- 1. Elasticity of Demand and Supply Chapter 4
- 2. Introduction The demand and supply analysis helps us to understand the direction in which price and quantity would change in response to shifts in demand or supply. What economists would like to know is ‘what will happen to demand/supply when price changes?’
- 3. Learning Outcomes Here we extend our understanding of supply and demand and consider the following: How the sensitivity of quantity demanded to a change in price is measured by the elasticity of demand and what factors influence it. How elasticity is measured at a point or over a range. How income elasticity is measured and how it varies with different types of goods. How elasticity of supply is measured and what it tells us about conditions of production. Some of the difficulties that arise in trying to estimate various elasticities from sales data.
- 4. Price elasticity of demand Demand elasticity is measured by a ratio: the percentage change in quantity demanded divided by the percentage change in price that brought it about. For normal, negatively sloped demand curves, elasticity is negative, but the relative size of two elasticities is usually assessed by comparing their absolute values.
- 5. Price elasticity of demand - formula / / P Q Q Q P E P P P Q Linear Function Point Definition 1 P P E a Q a1 is the estimated coefficient of P in regression equation
- 6. Calculation of Two Demand Elasticities Good A Quantity Price Good B Quantity Price 100 £1 200 £5 95 £1.10 140 £6 Original New % Change Elasticity -5% -10% -30% 20% -5%/10% = -0.5% -30%/20%=-1.5%
- 7. Elasticity is calculated by dividing the percentage change in quantity by the percentage change in price. Consider good A A rise in price of 10p on £1 or 10 percent causes a fall in quantity of 5 units from 100, or 5 percent. Dividing the 5 percent deduction in quantity by the 10 percent increase in price gives an elasticity of -0.5. Consider good B A 30 percent fall in quantity is caused by a 20 percent rise in price, making elasticity –1.5 Calculation of Two Demand Elasticities
- 8. Interpreting price elasticity The value of price elasticity of demand ranges from zero to minus infinity. In this section, however, we concentrate on absolute values, and so ask by how much the absolute value exceeds zero. Elasticity is zero if quantity demanded is unchanged when price changes, namely when quantity demanded does not respond to a price change.
- 9. As long as there is some positive response of quantity demanded to a change in price, the absolute value of elasticity will exceed zero. The greater the response, the larger the elasticity. Demand is said to be ‘elastic’
- 10. Whenever this value is less than one, however, the percentage change in quantity is less than the percentage change in price and demand is said to be inelastic.
- 11. When elasticity is equal to one, the two percentage changes are then equal to each other. This is called unit elasticity.
- 12. Summary
- 13. Note! ◦ 1. When elasticity of demand exceeds unity (demand is elastic), a fall in price increases total spending on the good and a rise in price reduces it. ◦ 2. When elasticity is less than unity (demand is inelastic), a fall in price reduces total spending on the good and a rise in price increases it. ◦ 3. When elasticity of demand is unity, a rise or a fall in price leaves total spending on the good unaffected.
- 14. What determines elasticity of demand? The main determinant of elasticity is the availability of substitutes. Closeness of substitutes—and thus measured elasticity —depends both on how the product is defined and on the time period under consideration.
- 15. Note! A product with close substitutes tends to have an elastic demand; one with no close substitutes tends to have an inelastic demand.
- 16. Factors affecting Elasticity of Demand •Perception of the good by the consumer : Necessities have inelastic demand while luxuries have elastic demand. •Availability of substitutes : Commodity which has number of substitutes to it will have elastic demand while commodity which has no substitutes has inelastic demand. •Share in total expenditure : Commodities which have a higher share in total expenditure will generally have elastic demand while those with lesser share have inelastic demand. •Timeframe : In the short run it might not be possible to substitute the commodities as it might take time to find substitutes while in the long run it might be easier to switch over. •Possibility of postponing the consumption •Several uses of a commodity
- 17. Importance of Elasticity of Demand : • Importance to a monopolist: A monopolist cannot determine the price of his product arbitrarily. He considers the demand in the market while fixing the price of the product. In case where the demand for the product is inelastic, he can fix a higher price, while in case the demand is elastic he would not fix a higher price. • Important in regulating prices especially of agricultural products: As demand for certain products especially agricultural products is inelastic, the government in order to increase the income of farmers, may regulate the supply and increase the price. • International Trade: If the demand for the country’s exports is elastic, a fall in their prices would cause an increase in their demand and thus improve the foreign exchange earnings of the county. • Taxes: The more inelastic the product the larger the proportion of the tax is paid by the buyer.
- 19. Curve D1 has zero elasticity: the quantity demanded does not change at all when price changes. Curve D2 has infinite elasticity at the price p0: a small price increase from p0 decreases quantity demanded from an indefinitely large amount to zero. Curve D3 has unit elasticity: a given percentage increase in price brings an equal percentage decrease in quantity demanded at all points on the curve. Curve D3 is a rectangular hyperbola for which price times quantity is a constant. Three Constant-elasticity Demand Curves
- 20. q p q p A B D Quantity 0 Elasticity on a Linear Demand Curve
- 21. Starting at point A and moving to point B, the ratio p/q is the slope of the line. Its reciprocal q/p is the first term in the percentage definition of elasticity. The second term in the definition is p/q, which is the ratio of the coordinates of point A. Since the slope p/q is constant, it is clear that the elasticity along the curve varies with the ratio p/q. This ratio is zero where the curve intersects the quantity axis and ‘infinity’ where it intersects the price axis. Point price Elasticity on a Linear Demand Curve
- 22. More frequently, than point price elasticity, arc price elasticity is calculated. In arc price elasticity, the average of the two prices and average of the two quantities is taken in the calculations. Arc Elasticity on a Linear Demand Curve 2 1 2 1 2 1 2 1 P Q Q P P E P P Q Q
- 23. There is an important relation between the price elasticity of demand and the firm’s total revenue and marginal revenue. Total revenue =P*Q MR = change in TR /change in quantity With a decline in price, TR increases if demand is elastic, TR is unchanged if demand is unit elastic and TR declines if demand is inelastic Price, Elasticity, Total Revenue and Marginal Revenue 1 1 P MR P E
- 24. If demand is elastic, a price decline leads to a proportionately larger increase in quantity demanded and so TR increases. If demand is unit elastic, a price decline leads to an equal proportionate increase in quantity demanded and so TR remains unchanged. If demand is inelastic, a price decline leads to a proportionately smaller increase in quantity demanded and so TR decreases. If the firm is a perfect competitor it faces a horizontal or infinitely elastic demand curve for the commodity. Thus, the change in TR in selling each additional unit of the commodity (MR) equals price Price, Elasticity, Total Revenue and Marginal Revenue
- 25. Marginal Revenue and Price Elasticity of Demand PX QX MRX 1 P E 1 P E 1 P E
- 26. Marginal Revenue and Price Elasticity of Demand Elasticity of demand varies from infinite to one to zero. So, what should happen if you were to reduce prices? From zero to the midpoint your total revenues increase because the elasticity of demand is greater than one, reaches its maximum at this point where elasticity of demand is equal to one and thereafter, revenues continue to decrease as you lower prices even further and it reaches zero at this point where elasticity of demand is equal to zero.
- 27. Marginal Revenue and Price Elasticity of Demand If like before, you wanted to raise prices but worried about the effect on revenue or income, the price elasticity of demand will come to your rescue. That depends on how far an increase in price P leads to a decrease in Q. In particular, if the percentage change in Q is less than the percentage change in P, then R will increase. This is just another way of saying that R will increase if the demand is inelastic. Suppose P goes up and now the percentage change in Q is higher than the percentage change in P in which case demand is elastic and you would expect the revenues to go down.
- 28. Marginal Revenue and Price Elasticity of Demand Thus, if demand is elastic at a given price level, then the company should cut its price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at the original quantity level, then the company should raise its prices, because the percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise.
- 30. At the point of intersection of two demand curves, the steeper curve has the lower elasticity. At the point of intersection p and q are common to both curves, and hence the ratio p/q is the same on both curves. Therefore, elasticity varies only with q/p. The absolute value of the slope of the steeper curve, p2/q, is larger than the absolute value of the slope, pl/q, of the flatter curve. Thus, the absolute value of the ratio q/p2 on the steeper curve is smaller than the ratio q/p1 on the flatter curve. So that elasticity is lower. Two Intersecting Demand Curves
- 31. q p D E A B Quantity 0 C Demand Elasticity on a Nonlinear Curve
- 32. Elasticity measured from one point on a nonlinear demand curve and using the percentage formula varies with the direction and magnitude of the change being considered. Elasticity is to be measured from point A, so the ratio p/q is given. The ratio plq is the slope of the line joining point A to the point reached on the curve after the price has changed. The smallest ratio occurs when the change is to point C. The highest ratio when it is to point E. Since the term in the elasticity formula, q/p, is the reciprocal of this slope, measured elasticity is largest when the change is to point C and smallest when it is to point E. Elasticity on a Nonlinear Demand Curve
- 33. q p D a b” Quantity 0 b’ Elasticity by the Exact Method
- 34. In this method the ratio q/p is taken as the reciprocal of the slope of the line that is tangent to point a. Thus there is only one measure elasticity at point a. It is p/q multiplied by q/p measured along the tangent T. There is no averaging of changes in p and q in this measure because only one point on the curve is used. Elasticity by the Exact Method
- 35. p2 p1 p0 q2 q0 q’1 q1 q’2 E2 E’2 E1 E’1 E0 Dl Dso Ds1 Ds2 Quantity Short-run and Long-run Demand Curves
- 36. As it takes time to adjust fully to a price range, a demand that is inelastic in the short run may prove elastic in the long run. Eg: Changes in prices of petrol – OPEC oil price shocks, initially demand for petrol was inelastic due to absence of substitutes, however in the long run more fuel efficient cars were manufactured DL is the long-run demand curve showing the quantity that will be bought after consumers become fully adjusted to each given price. Through each point on DL there is a short-run demand curve. It shows the quantities that will be bought at each price when consumers are fully adjusted to the price at which that particular short- run curve intersects the long-run curve. So at every other point on the short-run curve consumers are not fully adjusted to the price they face, possibly because they have an inappropriate stock of durable goods. Short-run and Long-run Demand Curves
- 37. For example, when consumers are fully adjusted to price p0 they are at point E0 consuming q0. Short-run variations in price then move them along the short-run demand curve DS0. Similarly, when they are fully adjusted to price p1, they are at E1 and short-run price variations move them along DS1. The line DS2 shows short-run variations in demand when consumers are fully adjusted to price p2. Short-run and Long-run Demand Curves
- 38. Quantity Income 0 The Relation Between Quantity Demanded and Income
- 39. Quantity y2 y1 0 Zero income elasticity qm Income The Relation Between Quantity Demanded and Income
- 40. Quantity Income y2 y1 0 Positive income elasticity Zero income elasticity qm The Relation Between Quantity Demanded and Income
- 41. Quantity Income y2 y1 0 Positive income elasticity Zero income elasticity Negative income elasticity [inferior good] qm The Relation Between Quantity Demanded and Income
- 42. Normal goods have positive income elasticities. Inferior goods have negative elasticities. Nothing is demanded at income less than y1, so for incomes below y1 income elasticity is zero. Between incomes of y1 and y2 quantity demanded rises as income rises, making income elasticity positive. As income rises above y2, quantity demanded falls from its peak at qm, making income elasticity negative. The Relation Between Quantity Demanded and Income
- 43. An inferior good is a good that decreases in demand when consumer income rises, unlike normal goods, for which the opposite is observed. As a consumer's income increases the demand of the cheap cars will decrease, while demand of costly cars will increase, so cheap cars are inferior goods. A Giffen good is one which people paradoxically consume more as the price rises, violating the law of demand. In normal situations, as the price of a good rises, the substitution effect causes consumers to purchase less of it and more of substitute goods. In the Giffen good situation, the income effect dominates, leading people to buy more of the good, even as its price rises. The classic example given by Marshall is of inferior quality staple foods, whose demand is driven by poverty that makes their purchasers unable to afford superior foodstuffs. As the price of the cheap staple rises, they can no longer afford to supplement their diet with better foods, and must consume more of the staple food.
- 44. Other demand elasticities The concept of demand elasticity can be broadened to measure the response to changes in any of the variables that influence demand. ◦ Income elasticity of demand ◦ Cross elasticity of demand
- 45. Income elasticity The responsiveness of demand for a product to changes in income is termed income elasticity of demand, and is defined as Point Definition / / I Q Q Q I E I I I Q a3 is the estimated coefficient of I in regression equation Linear Function 3 I I E a Q
- 46. Income elasticity Arc Definition 2 1 2 1 2 1 2 1 I Q Q I I E I I Q Q Normal Good Inferior Good 0 I E 0 I E
- 47. If the resulting percentage change in quantity demanded is larger than the percentage increase in income, hy will exceed unity. The product’s demand is then said to be income-elastic. If the percentage change in quantity demanded is smaller than the percentage change in income, hy will be less than unity. The product’s demand is then said to be income-inelastic.
- 49. Cross-elasticity The responsiveness of quantity demanded of one product to changes in the prices of other products is often of considerable interest. Point Definition / / X X X Y XY Y Y Y X Q Q Q P E P P P Q a4 is the estimated coefficient of I in regression equation Linear Function 4 Y XY X P E a Q
- 50. Cross-elasticity Arc Definition Substitutes Complements 2 1 2 1 2 1 2 1 X X Y Y XY Y Y X X Q Q P P E P P Q Q 0 XY E 0 XY E
- 52. Concept of cross demand elasticity is a very important concept in managerial decision making. Firms use this concept to measure the effect of changing the price of a product they sell on the demand for other related products that the firm also sells. Eg: Maruti can use cross price elasticity to measure the effect of change in the price of Swift on the demand for WagonR. Since WagonR and Swift are substitutes lowering the price of the former, will reduce the demand for the latter. However, in case of razor and razorblades, if the firm reduced the price of razor, there would be an increase in demand for razor blades. Cross-elasticity
- 53. A firm needs elasticity estimates to determine the optimal operational policies and the most effective way to respond to the policies of competing firms. If the demand for the product is price inelastic, the firm will not want to lower its price, as that would reduce its TR, increase its total costs (as more units of the commodity are being sold at the lower price). If the elasticity of the firm wrt advertising is positive and higher than its expenditure on quality and customer service, then the firm will concentrate its sales efforts on advertising rather than customer service and quality. If the firm has estimated that the cross price elasticity for its product wrt the price of competitor’s product is high, it will be quick to respond to a competitor’s price reduction, or it will lose substantial sales. Elasticity
- 54. Changes in demand for newspaper 50p 2,179,039 Price Average daily sales Percent change Pre-Sep.’93 Post-Sep.’93 Price Sales The Times Guardian 35p 45p 45p 420,154 362,099 2,196,464 Pre-Sep.’93 Post-Sep.’93 Daily Telegraph Independent 50p 45p 45p 45p -15.20 +17.5 -4.50 -1.95 0.0 -40.0 0.0 0.0 376,836 2,196,464 1,137,375 1,017,326 401,705 362,099
- 55. Example: Using Elasticities in Managerial Decision Making A firm with the demand function defined below expects a 5% increase in income (M) during the coming year. If the firm cannot change its rate of production, what price should it charge? Demand: Q = – 3P + 100M ◦ P = Current Real Price = 1,000 ◦ M = Current Income = 40
- 56. Example: Using Elasticities in Managerial Decision Making Elasticities ◦ Q = Current rate of production = 1,000 ◦ P = Price = - 3(1,000/1,000) = - 3 ◦ I = Income = 100(40/1,000) = 4 Price ◦ %ΔQ = - 3%ΔP + 4%ΔI ◦ 0 = -3%ΔP+ (4)(5) so %ΔP = 20/3 = 6.67% ◦ P = (1 + 0.0667)(1,000) = 1,066.67
- 59. The price elasticity of supply is defined as the percentage change in quantity supplied divided by the percentage change in price that brought it about.
- 60. S1 S2 S3 q1 p1 Quantity Quantity Quantity [iii]. Unit Elasticity [ii]. Infinite Elasticity [i]. Zero Elasticity Three Constant-elasticity Supply Curves p p q
- 61. Curve S1, has a zero elasticity, since the same quantity q1, is supplied whatever the price. Curve S2 has an infinite elasticity at price p1; nothing at all will be supplied at any price below p1, while an indefinitely large quantity will be supplied at the price of p1. Curve S3, as well as all other straight lines through the origin, has a unit elasticity, indicating that the percentage change in quantity equals the percentage change in price between any two points on the curve. Three Constant-elasticity Supply Curves
- 62. Factor influencing Elasticity of Supply Nature of commodity : Perishable goods as they cannot be stored for long, have inelastic supply, whilst durable goods have elastic supply It depends on how easily can producers shift from the production of other products to the one whose price has risen. Length of time: Elasticity of supply depends on the ease with which increases in production can be made without bringing any increase in cost of production. In the short run, when increase in production is brought about by increasing the variable factors, diminishing returns eventually result, thereby supply becomes relatively inelastic. In the long run, when all factors are variable, the supply curve tends to be more elastic. Technique of Production : Simple techniques of production more elastic is supply, complex techniques have inelastic supply as technology would need time to be installed and thus it would be difficult to respond immediately to increase in price. Estimate of future prices : If firms expect price to rise in future, inelastic is the supply and vice versa.