Elasticity of Demand and Supply

• Can we increase the revenue by increasing

price?
• How do we compare price sensitivity of
demand for different commodities?
• What information can be generated for
managerial decision making by knowing the
price and income sensitivity of demand?
 How sensitive is the demand to price?
• When the price of Walnut was Rs 1200/kg the
demand was 16,000 kg per week in a market. As
price increased to Rs 1800/kg the demand
decreased to 4000 kg.
• When Price of banana was Rs 3000/qtl the demand
in that market was 120 qtl when the price increased
to Rs 4000/qtl the demand decreased to 60 qtl.
• Can we compare sensitivity of demand to prices of
these two commodities?
 Can we have a unit-free Measure of
Responsiveness?
• Q/P = b
• (%Q/% P) = (Q/Q)/(P/P)
• Ep =(Q/ P).(P/Q)
• Elasticity is a percentage
relationship: percentage change in
one variable resulting from one
percent change in the other
 Can we have a unit-free Measure of
Responsiveness?
• Elasticity is a measure of the
responsiveness of one variable to
changes in another variable.
• Price Elasticity of Demand: Percentage
change in the quantity demanded of a
good resulting from a one percent
change in price
• Coefficient of Elasticity = Percentage
change in A/ Percentage change in B
 Price Elasticity of Demand

QX = a0 + a1PX + a2N + a3I + a4PY + a5T

Point Definition Q / Q Q P
EP   
P / P P Q

P
Linear Function EP  a1 
Q
 Demand Function for Good X
QX = a0 + a1PX + a2N + a3I + a4PY + a5T
QX = 160 - 10PX + 2N + 0.5I + 2PY + T
Demand Curve for Good X
Given N = 58, I = 36, PY = 12, T = 112
QX = 430 - 10PX
 Linear Demand Function
QX = a0 + a1PX + a2N + a3I + a4PY + a5T

PX
Intercept:
a0 + a2N + a3I + a4PY + a5T

Slope:
QX/PX = a1

QX
Relationship between elasticity and Revenue

Assuming
Q = 600 – 100P
Ep= -100* P/Q
Relationship between elasticity and Revenue

Inverse Demand Curve

P = 6 – 0.01Q
Total and Marginal Revenue Functions
TR = 6Q – 0.01Q2
MR = 6 – 0.02Q
 -

Source: R. F. Brooker
Source: R. F. Brooker
 -

Source: R. F. Brooker
 Extent of Elasticity
• Inelastic Demand: Elasticity less than one. Percentage change in
consumers purchase quantity is less than percentage change in
price.
• Completely Inelastic Demand (Perfect Inelasticity): Consumer will
buy a fixed quantity of a good regardless of the price
• Elastic Demand: Elasticity greater than one. Percentage change in
consumers purchase quantity is more than percentage change in
price.
• Infinitely Elastic Demand (Perfect elasticity): Consumers buy as
much of good as they can get at a single price, but for any higher
price the quantity demanded drops to zero
• Unitary Elastic: Elasticity equal to one. Percentage change in
consumers purchase quantity equal to percentage change in price
Source: R. F. Brooker
 Revenue and Ep
Elasticity Effect of Effect of Price
Price Decrease on
Increase on Revenue
Revenue
│Ep│<1 Revenue Revenue
Relative InElasticity Increases Decreases
│Ep│=1 No Change No Change in
Unitary elasticity in Revenue Revenue
│EP│>1 Revenue Revenue
Relative Elasticity decreases increases
Revenue and Ep
 Total Revenue Test
• If the demand is elastic, an increase (decrease) in
price will lead to a decrease (increase) in total
revenue.
• If demand is inelastic, an increase (decrease) in
price will lead to an increase (decrease) in total
revenue.
• Finally, total revenue is maximized at the point
where demand is unitary elastic.
• Managerial decision: whether to cut in price?
 Demand Curve Faced by a Firm Depends
on Market Structure
• Market demand curve
• Imperfect competition
– Firm’s demand curve has a negative slope
– Monopoly - same as market demand
– Oligopoly
– Monopolistic Competition
• Perfect Competition
– Firm is a price taker
– Firm’s demand curve is horizontal
Source: R. F. Brooker
Price Elasticity of Demand

Q2  Q1 P2  P1
Arc Definition EP  
P2  P1 Q2  Q1
Determinants of Price Elasticity of Demand

The demand for a commodity will be more price

elastic if:
• It has more close substitutes
• Proportion of total expenditure
• Durability of the product
– Possibility of postponing purchase
– Possibility of repair
• More time is available for buyers to adjust to a
price change
Demand Curve Faced by a Firm Depends on the
Type of Product
• Durable Goods
– Provide a stream of services over time
– Demand is volatile
• Nondurable Goods and Services
• Producers’ Goods
– Used in the production of other goods
– Demand is derived from demand for final goods or
services
Derived Demand Curve will be more inelastic

• The more essential is the component

• The inelastic is the demand curve for the final
product
• The smaller is the fraction of total cost going
to this component
• The more inelastic is the supply curve of
cooperating factors
 Income Elasticity of Demand
QX = a0 + a1PX + a2N + a3I + a4PY + a5T

Point Definition Q / Q Q I
EI   
I / I I Q

Linear Function I
EI  a3 
Q
Income Elasticity of Demand

Q2  Q1 I 2  I1
Arc Definition EI  
I 2  I1 Q2  Q1

Normal Good Inferior Good

EI  0 EI  0
 Very poor Moderately poor Non-poor lower Non-poor higher All

Income (Expenditure) elasticities of food

Cereals 0.514 0.424 0.312 -0.006 0.187

Pulses 0.993 0.895 0.793 0.580 0.716
Vegetables & fruits 0.759 0.785 0.811 0.839 0.817
Milk 2.342 2.018 1.773 1.556 1.640
Edible oils 0.935 0.876 0.817 0.695 0.772
Sugar 1.052 1.007 0.968 0.898 0.942
Other food commodities 0.840 0.872 0.895 0.894 0.887

Price elasticity of
Demand
Cereals -0.309 -0.242 -0.150 -0.127 -0.031
Pulses -0.710 -0.691 -0.661 -0.602 -0.635
Vegetables & fruits -0.893 -0.901 -0.908 -0.928 -0.917
Milk -0.820 -0.923 -0.999 -1.076 -1.035
Edible oils -0.476 -0.454 -0.415 -0.332 -0.377
Sugar -0.081 -0.083 -0.065 -0.036 -0.010
Other food commodities -1.301 -1.298 -1.285 -1.250 -1.259

Table 7. Income elasticities of food based on FCDS model

Food Income group

Very poor Moderately poor Non-poor lower Non-poor higher All

Rice 0.182 0.102 0.030 -0.025 0.024

Wheat 0.102 0.083 0.070 0.071 0.075
Coarse cereals -0.123 -0.154 -0.141 -0.095 -0.125
Pulses 0.578 0.423 0.279 0.105 0.219
Milk 0.862 0.694 0.539 0.276 0.429
Edible oils 0.703 0.537 0.375 0.156 0.297
Vegetables 0.693 0.518 0.370 0.174 0.259
Fruits 0.753 0.599 0.492 0.282 0.362
Meat, fish & eggs 1.034 0.900 0.799 0.531 0.669
Sugar 0.337 0.205 0.107 0.010 0.062
Other food commodities 1.160 1.003 0.911 0.638 0.748
Non-food commodities 2.403 2.421 2.321 1.819 1.993
 Short Run versus Long Run Elasticities
• Demand
– Price
• Non-durables: long run price elasticity is more than the
short run
• Durables: long run price elasticity is less than the short
run
– Income
• For most goods: long run income elasticity is larger
than the short run
• Durables: long run income elasticity is less than the
short run
– Cyclical industries: Sales tend to magnify cyclical changes in
gross domestic products and national income.
• Petrol
– Ep = -0.11 -0.22 –0.32 –0.49 –0.82 –1.17
– EI = 0.07 0.13 0.20 0.32 0.54 0.78
• Automobile
– EP = -1.20 -0.93 -0.75 -0.55 -0.42 0.40
– EI = 3.2 2.33 1.88 1.38 1.02 1.00
Source: Robert F. Brooker
Source: Robert F. Brooker
 Cross-Price Elasticity of Demand
QX = a0 + a1PX + a2N + a3I + a4PY + a5T

Point Definition QX / QX QX PY

E XY   
PY / PY PY QX

Linear Function
Cross-Price Elasticity of Demand

Arc Definition QX 2  QX 1 PY 2  PY 1
E XY  
PY 2  PY 1 QX 2  QX 1

Substitutes Complements

E XY  0 E XY  0
 Problems
• Supply of Gas Q= 140+ 4 Pg + 0.5 Po
• Demand for Gas Q= -4 Pg + 15 Po
• Po is Rs 40
• Cross Price elasticity at equilibrium?
Source: R. F. Brooker
Commodity Bread Poultry Vegetables Fruits Juices

Bread -.354 0.013 -.046 -.010 -.006

Poultry -.018 -.644 -.091 -.000 -.012

Vegetables -.086 -.049 -.724 -.029 -.001

Fruits -.092 -.023 -.087 -.712 -.046

Juices -.066 -.025 -.006 -.067 -1.011

Source: Robert F. Brooker
 Cross Price Elasticities
Raspuri Mallika Alphonso

Raspuri -3.07 1.56 0.01

Mallika 1.16 -3.01 0.14

Alphonso 0.18 0.09 -2.76

Price Elasticity for different brands of
wines in Italy
• Advertising Elasticity : Percentage
change in quantity relative to 1
percent change in advertising
expenses.
• Elasticity with respect to interest
rates
• The ABC company manufactures AM/FM radios
and sells on average 3000 units monthly at Rs
2500 to retail stores. Its closest competitor
produces a similar types of radio that sells for Rs
2800.
• If the demand for ABC’s product has an elasticity
coefficient of -3, how much will it sell per month
if the price is lowered to Rs 2200.
• If the competitor decreases price to 2400 and
the cross price elasticity is .3, what will ABC’s
monthly sales be?
 Policy Decision Making
An officer managing a public park is thinking of
increasing price in order to generate more
revenue. What information he/she should
collect/analyse to arrive at an appropriate
decision?
 Supply elasticity
• Price Elasticity of Supply: Percentage change
in quantity supplied resulting from a one
percent increase in price
• Point Elasticity of Demand: Price elasticity at a
particular point on the demand curve
• Arc Elasticity of Demand: Price elasticity
calculated over a range of prices
Price Elasticity of Supply of durables

SR LR

Primary 0.2 1.60

Supply
Secondary 0.48 0.31
Supply
Total 0.25 1.50
• Supply
– For most products long-run supply is much more
price elastic than short run supply – capacity
constraints
– For durables supply is more elastic in the short-
run – recycling; secondary supply
Market Equilibrium: Effect of Tax

Price
S1

D0
S0
P1

P0

Quantity
Q1 Q0
 Incidence of a Specific Tax
Price

S
Pb price
buyers pay
Tax =
$1.00 P0
PS price
producers
get

Q1 Q0 Quantity
 Incidence of a Specific Tax
• In the previous example, the tax was shared
almost equally by consumers and producers
• If demand is relatively inelastic, however,
burden of tax will fall mostly on buyers
– Cigarettes
• If supply is relatively inelastic, the burden of
tax will fall mostly on sellers
 Impact of Elasticities on Tax Burdens
Burden on Buyer Burden on Seller
Price D Price S

Pb

S
t Pb
P0 P0
PS
t
D
PS

Q1 Q0 Quantity Q1 Q0 Quantity
 The Impact of a Tax or Subsidy
• We can calculate the percentage of a tax
borne by consumers using pass-through
fraction
– ES/(ES - Ed)
– Tells fraction of tax “passed through” to
consumers through higher prices
– For example, when demand is perfectly inelastic
(Ed = 0), the pass-through fraction is 1 – consumers
bear 100% of tax
Market Mechanism: Cob-Web Model

Price
S1
D1

P3
P1
P2

Quantity
Q2 Q1 Q3
Market Mechanism: Cob-Web Model

Price
S1
D1

P3
P1

P2

Quantity
Q2 Q1Q3
 Computer Use in India
• 25% growth between (2001/2 to 2006/7)
• But penetration (per thousand population) in India is low
– India 23
– China 79
– Brazil 139
– Russia 153
• Taxes 20.36%. In many other countries taxes are removed
Regressing sales of desktops on its prices (in US dollars)
and per capita deflated income shows the following results
 
DDT = 10.98 – 0.11 DPT + 0.02 DPCI
(-5.95) (4.39)
 R-square =.934
 
Price elasticity of demand at mean level is 1.25
 Income elasticity of demand at mean level is 0.44
 
The result for the notebook is as follows
 
DNB =-149.29 – 0.15 PNB + 0.084 DPCI
(-1.74) (7.58)
R-square =.922
 
Price elasticity of demand at mean level is 0.58
 
Income elasticity of demand at mean level is 4.10
• D = 10.98 – 0.11 P + 0.02 PCI
• D=Demand for personal computers (in ‘00000)
• P= Price of personal computer (in $)
• PCI = Per capita income ($/year)
• Current level: PCI=400
• D = 18.98 – 0.11 P
 Regression Results (log form)
Desktop
Log Qd = 8.20 – 1. 40 Log DPd + 0.35 Log DPCY
(3.24) (-5.66) (2.86) 
R-Square = 0.89

Notebook
Log Qn = -12.96 –1.14 Log DPn + 2.52 Log DPCY
(-2.09) (-3.24) (5.51)
 R-square =.924
• A pizza outlet owner is thinking of decreasing
the price of pizza by 1 percent. The current
sale value of pizza is Rs 4000 and that of
softdrink is Rs 2000 per day. If the own price
elasticity of pizza is -1.5 and cross price
elasticity with soft drink is -4, what will be the
impact on daily sales?