Elasticity and Its

Application

.
Elasticity – The concept
 The responsiveness of one variable to
changes in another
 When price rises what happens to
demand?
 Demand falls
 BUT!
 How much does demand fall?

.
Elasticity – The concept
 If price rises by 10% - what happens to
demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which
demand will change

.
 Elasticity . . .

 … is a measure of how much buyers and

sellers respond to changes in market
conditions

… allows us to analyze supply and

demand with greater precision.

.
 Price Elasticity of Demand

 Price elasticity of demand is the

percentage change in quantity demanded
given a percent change in the price.

 It is a measure of how much the quantity

demanded of a good responds to a change
in the price of that good.

.
 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Time Horizon

.
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :

 if the good is a luxury.

 the longer the time period.
 the larger the number of close
substitutes.

.
 Computing the Price Elasticity
of Demand
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price. Percentage Change
in Quantity Demanded
Price Elasticity of Demand =
Percentage Change
in Price

The Percentage Method

.
 Computing the Price Elasticity
of Demand
Percentage change in quatity demanded
Price elasticity of demand 
Percentage change in price
Example: If the price of an ice cream cone increases
from 2.00 to 2.20 and the amount you buy falls from 10
to 8 cones then your elasticity of demand would be
calculated as:
(10  8 )
 100
10 20 percent
 2
( 2.20  2.00 )
 100 10 percent
2.00
.
 Ranges of Elasticity
 Perfectly Inelastic
Quantity demanded does not respond to
price changes.
 Inelastic Demand
Quantity demanded does not respond
strongly to price changes.
Price elasticity of demand is less than one.

.
 Ranges of Elasticity
 Unit Elastic
Quantity demanded changes by the same
percentage as the price.
 Elastic Demand
Quantity demanded responds strongly to
changes in price.
Price elasticity of demand is greater than one.
 Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.

.
A Variety of Demand Curves

Because the price elasticity

of demand measures how
much quantity demanded
responds to the price, it is
closely related to the slope of
the demand curve.

.
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
.
 Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% 5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
.
 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% 5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
.
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% 5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above 4, quantity
demanded is zero.

4 Demand

2. At exactly 4,
consumers will
buy any quantity.

3. At a price below 4, Quantity

quantity demanded is infinite.
.
 Total revenue is The importance of
price x quantity
Elasticity sold. In this
example, TR = 5 x
elasticity is the
information it
provides on the
Price 100 = 500. effect on total
This value is revenue of
represented by the changes in price.
shaded rectangle.

Total Revenue

100 Quantity Demanded

.
 If the firm decides

Elasticity to decrease price

to (say) 3, the
Price degree of price
elasticity of the
demand curve
would determine
the extent of the
5 increase in
demand and the
change therefore
in total revenue.
3

Total Revenue
D
100 140 Quantity Demanded

.
Elasticity
Price
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded

.
 Elasticity
Price
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20

.
Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
 Reducing price  Reducing price
would increase TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

.
 Income elasticity of
demand =
Percentage change in quatity demanded
Percentage change in income

.
Types of Income Elasticity
 Zero Income Elasticity : Change in income has
no impact on quantity demanded.
 Negative Income Elasticity : Increase in income
leads the quantity demanded to fall.
 Positive income Elasticity : Increase in income
leads the quantity demanded to increase. It can
be of three types : Low, Unitary & high.

.
 Income Elasticity of Demand:
 The responsiveness of demand to changes in
incomes.
 Normal Good – demand rises as income
rises and vice versa
 Inferior Good – demand falls as income
rises and vice versa

.
 Cross Elasticity:
 The responsiveness of demand of one
good to changes in the price of a related
good – either a substitute or a
complement
__% Δ in Qd of Good T_
Xed =
% Δ Price of good Y

.
Importance of Elasticity
 Relationship between changes in price
and total revenue
 Importance in determining what goods to
tax (tax revenue)
 Importance in analysing time lags in
production
 Influences the behaviour of a firm

.
Importance of Elasticity
Concepts
 For a Businessman : If a businessman finds
that the demand is inelastic, he is free to
increase prices. In case if the demand is elastic,
by slightly reducing the price, the demand will
increase sharply and hence the total revenue
will also increase.
 The better a company can assess future
demand, the better it can plan its resources.
Each company is exposed to three types of
factors influencing demand: company,
competitive and macroeconomic factors. 

.
Demand Forecasting
 A forecast is a prediction or anticipation
of any event which is likely to happen in
future.
 Demand forecast is the prediction of the
future demand for a firm’s product.

.
Forecasts are necessary for :
 Scheduling of the production process.
 Preparations of budgets.
 Manpower Planning.
 Setting targets of sales executives.
 Advertising & promotion decisions.
 Decisions about expansion of a firm.
 Other decisions like long term investment
plans, warehousing and inventory decisions.

.
Methods of Demand
forecasting
 There are two different sets of methods
for demand forecasting :
 Interview & survey methods ( for short
term forecasts )
 Projection Approach ( for long term
forecasts )

.
Interview and Survey approach

 To anticipate the demand for a product,

information needs to be collected about
the expected expenditure patterns of
consumers. Depending on the various
approaches to collect this information,
different sub – methods are formulated.
 We will study them one by one.

.
Interview and Survey approach
 Executive Opinion :
 In small companies, usually the owner
takes the responsibility of forecasting.
 As a result of the experience and
knowledge he is expected to have, he can
predict what would be the course of
activities in future and plan his own
activities accordingly.

.
Interview and Survey approach

 Opinion polling method : Information about

the consumer’s expenditure can be collected
either by the market research department
or through the wholesalers and retailers.
 As a result of technological advancements, it
is now possible to collect this information by
the means of internet.

.
Interview and Survey approach

 Collective opinion method :

 Jury is a group of individuals, usually the top
bosses or sales, production, marketing
managers having experience in different fields.
 The advantage of this method is that instead of
basing the forecast on the opinion of one single
individual, a more accurate forecast can be
drawn.

.
Interview and Survey approach

 Sample survey method :

 The total number of customers of a
company is called as its population.
When this number is more, it is not
possible to collect information for all the
customers. When only a few customers
are contacted, it is called as a Sample
Survey.

.
User’s Expectations

Consumer and industrial companies

often poll their actual or potential
customers.
Some Industrial manufacturers ask
about the quantities of products
their customers may purchase in
future and take this as their forecast.

.
Delphi Method

Administering a series of questionnaires to

panels of experts. This method gathers
information from all experts and the opinion of
all the experts is shared by all other experts.
In case if an expert finds that his own forecast
is unrealistic, after going through the opinion
of other experts, there is a chance for
corrections. 

.
Projection Approach
 In this method, the past experience is
projected for the future. This can be done
by tow methods :
 Correlation or regression analysis.
 Time series analysis.

.
 Classical approach to time series analysis:
Past sales can be used to forecast future demand.
Past sales are viewed from the angles of trends,
various cycles of business, seasonality and then a
forecast is drawn after checking the possibility of
the same treads, cycles and seasonality factors.

This method is easy to use, it is based on past

behavior and does not include new company,
competitor or macroeconomic developments.

.
Naïve Method

Next Year’s Sales = This Year’s Sales X This Year’s Sales

Last Year’s Sales

.
Moving Average

Moving averages are used to allow for

marketplace factors changing at different
rates and at different times.

.
EXAMPLE OF MOVING-AVERAGE FORECAST

SALES SALES FOR THREE-YEAR

PERIOD VOLUME THREE-YEAR MOVING
PERIOD AVERAGE
1 200
2 250
3 300 750
4 350 900 300
5 450 1100 ( 3) = 366.6
6 ?
Period 6 Forecast = 366.6

.
Trend Projections – Least Squares

Eyeball fitting is simply a plot of the data

with a line drawn through them that the
forecaster feels most accurately fits the
linear trend of the data.

.
A TREND FORECAST OF SALES

O b s e r v e d S a le s F o re c a s t S a le s
600

500

400 T re n d
L in e
300
S a le s

200

10 0

0
19 8 4 19 8 5 19 8 6 19 8 7 19 8 8 19 8 9 19 9 0
T im e

.
Use of economic indicators
 This method bases demand on certain
economic indicators e.g,
 Construction contracts sanctioned for the
demand for building material, say cement etc
 Personal income for the demand for consumer
goods
 Automobile registration for the demand for
accessories, petrol etc.
 Agricultural income for the demand of
agricultural inputs, tractors, fertilizers etc.

.
Categories of New Products
New-To-The-World
New-To-The-World

New
New Product
Product Lines
Lines
Six
Six
Categories
Categories Product
Product Line
Line Additions
Additions
of
of
New
New Improvements/Revisions
Improvements/Revisions
Products
Products
Repositioned
Repositioned Products
Products

Lower-Priced
Lower-Priced Products
Products
.
Forecasting of New Products
 Evolutionary method : Whenever a new
product has been evolved from an existing
product ( eg. Colour TV from Black & White
TV ), the information of the existing product
may be used for prediction of future for the
new product.
 Substitution method : Many new goods are
purchased by customers for replacing the old
ones. ( Eg. LCD TV’s in place of Colour TV’s).

.
Forecasting of New Products
 Growth pattern methods : To predict the
demand for a new product, the growth pattern
of an established related goods can be
understood.
 Opinion polling method : This method
advocates the direct questioning to the
probable buyers or the influencers of sales of
such products. (Eg. demand for drugs can be
ascertained by asking the doctors )

.
Forecasting of New Products

 Sample survey method : A product is

first introduced in a test market ( small
city having profiles of customers of
metros ). Responses from these markets
are taken as a base for forecasts.
 Indirect opinion polling : Instead of
asking the probable buyers, here, the
resellers are consulted.