Sessions 7 & 8

Sessions 7 & 8
Elasticity and Its

Applications
(With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 5)
Session Objectives:
 What is elasticity? What kinds of issues

can elasticity help us understand?
 What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue &
expenditure?
 What are the income and cross-price
elasticities of demand?
[MBA - 2008-10]
18.08.2008 & Dr. Jaydeep Mukherjee
20.08.2008 Ravenshaw University
An Example
 You design websites for local businesses.
 You charge Rs.50,000 per website, and currently
design 12 websites per month, so that your total
revenue is Rs. 6,oo,ooo. Earlier you were designing
15 websites per month @ Rs.30,000 per website
 Your costs are rising (including the opportunity cost
of your time), so you’re thinking of raising the price
to Rs. 80,000.
 The law of demand says that you won’t sell as many
websites if you raise your price. How many fewer
websites? What will be the impact on your revenue?
[MBA - 2008-10]
Elasticity of Demand
 Basic idea: Elasticity measures how much one variable
responds to changes in another variable.
 In the given example, elasticity measures how much demand
for your websites will fall if you raise your price
 Price elasticity of demand: a measure of how much the
quantity demanded of a good responds to a change in the
price of that good, computed as
Price elasticity of demand =% change in Qd / % change in P
 Loosely speaking, it measures the price-sensitivity of buyers’
demand
[MBA - 2008-10]
P
Price elasticity of demand = 15% / 10%
Price rises
by 10%
Along a D curve, P and Q move in opposite
directions, which would make price
elasticity negative.
Q
We will drop the minus sign and report Demand falls
all price elasticities as positive numbers by 15%
[MBA - 2008-10]
P
In our example, demand falls from 15 to
12 websites per month 80,000 C
Compute price elasticity of demand

from A to B. 50,000 B
A
Find the quantity demanded when 30,000
price rises to Rs. 80,000
Anything striking? ? 12 15 Q
Suppose the market demand for burgers is given by the equation

Qd = 60,000,000 – 1,000,000P
For a price increase from Rs. 30 to Rs. 40 per burger, what is the price
elasticity
[MBA of demand?
- 2008-10]
 Use the following information to calculate the price elasticity of
demand for hotel rooms: P = Rs. 700, Qd = 300; P =Rs. 900, Qd =
200
 Problem: The standard method gives different answers depending on
where you start.
 The midpoint formula is preferable when calculating the price elasticity of

demand because it gives the same answer regardless of the direction of the
price change.
(Q2  Q1 ) /[(Q2  Q1 ) / 2]
Price elasticity of demand =
( P2  P1 ) /[( P2  P1 ) / 2]
Quick Activity:
 What will be the price elasticity of demand for websites using
midpoint method?
[MBA - 2008-10]
Determinants of Price Elasticity
Example 1:
 Consider two commodities fish and salt. Suppose
prices of both these goods rises by 20%. For which
good demand drops the most?
 Fish, since it has close substitutes in the form of
veg and other non-veg food items; while salt has no
close substitutes.
Lesson 1:
Price elasticity is higher, when close substitutes are
available
[MBA - 2008-10]
Example 2:
 Consider the example “blue-jeans” vs. “clothing”. Suppose
prices of both these goods rises by 20%. For which good
demand drops the most?
 For narrowly defined goods such as blue-jeans there are many
close substitutes, whereas for broadly defined goods like
clothing, there are fewer (here no) substitutes.
Lesson 2:
Price elasticity is higher for narrowly defined goods than
broadly defined ones.
[MBA - 2008-10]
Example 3:
 Consider the combination “insulin” vs. “Goa Cruises”. Suppose
prices of both of these rises by 20%. For which good demand
drops the most?
 To millions of diabetics, insulin is a necessity. A rise in its
price would cause little or no decrease in demand. A cruise is
a luxury. If the price rises, some people will forego it.
Lesson 3:
Price elasticity is higher for luxuries, than for necessities.
[MBA - 2008-10]
Example 4:
 Suppose price of petrol rises by 20%. Does demand drop
more in the short run or in the long run?
 There’s not much people can do in the short run, other than
ride the bus, but options are limited. In the long run, people
can change into smaller, fuel-efficient cars or can arrange for
a carpool or even live closer to where they work.
Lesson 4:
Price elasticity is higher in the long run, than in the short run
[MBA - 2008-10]
The price elasticity of demand depends on:
 the extent to which close substitutes are available
 whether the good is a necessity or a luxury
 how broadly or narrowly the good is defined
 the time horizon: elasticity is higher in the long run
than the short run.
[MBA - 2008-10]
The Variety of Demand Curves
 Economists classify demand curves according to
their elasticity.
 The price elasticity of demand is closely related to
the slope of the demand curve.
Rule of thumb:
 The flatter the curve, the bigger the elasticity.
 The steeper the curve, the smaller the elasticity
[MBA - 2008-10]
Inelastic Demand
 Quantity demanded does not respond strongly to
price changes.
 Price elasticity of demand is less than one.
Elastic Demand
 Quantity demanded responds strongly to changes
in price.
 Price elasticity of demand is greater than one.
[MBA - 2008-10]
Perfectly Inelastic
 Quantity demanded does not respond to price changes.
 Price elasticity of demand is equal to zero
Perfectly Elastic
 Quantity demanded changes infinitely with any change in price.
 Price elasticity of demand is infinite
Unit Elastic
 Quantity demanded changes by the same percentage as the price.
 Price elasticity of demand is equal to one
[MBA - 2008-10]
For a straight line demand curve, slope is constant
but elasticity varies from zero to infinity.
Suppose that the demand equation is as follows:
Qd = 100 – 4P
 Draw the demand curve
 Calculate the price elasticity of demand at P=0, 25, 12.5, 10,
& 20
 Interpret your results.
At any point on a linear demand curve price elasticity of demand equals the
ratio of the lower to the upper portion of the demand curve.
[MBA - 2008-10]
Total, Average and Marginal Revenue
 Total revenue is the amount paid by buyers and received by
sellers of a good.
 Computed as the price of the good times the quantity sold, i.e.,
TR = P x Q.
 Average revenue is the total revenue divided by the number of
units sold. Average revenue curve is nothing but the demand
curve.
 Marginal revenue is the extra revenue that the seller gets by
offering an extra unit for sale. Thus MR = Δ TR/ΔQ. Graphically,
MR at a point on TR curve is the slope of the TR curve at that
point.
[MBA - 2008-10]
Price (Rs.) Quantity TR =PxQ AR =TR/Q MR=ΔTR/ΔQ
10 1 10 10 ___
9 2 18 9 8
8 3 24 8 6
7 4 28 7 4
6 5 30 6 2
5 6 30 5 0
4 7 28 4 -2
3 8 24 3 -4
2 9 18 2 -6
1 10
[MBA - 2008-10] 10 1 -8
Observations:
 When output is zero, TR is also zero; so that TR curve starts from the
origin and AR and MR curve have the same vertical intercept (for all
practical purposes!!!).
 TR increases as price goes from Re.1 to Rs.5 and then decreases for
prices greater than Rs.6
 MR declines as quantity increases. MR is zero when TR reaches
maximum at an output level of 5 units. Beyond 6 units, when TR starts
decreasing, MR becomes negative. Why?
 Because price and quantity are inversely related, to sell extra units, the
firm must reduce the price of all the units sold. Negative MR implies
that rupees received from selling the extra unit are not sufficient to
compensate for the rupees lost as a result of selling all other units at a
lower price.
 AR declines at a rate 1 per unit, whereas MR declines at a rate of 2 per
unit.[MBA
This- means
2008-10]MR curve is twice as steep as a corresponding AR (or
a linear demand
18.08.2008 & curve). Dr. Jaydeep Mukherjee
TR
Quick Activity:
The demand function for
fountain pen is given as
Qd = 40 –2P.
At Q = 5 units, calculate the
TR marginal revenue.
Q
6
AR
MR
AR
[MBA - 2008-10]
20.08.2008 6 Ravenshaw University
MR Q
Price Elasticity and Total Revenue
 A price increase has two effects on revenue:
• Higher P means more revenue on each unit you sell.
• But you sell fewer units (lower Q), due to Law of Demand.
 Which of these two effects is bigger?
 It depends on the price elasticity of demand.
[MBA - 2008-10]
Price Elasticity and Total Revenue
A price increase will have one of the following
effects, depending on the price elasticity of demand:
 TR will increase if demand is inelastic (0<ep<1)
 TR will decrease if demand is elastic (ep>1)
 TR will remain unchanged if demand is unitary elastic (ep=1)
Problems!
 Pharmacists raise the price of insulin by 10%. Does total
revenue of pharmacists rise or fall?
 As a result of a fare war, the price of air travel falls 20%. Does
these companies’ total revenue rise or fall?
[MBA - 2008-10]
Application - 1
How much tuition for University Students?
 The Board of Trustees of a leading state University, with a current
student strength of 4000, is faced with a critical financial problem. At
present tuition rates, the University is losing Rs.10 lakhs per year.
 The President of the Board of Trustees urges a 25% increase in tuition
from the present Rs.1000 per year to tide over this financial crisis.
 However an economics professor of the same University discovers a
journal article that estimates the elasticity for enrollment at state
Universities as 1.3 with respect to tuition changes.
Should the University proceed with the proposed hike in tuition fees?
[MBA - 2008-10]
Application - 2
Can good news for farming be bad news for farmers?
 What happens to wheat farmers and the market for wheat
when university agronomists discover a new wheat hybrid that
is more productive than existing varieties?
 Because the hybrid increases the amount of wheat that can be
produced on each acre of land, farmers are now willing to supply more
wheat at any given price.
 Supply curve shifts to the right; with an unchanged demand curve
price of wheat falls from Rs.12 per kg. to Rs.10 per kg.
 Empirically, it is observed that the demand for basic foodstuffs such as
wheat is usually inelastic because these items are relatively
inexpensive and have few close substitutes.
 As such quantity of wheat sold rises only slightly, so that revenue that
farmers receive by selling their crops, falls and they are worse off.
[MBA - 2008-10]
Application - 2 1. When demand is inelastic,
an increase in supply . . .
2. . . . leads Price of
wheat S1
to a large fall S2
in price . . .
Rs.12
Rs.10
Demand
100 110 Quantity

of wheat
3. . . . and a proportionately smaller
[MBA - 2008-10]
increase in quantity sold. As a result,
18.08.2008 & revenue falls from
Dr. Jaydeep Rs.1200 to Rs.1100.
Mukherjee
Application - 2
Question:
If farmers are made worse off by the discovery of the new
hybrid, why do they adopt it?
 Assumption of perfect competition!
 Each farmer is only a small part of the market for wheat, so that
he is a price taker.
 For any given price of wheat, it is better to use the new hybrid
to produce and sell more wheat.
 However, when all farmers do this, the supply of wheat
increases, the price falls and the farmers are worse off.
[MBA - 2008-10]
Application - 3
Does drug interdiction increase or decrease drug-related crime?
 One side effect of illegal drug use is crime: Users often turn to
crime to finance their habit.
 We examine two policies designed to reduce illegal drug use
and see what effects they have on drug-related crime.
 For simplicity, we assume the total rupee value of drug-related
crime equals total expenditure on drugs.
 Demand for illegal drugs is inelastic, due to addiction issues.
[MBA - 2008-10]
Application - 3
Policy 1: Interdiction
 Interdiction reduces the supply of drugs.
 Since demand for drugs is inelastic, P rises proportionally more
than Q falls.
 Result: an increase in total spending on drugs, and in drug-
related crime
[MBA - 2008-10]
Application - 3
Policy 2: Education
 Education reduces the demand for drugs.
 P and Q fall.
 Result: a decrease in total spending on drugs, and in drug-
related crime
Price S
D1
D2
[MBA - 2008-10]
Quantity
Income Elasticity of Demand
Measure the responsiveness of demand to changes in income
Income elasticity of demand =% change in Qd / % change in I
 Recall: An increase in income causes an increase in

demand for a normal good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.
[MBA - 2008-10]
Income Elasticity of Demand
Classification of goods
 If 0<eI<1, the goods are referred to as necessities. For such
goods demand is relatively unaffected by changes in income.
Example: bread. As families become more affluent, it will
consume more bread, but the increase is usually not
proportionate to the increase in income.
 If eI>1, the goods are referred to as luxuries. For such goods
change in demand is proportionately more than change in
income. Example: purchase of necklace. As families become
wealthier, they have more disposable income and their
consumption on these luxury goods represent a larger share of
their incomes.
[MBA - 2008-10]
Income Elasticity and Decision Making
 Any economy is subject to business cycles with fluctuations in
income.
 During periods of expansion, incomes are rising and firms
selling luxury items such as electronic goods and exotic
vacations will find that the demand for their products will
increase at a rate faster than the rate of income growth.
During recession, demand for such goods decrease rapidly.
 Conversely, sellers of necessities such as fuel and basic food
items will not benefit as much during periods of economic
prosperity, but will also find that their markets are somewhat
recession-proof.
[MBA - 2008-10]
Income Elasticity and Engel’s Law
 In 19th century, a German statistician, Ernst Engel studied the
consumption patterns of a large number of households and
concluded that the percentage of income spent on food
decreases as incomes increase. That is, food is a necessity.
 One of the implications of Engel’s law is that farmers may not
prosper as much as those in other occupations during periods
of economic prosperity. However, they may be somewhat
recession-proof.
[MBA - 2008-10]
Cross-Price Elasticity of Demand
Measure the responsiveness of demand to changes in prices of related
goods
 The cross-price elasticity of demand measures the response of
demand for one good to changes in the price of another good.
 Cross-price elasticity of demand =
% change in Qd for good 1 / % change in price of good 2
 For substitutes, cross-price elasticity > 0
 An increase in price of Pepsi causes an increase in demand for
Coca Cola.
 For complements, cross-price elasticity < 0
 An increase in price of ketchup causes decrease in demand for
burgers.
[MBA - 2008-10]
Cross-Price Elasticity of Demand
 The price of apples rises from Rs.40.00 per kg. to Rs.50 per kg. As a
result, the quantity of oranges demanded rises from 8,000 per week to
9,500. Calculate the cross-price elasticity of demand.
 The following estimate is available for good X. Calculate the cross-price
elasticity of demand between X and Y.
Price of good X (Rs.) Quantity demanded Price of good Y (Rs.)
of good X (in units)
20 60 25
20 40 35
30 30 30
[MBA - 2008-10]

Sessions 7 & 8

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Sessions 7 & 8

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Sessions 7 & 8

Elasticity and Its

 What is elasticity? What kinds of issues

Compute price elasticity of demand

Suppose the market demand for burgers is given by the equation

 The midpoint formula is preferable when calculating the price elasticity of

100 110 Quantity

Income elasticity of demand =% change in Qd / % change in I

 Recall: An increase in income causes an increase in

Você também pode gostar

Sessions 7 &amp; 8

Enviado por

Dados do documento

Descrição original:

Direitos autorais

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Compartilhar este documento

Compartilhar ou incorporar documento

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Este conteúdo é inapropriado?

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Sessions 7 &amp; 8

Enviado por

Direitos autorais:

Formatos disponíveis

Sessions 7 & 8

Elasticity and Its

 What is elasticity? What kinds of issues

Compute price elasticity of demand

Suppose the market demand for burgers is given by the equation

 The midpoint formula is preferable when calculating the price elasticity of

100 110 Quantity

Income elasticity of demand =% change in Qd / % change in I

 Recall: An increase in income causes an increase in

Você também pode gostar

Sessions 7 & 8

Sessions 7 & 8