Session 2-Elasticity and Its Application-1

Managerial Economics
Session II: Elasticity and its

Application-1
Instructor
Rijan Dhakal
9851069004
dhakalrijan2010@gmail.com
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 perper month.
month.
Your
Your costs
costs are
are rising
rising (including
(including the the opp.
opp. cost
cost of
of
your
your time),
time), soso you’re
you’re thinking
thinking of of raising
raising the
the
price
price to
to $250.
$250.
The
The law
law ofof demand
demand sayssays thatthat 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 fewer
fewer websites?
websites? How How muchmuch will
will your
your
revenue
revenue fall,
fall, or
or might
might itit increase?
increase?
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
Elasticity
Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
◦ One type of elasticity, basically known as price
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.
AND ITS APPLICATION
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.
AND ITS APPLICATION
=
P
Example:
P rises
Price P2
by 10%
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
AND ITS APPLICATION
=
P
P2
P1
D
Q
Q2 Q1
AND ITS APPLICATION
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
AND ITS APPLICATION
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
D From B to A,
P falls 20%, Q rises 50%,
Q
8 12 elasticity = 50/20 = 2.50
AND ITS APPLICATION
 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, also 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!
AND ITS APPLICATION
 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
AND ITS APPLICATION
A C T I V E L E A R N I N G 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
11
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%
12
Calculating Price Elasticity of Demand
Two Ways: Arc elasticity Calculation and Point
Elasticity Calculation
 Arc Elasticity: Important
ImportantNote:
Note:
Along
AlongaaDDcurve,
curve,PPand
and
Q QQmove
movein inopposite
opposite
%Q Q Q p directions,
directions,which
whichwould
would
   make
%p p p Q makeprice
priceelasticity
elasticity
negative
negativemost
mostof
ofthe
the
p cases.
cases.(E
(E<0)
<0)
where P & Q are average values
 Example
◦ If a 1% increase in price results in a 3% decrease in quantity
demanded, the elasticity of demand is  = -3%/1% = -3.
Point Elasticity: Elasticity at a particular point (price)
 Use of derivative: dQ/dP : denotes rate at which quantity
changes with respect to Price: Q
p
 For a linear demand equation: dQ/dP is constant.

 Eg:Equation of a linear demand curve is: Q  a  bp
 And, the derivative of the equation is: b. Therefore,
Q
b
p Where b is the slope
Q p p
◦ From the point elasticity concept,  b
p Q Q
the elasticity of demand is:
The estimated linear demand function for pork is:
Q = 286 -20p
◦ where Q is the quantity of pork demanded in million kg
per year and p is the price of pork in $ per year.
◦ At the equilibrium point of p = $3.30 and Q = 220 Find
the elasticity of demand for pork:
The estimated linear demand function for pork is:
Q = 286 -20p
◦ where Q is the quantity of pork demanded in million kg
per year and p is the price of pork in $ per year.
◦ At the equilibrium point of p = $3.30 and Q = 220 the
elasticity of demand for pork:
p 3.30
  b  20   0.3
Q 220
Non-linear demand function-Numerical Example
Consider the following non-linear demand function:
Q = Pα
If the value of α = -2, is the demand Price elastic or
inelastic?
Non-linear demand function-Numerical Example
Consider the following non-linear demand function:
Q = Pα
If the value of α = -2, is the demand Price elastic or
inelastic?
Solution:
Differentiating Q = Pα
dQ/dP = α Pα-1
Therefore, E = α Pα-1 (P /Q) = (α Pα-1+1) / Q = (α Pα) / Q
Since, Q = Pα
E=α
If, α = -2, E = -2. So, the demand is Price Elastic.
What determines the Elasticity of Demand? EXAMPLE 1:
Wai Wai vs. Yogurt or curd
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
◦ Wai Wai has lots of close substitutes
(e.g., Rum Pum, Mayoz etc.),
so buyers can easily switch if the price rises.
◦ Yogurt 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.
AND ITS APPLICATION
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
◦ For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos, or even cotton pant).
◦ There are fewer substitutes available for broadly
defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
AND ITS APPLICATION
EXAMPLE 3:
Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.
◦ 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.
AND ITS APPLICATION
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the Long
Run
 The price of gasoline 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.
AND ITS APPLICATION
The Determinants of Price Elasticity:
A Summary
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.
AND ITS APPLICATION
The Variety of Demand Curves
Economists classify demand curves according to
their elasticity.
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.
The next 5 slides present the different
classifications, from least to most elastic.
AND ITS APPLICATION
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
AND ITS APPLICATION
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
AND ITS APPLICATION
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
D
intermediate
P falls Q
1
Q rises by 10%
AND ITS APPLICATION
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
>1
Q rises more
than 10%
AND ITS APPLICATION
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
AND ITS APPLICATION
Elasticity of a Linear Demand Curve
P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0 constant,
67%
but its
40% elasticity
10 E = = 0.2
200% is not.
$0 Q
0 20 40 60
AND ITS APPLICATION
Price Elasticity and Total Revenue
 Continuingour 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.
AND ITS APPLICATION
Price elasticity Percentage change in Q
=
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.
AND ITS APPLICATION
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
AND ITS APPLICATION
Price elasticity Percentage change in Q
=
demand is inelastic, then Revenue = P x Q

 If
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.
AND ITS APPLICATION
Now, demand is
increased
Demand for
inelastic:
revenue due
your websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
AND ITS APPLICATION
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure 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?
36
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.
37
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.
38
Thank you

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Managerial Economics

Session II: Elasticity and its

Price elasticity of demand measures how

end value – start value

The price elasticity of demand equals

 For a linear demand equation: dQ/dP is constant.

demand is inelastic, then Revenue = P x Q

price elast. of demand < 1

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