ZANZIBAR UNIVERSITY

MANAGERIAL ECONOMICS ALYF 601

Demand Function & Elasticity of
demand

SALIM HAMAD SULEIMAN (Ph.D)

Email: salimsule1@hotmail.com
0772 123 118
1
 Demand Function

Demand Function is a comprehensive

formulation which specifies the factors that
influence the demand for the product.
Demand function states the relationship
between the demand for a product and its
determinants.
Q = f(P, P°, Y)
Q= 25 +3Y + P° - 2P
2
 Qd = 500 – 4p
QS = -100 + 2p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of
barrels per year

3
a. The equilibrium price of cranberries is calculated by
equating demand to supply:

Qd  Qs
500  4 p  100  2 p
500  100  2 p  4 p
p*  $100

b. Use equilibrium price with either demand or supply

to get equilibrium quantity:

Q d  500  4 p
Q d  500  4(100)
Q d  100
4
 Example: The Market For Cranberries
Price

125
Market Supply: P = 50 + QS/2

P*=100 •
50

Market Demand: P = 125 - Qd/4

Q* = 100 Quantity

5
 Q d  500  4 p
Q s  100  2 p
p = price of cranberries (dollars per barrel)
Q = demand or supply in millions of
barrels per year

Assume that a plague reduced cranberry supply by 100 and fear

of inflection likewise reduced cranberry demand by 100 so that:
Q d  500  4 p  100
Q d  400  4 p
Q s  100  2 p  100
Q s  200  2 p
6
a. The new equilibrium price of cranberries is
calculated by equating demand to supply:
Q d  QS
400 – 4p  - 200  2p
400  200  2p  4p
p *  $100
b. Use equilibrium price with either demand or supply
to get equilibrium quantity:

7
 Example: The Market For Cranberries
New Market Supply: P = 100 + QS/2
Price

125
Old Market Supply: P = 50 + QS/2

POLD=PNew •
50

Old Market Demand: P = 125 - Qd/4

QNew QOLD Quantity

New Market Demand: P = 100 - Qd/4

8
Percentages and Elasticity
Which of the following seem more
serious:
An increase of 50 cents or an increase of 50% in
the price of a hamburger
An increase of $100 or an increase of 1% in the
price of a new car
Percentage changes are often more
important than the amount of change
Therefore economists often use elasticities to
examine percentage change or responsiveness
9
Price Elasticity
Price Elasticity of Demand (Ep)
The responsiveness of quantity
demanded of a commodity to
changes in its price
Related to the slope, but
concerned with percentage
changes
10
Impact of a Change in Supply &
Therefore Price on the Quantity Demanded
Price (dollars per pizza)

40.00 … a S0
large An increase S1
30.00 fall in in supply
price... brings ... Large price
change and
20.00 small quantity
change
10.00
… and a small
5.00 increase in quantity
Da
0 5 10 13 15 20 25
Quantity (pizzas per hour)
11
Impact of a Change in Supply…
An increase
Price (dollars per pizza)

40.00 in supply
S0
brings ... S1
30.00 … a small Small price
fall in price...
change and
20.00 large quantity
change
15.00
Db
10.00
… and a large
increase in quantity

0 5 10 15 17 20 25
Quantity (pizzas per hour)
12
Price Elasticity
Price Elasticity of Demand

Percentage change in quantity demanded

Ep 
Percentage change in price

%Qd
Ep 
%P
The ratio of the two percentages is a
number without units.
13
 Price Elasticity
Example
◦ Price of oil increases 10%
◦ Quantity demanded decreases 1%

-1%
Ep   .1
10%

When calculating the price elasticity of

demand, we ignore the minus sign for
% change in Q.
14
TYPES OF ELASTICITY
Hypothetical Demand Elasticities for 4 Products
Product % Change in % Change in Elasticity
price (%P) quantity (%QD/%P)
demanded
(%QD)

Insulin + 10% 0% 0  Perfectly

inelastic
Basic
Telephone + 10%  -1% .1  Inelastic
service

Beef + 10%  -10% 1.0 

Unitarily
elastic

Bananas + 10%  -30% 3.0Elastic

15
Price Elasticity Ranges: Extreme Price Elasticities

D P1 never touches
the demand curve
Perfect
inelasticity, Perfect
P1 P1 elasticity,
zero elasticity,
infinite
no matter how
elasticity,
Price

much Price
the slightest
changes, 30
D increase
Quantity
P0 in price will
Price
stays the
lead to
same;
zero sales.
insulin

0 8 0 Quantity Demanded per Year

Quantity Demanded per Year
(millions of units) (millions of units)
16
 Price Elasticity Ranges
Summary from Table
 Elastic Demand
%Q  %P; EP  1
 Unit Elastic
%Q  %P; EP  1
 Inelastic Demand
%Q  %P; EP  1
17
Elasticity
Calculating elasticity
of Demand
Change in Q Change in P
Ep 
Sum of quantities/2 Sum of prices/2

Change in Q Change in P
or Ep 
(Q1  Q2 )/2 (P1  P2 )/2

Q P
or Ep 
Avg. Q Avg. P

18
 Calculating the Elasticity of Demand
Price (dollars/pizza)
Original
point
20.50
Q /Qave 2/10
Elasticity = = =4
P/Pave 1/20
ΔP=1
20.00 New
point
19.50
D
Quantity (pizzas/hour)
9 10 11
Qave =1/2(11+9)=10
Pave =1/2(20.50+19.50)=20
ΔQ=2 19
 Elasticity of Demand (mid-point)
Q =2
X 100
% Q Q1 + Q2 (9 + 11)
=20% = 10
2 20%
Ed = = Ed = = 4
5%
 P = $1.00
X 100
% P P1 + P2 ($20.50 + $19.50)
=5% = $20
2
Always use the mid-point formula for calculating elasticity
20
Changes in Elasticity Along a Linear Demand
1.10
1.00 Elastic (EP > 1)
.90
Unit-elastic (EP = 1)
.80
Price per Minute ($)

.70 Inelastic (EP < 1)

.60
.50 Demand,
.40 or average
.30 revenue curve
.20 D
.10

0 1 2 3 4 5 6 7 8 9 10 11
Quantity per Period (billions of minutes)

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The Relationship Between Price Elasticity of Demand and
Total Revenues for Cellular Phone Service

Quantity Total Elasticity

Price Demanded Revenue Ep

$1.10 0 0
21.000
1.00 1 1.0
.90 2 6.333
1.8
3.400 Elastic
.80 3 2.4
.70 4 2.143
2.8
.60 5 3.0 1.144
.50 6 3.0 1.000 Unit-elastic
.40 7 2.8 .692
.30 8 .467
2.4 Inelastic
.20 9 .294
1.8
.10 10 .158
1.0
22
Total Revenue and Elasticity
Total Revenue
=
Price Per Good
X
# of Goods Sold

TR = P X Q

Assumption : Costs are constant

23
 1.10 Elastic
demand

.80
Unit

Price
elastic
.55
Inelastic
demand

0 Quantity
55 110
3.00 Maximum
Total Revenue

total revenue
(dollars)

When demand
is inelastic,
When demand is price cut decreases
elastic, price cut total revenue
increases total
revenue
Quantity
0 55 110
24
 Relationship Between Price
Elasticity of Demand and Total Revenues

Price Elasticity Effect of Price Change

of Demand on Total Revenues (TR)

Price Price
Decrease Increase

Inelastic (EP < 1) TR  TR

Unit-elastic (EP = 1) No change No change Elastic (EP > 1)

TR TR 

25
Total Revenue and Elasticity
Total Revenue Test:
Estimate the price elasticity of
demand by observing the change in
total revenue that results from a
change in price (ceteris paribus).

Note that revenue is maximized

when elasticity of demand = -1.
26
Question
2 drivers - Tom & Jerry each drive to to a gas station.
Before looking at the price, each places an order.
Tom says, “I’d like 10 litres of gas”.
Jerry says, “I’d like $10 of gas”.
What is each driver’s price elasticity of demand?

27
Determinants of Price Elasticity of Demand

Existence of substitutes
The length of time allowed for
adjustment
More specifically a good is defined
(more specific = more substitutes)
Necessity or not
Share of budget
28
Demand Elasticity and Time

D2
Price per Unit

P1

Pe As time passes, the

demand curve rotates
to D2 and then to D3
and quantity demanded
lowers first to Q1 and
then to Q2

Q3 Q2 Q1
Quantity Supplied per Period
29
Elasticity: Example
You are the consulting economist to the Guelph
transportation commission,
The current fare is $.80
There are 25,000 riders per day
For each $.01 increase (decrease) in the fare, rider
ship decreases (increases) by 500 riders per day.
What is the price elasticity of demand at the
current fare?
Should fares be raised or lowered?
What fare will maximize revenue?
30
Cross Price Elasticity of Demand
Demand is affected by the price of substitutes and
compliments
An increase in the price of a substitute increases demand
An increase in the price of a complement decreases
demand
This effect can be measured using cross price
elasticity
If the cross price elasticity is zero, the good is neither a
complement nor a substitute

31
Cross Price Elasticity of Demand

Percentage change in quantity demanded of X

Є 
Qi,Pj Percentage change in price of Y

Є Qi,Pj = Change in X Change in Price of Y

---------------
(X1 + X2)/2
/ ----------------------------
(Py1 + Py2)/2

Substitutes – Positive Cross Price Elasticity

Complements – Negative Cross Price Elasticity
32
 Cross Price Elasticity of Demand Example

“Recent cat attacks have prompted cat

owners to buy guns for self-defense”

Originally, 2 Econ students owned a cat. After the price of guns went from $100 to $200, only 1
Econ student owned a cat.
Calculate the cross-price elasticity of demand

33
 Cross-Price Elasticity
 Q = -1
X 100
% Qi Q1 + Q2 (2 + 1)
=-66% = 1.5
2 -66%
ЄQ,P = = ЄQi,Pj = = -1
66%
 P = $100
X 100
% PJ P1 + P2 ($100 + $200)
=66% = $150
2
Are cats and guns substitutes or compliments?
34
Income Elasticity of Demand

Income Elasticity of demand refers to a

HORIZONTAL SHIFT in the demand curve
resulting from an income change

Price elasticity of demand refers to a

MOVEMENT ALONG THE DEMAND
CURVE in response to a price change
35
Income Elasticity of Demand
Percentage change in quantity demanded
Є Q,I 
Percentage change in income

Є Q,I= Change in Q Change in M

---------------
(Q1 + Q2)/2
/ ----------------------------
(M1 + M2)/2

Normal Good – Positive Shift/Elasticity

Inferior Good – Negative Shift/Elasticity
36
 Income Elasticity of Demand Example
In Zanzibar, the average family will own 4 Toyotas in their
lifetime.
If average family income rose from $140K to $160K a year,
the average family would own 2 Toyotas over their lifetime

i. Calculate Income Elasticity of Demand for Toyotas in

Zanzibar.
ii. Are Toyotas normal or inferior goods in Zanzibar?

37
 Income Elasticity of Demand
 Q = -2
X 100
% Q Q1 + Q2 (4 + 2)
=-66% =3
2 -66%
ЄQ,I = = ЄQi,Pj = = -5
13.3%
 I = $20K
X 100
% I I1 + I2 ($140K + $160K)
=13.3% = $150K
2
In Zanzibar, are Toyotas normal or inferior goods?
Guess which brand is the luxury car. 38
Elasticity of Supply
Calculating elasticity

Change in Q Change in P
Ep 
Sum of quantities/2 Sum of prices/2

Change in Q Change in P
or Ep 
(Q1  Q2 )/2 (P1  P2 )/2

Q P
or Ep 
Avg. Q Avg. P

39
How a Change in Demand Changes Price and Quantity

An increase
in demand
Price (dollars per pizza)

40.00 brings ... Sa

Large price change and
small quantity change
30.00

20.00
… a large
price rise...
10.00
… and a small
D1
quantity increase
D0
0 5 10 13 15 20 25
Quantity (pizzas per hour)
40
How a Change in Demand Changes Price and Quantity
An increase Small price
change and
Price (dollars per pizza)

in demand
40.00 brings ... large quantity
change
30.00
Sb
21.00
20.00
… a small
10.00 price rise... … and a large
quantity increase D1

D0
0 5 10 15 20 25
Quantity (pizzas per hour)
41
Elasticity of Supply

Elasticity of supply ranges

◦ (from) Perfectly Elastic Supply
◦ Quantity supplied falls to 0 when there is any
decrease in price

◦ (to) Perfectly Inelastic Supply

◦ Quantity supplied is constant no matter what
happens to price
Notice: There is no total revenue test for supply
since price and quantity are directly related
42
 Supply Elasticity Ranges
S
Price

Elasticity of

Price
supply = 0
Elasticity of
supply = 
S
Quantity supplied is
the same for any Suppliers will offer
price! ANY quantity at this
price

0 Quantity 0 Quantity
43
 Elasticity of Supply: Depends On:
1. Resource substitution possibilities,
-The more unique the resource, the more
inelastic the supply.

2. Time frame for the supply decision,

Momentary supply
Long-run supply
Short-run supply
- The longer producers have to adjust to a price
change, the more elastic is supply.

44
Supply Elasticity and Time

S1 S2
Price per Unit

P1

Pe As time passes, the

supply curve rotates
to S2 and then to S3
and quantity supplied
rises first to Q1 and
then to Q2

Qe Q1 Q2
Quantity Supplied per Period
45
 Elasticity: example-Tax Burden
Government levies a tax on a good:
◦who actually pays the tax,
◦ what is the incidence of the tax,
◦ who bears the burden of the tax.

Suppose that the tax is levied on the seller;

i.e., the seller has to pay the tax

Supply is affected
46
Explain the Effects of the Sales Tax
A $10 sales (excise) tax per MP3 player is imposed on the
sellers of MP3 players.

There are now two “prices” for MP3 players: an after- tax
price faced by buyers, and an after-tax price faced by
sellers.

Will the price faced by buyers increase $10 after

introducing the sales tax? By how much?
Will the price faced by sellers change? By how much?

47
Sales Tax Imposed on the Sellers
Supply is affected
S + tax

110 S
Price (dollars per player)

$10 tax
105
Tax After Tax
revenue Market Price
100

95
DA

3 4 5 6
Quantity (thousands of MP3 players per week)
48
Sales Tax: Who Pays?
Tax Wedge
S + tax

110 S
Price (dollars per player)

$10 tax
After Tax
105 Market Price
Buyer pays t
100 a Original Market Price
Seller pays x
95 After Tax
Price to Seller
DA
3 4 5 6
Quantity (thousands of MP3 players per week)
49
Summary:
Taxes discourage market activity

Burden is shared, buyers pay more, sellers receive

less,
and

•Tax burden falls most heavily on the

side of the market that is least elastic
in its response to a price change.

50
The Sales Tax: Who Pays?
Demand Relatively Inelastic

S + tax

110 S
Price (dollars per player)

108 $10 tax

105

100
98
95
DA
3 4 5 6
Quantity (thousands of MP3 players per week)
51
The Sales Tax: Who Pays? Demand Relatively
More Elastic.
Tax Wedge S + tax

110 S
Price (dollars per player)

DA $10 tax
105
103
100 Original Market Price

95
93

3 4 5 6
Quantity (thousands of MP3 players per week)
52
Sales Tax: Who Pays When Tax Is
Imposed on the Buyer?

110 S
Price (dollars per player)

D-tax
105

100 Original Market Price

95
DA
3 4 5 6
Quantity (thousands of MP3 players per week)
53
AHSANTENI
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