts in Demand
Change in Quantity Demanded
Occurs when price changes
Movement along demand curve
Shifts in Demand Curve
Occurs when one of the other variables, or
determinants of demand, changes
Demand curve shifts rightward or leftward
Shifts in Demand
Giffen Good
 Supply

Quantity Supplied (Qs)

Amount of a good or service offered for sale
during a given period of time at a given price
 Supply
Six variables that influence Qs
Price of good or service (P)
Input prices (PI )
Prices of goods related in production (Pr)
Technological advances (T)
Expected future price of product (Pe)
Number of firms producing product (F)
General supply function

Qs = f ( P, PI , Pr , T , Pe , F )
 General Supply Function
Qs =h + kP + lPI + mPr + nT + rPe + sF
k, l, m, n, r, & s are slope parameters
Measure effect on Qs of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is
related to Qs
Positive sign indicates direct relationship
Negative sign indicates inverse relationship
 General Supply Function
Variable Relation to Qs Sign of Slope Parameter

P Direct k = Qs/P is positive

PI Inverse l = Qs/PI is negative

Inverse for substitutes m = Qs/Pr is negative

Pr m = Qs/Pr is positive
Direct for complements

T Direct n = Qs/T is positive

Pe Inverse r = Qs/Pe is negative

F Direct s = Qs/F is positive

Direct Supply Function
The direct supply function, or simply supply,
shows how quantity supplied, Qs , is related to
product price, P, when all other variables are
held constant.
Qs = f(P)
 Direct Supply Function
Law of Supply
Statement of the Law: Other things being equal,
the supply of a commodity increases with a rise
in its price and decreases with a fall in its price.
In other words, the supply of a commodity expands
as the price rises and contracts as the price falls,
ceteris paribus.
Qs increases when P rises and Qs decreases when P
falls, all else constant.
 Graphing Supply Curves
A point on a direct supply curve shows either:
Maximum amount of a good that will be
offered for sale at a given price
Minimum price necessary to induce producers
to voluntarily offer a particular quantity for
sale
A Supply Curve
 Shifts in Supply Curves
Change in quantity supplied
Occurs when price changes
Movement along supply curve
Shifts in supply
Occurs when one of the other variables, or
determinants of supply, changes
Supply curve shifts rightward or leftward
Shifts in Supply
 Market Equilibrium
Market Equilibrium: Market Equilibrium is a situation
in which at the prevailing price, consumers can buy all
of a good they want and producers can sell all of a
good they want.
Market will be in equilibrium when price is at a
level for which quantity demanded equals quantity
supplied.
At the point of intersection, Qd = Qs
Equilibrium price and quantity are determined by
the intersection of demand and supply curves at a
given price and time.
Market Equilibrium
 Market Equilibrium
Excess demand (shortage)
Exists when quantity demanded exceeds quantity
supplied
Excess supply (surplus)
Exists when quantity supplied exceeds quantity
demanded
ELASTICITY AND DEMAND
 Elasticity of Demand
Elasticity of Demand: Elasticity of demand
measures the responsiveness of demand for a
commodity to changes in the variables of a given
demand function.

Technically, elasticity of demand is the extent of

variation in demand due to changes in the
determinants of demand.
 Three kinds of Elasticities of Demand
1. Price Elasticity of Demand: The extent (degree) of
responsiveness (change) of demand for a commodity to a
given change in price, other demand determinants remaining
constant.
2. Income Elasticity of Demand: The extent (degree) of
responsiveness (change) of demand for a commodity to a
given change in income, other demand determinants
remaining constant.
3. Cross Price Elasticity of Demand (Cross Elasticity): The
extent (degree) of responsiveness (change) of demand for a
commodity to a given change in the price of some other
related commodity, other demand determinants remaining
constant.
 Price Elasticity of Demand (E)
Measures responsiveness or sensitivity of
consumers to changes in the price of a good or
service.
The percentage change in quantity demanded
E=
The percentage change in price

Note: P and Q are inversely related by the law of demand so E

is always negative. The larger (smaller) the absolute value of E,
the more (less) sensitive buyers are to a change in price.
Price Elasticity of Demand
Price ($) Quantity of Demand
(Units)
140 0
120 200
100 400
80 600
60 800
40 1000
20 1200
Price Elasticity of Demand (E)

Elasticity Responsiveness E
Elastic %Q>%P E> 1
Unitary Elastic %Q=%P E= 1
Inelastic %Q<%P E< 1
 Price Elasticity of Demand (E)

Elasticity Responsiveness E
Demand is said to be elastic if

Elastic
the percentage change in
demand (in absolute value) is E> 1
more than the percentage
change in price.
Demand is said to be unitary
elastic if the percentage
Unitary Elastic change in demand (in absolute E= 1
value) equals the percentage
change in price.
Demand is said to be inelastic
if the percentage change in
Inelastic demand (in absolute value) is E< 1
less than the percentage
change in price.
Measurement of Price Elasticity of Demand

1. Percentage (Ratio) Method: A measurement

of demand elasticity which is calculated by
dividing the percentage change in quantity
demanded by the percentage change in price.
%Q
E=
%P
Measurement of Price Elasticity of Demand

2. Point Method: A measurement of demand

elasticity which is calculated by multiplying the
slope of demand (Q/P) times the ratio of price
to quantity (P/Q).
Q P
E=
P Q
Measurement of Price Elasticity of Demand
Measurement of Price Elasticity of Demand

Choice of Method: The choice of method

depends on the length of demand over which E
is measured.
1. Point Method: If the change in price is
relatively small.
2. Interval Method: When the price change
spans a sizable arc along the demand curve.
 Managerial Applications: Price Elasticity of Demand (E)
%Q
E=
%P
1. Prediction of Percentage Change in Quantity
Demanded: Percentage change in quantity
demanded can be predicted for a given percentage
change in price as: %Qd = %P x E
2. Prediction of Percentage Change in Price:
Percentage change in price required for a given
change in quantity demanded can be predicted as:
%P = %Qd E
 Price Elasticity & Total Revenue
Total Revenue (TR): TR is the total expenditure by
consumers on the commodity (total amount paid to the
producers) and is simply the price of the commodity times
quantity demanded.
TR=PxQ

The change in price (Price Effect) and the change in

quantity (Quantity Effect) have opposite effects on total
revenue and it is the relative strengths of these two
effects that will determine the overall effect on TR.
 Price Elasticity & Total Revenue
Price Effect: The effect on TR of changing price, holding
output constant.
1. When a manager raises the price of a product, the
increase in price by itself would increase TR if the
quantity sold remained constant.
2. Conversely, when a manager lowers price, the decrease in
price would decrease total revenue if the quantity sold
remained constant.
However, when prices changes, the quantity sold does not remain
constant, it moves in the opposite direction of price.
 Price Elasticity & Total Revenue
Quantity Effect: The effect on TR of changing output,
holding price constant.
1. When quantity increases in response to a decrease in
price, the increase in quantity, by itself would increase
TR if the price of the product remained constant.
2. Conversely, when quantity demanded falls after a
price increase, the reduction in quantity, by itself would
decrease TR if the price of the product remained
constant.
 Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

%Q>%P %Q=%P %Q<%P
Quantity-effect No dominant Price-effect
dominates effect dominates
Price
TR falls No change in TR TR rises
rises
Price
TR rises No change in TR TR falls
falls
 Marginal Revenue
Marginal Revenue (MR) is the change in
total revenue per unit change in output.
Marginal Revenue: The addition to total
revenue due to selling one additional (more)
unit of output.
Since MR measures the rate of change in
total revenue as quantity changes, MR is the
slope of the total revenue (TR) curve.
TR
MR =
Q
Demand and Marginal Revenue
Price Quantity TR = P MR =
(Units) Q TR/Q
$4.50 0 $0 ---
4.00 1 $4 $4
3.50 2 $7 $3
3.10 3 $9.30 $2.30
2.80 4 $11.20 $1.90
2.40 5 $12 $0.80
2.00 6 $12 $0
1.50 7 $10.50 -$1.50
 MR, TR, & Price Elasticity
Marginal Price elasticity
Total revenue
revenue of demand
MR > 0 TR increases as Elastic
Q increases (E> 1)
(P decreases)
MR = 0 TR is maximized Unit elastic
(E= 1)
MR < 0 TR decreases as Inelastic
Q increases (E< 1)
(P decreases)
 Marginal Revenue and Price Elasticity: The
Relationship
When MR is positive, TR increases as
quantity increases (and the price
decreases) and the demand is elastic.
When MR is 0, the price elasticity of
demand is unitary.
When MR is negative, TR decrease as
quantity increases (and the price
decreases) and the demand is inelastic.
 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
 Income Elasticity of Demand
Income elasticity (EM) measures the degree of
responsiveness of quantity demanded to
changes in income, holding the price of the
good and all other demand determinants
constant.
Positive for a normal good
Negative for an inferior good
%Qd Qd M Q Average M
=
EM = =
E
%M M Qd M
M Average Q

Percentage Method Point Method Interval/Arc Method

 Income Elasticity of Demand and
Classification of Goods
Income Elasticity of Demand Type of Good

1. Em = POSITIVE Normal Good

2. Em = NEGATIVE Inferior Good
3. Em = POSITIVE and Em >1 Luxury Good
4. Em = POSITIVE and Em <1 Necessary Good
5. Em = 0 Neutral Good
 Cross-Price Elasticity
Cross-price elasticity (EXY) measures the degree
of responsiveness of quantity demanded of good
X to changes in the price of related good Y,
holding the price of good X and all other demand
determinants for good X constant.
Positive when the two goods are substitutes
Negative when the two goods are complements
%Q X Q X PY Q Average PR
=
E XY = E=
%PY PY Q X PR Average Q
XR

Percentage Method Point Method Interval/Arc Method

 Cross-Price Elasticity of Demand
Cross-Price Elasticity of Demand Type of Good

1. E XY = %Q X > 0 Substitutes (An increase in the

%PY price of (commodity) Y increases
the quantity demanded of
(commodity) X.
2. E %Q X Complements (An increase in the
= <0
%PY
XY
price of (commodity) Y decreases
the quantity demanded of
(commodity) X.
3. E XY = %Q X = 0 Independent Goods (An increase in
%PY the price of (commodity) Y does
not change the quantity demanded
of (commodity) X.
 Cross Price Elasticity of Demand

Original Original Changed Changed

Commodity Price Quantity Price Quantity
(Rs.) (Units) (Rs.) (Units)
Tea 30 50 30 60
Coffee 40 30 50 20

Bread 20 80 20 70
Butter 75 80 80 75
Cross Price Elasticity of Demand
Cross Price Elasticity of Demand