Elasticity of Demand Elasticity of Demand and Supplyand Supply

Elasticity of Demand Elasticity of Demand and Supplyand Supply

Prof. Rama DeshmukhProf. Rama Deshmukh

• Concept • Definition• 4 types and • 3 methods of measurement• Determinants of price

elasticity

• Elasticity is degree of responsiveness

• Concepts : 1) Price elasticity of demand2) Income elasticity of demand3) Cross elasticity of demand4) Promotional elasticity of

demand

3 methods of measurement

1 ) Percentage or proportionate method

e =% change in demand / % change in

price. The formula is e = P/Q. d Q /d P This formula is biased, therefore a better

formula is :e =d Q / (Q1 + Q2 / 2) -------------------------- d P /( P1 + P2 / 2)

Given the demand schedule, calculate the

e• When price

change from 5 to 3

• e = 2

Price Qty

6 0

5 20

4 40

3 60

2 80

1 100

2) Point elasticity method

• On a linear demand curve e = lower segment upon upper segment of a curve

• On a non-linear demand curve first a tangent needs to be drawn before deciding value of e.

E=1

e>1

E<1

E=0

E=∞

3) Total outlay method• Total revenue or outlay remains unchanged if

e =1 Reason: if e =1 then % d D would be same as % d P and TR = P.Q . IF price rises demand would contract proportionately keeping TR unaltered.

• If e < 1 what will happen to TR when P rises or falls ?increase

• If e >1 what will happen to TR when P rises or falls?decrease

Relation between AR, MR and Price elasticity

• TR= PQ• AR= PQ/Q=P• MR= δTR/δQ• MR= P* (δQ/δQ)

+Q*(δP/δQ)= P+Q*(δP/δQ)= P {1+Q/P*δP/δQ}

• e= (P/Q)*(δQ/δP)• MR= AR-(AR/IeI)

TR

MR

AR

• Let us consider the demand function as Q=120-P. Estimate quantity when price is 120, 100, 60, 20. Also find the value of MR when P= 100

• TR= (120-Q)Q= 120Q-Q2

• MR= 120-2Q• When P=100, MR= 80

5 types of Price elasticity of demand

1) E =1 ,here demand curve is straight line or rectangular hyperbola.

2) A relatively elastic demand curve is to the right and flatter or gently falling.

3) Whereas relatively inelastic curve is steeply falling and to the left.

Perfectly elastic and inelastic demand

• e=infinity• The demand

curve is parallel to X axis

• e =0• Demand curve

is parallel to Y axis.

1) Price elasticity of demand = (δQ/δP)* P/Q

2) Income elasticity of demand3) Cross elasticity of demand4) Promotional elasticity of

demand

• The demand function for mutton for Ravi is given as: Q= 5850-6Pm+2Pc+0.15Y where Y=8000, Pm=125, Pc=70. Calculate income elasticity and cross elasticity

• ey=(δQ/δY)*(Y/Q)• Q= 5850-(6*125)+(2*70)+(0.15*8000)=

6440• ey= 0.15*(8000/6440)= 0.186

Determinants of price elasticity

• Nature of commodity• Availability of substitutes• Weightage in the consumption• Time factor in the adjustment of

the consumption pattern• Range of commodity use

Cross Elasticity of Demand

Cross elasticity of demand is the ratio of percentage change in the quantity demanded

For one product to a percentage change in the price of another related product, other factors remaining constant.

If the two products are good substitutes, the value of cross elasticity will be positive.

If the two products are good complementary, the value of cross elasticity will be negative.

Application of cross elasticity of demand

• The knowledge of cross elasticity of demand is very important in managerial decision making for developing an appropriate price strategy. Firms selling multiple products use cross elasticity of demand to analyze the effect of change in the price of on product to the demand of others.

• Firms producing similar kinds of product and services operating in same industry having a positive cross elasticity of demand.

• Eg:- P&G and HLL are having a positive cross elasticity• Of demand between each other in fabric and home care• products. Hence, if HLL plans to increase the price of• Surf, a washing detergent, the demand for P & G’s• similar products like Ariel and Tide will increase.

Determinants of promotional elasticity

• Level of total sales• Advertisement of the rival firms• Cumulative effect of the past advt.• Other factors

QuizQuizQuizQuiz

The demand for the commodity is said to be

elastic if the total amount spent on the commodity

is -

• Less when the price is low then when the price is high

• Same whether the price is high or low

• More when the price is low than when the price is high

Prices can be increased to shift the excise duty to consumer if the product subjected to duty is --

• In relatively inelastic demand• In relatively elastic supply• Perishable good• Widely used• Luxury item

How would you indicate relatively elastic

demand?• E = 0• E < 1• E > 1• E = 1

A fall in the price of a commodity leads to

• Shift in the demand• Fall in the demand• Rise in the consumer’s real income• Fall in the consumers real income

When the demand is elastic, a price reduction

--• Will increase total revenue• Will decrease total revenue• Will not affect total revenue

Which of the following statements are true?

• Elasticity of demand is determined by substitution possibilities

• If the demand is inelastic, a change in the price will not affect the quantity sold

• If total revenue falls when the price increases, demand is elastic

If the income elasticity of demand is greater than

unity, the commodity is --• Necessity• Luxury• Normal good• Non-related good