ME4

Measurement of Demand
Determinants of price elasticity
Income elasticity of Demand
Cross price elasticity
Applications of elasticity in managerial decisions
Relationship among price elasticity, total revenue, average revenue and
marginal revenue
Elasticity of Supply
Quantitative Response
• It is not only important to know the determinants of consumer demand, but also to
measure their impact
• Price change impacts demand, but by how much. Similarly, for other independent
variables
• Often, a reduction in price may lead to increase in revenue
• Should the focus be on promoting the product, or to improve the quality
• These are important management decisions for success
• Thus degree of responsiveness of dependent variable to change in independent
variables is highly important
• This responsiveness is the Elasticity
• Elasticity refers to the measure of responsiveness in the quantity demanded of a
commodity to changes in each of the forces that determine demand.
• Responsiveness of quantity demanded to change in its price can be
measured by inverse of slope of demand curve (ΔQ/ ΔP)
• Disadvantage because change in unit will change value; also
comparison across goods meaningless
• To avoid these use percentage changes
• The price elasticity of demand (Ep) is given by the percentage change
in the quantity demanded of the commodity divided by the
percentage change in its price, holding constant all the other variables
in the demand function.
 Price Elasticity of Demand (E)
• Measures responsiveness or sensitivity of consumers to
changes in the price of a good
 Q
E 
 P
• P & Q are inversely related by the law of demand so E is always negative
• The larger the absolute value of E, the more sensitive buyers are to a change in price
• Percentage change in quantity demanded can be predicted for a given percentage change in price
as:
• %Qd = %P x E
• Percentage change in price required for a given change in quantity demanded can be predicted as:
• %P = %Qd ÷ E
• If E is Known
• QX = a0 + a1PX + a2N + a3I + a4PY + a5T
• Point definition Q / Q Q P
EP   
P / P P Q
• Price elasticity can be calculated by multiplying the slope of demand
(Q/P) times the ratio of price to quantity (P/Q)
P
EP  a1 
Q
Q
 Q 100
Q P
 
Q
E 
P
 P P
100
P Q
LINEAR DEMAND CURVE
● linear demand curve Demand curve that is a straight line.

Q  a  bP
FIGURE 2.11
LINEAR DEMAND CURVE
The price elasticity of demand
depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.
The elasticity becomes smaller
as we move down the curve.
What will be the elasticity for a movement from C to F, and
from F to C
• Slope is only a component of elasticity of demand
• Even on a linear demand curve elasticities vary
• At B it is -5; at F it is -1 ; at H it is -1/5
• At A it is -∞; At J it is 0
• For linear demand, price and Evary directly
• The higher the price, the more elastic is demand
• The lower the price, the less elastic is demand
• For curvilinear demand, no general rule about the relation between price and quantity( Special case of Q = aPb which has a
constant price elasticity (equal to b) for all prices)
• Further for a movement from C to F, the price elasticity is -2; whereas from F to C it is -1. To avoid this anomaly,
take average of prices and quantities
• Arc Definition=
• Arc price elasticity is -1.4 (between the above two values)
Q Q P  P
P E 
2 1
 2 1

2 P  P Q Q
1 2 1

• When calculating price elasticity of demand over an interval of demand, use the interval or arc elasticity formula
• If the price change is relatively small, a point calculation is suitable
• If the price change spans a sizable arc along the demand curve, the interval calculation provides a better measure
Price Elasticity of Demand

• Negative according to the “law of demand”

Elastic: EQX , PX  1

Inelastic: EQX , PX  1

Unitary: EQX , PX  1
Price Elasticity of Demand (E)

Table 6.1
Elasticity Responsiveness E
Elastic %∆Q> %∆P E> 1
Unitary Elastic %∆Q= %∆P E= 1
Inelastic %∆Q< %∆P E< 1
• Variety of demand curves
• Demand is elastic
• Price elasticity of demand > 1
• Demand is inelastic
• Price elasticity of demand < 1
• Demand has unit elasticity
• Price elasticity of demand = 1
• Demand is perfectly inelastic
• Price elasticity of demand = 0
• Demand curve is vertical
• Demand is perfectly elastic
• Price elasticity of demand = infinity
• Demand curve is horizontal
• The flatter the demand curve
• The greater the price elasticity of demand
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is
Elasticity Equals 0 Less Than 1

Price Price
1. An Demand 1. A 22% 2. … leads
increase in increase to an 11%
price… in price… decrease in
quantity
$5 $5 demanded
4 4
2. …leaves
the quantity
demanded Demand
unchanged

0 100 0 90 100
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity
Equals 1
Price
Demand

$5
1. A 22%
increase 4
in price…
2. … leads to a 22%
decrease in quantity
demanded
0 80 100
Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
The Price Elasticity of Demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity

Price Price 1. At any price

A 22% above $4, quantity
increase demanded is zero 2. At exactly $4,
in price… consumers will
buy any quantity
$5
4 Demand $4
Demand
2. … leads to a 3. At a price
67% decrease below $4, quantity
in quantity demanded is infinite
demanded
0 50 100 0
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
LINEAR DEMAND CURVE

FIGURE 2.12
(a) INFINITELY ELASTIC
DEMAND
(a) For a horizontal
demand curve, ∆Q/∆P is
infinite. Because a tiny
change in price leads to an
enormous change in
demand, the elasticity of
demand is infinite.

● infinitely elastic demand Principle that consumers will buy as much of a

good as they can get at a single price, but for any higher price the quantity
demanded drops to zero, while for any lower price the quantity demanded
increases without limit.
LINEAR DEMAND CURVE

FIGURE 2.12
(b) COMPLETELY
INELASTIC DEMAND
(b) For a vertical demand
curve, ∆Q/ ∆P is zero.
Because the quantity
demanded is the same no
matter what the price, the
elasticity of demand is zero.

● completely inelastic demand Principle that consumers will buy a fixed

quantity of a good regardless of its price.
• Relation between price elasticity of demand , firm’s total revenue and MR
• Total revenue (TR) is equal to price (P) times quantity (Q)
• Marginal revenue (MR) is the change in total revenue per unit change in output or sales
(quantity demanded).
• That is, TR = P.Q
• MR =ΔTR/ ΔQ
• Since MR measures the rate of change in total revenue as quantity changes, MR is the slope
of the total revenue (TR) curve
• When demand is linear,
P = A + BQ (A > 0, B < 0)
• Marginal revenue is also linear, intersects the vertical (price) axis at the same point as demand, & is twice
as steep as demand
MR = A + 2BQ
Demand & Marginal Revenue
Unit sales (Q) Price TR = P  Q MR = TR/Q
0 $4.50 $ 0 --

1 4.00 $4.00 $4.00

$7.00 $3.00
2 3.50
$9.30 $2.30
3 3.10
$11.20 $1.90
4 2.80
$12.00 $0.80
5 2.40 $12.00 $0
6 2.00 $10.50 $-1.50
7 1.50
 Marginal Revenue & Price Elasticity
• For all demand & marginal revenue curves, the relation between marginal revenue, price, &
elasticity can be expressed as

 1
MR  P  1  
 E
• MR= d(PQ)/dQ= P + QdP/dQ
• = P{1 + dP/dQ * Q/P} = P{ 1+ 1/Ep}

• With a decline in price, TR increases if demand is elastic; remains unchanged if demand is unitary;
and declines if demand is inelastic
• Reason price decline leads to proportionately larger increase in quantity demanded, and so total
revenue increases
• Unitary: equal proportionate increase
Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

%∆Q> %∆P %∆Q= %∆P %∆Q< %∆P
Quantity-effect No dominant Price-effect
dominates effect dominates
Price
rises TR falls No change in TR TR rises
Price
falls TR rises No change in TR TR falls
Price Elasticity, Total Revenue, and Marginal Revenue
• Along a linear demand curve a movement down the demand curve
will lead to increase in TR above the midpoint, and fall after the
midpoint, with TR unchanged at midpoint
• TR is maximum at elasticity =1
• The relationship between TR, MR and price elasticity of demand can
also be shown graphically
Total Revenue, Marginal Revenue, and Price Elasticity

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Linear Demand, MR, & Elasticity (Figure 6.5)
Marginal Revenue and Price Elasticity of
Demand

PX
EP  1
EP  1

EP  1

QX
MRX
MR, TR, & Price Elasticity (Table 6.4)

Marginal Price elasticity

revenue Total revenue of demand
MR > 0 TR increases as Q
Elastic (│E│>
increases (P
decreases) 1)
MR = 0 TR is maximized Unit Elastic
(│E│= 1)
MR < 0 TR decreases as Q Inelastic
increases (P (│E│< 1)
decreases)
 Factors Affecting Price Elasticity of Demand
• Availability of substitutes
• The better & more numerous the substitutes for a good, the more elastic is demand
• Availability of close substitutes
• Goods with close substitutes – more elastic demand(Demand for sugar more elastic than salt)
• Narrowly defined markets – more elastic demand because greater number of
substitutes(EX price elasticity of coke greater than soft drinks)
• Narrowly defined need: Ex- I need Pizza , (Demand for a commodity will be less elastic )
• Percentage of consumer’s budget
• The greater the percentage of the consumer’s budget spent on the good, the more elastic is
demand
• Time period of adjustment
• The longer the time period consumers have to adjust to price changes, the more elastic is demand
• Nature of goods:
• Necessities – inelastic demand
Price Elasticities in the Real World

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Income elasticity of demand
• How much the quantity demanded of a good responds to a change in consumers’
income
• Income elasticity (EM) measures the responsiveness of quantity demanded to
changes in income, holding the price of the good & all other demand determinants
constant
• Percentage change in quantity demanded divided by the percentage change in
income
Normal goods
Positive income elasticity
Necessities
Smaller income elasticities
Luxuries
Large income elasticities
Inferior goods
Negative income elasticities
Income Elasticity
d
%QX
EQX , I 
%I
+ Normal Good

- Inferior Good
Income Elasticity of Demand

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

I
Linear Function EI  a3 
Q
As with price elasticity income elasticity also gives different
results depending on whether income rises or falls. So

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

Normal Good Inferior Good

EI  0 EI  0
• Income elasticity of demand is useful in forecasting firms’ sales under
different economic conditions
• With low income elasticity won’t be affected by boom or recession
• Also used in identifying market for its products
 Cross-Price Elasticity
• Cross-price elasticity (EXR) measures the responsiveness of quantity
demanded of good X to changes in the price of related good R,
holding the price of good X & all other demand determinants for
good X constant
• Positive when the two goods are substitutes
• Negative when the two goods are complements

 QX QX PR
E XR   
 PR PR QX
Cross-Price Elasticity of Demand

QX / QX QX PY
Point Definition E XY   
PY / PY PY QX

Linear Function PY
E XY  a4 
QX
Cross-Price Elasticity of Demand

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

Substitutes Complements
E XY  0 E XY  0
Demand Elasticities for Alcoholic Beverages In the United
States

© aaPress, 2016. All rights reserved.

 Using elasticities in managerial decision making
• Useful in studying impact on related products that the firm also sells
• Coke and Thums up
• If demand for product inelastic, you would not want to reduce price: why?
• If elasticity of your sales wrt advertising is positive and higher than expenditure on product
quality and customer service, then you would want to concentrate more on advertising
• If cross price elasticity of your product wrt competitor is very high, then you need to respond
to any cut in price by competitor to prevent any loss in sales
• But be careful of not starting a price war
• If income elasticity is very low, then either improve quality or move into other product lines
with high income elasticity
• A high positive cross price elasticity often used to define an industry
• Used by Courts to decide anti-trust cases
• EX DuPont argued that cellophane was just one of many flexible packaging materials that also included
waxed paper, aluminium foil, and many others
• Court concluded that DuPont had not monopolized the market as it had only 20% share
• Identify important variables affecting demand and estimate demand
function. Suppose the estimated regression for your product (say coffee) is
• Qx = 1.5 – 3.0 Px + 0.8 I +2.0 Ps - 0.6 Pc + 1.2 A
• Where Px =2, I = 2.5, Ps =1.8, Pc = 0.5, A= 1
• Qx = 2, εd =-3, εi =1, εd s =1.8, εd c =-0.15, εa = 0.6
• These elasticities can be used to forecast demand for its product next year
• Suppose it decides to increase its price by 5%, advertising by12%, income
expected to rise by 4%, price of substitute to rise by 7%, and complements
to fall by 8%’
• Next year sales would be
\
• Q’x = Qx + Qx (Δ Px / Px ) εd + Qx (Δ I / I ) εi + Qx (Δ Ps / Ps ) εds + Qx (Δ Pc /
Pc) εd s + Qx (Δ A / A ) εa

• Q’x = 2+ 2(5%)(-3) + 2(4%)(1) +2(7%)(1.8)+2(-8%)(-0.15)+2(12%)(0.6)

• Q’x = 2.2
Business travellers and vacationers have following demand for airline tickets. As
price of tickets rises from 200 to 250 what is εd for business travellers , vacationers.
Why vacationers may have different εd.

Price Quantity demanded (business Quantity demanded (Vacationers)

travellers)
150 2100 tickets 1000
200 2000 800
250 1900 600
300 1800 400
• Following information about good x and y
• Income elasticity of demand for good x is -3
• Cross- price elasticity of demand for good x wrt price of good y is 2
• Would an increase in income and a decrease in the price of good y
unambiguously decrease demand for good x? Why or why not?
Problems and Applications
Problems Applications-1
• According to a Financial Report by a Consultant, Air
Tel’s own price elasticity of demand for long
distance services is -8.64.
• Air Tel needs to boost revenues in order to meet its
marketing goals.
• To accomplish this goal, should Air Tel raise or
lower its price?
Answer: Lower price!
• Since demand is elastic, a reduction in price will
increase quantity demanded by a greater
percentage than the price decline, resulting in
more revenues for Air Tel.
 Problems Applications-2
If Air Tel lowered price by 3 percent,
what would happen to the volume
of long distance telephone calls
routed through Air Tel?
Answer
• Calls would increase by 25.92 percent!
d
%QX
EQX , PX  8.64 
%PX
d
%QX
 8.64 
 3%
 3%   8.64   %QX
d

d
%QX  25.92%
 Problems Applications-3

• According to Report by consultant, Air Tel’s cross

price elasticity of demand for long distance services is
9.06.
• If Idea and other competitors reduced their prices by
4 percent, what would happen to the demand for Air
Tel services?
 Answer
• Air Tel’s demand would fall by 36.24 percent!

d
%QX
EQX , PY  9.06 
%PY
d
%QX
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%
Case study 3-5: Cross price elasticities of
demand in the real world
Commodity X Commodity Y Elasticity
Tea(India) Coffee(India) 0.3457
Margarine (USA) Butter (USA) 1.53
Pork(USA) Beef(USA) 0.40
Pork (UK) Beef(UK) 0.00
Mutton(UK) Beef(UK) 0.28
Entertainment(US) Food (US) -0.72
• Tea and Coffee are substitutes as 1% increase in price of tea leads to
0.35% increase in demand for coffee
• Margarine and butter are substitutes in USA
• Mutton and beef are substitutes in UK
• Pork and beef in UK are unrelated
• Entertainment and food are complementary in USA- 1% increase in
price of food leads to 0.72 reduction in demand for entertainment in
US