Economics for Managers

Income Elasticity, Cross

price elasticity
Recap

 Important for a manager/ for an

entrepreneur, to understand price elasticity
 And, obviously, would you prefer a high
price-elasticity or a low price-elasticity?
– What factors, then, might affect price elasticity?
What sort of businesses will have high/ low
elasticity? Would you have control over the price
elasticity?
Recap:Factors affecting Price
Elasticity

 Number of Substitutes: Brand-specific

elasticity and product-specific elasticity.
Reading done?
 Necessities vs luxuries-Eg Air Purifier
 Share of exp on the commodity in the total
budget-Tooth brush
 Time period: Short run and long run
Learning Objective, Session 3

 At the end of these sessions, you should be

able to:
– Incorporate understanding of income elasticity,
cross-price elasticity and demand

What do you think

these new terms will be
about?
Equilibrium Analysis

 Equilibrium analysis
We go even deeper!
Equilibrium Analysis
We saw how demand and supply
forces establish the equilibrium
ceteris paribus.
DEMAND But now let us introduce something
‘exogeneous’; something coming
from outside
SUPPLY
Price

Quantity
Equilibrium Analysis
For example, let us assume that this
diagram represents the market for
air transportation in India, say in
DEMAND 2017 (. Assume that there is a
substantial increase in the per
capita income in India. How will you
represent this shift in the system? SUPPLY
Price

Quantity
Equilibrium Analysis
For example, let us assume that this
diagram represents the market for
air transportation in India, say in
DEMAND 2017 (was it?). Assume that there is
a substantial increase in the per
capita income in India. How will you
represent this shift in the system? SUPPLY
Price

Quantity
Shifts in Demand/ Supply

 Our two-dimensional diagram can only show

in demand for a good/ product as a function
of changes in its own price
 Changes in equilibrium caused to changes in
exogenous factors like, for example, income
are therefore referred to as ‘shifts’
 This shift, note, could happen also due to
changes in consumer preferences/ tastes
(Salad Days)
Income Elasticity of Demand

 How do we now, measure, the income

elasticity of demand for our market for air
travel?
 Recollect, we defined the price elasticity of
demand as ∆Q /∆P * P/Q
 So: quick! What should income elasticity be
defined as?
Income Elasticity of Demand

 How do we now, measure, the income

elasticity of demand for our market for air
travel?
 Recollect, we defined the price elasticity of
demand as ∆Q /∆P * P/Q
 So: quick! What should income elasticity be
defined as?
 Right! Income Elasticity is = ∆Q /∆I * I/Q
 So relevant
today!
Income Elasticity

 Income Elasticity = ∆Q /∆I * I/Q

– Could be positive or negative, high or low
 Positive and high: Example?
 Positive and low: Example?
 Negative: Example?
 So relevant
today!
Income Elasticity

 Income Elasticity = ∆Q /∆I * I/Q

– Could be positive or negative, high or low
 Positive and high: Demand fluctuates in same direction with
large magnitude. Example: Superior good/ Discretionary Spend
on Consumables (Example?) or Non-Consumables
(Examples?)
 Positive and low: Demand fluctuates in same direction with
small magnitude (Examples?)
 Negative: Inferior good (Examples?)
Income Elasticity

 Income Elasticity = ∆Q /∆I * I/Q

– Could be positive or negative, high or low
 Positive and high: Demand fluctuates in same direction with
large magnitude. Example: Superior good/ Discretionary Spend
on Consumables (Business class Air travel, 5 Star Holidays) or
Non-Consumables (Luxury cars, Gadgets) which are called
cyclical Industries.
 Positive and low: Demand fluctuates in same direction with
small magnitude (Normal Holidays, Eating Out)
 Negative: Inferior good (Footwear, Education Type Choices)
 Now read (yes, again!) Section 2.5 of P&R lots of interesting
things!
A Peek: Cyclical industries

 Demand for durables fluctuate sharply with

changes in income

 Reflects changes in GDP/ Per Capita Income

 Demand reflects GDP/ Per Capita Income

cycles; and magnified!
Cyclical Industry, Discretionary
spend….

Airtraffic%change
% Annual GDP gr

Year on year(in red)

Could be
automobiles

years
The Elasticities Test!

Positive Negative
Low High Low High
Price Elasticity ? ? ? ?

Income Elasticity ? ? ? ?

Fill it up with
illustrative
numbers
The Elasticities Test!

Positive Negative
Low High Low High
Price Elasticity XXX XXX < 1 (eg -.25) > 1 (eg -2)
Inelastic Elastic

Income Elasticity <1(eg .25) >1 (eg 2) <1 (eg -.25) >1 (eg -2)
Normal Superior Inferior Inferior

Note: Since PE is always negative, we ignore

the negative sign while reporting it. So, we refer
to PE as .25, 2 etc
And now examples for all these?
The Elasticities Test!

Positive Negative
Low High Low High
Price Elasticity XXX XXX < 1 (eg -.25) > 1 (eg -2)
Inelastic Elastic
e.g. Petrol e.g. SUVs

Income Elasticity <1(eg .25) >1 (eg <1 (eg -.25) >1 (eg -2)
Normal 2) Inferior Inferior
e.g. Shoes Superior Unprocessed Cheap
Air Cereals plastic/
Travel Metal Toys
How do you interpret?

 SUVs PE of 2
 IE of +2 for air travel
 IE of -.25 for unprocessed cereals
How do you interpret?

 SUVs PE of 2: If price goes up by 5%, Qd goes down

by 10%
 IE of +2 for air travel: If GDP (or per capita income)
goes up by 4%, Qd for air travel (however measured,
passengers, flying miles) goes up by 8%
 IE of -.25 for unprocessed cereals: If GDP (or per
capita income) goes up by 4%, Qd for unprocessed
cereals (however measured, million kgs, tons) goes
down by 1%
Equilibrium Analysis
Go back to our example of the
market for air transportation in
India. Assume that there is a
DEMAND substantial increase in upper class
rail fares in India (was it in 2017?).
How will you represent this new
shift in the system? SUPPLY
Price

Quantity
Equilibrium Analysis

Though the underlying driver is

very different, this ‘shift’ is similar
DEMAND in effect

SUPPLY
Price

Quantity
Now…..

 How should we measure this? And what

should we call it? Anyone?
Substitutes, Complements

 Cross Price Elasticity

Cross-Price elasticity

 Cross-Price Elasticity = ∆Qx / ∆Py * Py/Qx

 If Positive: Examples?

 If Negative: Examples?
Cross-Price elasticity

 Cross-Price Elasticity = ∆Qx / ∆Py * Py/Qx

 If Positive: Substitutes. Like air and rail

transport

 If Negative: Complements. Like fuel prices

and automobiles
Shifts

 We saw an example of a shift in demand.

What could cause shifts in supply?
Shifts in Supply
We saw an example of a
shift in demand. What
DEMAND could cause shifts in
supply? Examples?
SUPPLY
Price

Quantity
Shifts in Supply
These shifts could be caused by a variety of
exogeneous factors like technological changes,
DEMAND input prices, number of suppliers
Example: telecom, computers, semiconductors
SUPPLY
Price

Quantity
Comparative Statics

 The analysis of shifts of Demand and Supply

curves and the resultant new equilibrium is
what is referred to as “comparative statics”
Valentine’s Day Q 1

 In Aug 1991, price per rose stem was $0.20

and about 2 mill stems were sold. In Feb
1992, price was $0.50 and about 9 mill stems
were sold.
Show the above two sets of outcomes
diagrammatically.
Valentine’s Day Q 2

Show, with a diagram , a situation other than

the one you have shown in the first question,
where the outcome would be higher price AND
higher quantity. Why does it NOT work in real
life?
Computers market Q 1

 The price of computers ( 1988 equal to 100) ,

came down to 10 in 2008. That Demand for
computers expanded hugely is common
knowledge. What then ought to have
happened for price to fall by such a huge
margin? Show this diagramatically.
Technical Terms!- Optional
 Assume P= 100, Q =100, Revenue = PQ =
10000. Price goes up by 10%
 Price inelastic: P =110, Q= 92 (say) then new
PQ = 10120; therefore 1.2% increase
 Price elastic: P =110, Q= 88 (say) then new
PQ = 9680; therefore 3.2% decrease
 Unit elastic: P =110, Q= 90 (say) then new PQ
= 9900; therefore 0.1% decrease (!!!! WHY?!!)
The Math- Optional

 Unit Elastic:
 (P+∆P)*(Q-∆Q) = PQ -P∆Q + Q∆P - ∆P∆Q
 Unit Elasticity by definition: (∆Q/ ∆P)*(P/Q) =-1;
(P∆Q/ Q∆P) = -1; -P∆Q = Q∆P; -P∆Q + Q∆P =
0
 That means (P+∆P)*(Q-∆Q) = PQ -∆P∆Q
 So? If ∆P, ∆Q is small we get our desired
results