Managerial Economics

Module 2: Analysis of Market

Demand and Supply
Module 2: Analysis of Market
Demand and Supply

Lecture 3:
 Elasticity of Demand and its Determinants

 Measurement of Elasticity – Point and Arc Elasticity

 Other Elasticities of Demand and Its Implications

 Price Elasticity and Revenue - Implication for Business

 Business Application of Income and Cross Elasticities

 Demand Elasticities
 Look at the demand function:
QD=f(P, PY, I, Tastes, Expect., Buyers,
Govt, ε )
 Causality goes from right to left in function.
 Can examine responsiveness along the
demand curve.
 Price elasticity: ε =%∆ Q/%∆ P
 In words, this is the percent change in
quantity demanded brought about by the
percent change in price.

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 Price elasticity: ε =%∆ Q/%∆ P

 Causality: denominator numerator!

 An elastic response is one where
numerator is greater than denominator.
 i.e., %∆ Q>%∆ P so ε < −1
 Imagine extreme example.
 An inelastic response is one where
numerator is smaller than denominator.
i.e., %∆ Q<%∆ P so ε > −1
 Again, imagine extreme example.

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 Look at the Extremes
 Perfectly Elastic D  Perfectly Inelastic D
ε = −infinite

P P D
ε =0
D

Q
Q

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 Relatively Elastic vs. Relatively
Inelastic Demand Curves

P
D’ is relatively more elastic
than D

P1

P2
D’
D
Q
Q1 Q2 Q2’
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 Determinants of ε
 Number of close substitutes
 Market vs. brand level
 Nature of goods – Necessities/ Luxuries
 Importance of goods in budget
 Time taken to readjust habit, usage
behaviour, etc.
 No. of uses of a product
 Price Level

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 Measurement of Elasticity: Point
Elasticity Formula
 Point elasticity
 Point elasticity is
responsiveness at a point
along the demand function;
ε = ∆ Q/Q
Price
responsiveness
∆ P/P
at this point
 Simplifying gives:
ε = (∆ Q/∆ P) ∗ (P /Q)
 In limiting case: P1
ε = δ Q/ δ P ∗ (P /Q)
ε = 1/ (Slope) ∗ (P /Q) D

Q
Q1

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 Look at our mathematical demand
function
 Assume equilibrium P and Q:
Q=13,750 and P=190
 Demand function
QDX =15000 - 25PX + 10PY+2.5*I
 Derive demand curve by holding PY and I
constant (e.g., at PY=100, and I=1000) giving:
QDX =18500-25PX
 Derive ε = (δ Q/δ P)* P /Q
 What is P and Q?

What is δ Q/δ P?

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 Elasticity calculation

ε = (∆ Q/∆ P)* P /Q
ε = -25*190/13750 = -0.34

What is the interpretation?

 Price Elasticity varies along Linear
Demand Curve
 ∆Q /∆P = 1/ (slope of dd line) = QN/ RQ and
 At R; P/Q = OP/OQ
QN OP QN QN
Price

ε= × = =
QR OQ OQ RP
M (Since Since RQ = OP
Demand and OQ = RP)
Line
∆MPR and ∆RQN are similar
P
∆P
R
Angle of triangles;∴ Ratio of their
P-∆P R’
slope of
∆Q demand line respective sides are equal.
QN RN
Or, =
O RP RM
Q Q+∆Q N
RN Lower Segment
Quantity ε= =
RM Upper Segment
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 For Constant Elasticity Demand
Curve, ε = constant
 In case of demand curve (refer Fig 2 b), when ∆P
approaches zero, point R’ will approach R and
 In this limiting case, slope of
Price

Demand
Curve
the demand curve at R is the
slope of tangent MN at point R
Tangent to DD
M curve of the demand curve
 ∆Q/∆P= dQ/dP
=1/ (slope of dd curve)
Angle of
R slope of = QN/ RQ
P
R’ tangent to  Rest of derivation remains
DD curve
P-∆P
same, here also ε = RN/RM =
=Lower Segment/ Upper Segment
 For Const. Elasticity dd-curve:
O
Q Q+∆Q
eg. Q=aP-b, the ratio is constant
N
Quantity
& equal to –b; ε = -b
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 Price Elasticity varies along Linear
Demand Curve
 At low prices, %∆ Q<
%∆ P so | ε | < 1
i.e., Quantity
P


unresponsive to Price
|ε | > 1  At high prices,
elastic
%∆ Q>%∆ P so
|ε | =
1 |ε | > 1
PM
unit  i.e., Quantity
|ε | < 1 responsive to Price
elastic
inelastic
Q
QM
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 Price Elasticity and Revenues
 Suppose we look at P increase along D curve.
 Revenues = P*Q
 Impact on expenditure depends on which effect is
greater.
 For elastic responses, | ε | > 1 so %∆ Q>
%∆ P
 Thus, when P increases, Q decreases by more!
 Revenues = P*Q falls
 Vice versa when P decreases revenue goes up
 For inelastic response, | ε | < 1 so %∆ Q<
%∆ P
 Thus, when P increases, Q decreases by less!
 Revenues = P*Q rises
 Vice versa when P decreases, revenue falls
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 Elasticity and Revenue: When demand
is elastic (| ε | >1) - Graphical
Illustration
 Decrease in price
leads to increase in
revenue – when Rs
elastic demand
 (Illustration) the
total revenue
rectangle becomes
larger when price
is lowered as
depicted in the
figure
 Vice versa rise in P
leads to fall in R
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 Elasticity and Revenue: When demand
is inelastic (| ε | <1) - Illustration
 Decrease in price
will lead to decrease Rs.
in revenue - when
inelastic demand
 (Illustration)
decrease in price
decreases the total
revenue rectangle,
as seen in the
figure.
 Vice versa rise in P
leads to rise in R

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 Price Elasticity and Revenues:
Mathematical Derivation
 R= P * Q
 Therefore, dR/dQ = P+Q*dP/dQ
⇒ MR= P[1+ (Q/P)*dP/dQ]= P (1 + 1/ep)
ep is negative therefore ep= -|ep|
⇒ MR = P (1 - 1/|ep|)
(Note: P is non-negative entity)
 Marginal revenue (MR) is the rate of change in
revenue with change in quantity.
 Decrease in P means increase in Q (i.e. moving left to
right along the demand curve); +ve MR will result in
rise in R and negative MR will result in fall in R.

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 Price Elasticity and Revenues
Elasticity of Marg. Effect of Fall Effect of Rise
Demand Reven. in Price on R in Price on R

Elastic MR is Revenue Revenue falls.

demand | +ve rises.
ep|> 1

Unit Elastic, MR is Revenue is Revenue is

|ep|=1 zero unchanged unchanged

Inelastic MR is Revenue Revenue rises.

Demand | -ve falls.
ep|<1

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 Price Elasticity & Revenues
 Look at price increase.
 In inelastic range (lower
P segment of demand line i.e.
when P< PM or alternatively Q>
| ε | >1 QM), revenue rises as P increases.
 At unit elastic point (at mid-
point, when P= PM or Q= QM ,
PM
|ε |
revenue is unchanged as P
= 1
|ε | < 1 increases.
 In elastic range (upper
segment of demand line i.e.
Q when P> PM or alternatively Q<
QM
QM), revenues fall as P increases.

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 Implication 1: Firms prefer to
operate in elastic region of demand
 In inelastic range,
firms would find their
Rs. revenues increasing if
they reduce output
i.e. increase the price
- they will do so until
Demand they are out of the
Line
inelastic range.
 The result is that each
firm seeks to produce
in the elastic range of
MR
demand
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 More Implication for Businesses
 Where in the elastic region depends
upon production and cost side of story
 A company may sell more of output at
lower prices i.e. in inelastic range of
prices but only to get lower revenues.
 More of luxury goods (since they have
ep > 1) can be sold at lower prices
resulting in increase in total revenue.
 Firms dealing in luxury goods do manipulate
prices through promotional schemes and
often indulge in price wars with competition
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 Arc Elasticity and Its Measurement
 Arc elasticity is simply an average elasticity
along a range of the demand curve.
 Arc elasticity: Price

Responsiveness along
a range of demand
function; ε = average
∆ Q/((Q1+ Q2)/2)
P2 response }
P1
∆ P/ ((P1+ P2)/2) D
 Simplifying: Q
Q2 Q1
∆Q P1 + P2
ε= ×
∆P Q1 + Q2
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 Comments
 Don’t forget the economics behind your
calculations
 i.e., Don’t lose the forest for the trees!
 Know how to calculate these, and how
to manipulate them.

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 Look at an Example
 Suppose the price elasticity of demand
is ε = -3.6, and you expect a 5% price
increase next year.
 What should happen to the quantity
demanded?
 Answer:
ε = %∆ Q/∆ %P
−3.6 = %∆ Q/(+5)
Solving for %∆ Q=5*(-3.6)=-18%

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 Constant Elasticity Demand Function:
QX=α PXβ 1 ∗ Ι β 2 ∗ PYβ 3
 One of the special type of functions.
 QX=α PXβ 1 ∗ Ι β 2
∗ PY β 3

P  δ QX/δ PX = α β PX β 1 −1 ∗ Ι β 2
∗ PY β 3
1

= β 1 (α PXβ 1 ∗ Ι β 2
∗ PYβ 3)/PX
⇒ δ QX/δ PX = β 1 (QX/ PX)
⇒ β 1 = (δ QX/δ PX) (PX/QX)
⇒ β 1 =ε P
D
 Therefore β 1 is price
Q elasticity of demand.

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 Constant Elasticity Demand Function:
QX=α PXβ 1 ∗ Ι β 2 ∗ PYβ 3 (Contd.)
 Similarly β 2 and β 3 are interpreted
respectively as income and cross
elasticities.
 These don’t vary as you move
along the demand curve
 How do revenues vary along the curve?
(We investigated this in slide nos. 17-19.)

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 Other Elasticity Concepts
 Value of ε I
determines type of good.
 Concept can be easily generalized.
 Indeed formula looks very similar
 Our focus is on Demand and Supply
elasticities, although these also exist for
costs.
 Also, you will need to interpret and calculate
the elasticity.

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 Income Elasticity of Demand
 Recall demand function is:
Q=f (P, I, Prelated , Tastes, #Buyers,
Expectations, Govt. Influence, χ )
 Change in I causes shift in demand.
 Size of shift depends on income elasticity.
ε I = %∆ Q/%∆ I
 Can derive using point or arc formula.
By Point Formula: ε ∂Q I I
I = × (= 1
× )
∂I Q slope of Engel curve
Q
By Arc Formula: ∆Q I
εI = ×
∆I Q
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 Values for Income Elasticity (ε I)
 Sign indicates normal or inferior
ε I >0 implies normal good.
ε I <0 implies inferior good.
 Normal goods may be necessity or
luxury.
 Can look at the Engel's curve (Income
Vs Quantity Demanded Plot).
 For normal goods, slope of Engel’s curve is
positive
 For inferior goods, slope of Engel’s curve is
negative

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 Engel's Curves: Normal Goods (Positively
Sloped Engel’s Curves)
 Necessity:  Luxury:
Income inelastic Income elastic

I
I
0< ε I< 1 ε I > 1

Q Q

NOTE: These are not demand

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 Engel's Curve: Inferior Good (Negatively
Sloped Engel’s Curves)
I
 Inferior Goods have
negative income
elasticities: ε I < 0

Q
I
 Goods may be both ε I<0
normal (low income
levels) and become
inferior (high income
ε I>0
levels).
Q
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 Uses of Income Elasticity in Business
Decisions
 While price and cross elasticities are of greater
significance in pricing and revenue maximizing
decisions in the short run, income elasticity
assumes significance in long term demand
forecasting, production planning and
management, as businesses try to adjust to
different phases of a business/ economic cycle.
 In forecasting demand only the relevant
concept of income and data should be used.
 The concept of income elasticity is also used
 to define normal and inferior goods and
 classify normal goods into the category of necessities,
comforts and luxuries.
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 Cross Price Elasticity (ε XY )

QX = f (PX , I, PY, Tastes, #Buyers,

Expectations, Govt. Influence, χ )
 Change in PY causes shift in demand for X.
 Size of shift depends on cross-price elasticity.
ε = %∆ QX / %∆ PY
XY

 Can be measured using point elasticity formula

or arc elasticity formula
 Sign indicates relationship between goods
ε XY > 0 implies goods are substitutes.
ε XY < 0 implies goods are complements.

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 Magnitude shows size of shift in
Demand (assume Psubst increases)
 ε XY >1  ε <1
XY

PX
PX

D’ D’
D D
QX QX

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 Application of Cross Elasticity in
Business Decisions
 Used to identify/ distinguish between
substitute and complimentary goods
 Magnitude of cross elasticity is also
important in pricing decisions.
 If a commodity is elastic to the price
changes of substitute (cross elasticity > 1),
it is advisable to decrease the price rather
than increasing the price.
 In case of complimentary goods, it is better
to reduce the price to maintain the demand
if price of complimentary good rises.

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 Application of Cross Elasticity in Business
Decisions (contd.)
 The firms can forecast the demand for
its products and can be prepared to
take necessary measures against
fluctuating prices if accurate measures
of cross elasticities of substitutes and
compliments are available.

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 Can also look at Supply Elasticity
(η )
 Recall the supply function:
QS =f (P, PINPUT, Technology, POTHER,
#Sellers, Govt. Influence,µ )
 Can examine responsiveness along the
supply curve.

Price elasticity: η =%∆ Q/%∆ P
 Elastic responses represent flat supply
curves, inelastic responses give steep
supply curves.

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 Elastic vs. Inelastic Supply

P
S(η < 1 )

S (η > 1 )

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