CHAPTER 4 Appendix

The Mathematics of Demand Elasticity

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 Chapter 4 - Appendix

4A.1 The Elasticity - ‘Optimization Technique’ : Differential Calculus

4A.1 The Mathematics of Elasticity

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The Optimization Technique

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 Optimization Technique

Differential Calculus: Concept and Rules of Differentiation

Optimization techniques are an important set of tools required for efficiently

managing firm’s resources.

We use differential calculus to solve certain types of optimization problems.

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 Differential Calculus - The Concept of a Derivative:

In explaining the slope of a continuous and smooth non-linear curve when a change
in the independent variable, that is, AX gets smaller and approaches zero,
∆Y /∆X becomes better approximation of the slope the function, Y = f (X),
at a particular point.
Thus, if ∆X is infinitesimally small, ∆Y /∆X measures the slope of the function at a
particular point and is called the derivative of the function with respect to X.
The derivative dY /dX or more precisely the first derivative of a function is defined
as limit of the ratio ∆Y /∆X as ∆X approaches zero.
Thus dY/dX = limit ∆X→0 ∆Y/∆X

Derivative of a function [Y=f (X)] is written as d (fX) / dX Or f’ (X)

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 Optimization Technique

Rules of Differentiation:

Process of finding the derivative of a function is called differentiation.

Derivative of a function represents the change in the dependent variable due to a
infinitesimally small change in the independent variable and is
written as
dY / dX for a function Y = f (X).

A series of rules have been derived for differentiating various types of functions.
We describe below these rules of differentiation.

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 Differential Calculus - The Concept of a Derivative:

We describe below the rules of differentiation :

Derivative of a Constant Function:

A constant function is expressed as

Y=f(X) = a
Where ‘a’ is constant. The constant ‘a’ implies that Y does not vary as X varies, that is.
Y is independent of X.

Therefore, the derivative of a constant function is equal to zero.

Thus, in this constant function
dy/dx = 0

Example Y = 2.5

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 Differential Calculus - The Concept of a Derivative:

A power function takes the following form:

Y = aXb Where a and b are constants. Here a is the coefficient of the X term and the variable X is raised
to the power b. The derivative of this power function is equal to the power b multiplied by the
coefficient a times the variable X raised to the power b – 1.

Thus rule for the derivative of power function (Y = a Xb) is

dY / dX = b. a. Xb-1

Example Y= X (Power function where x raised to 1 )

Y = 1.5 X
Y= X2 (Quadratic power function where x raised to 2 )
Y = 3 X2
Y = 3 X-5

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The Mathematics of Elasticity

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 The Formulas Used to Calculate Elasticity

1. ‘Percentage’ Change Method to Calculate Price Elasticity of Demand

2. ‘Arc’ Elasticity of Demand Method to Calculate Price Elasticity
3. ‘Point’ Elasticity of Demand Method to Calculate Price Elasticity

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 The Formulas Used to Calculate Elasticity

1. Percentage Change Method to Calculate Price Elasticity of Demand

%D Quantity
Ep =
%D Price
Example : 10% increase in P leading to 15% decrease in Qd,
Price Elasticity of Demand = ?

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 The Formulas Used to Calculate Elasticity

2. Arc Elasticity of Demand Method to Calculate Price Elasticity

Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
Example : An increase in P from $200 to $250 leading to
decrease in Qd from 12 to 8, Price Elasticity of Demand = ?

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 The Formulas Used to Calculate Elasticity

3. Point Elasticity of Demand Method to Calculate Price Elasticity

Example : Qd = 2,000 – 20P, Price Elasticity of Demand when P = $70 ?

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 The Types of Price Elasticity of Demand

• Elasticity varies along a linear

demand curve.

• Categories of Elasticity

– Relative elasticity of demand: Ep > 1

– Relative inelasticity of demand: 0 < Ep < 1
– Unitary elasticity of demand: Ep = 1 (- or +)
– Perfect elasticity: Ep = ∞
– Perfect inelasticity: Ep = 0

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 Types of Elasticity

Perfectly Elastic Demand

A demand relationship in which the percentage change in quantity
demanded is larger than the percentage change in price in absolute value
(a demand elasticity with an absolute value greater than 1).
Perfectly Inelastic Demand
Demand that responds somewhat, but not a great deal, to changes
in price. Inelastic demand always has a numerical value between zero and -1
or less than zero.
Unit Elastic A demand relationship in which the percentage change in quantity of a
product demanded is the same as the percentage change in price in absolute
value (a demand elasticity of -1 or +1).

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 Elasticity of a Linear Demand Curve
Example :
What is the Slope of a Linear
P Demand Curve?
$30 a
Calculate Elasticity of the
b Linear Demand Curve :
20
Ep between a-b ?
c Ep between b-c ?
10 Ep between c-d ?
d What do you observe?
$0 Q
0 20 40 60

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16
 Formulas Used to Calculate Other Elasticities

1. Method to Calculate Price Elasticity of Supply

2. Method to Calculate Cross Price Elasticity of Demand
3. Method to Calculate Income Elasticity of Demand

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 Other Important Elasticities

Elasticity Of Supply

elasticity of supply A measure of the response of

quantity of a good supplied to a change in price of that
good. Likely to be positive in output markets.

% change in quantity supplied

elasticity of supply 
% change in price

Percentage Change Method vs Arc Method

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 Price Elasticity of Supply : Mid Point / Arc Method

Example :

Assume Q1 = 3, Q2 = 10 and P1 = 4, P2 = 9
Calculate Price Elasticity of Supply, Es.

Cross-price elasticity of demand = (dQ / dP')*(P'/Q)

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 Other Important Elasticities

Cross-Price Elasticity Of Demand

A measure of the response of the quantity of
one good demanded to a change in the price of
another good.
% change in quantity of Y demanded
cross - price elasticity of demand 
% change in price of X

Income Elasticity of Demand A measure of the responsiveness of demand to

changes in income.
% change in quantity demanded
income elasticity of demand 
% change in income

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 Other Important Elasticities using Calculus

Cross-Price Elasticity Of Demand

at the Point

Cross-price elasticity of demand = (dQ / dP'')*(P''/Q)

Income Elasticity of Demand at the Point

Income elasticity of demand = (dQ / dI)*(I/Q)

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 Income & Cross Price Elasticities of Demand using Calculus

Assignment :
Smooth Sailing Inc., has estimated demand function for it’s sailboats as follows :
Qd = 89,830 – 40Ps + 20Px + 15Py +2 I + 0.001A + 10W
Where,
Qd = quantity purchased,
Ps = price of Smooth Sailing sailboats, Px = price of Company X’s sailboat,
Py = price of Company Y’s motorboat, I = per capita income in dollars,
A = dollars spent on advertising and W = number of favorable days of weather.

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 Price Elasticity Summary

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 Chapter 4 and Appendix

Book :

• Managerial Economics Economic Tools for Today’s Decision Makers

Paul G. Keat, Philip K. Y. Young, Stephen E. Erfle - 7th Edition

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