Elasticity of Demand

Elasticity means the measurement of responsiveness

of one variable to other variable.
X =f (Y), X = dependent variable, Y = Independent
variable (If Y change how it is going to affect
for X - elasticity measure it)
An elasticity of demand = (% change in the
demand for good A)/% change in an
independent variable
Main Demand Elasticities
 Price elasticity of demand
 Cross price elasticity of demand
 Income elasticity of demand
1
 Other Elasticities
 Supply elasticity
 Advertising and cross advertising
elasticity
Conjectural price elasticity
Imports and exports elasticities

2
Price elasticity of demand (the percentage change in
the quantity of a good demanded divided by the
corresponding percentage change in its price. This is
related with the movement along the demand curve)

Point elasticity = AQ% = AQ/Q = AQ X P

AP % AP/P AP Q

3
Elasticity measure gives two pieces of information:

• It shows sign of the relationship between

changes in the relevant variables.

• It measures the extent to which quantity

responds to a change in price.

Generally price elasticity can be in three ranges:

1. Price inelastic ( 0 - 1), Ed < 1

2. Unitary (1), Ed = 1

3. Price elastic (1 and infinity), Ed > 1

4
Arc elasticity allows you to calculate elasticity in two
price and two quantity combinations
Change in Q Q2-Q1
Average Q = (Q2+Q1)/2 = A Q . P2+P1
Change in P P2-P1 AP Q2+Q1
Average P (P2+P1)/2
Price

P2 A

AP C

P1 B

AQ
Quantity
0 Q1 Q2 demanded 5
Elasticity along a linear demand curve

P Ed = 00 : Perfect elastic
Ed > 1 : Elastic range
Ed = 1 : Point of unitary elasticity
Ed < 1 : Inelastic range
Ed = 0 : Perfect inelastic
0 Qd

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Graphical Representation of Elasticity

1. Unitary Elasticity

D
P

P up 5% Qd 5%
down
P2 P down 5% Qd 5%
up
5%
P1

5% D

0 Q1 Q2 Qd
7
2. Inelastic situation
(relative)
P
D
P up 20% Qd 5%
down
D1

P2
20% Large range of price changes but
P1 Small changes of quantity of demand

5% D
Qd
0 Q1 Q2
8
3. Elastic situation
(relative)
P
P up 5% Qd 20%
Down
D

Small range of price changes but

P2 massive changes of quantity of demand
5%
P1

D
20%
Qd
0 Q1 Q2
9
4. Perfect Inelastic situation

P D

P3

P2

P1
Qd
0 Q1
10
5. Perfect Elastic situation

P D

Qd
0 Q1 Q2
11
Factors affect for the price elasticity
 Time period (more time lesser elasticity)
 addictive nature for good/services (more
addiction lesser elasticity)
 availability of substitutes their quality
 price range, and the necessity of the goods
 share of income spent on good
 consumers ability to change his environment

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Importance of price elasticity
• to determine pricing policies/strategy
• to select inputs
• to select markets
• to maximize revenue
• to government taxation policies

Firm and the market elasticity

(Depends on the market structure: Monopoly –
same, other markets – different)

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Cross elasticity of Demand
This is related with the shift in demand curve. It can be
defined as the responsiveness of demand for one product to
changes in prices of other product.

Ex = (% change in quantity demanded of good A)/(% change

in price of B)

Epx = AQy . Px
APx Py

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Importance
 to check the impact of prices of other goods to
the good concerned
 to formulate a good pricing strategy
 to analyse risks associated with the goods
 check the effectiveness of advertising to create a
brand loyalty
 to measure interrelationship between industries
 identify the boundaries of market in differentiated
products

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Nature of Cross Price Elasticity
1) Cross price elasticity for substitute goods
are positive

2) Cross price elasticity for complement

goods are negative

3) Cross price elasticity for independent

goods are zero

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 Complements and Substitutes

Cross-Price Ed = % change in demand for own product

% change in price of another product

Cross Ed < 0 (-) Cross Ed > 0 (+)

“Complements” “Substitutes”

e.g.1. DVD demand rises as price e.g.1. Rise in price of petrol

of DVD machines declines
e.g.2. Demand for flights to
Canary Isles over Y2K fall as
price of accommodation rises
increases demand for public
transport
e.g.2. Fall in price of mobile
phones decreases demand for
BT lines 17
Income Elasticity of demand
This measures the responsiveness of quantity demanded to
change in income, holding other factors are constant.
This related with the shift in demand curve due to changes in
income.
Ey = % change in quantity demanded EY = AQ . Y
% change in disposable Y AY Q
For normal goods this is positive and for inferior goods this is
negative
Importance (to check future demand, decisions on investment,
policy decisions in international trade, effects of changes in real
income)
Elasticity can be measure for other variables such as advertising 18
and interest rates, etc.
 Income Elasticity Value and Type of Good

Value of Ey and Descriptor Type of good

Terminology

Income inelastic (Ey = 0 - A change in income leads Normal good “necessities”

1) to a less than
proportionate change in
demand.

Income elastic (Ey > 1) A change in income leads Normal good ‘luxuries’
to a greater than
proportionate change in
demand.

Zero income elasticity (Ey Demand stays constant Inferior good

= 0) despite a change in
income.

Negative income elasticity Quantity demanded falls Inferior good

(Ey < 0) as income increases, and
vice versa.
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Income and Elasticity - Relationship

Income Income
Y Elasticity < 0

A Income Elasticity =
0

Income Elasticity>0
Demand
0 Qd 20

O – A = Normal good, A - Y = Inferior good

Income Elasticity – Examples (Looking at this coefficient name which
good is Normal and inferior)

Good Category Consumers’ change in Income

expenditure expenditure elasticity of
(£M, 1985) (%) demand
1981 1991
Cars & other vehicles 7,754 10,657 37.44 1.25
Furniture & Floor coverings 4,031 4,893 21.38 0.72
Food 30,217 33,409 10.56 0.35
Beer 8,561 8,211 -4.09 -0.14
Other alcoholic drink 6,363 7,616 19.69 0.66
Tobacco 8,167 6,569 -19.57 -0.66
Clothing 9,563 14,410 50.21 1.68
Footwear 2,195 2,895 31.89 1.07
Energy products 17,319 21,331 23.16 0.78
note : In the same period, real national disposable income rose by 29.86% 21
source : Pass & Lowes (1994)
Relationship between TR, AR and MR

Total Revenue = TR = P . Q

Average Revenue: TR/Q = P . Q/Q = AR = P

Marginal Revenue: d(TR)/d(Q) = MR

Angel’s Law

The proportions of expenditure on all necessities (foods) declines as

incomes rise and in contrast the proportionate expenditure on luxuries
(durable) would increase. (this is related with the consumer’s
bahaviour with income increases) 22
 The effect of Elasticity on revenue

price (£)
of a price change
x
Elastic Range

 at point y, Ed = 1 p*
y
Unitary
 between x and y, Ed > 1 Inelastic Range
AR
 between y and z, Ed < 1 0
z

total revenue (£)

quantity
MR
 between x and y, TR increases
(i.e. MR is +ve)
 at y TR is at its maximum
(i.e. MR = 0)
 between y and z, TR
decreases (i.e. MR is -ve) 0 q* quantity23
The Effect of Price Elasticity on revenue of a price change

Value of Ep and Descriptor Change in total revenue

Terminology from sales (TR)
Perfect inelastic (Ep = Price change has no effect Increased price leads to
0) on demand increase TR.
Relatively inelastic (Ep A % change in price leads to Increased price leads to
= 0 -1 smaller % change in demand increase TR.

Unitary elasticity (Ep = A % change in price leads to Any price change leaves TR
1 same % change in demand constant.

Relatively elastic (Ep A % change in price leads to Increased price leads to

= 1 - Infinity) greater % change in demand decrease TR.

Perfectly elastic A small % price change leads A price rise results in zero
(Infinity <) to an infinitely large % TR.
change in demand 24
 The Cross- Price Elasticity and Relationships between Goods

Value of Ex and Descriptor Relationships

Terminology between Goods

Positive cross-elasticity Increase in the price of Substitutes

(Ex > 0) good B leads to an
increase in the demand for
good A, and vice versa.
Negative cross-elasticity Increase in the price of Complements
(Ex < 0) good B leads to a
decrease in the demand
for good A, and vice versa.

Zero cross-elasticity (Ex = A change in the price of Little or no relationship

0) good B has no effect upon between the goods
the demand for good A.

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Supply Elasticity
This always should go with lag: If price changes it takes sometime to
respond supply to price changes in some sectors.
Es = % change in quantity supplied/% change in price
S
S

Es > 1, Es < 1, Inelastic

Elastic S
S
S

Es =1, Unitary Es = 00 Es = 0 26

perfect elastic Perfect inelastic

Advertising Elasticity
A measure of the effect of a change in advertising upon the
sales of a given good.
Ea = (% change in quantity demanded of good A)/(% change
in expenditure on advertising good A)
If Ea >1: Inelastic (large amount of expenditure needed to
increase demand).
If Ea<1: Elastic (small amount of expenditure needed to
increase demand).
Cross Advertising Elasticity
A measure of the responsiveness of the quantity of demand
of one good to a change in the expenditure upon advertising
on another good. Positive for complements and negative for
substitutes.
27
Conjectural Price Elasticity

This measures interdependence between firms and

a good measure to forecast price changes in
retaliation specially in oligopolistic markets. This
will help to firm’s pricing decision making strategy.

Ec = (Expected % change in the price charged by

firm B)/(Actual % change in price charged by firm
A)

28
Exports and Imports Elasticity
Price elasticity of demand for exports = (% change in the
demand for exports in country x/% change in price of
exports in country A)
Income elasticity of demand for exports = (% change in
the demand for exports in country x/% change in
disposable income abroad)
Price elasticity of demand for imports = (% change in the
demand for imports in country x/% change in price of
imports in country A)
Income elasticity of demand for imports = (% change in
the demand for imports in country x/% change in
disposable income aboard)
These elasticities are important to policy decisions in
external trade and devaluation. 29
Demand Estimation
Identification of firm’s real demand curve helps to
determine

 the correct price,

 inputs requirements
 profit maximising output

Identification of demand

 Consumer interviews
 Consumer surveys
 Consumer clinics and focus groups
 Market studies
 Market experiments in test stores 30
Statistical Estimation of Demand

Regression technique (Identification of

variables, obtain data on variables, equation
specification, estimation of regression
parameters, interpretation of regression
results: coefficient of determination, F and t
statistics, SE, problems of regression:
Auto correlation, multi-collinearity,
heteroscedasticity).

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Demand Forecasting Methods
• Deterministic Time Series Analysis (secular trend,
cyclical fluctuation, seasonal variation and random
influences).
• Trend projection, extrapolation or curve fitting
• Barometric or lag or lead indicator methods.
• Econometric models (Single, multiple, lag, structural
model…etc).
• Input-output analysis (interrelationships).
• Opinion polling and survey techniques (future plans).

Techniques selection depends on the forecasting

distance, complexity of the forecasting problem, lead
time, accuracy, relationship, resources and time
availability, etc.
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Product Life Cycle
This shows four stages of demand for a product.
Introduction phase - demand increases slowly.
Growth phase - demand increases rapidly.
Maturity phase - demand increases less slowly.
Decline phase - demand decreases.
Maturity
Sales (units sold)

Launch Growth Decline

(saturation)

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0 Time
Characteristics Approach to Demand
This says that consumers are demanded goods
because of their characteristics rather than consumers
own sake.

Therefore, managers should learn how to incorporate

the consumer desired characteristics to products and
services.

This can show by using indifference curve analysis.

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Market Segmentation

Market segments or niches are groups of consumers with similar tastes and
preference patterns. Maximum number of market segments will not exceed the
number of potential customers.

Market can be segmented according to product characteristics,

consumer income level, age and geographic area. Elasticities can help
to identify market segments.

Segmentation can aid in: identifying competitors, new product

development, targeting advertising expenditure, branding and exploiting
market niches.

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Market Segmentation : Mobile Internet Access

Access to www

WAP
Laptop Phones
Desktop
computers
PCs

Not portable Highly portable

Mobile phones

No access to www
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Segmentation Example 1 : Beer
• Which are the growing
Beer Category product segments through the
1990s?
51% • In which product segments
are branding and advertising
49% most important?
Ales Lagers

Product Format Retail Outlet

29% 20%

71% 80%
Draught Packaged On-sale Off-sale
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 Segmentation Example 2 : Paint
Overall market Paint
Broad sectors Decorative paint Industrial paint
Major users DIY Professional General Specialised
Decorators Industrial

Product group Primer Matt Gloss Special etc.

Purpose

Product line Basic De Luxe Super de luxe

Colour range White Blue Red etc.

Packaging Can/brush Aerosol Tray/roller

Distribution outlets Wholesaler Retailer

Geographical cover Local Regional National International

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Criticism about demand theory

1) Consumers rationality is unpractical.

2) Demand not always behave as it is stated in

the law.

3) Price is not the main concern of consumer.

They concern about quality, reliability, design,
after sales services, brand names,
recommendations from friends, previous
experience, consumer guides, advertisements,
etc.
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1) Self -Study
Demand Estimation
1) Specify the demand function for the following
products.
2) How do you estimate market demand for the
following products?
1) a new version of Microsoft Office?
2) a new brand of toothpaste?
3) internet bank accounts?
4) car exhaust systems?
5) theatre performances?
6) a new toll road?
7) electricity supply?
8) Sri Lankan tourist sector/Sri Lankan airline
9) Sri Lankan seaports
10) Sri Lankan professionals 40
 Questions to discuss
 Explain market mechanism (demand, supply functions
and equilibrium price) with an example.
 Distinguish between movement along the supply curve
and shift in demand curve.
 Explain demand estimation techniques.
 Explain demand forecasting techniques.
 Distinguish between consumer and producer surplus.
 Explain main demand elasticity concepts with examples.
 Distinguish point elasticity and arc elasticity.
 Distinguish between cross price and income elasticity.
 Explain why elasticity is so important to managers to take
business decisions.
 Discuss how businessman make good money after
understanding market mechanism.
 Why agricultural sector and soft skilled workers are not
getting fair deals from market mechanism?
 How do you explain the impact of current fertilizer issue
in Sri Lankan food prices? 41
References

 Chapter 3 and 4 in McGuigan R.J, Moyer, R.C and

Harris F.H (2005), Managerial Economics,
Applications, strategy and Tactics, ISBN: 0-324-
05881-0.
 Chapter 3 in Worthington.I, Britton.C and Reese. A
(2001), Economics for Business: Blending Theory
and Practice, ISBN: 0273632450, Publisher:
Financial Times/Prentice Hall.

42
Self study - Extra case readings

3rd Chapter of Worthington I, Britton C., and

Reese A. (2009), Economics for Business:
Blending Theory and Practice, ISBN:
0273632450, Publisher: Financial
Times/Prentice Hall.
 Online piracy threatens the film industry.
 Careless talk costs customers!.
 The price of texting.
 What your supermarket says about you. 43
Take Home Group Case Analysis
How the H-P used tactics of the
Japanese to beat them at their game.
Class should be divided into groups.
Study case and analyze.
Please write your answers with group
members names.
Each group can select presenter/speaker
(maximum five minutes) - Optional.

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