Managerial Economics

PGDM- HR : 2019– 2021

Term 1 (July – September, 2019)
(Lecture 06)
 Market Equilibrium

P
$6.00 D S
Equilibrium:
$5.00 P has reached the level
$4.00 where quantity supplied
equals quantity
$3.00
demanded
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
2
 Equilibrium Price: The price that equates quantity
supplied with quantity demanded (Max WTP = Min WTA)

P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
3
Equilibrium quantity: The quantity supplied and quantity
demanded at the equilibrium price

P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
4
 Surplus (excess supply):When quantity supplied is
greater than quantity demanded

P Example:
$6.00 D Surplus S
If P = $5,
$5.00
then
$4.00 QD = 9 lattes
$3.00 and
QS = 25 lattes
$2.00
resulting in a
$1.00 surplus of 16 lattes
$0.00 Q
0 5 10 15 20 25 30 35
5
 Surplus (excess supply):When quantity supplied is
greater than quantity demanded

P
$6.00 D Surplus S Facing a surplus,
sellers try to increase sales
$5.00 by cutting price.
$4.00 This causes
$3.00 QD to rise and QS to fall…
$2.00 …which reduces the
surplus.
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
6
 Surplus (excess supply):When quantity supplied is
greater than quantity demanded

P
$6.00 D Surplus S Facing a surplus,
sellers try to increase sales
$5.00 by cutting price.
$4.00 This causes
$3.00 QD to rise and QS to fall.
$2.00 Prices continue to fall until
market reaches
$1.00 equilibrium.
$0.00 Q
0 5 10 15 20 25 30 35
7
 Shortage (excess demand): when quantity demanded is
greater than quantity supplied

P
$6.00 D S Example:
If P = $1,
$5.00
then
$4.00 QD = 21 lattes
$3.00 and
QS = 5 lattes
$2.00
resulting in a
$1.00 shortage of 16 lattes
$0.00 Shortage Q
0 5 10 15 20 25 30 35
8
 Shortage (excess demand): when quantity demanded is
greater than quantity supplied

P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise,
$3.00 …which reduces the
$2.00
shortage.

$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35
9
 Shortage (excess demand): when quantity demanded is
greater than quantity supplied

P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise.
$3.00 Prices continue to rise
$2.00 until market reaches
equilibrium.
$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35
10
Example 1: The Market for Diesel Cars
P
price of
S1
diesel cars

P1

D1
Q
Q1
quantity of
diesel cars
Example 1:A Shift in Demand
Event to be analyzed: P
Increase in price of Petrol. S1
STEP 1: P2
D curve shifts
because
STEP 2:
price of gas P1
affects demand for
D shifts right
hybrids.
because
STEP 3: high gas price
S curvehybrids
makes does not shift,
more D1 D2
The shiftprice
because causes an increase
of gas does
attractive relative to Q
in price
not affectand quantity
cost of of diesel Q1 Q2
other cars.
cars.
producing hybrids.
Example 1:A Shift in Demand
P
Notice:
When P rises, S1
producers supply P2
a larger quantity
of diesel cars, even P1
though the S curve
has not shifted.
Always be careful D1 D2
to distinguish b/w Q
a shift in a curve Q1 Q2
and a movement
along the curve.
Example 2:A Shift in Supply
Event: New technology
reduces cost of producing P
diesel cars. S1 S2
STEP 1:
S curve shifts
because
STEP 2:
event affects P1
cost of production.
S shifts right P2
D curve event
because does not shift,
reduces
STEP 3: production
because
cost, D1
The shift causes
technology is notprice
one of
makes production more Q
to fall
the and quantity
factors that to
affect Q1 Q2
profitable at any given
rise.
demand.
price.
Example3: A Shift in Both Supply and Demand
Events:
price of fuel rises AND P
new technology reduces S1 S2
production costs
STEP 1: P2
Both curves shift.
P1
STEP 2:
Both shift to the right.
STEP 3: D1 D2
Q rises, but effect Q
on P is ambiguous: Q1 Q2
If demand increases more than
supply, P rises.
15
Example3: A Shift in Both Supply and Demand
EVENTS:
price of fuel rises AND P
new technology reduces S1 S2
production costs

STEP 3, cont.
P1
But if supply
increases more P2
than demand,
D1 D2
P falls.
Q
Q1 Q2
 Shifts in Supply and Demand

Use the three-step method to analyze the effects of each event on the
equilibrium price and quantity of music downloads.

Event A: A fall in the price of CDs

Event B: Sellers of music downloads negotiate a reduction in
the royalties they must pay for each song they sell.
Event C: Events A and B both occur.
A. Fall in price of CDs

The market for

STEPS
P music downloads
1. D curve shifts S1
2. D shifts left
P1
3. P and Q both fall.
P2

D2 D1
Q
Q2 Q1
B. Fall in cost of royalties

STEPS The market for

P music downloads
1. S curve shifts
S1 S2
(Royalties are part of
2. S shifts right
sellers’ costs) P1
3. P falls,
Q rises. P2

D1
Q
Q1 Q2
C. Fall in price of CDs and fall in cost of
royalties

Results
Results
PP unambiguously
unambiguously falls.falls.
Effect
Effect on
on QQ isis ambiguous:
ambiguous:
The
The fall
fall in
in demand
demand reduces
reduces Q;
Q;
The
The increase
increase in in supply
supply increases
increases Q.
Q.
A Funny Exercise

Explain the story told by this image with the help of Demand
Supply Tools…..
21
Example
Demand is given by QD = 620 ‑ 10·P and supply is given by QS =
100 + 3·P. What is the price and quantity when the market is in
equilibrium?

Answer:
In equilibrium,
QD = QS,
620 ‑ 10·P = 100 + 3·P
So, the equilibrium Price is 40
And the equilibrium quantity is 220.

22
Problem
In Rolling Stone magazine, several fans and rock stars, including Pearl Jam, were bemoaning the high
price of concert tickets. One superstar argued, “It just isn’t worth $75 to see me play. No one should
have to pay that much to go to a concert.” Assume this star sold out arenas around the country at an
average ticket price of $75.

a)How would you evaluate the arguments that ticket prices are too high?

b)Suppose that due to this star’s protests, ticket prices were lowered to $50. In what sense is this
price too low? Draw a diagram using supply and demand curves to support your argument.

c)Suppose Pearl Jam really wanted to bring down ticket prices. Since the band controls the
supply of its services, what do you recommend they do? Explain using a supply and demand
diagram.

d) Suppose the band’s next CD was a total flop. Do you think they would still have to worry about
ticket prices being too high? Why or why not? Draw a supply and demand diagram to support your
argument.

e)Suppose the group announced their next tour was going to be their last. What effect would this
likely have on the demand for and price of tickets? Illustrate with a supply and demand diagram.
23
Problem
Suppose Xerox outsources the manufacturing of an important component of its laser jet
printer to Canon. As a part of the arrangement, Xerox has to share some of important
features of the product with Canon. Canon takes advantage of it and launches cheaper
laser printer in the market. The Canon product is 90% identical to the Xerox laser printer
in terms of looks, features and after-sales services. In order to compete in the market, in
the short run, one obvious way out for Xerox is to make a new contract with another firm
which increases the cost of production of Xerox printer.

a) Assume that the Xerox Printer Market was in equilibrium before Canon launched
its product. Using a demand-supply graph, answer if there would be any change in
market equilibrium in the Xerox printer market.

b) Now suppose, a smart MBA with an engineering degree joins Xerox. After
working for six months at Xerox, he/she presents a new business model to Xerox
management which involves manufacturing of the important component (referred
earlier) by Xerox itself at lower cost than the cost of outsourcing. Will this new
business plan change the new equilibrium (if any) you got in part (a)?
24
Problem
A survey indicated that chocolate is Americans’ favorite ice cream
flavor. A severe drought in the Midwest causes dairy farmers to
reduce the number of milk-producing cattle in their herds by a
third. These dairy farmers supply cream that is used to
manufacture chocolate ice cream. At the same time a new report
by the American Medical Association reveals that chocolate does,
in fact, have significant health benefits.

Assume that the Chocolate Ice Cream market was in equilibrium.

Using the tool of demand and supply, analyze the impact of the
changing scenarios on equilibrium “quantity demanded” and
price of Chocolate Ice Cream. If you use graph, label it properly.

25
Three Steps to Analyze Changes in Equilibrium

To
To determine
determine the
the effects
effects of
of any
any event,
event,
1.1. Decide
Decidewhether
whetherevent
eventshifts
shiftsSScurve,
curve,
DDcurve,
curve,or
orboth.
both.
2.2. Decide
Decidein
inwhich
whichdirection
directioncurve
curveshifts.
shifts.
3.3. Use
Usesupply-demand
supply-demanddiagram
diagramto
tosee
see
how
howthe
theshift
shiftchanges
changeseq’m
eq’mPPand
andQ.
Q.
Suggested Readings

• Shuttlecock Production in Uluberia, West Bengal (The article sent

through e-mail)

• Discovery of Jojoba Beans caused a collapse of Whale Oil Lubricant

Price (See Slide #42)

• Exchange Rate Impacts on Demand: Cummins Engine Company (See

Slides #43 and 44)

27
 A note on Equilibrium Price
• The objective of Demand supply analysis is to find a price at which the
market is clear. We know it is the equilibrium price.
• Other than Market clearing explanation of equilibrium price what else
can you say about this price?
– In the simplest manner, equilibrium price can be defined as the market
value of a product or service and at this value the willingness to accept
(WTA) of the sellers matches with willingness to pay (WTP) of the
buyers.

28
 Shuttlecock Production in Uluberia

• Dwindling supply of white duck feathers

• Lack of Mechanization
• Soaring competition from Chinese players
using alternative products
• E commerce??
• PV Sindhu, Saina Nehwal etc.
• Japan's Yonex, RSL Tourney from England
Elasticity of Demand
Elasticity

• Basic idea:
Elasticity measures how much one variable responds to
changes in another variable.
– One type of elasticity measures how much demand for your
websites will fall if you raise your price.
• Definition:
Elasticity is a numerical measure of the responsiveness of Qd
or Qs to one of its determinants.

34
Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P

• Price elasticity of demand measures how

much Qd responds to a change in P.
 Loosely speaking, it measures the price-sensitivity of
buyers’ demand.

35
Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
of demand P1
equals D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
36
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along
AlongaaDDcurve,
curve,PPandandQQmove
move
in
inopposite
oppositedirections,
directions,which
which P2
would
wouldmake
makeprice
priceelasticity
elasticity
negative. P1
negative.
We D
Wewill
willdrop
dropthetheminus
minussign
sign
and
andreport
reportall
allprice
priceelasticities
elasticities Q
as Q2 Q1
as
positive
positivenumbers.
numbers.

37
Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

38
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending on
your websites where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

39
Calculating Percentage Changes
• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint
 The midpoint is the number halfway between the
start & end values, the average of those values.
 It doesn’t matter which value you use as the “start”
and which as the “end” – you get the same answer
either way!

40
Calculating Percentage Changes
• Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8

41
What determines price elasticity?
To learn the determinants of price elasticity, we look at a series of
examples.

Each compares two common goods.

In each example:
– Suppose the prices of both goods rise by 20%.
– The good for which Qd falls the most (in percent) has the
highest price elasticity of demand.
Which good is it? Why?
– What lesson does the example teach us about the
determinants of the price elasticity of demand?

42
The Determinants of Price Elasticity

The
The price
price elasticity
elasticity of
of demand
demand depends
depends on:
on:
–– the
the extent
extent to
to which
which close
close substitutes
substitutes areare available
available
–– whether
whether the
the good
good isis aa necessity
necessity or
or aa luxury
luxury
–– how
how broadly
broadly or
or narrowly
narrowly the
the good
good isis defined
defined
–– the
the time
time horizon
horizon –– elasticity
elasticity isis higher
higher inin the
the long
long
run
run than
than the
the short
short run
run

43
EXAMPLE 2: Breakfast cereal vs. Sunscreen

• The prices of both of these goods rise by 20%. For which

good does Qd drop the most? Why?
– Breakfast cereal has close substitutes (e.g., pancakes, Eggo
waffles, leftover pizza), so buyers can easily switch if the
price rises.
– Sunscreen has no close substitutes, so consumers would
probably not buy much less if its price rises.
• Lesson: Price elasticity is higher when close substitutes are
available.
EXAMPLE 1: Insulin vs. Caribbean Cruises

• The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?
– 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: Price elasticity is higher for luxuries than for
necessities.
EXAMPLE 3: “Blue Jeans” vs. “Clothing”

• The prices of both goods rise by 20%. For which good does Qd
drop the most? Why?
– For a narrowly defined good such as blue jeans, there are
many substitutes (black jeans, khakis, Grey Jeans).

– There are fewer substitutes available for broadly defined

goods. Actually, there is no substitutes for clothing.

• Lesson: Price elasticity is higher for narrowly defined goods

than broadly defined ones.
EXAMPLE 4: Car Fuel in the Short Run vs. Car Fuel
in the Long Run

• The price of petrol rises 20%. Does Qd drop more in the short
run or the long run? Why?
– There’s not much people can do in the short run, other than
ride the bus or carpool.
– In the long run, people can buy smaller cars or live closer to
where they work.

• Lesson: Price elasticity is higher in the long run than the

short run.
The Variety of Demand Curves

• 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.
• Five different classifications of D curves.…

48
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
49
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
50
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

51
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
52
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q Very Large
= = = infinity
of demand % change in P Very Low(almost 0%)

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
53
Problem

Use the following

information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

54
Answers

Use midpoint method to calculate

% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals

50%
= 2.0
25%
55
 A scenario…
You
You design
design websites
websites forfor local
local businesses.
businesses.
You
You charge
charge $200
$200 per
per website,
website, andand currently
currently sell
sell 12
12 websites
websites per
per
month.
month.
Your
Your costs
costs are
are rising
rising (including
(including thethe opportunity
opportunity cost
cost of
of your
your
time),
time), so
so you
you consider
consider raising
raising the
the price
price to
to $250.
$250.

The
The law
law of
of demand
demand says
says that
that you
you won’t
won’t sell
sell as
as many
many websites
websites ifif
you
you raise
raise your
your price.
price.

How
How many
many fewerfewer websites?
websites? How
How much
much will
will your
your revenue
revenue fall,
fall,
or
or might
might itit increase?
increase?

56
Price Elasticity and Total Revenue

• Continuing our scenario, if you raise your price

from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
• 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.

57
Price Elasticity and Total Revenue

Price elasticity Percentage change in Q

=
of demand Percentage change in P

Revenue = P x Q

• If demand is elastic, then

price elast. of demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls. 58
Price Elasticity and Total Revenue
Elastic demand
Demand for
(elasticity = 1.8) P your websites
If P = $200,
Q = 12 and revenue $250 increased revenue
= $2400. due to higher P

$200
If P = $250, lost
D
Q = 8 and revenue
due to
revenue = $2000.
lower Q
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
59
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
• If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
• In our example, suppose that Q only falls to 10 (instead
of 8) when you raise your price to $250.
60
Price Elasticity and Total Revenue
Now, demand is
inelastic:
elasticity = 0.82 P
If P = $200,
Q = 12 and revenue
$250
= $2400. increased revenue due to
higher P

$200
If P = $250, lost
reven
Q = 10 and ue D
due
revenue = $2500. to
lower
Q
When D is inelastic, Q
10 12
a price increase
causes revenue to rise. Demand for your websites
61
Elasticity, Revenue, Profit: Summary

62
Problem

A. Pharmacies raise the price of insulin by 10%. Does total

Revenue on insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls
20%. Does luxury cruise companies’ total revenue rise or
fall?

63
Answers

A. Pharmacies raise the price of insulin by 10%. Does

total revenue from insulin rise or fall?
Revenue = P x Q
Since demand is inelastic, Q will fall less
than 10%, so Revenue rises.

64
Answers

B. As a result of a fare war, the price of a luxury cruise

falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue. Which
effect is bigger?
Since demand is elastic, Q will increase more than
20%, so revenue rises.
65
Problem

The manager of the Sell-Rite drug store accidentally

mismarked a shipment of 20-pound bags of charcoal at
$4.38 instead of the regular price of $5.18. At the end
of a week, the store's inventory of 200 bags of charcoal
was completely sold out. The store normally sells an
average of 150 bags per week. What is the store's price
elasticity of demand for charcoal? Give an economic
interpretation of the numerical value obtained.

66
Problem

Consider the following demand schedule for DVDs.

Points Price (Rs.) Quantity Demanded

A.   6 0
B.  4 10
C.  2 20
D.  0 30
a) Compute the Total Revenue and Price Elasticity of demand (between two successive points
like points A and B) on the demand curve to be drawn from this schedule and generate two
additional columns in the table above.
b) Graph the prices and quantity and indicate the region on the graph, where demand is elastic,
unitary elastic and inelastic.
c) Now comparing the two new columns you generated in part (a) verify whether your
calculation is consistent with the theoretical relationship you learnt between Total Revenue
and Elasticity. You can consider the possible points on the demand curve other than the points
given here to support your answer.
67
Other Types of Elasticity of Demand
• Income elasticity of demand: measures the response of Qd to
a change in consumer income

Income elasticity of Percent change in Qd

demand =
Percent change in income

 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.

68
Other Types of Elasticity of Demand
• Cross-price elasticity of demand:
measures the response of demand for one good to changes in
the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2

 For substitutes, cross-price elasticity > 0

(e.g., an increase in price of mutton causes an increase in
demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes decrease in
demand for software)
69
Other Types of Elasticity of Demand
• Promotional/Advertising Elasticity of demand:

Advertising Elasticity % change in Qd for good

=
% change in Advertising
Expenditure

70
Problem
Suppose Xerox outsources the manufacturing of an important component of its laser jet
printer to Canon. As a part of the arrangement, Xerox has to share some of important
features of the product with Canon. Canon takes advantage of it and launches cheaper
laser printer in the market. The Canon product is 90% identical to the Xerox laser printer
in terms of looks, features and after-sales services. In order to compete in the market, in
the short run, one obvious way out for Xerox is to make a new contract with another firm
which increases the cost of production of Xerox printer.

a) Assume that the Xerox Printer Market was in equilibrium before Canon launched
its product. Using a demand-supply graph, answer if there would be any change in
market equilibrium in the Xerox printer market.

b) Now suppose, a smart MBA with an engineering degree joins Xerox. After
working for six months at Xerox, he/she presents a new business model to Xerox
management which involves manufacturing of the important component (referred
earlier) by Xerox itself at lower cost than the cost of outsourcing. Will this new
business plan change the new equilibrium (if any) you got in part (a)?
71
Problem
A survey indicated that chocolate is Americans’ favorite ice cream
flavor. A severe drought in the Midwest causes dairy farmers to
reduce the number of milk-producing cattle in their herds by a
third. These dairy farmers supply cream that is used to
manufacture chocolate ice cream. At the same time a new report
by the American Medical Association reveals that chocolate does,
in fact, have significant health benefits.
Assume that the Chocolate Ice Cream market was in equilibrium.
Using the tool of demand and supply, analyze the impact of the
changing scenarios on equilibrium “quantity demanded” and
price of Chocolate Ice Cream. If you use graph, label it properly.

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Problem
• Amazon.com, the online bookseller, wants to increase its total revenue. One strategy
is to offer a 10% discount on every book it sells. Amazon.com knows that its
customers can be divided into two distinct groups according to their likely responses
to the discount. The accompanying table shows how the two groups respond to the
discount.

– Calculate the price elasticities of demand for group A and group B.

– Explain how the discount will affect total revenue from each group. If
Amazon.com wants to increase its total revenue, should discounts be offered to
group A or to group B, to neither group, or to both groups? 73
Problem
At an Asian Mobile Service provider, the demand for voice calls had an own
price elasticity of (– 0.085) and cross price elasticity with respect to the price
of SMS of (– 0.078). The demand for SMS had an own price elasticity of (–
0.03) and cross price elasticity with repect to the price of voice calls of (–
0.003).
(Source: Youngsoo Kim, Rahul Telang, William B. Vogt, and Ramayya
Krishnan, “An Empirical analysis of mobile voice service and SMS: A
structural model” Management Science, 2010)

• For which service was the demand more price elastic? (2 Points)
• How would you describe the relation between the demand for voice
calls and SMS?
• Which is the relatively stronger complements/substitutes? (i) SMS for
voice calls, or (ii) voice calls for SMS?
• Describe the impact on revenues from (i) voice and (ii) SMS if the
provider were to raise the price of voice calls by 5%.

74
 Problem
Imagine yourself as a Kansas wheat farmer. Because you earn all your income
from selling wheat, you devote much effort to making your land as productive as it
can be. You monitor weather and soil conditions, check your fields for pests and
disease, and study the latest advances in farm technology. You know that the more
wheat you grow, the more you will have to sell after the harvest, and the higher
will be your income and your standard of living.

One day Kansas State University announces a major discovery. Researchers in its
agronomy department have devised a new hybrid of wheat that raises the amount
farmers can produce from each acre of land by 20 percent.

 How should you react to this news?

 Should you use the new hybrid?

 Does this discovery make you better off or worse off than you were before?
 Solution

In this case, the discovery of the new hybrid affects the supply curve. 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. In other words,
the supply curve shifts to the right. The demand curve remains the same because
consumers’ desire to buy wheat products at any given price is not affected by the
introduction of a new hybrid. Figure 5-8 shows an example of such a change.
When the supply curve shifts from S1 to S2, the quantity of wheat sold increases
from 100 to 110, and the price of wheat falls from $3 to $2.

But does this discovery make farmers better off? As a first cut to answering this
question, consider what happens to the total revenue received by farmers. Farmers’
total revenue is P *Q, the price of the wheat times the quantity sold. The discovery
affects farmers in two conflicting ways. The hybrid allows farmers to produce
more wheat (Q rises), but now each bushel of wheat sells for less (P falls).
 Solution (contd.)

Whether total revenue rises or falls depends on the elasticity of demand. In practice, the demand for
basic foodstuffs such as wheat is usually inelastic, for these items are relatively inexpensive and have
few good substitutes. When the demand curve is inelastic, as it is in Figure 5-8, a decrease in price
causes total revenue to fall. You can see this in the figure: The price of wheat falls substantially, whereas
the quantity of wheat sold rises only slightly. Total revenue falls from $300 to $220. Thus, the discovery
of the new hybrid lowers the total revenue that farmers receive for the sale of their crops.

If farmers are made worse off by the discovery of this new hybrid, why do they adopt it? The answer to
this question goes to the heart of how competitive markets work. Because each farmer is a small part of
the market for wheat, he or she takes the price of wheat as given. For any given price of wheat, it is
better to use the new hybrid in order to produce and sell more wheat. Yet when all farmers do this, the
supply of wheat rises, the price falls, and farmers are worse off.

This analysis of the market for farm products also helps to explain a seeming paradox of public policy:
Certain farm programs try to help farmers by inducing them not to plant crops on all of their land. Why
do these programs do this? Their purpose is to reduce the supply of farm products and thereby raise
prices. With inelastic demand for their products, farmers as a group receive greater total revenue if they
supply a smaller crop to the market. No single farmer would choose to leave his land fallow on his own
because each takes the market price as given. But if all farmers do so together, each of them can be
better off.
Solution (contd.): Graphical Exposition
Empirical Estimates of Price Elasticity of Demand

79
Empirical Estimates of Income Elasticity of Demand

80