Lecture 4 - Concept of Market Equilibrium, Elasticity and Its Application

7/30/2019 Lecture 4 - Concept of Market Equilibrium, Elasticity and Its Application

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Managerial Economics

PGDM : 2013 15Term 1 (June September, 2013)

(Lecture 4)

1


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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Market Equilibrium

D SEquilibrium:

P has reached the level

where quantity supplied

equals quantity

demanded

2


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D S

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Equilibrium Price: The price that equates quantity

supplied with quantity demanded (Max WTP = Min WTA)

P QD QS

$0 24 0

1 21 5

2 18 10

3 15 15

4 12 205 9 25

6 6 30

3


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D S

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Equilibrium quantity: The quantity supplied and quantity

demanded at the equilibrium price

P QD QS

$0 24 0

1 21 5

2 18 10

3 15 15

4 12 205 9 25

6 6 30

4


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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S

Surplus (excess supply):When quantity supplied is

greater than quantity demanded

SurplusExample:

IfP = $5,

thenQD = 9 lattes

and

QS = 25 lattes

resulting in asurplus of 16 lattes

5


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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S Facing a surplus,

sellers try to increase sales

by cutting price.

This causes

QD to rise

Surplus

which reduces the

surplus.

andQS to fall

6




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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S Facing a surplus,

sellers try to increase sales

by cutting price.

This causes

QD to rise andQS to fall.

Surplus

Prices continue to fall until

market reachesequilibrium.

7




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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S

Shortage (excess demand): when quantity demanded is

greater than quantity supplied

Example:

IfP = $1,

thenQD = 21 lattes

and

QS = 5 lattes

resulting in ashortage of 16 lattes

Shortage

8


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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S Facing a shortage,

sellers raise the price,

causing QD

to fall

which reduces the

shortage.

andQS to rise,

Shortage

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

D S Facing a shortage,

sellers raise the price,

causing QD

to fallandQS to rise.

Shortage

Prices continue to rise

until market reaches

equilibrium.

10




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11

EXAMPLES


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Demand Curve

A. The price of iPods falls

B. The price of music

downloads falls

C. The price of CDs falls

12

Draw a demand curve for music downloads. What

happens to it in each of the following scenarios?

Why?


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A. Price of iPods falls

13

Q2

Price of

music

down-

loads

Quantity of

music downloads

D1 D2

P1

Q1

Music downloads

and iPods are

complements.

A fall in price of

iPods shifts the

demand curve for

music downloads

to the right.

Music downloads

and iPods are

complements.

A fall in price of

iPods shifts the

demand curve for

music downloads

to the right.


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B. Price of music downloads falls

14

TheD curve

does not shift.

Move down along curveto a point with lowerP,

higherQ.

TheD curve

does not shift.

Move down along curveto a point with lowerP,

higherQ.

Price of

music

down-

loads

Quantity of

music downloads

D1

P1

Q1 Q2

P2


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C. Price of CDs falls

15

P1

Q1

CDs and

music downloads are

substitutes.

A fall in price of CDsshifts demand for

music downloads

to the left.

CDs and

music downloads are

substitutes.

A fall in price of CDsshifts demand for

music downloads

to the left.

Price of

music

down-

loads

Quantity of

music downloads

D1D2

Q2


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Supply Curve

16

Draw a supply curve for tax

return preparation software.

What happens to it in each

of the following scenarios?A. Retailers cut the price of

the software.

B. A technological advance

allows the software to be

produced at lower cost.

C. Professional tax return preparers raise the price of the

services they provide.


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A. Fall in price of tax return software

17

Scurve does

not shift.

Move downalong the curve

to a lowerP

and lowerQ.

Scurve does

not shift.

Move downalong the curve

to a lowerP

and lowerQ.

Price of

tax return

software

Quantity of tax

return software

S1

P1

Q1Q2

P2


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B. Fall in cost of producing the software

18

Scurve shifts

to the right:

at each price,Q increases.

Scurve shifts

to the right:

at each price,Q increases.

Price of

tax return

software

Quantity of tax

return software

S1

P1

Q1

S2

Q2


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C. Professional preparers raise their price

19

This shifts the

demand curve for

tax preparationsoftware, not the

supply curve.

This shifts the

demand curve for

tax preparationsoftware, not the

supply curve.

Price of

tax return

software

Quantity of tax

return software

S1


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Three Steps to Analyze Changes in Equilibrium

To determine the effects of any event,

1. Decide whether event shiftsScurve,

D curve, or both.2. Decide in which direction curve shifts.

3. Use supply-demand diagram to see

how the shift changes eqmPandQ.


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Example 1: The Market for Diesel Cars

P

Q

D1

S1

P1

Q1

price of

hybrid cars

quantity of

hybrid cars


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STEP 1:

D curve shifts

because price of gas

affects demand for

hybrids.

Scurve does not shift,

because price of gasdoes not affect cost of

producing hybrids.

STEP 2:

D shifts right

because high gas price

makes hybrids more

attractive relative to

other cars.

Example 1:A Shift in Demand

Event to be analyzed:

Increase in price of Petrol.

P

Q

D1

S1

P1

Q1

D2

P2

Q2

STEP 3:

The shift causes an increasein price and quantity of

hybrid cars.


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P

Q

D1

S1

P1

Q1

D2

P2

Q2

Notice:

WhenPrises,

producers supply

a larger quantity

of hybrids, eventhough theScurve

has not shifted.

Always be carefulAlways be careful

to distinguish b/wto distinguish b/wa shift in a curvea shift in a curve

and a movementand a movement

along the curve.along the curve.

Example 1:A Shift in Demand


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STEP 1:

Scurve shifts

because event affects

cost of production.

D curve does not shift,

because production

technology is not one ofthe factors that affect

demand.

STEP 2:

Sshifts right

because event reduces

cost,

makes production more

profitable at any given

price.

Example 2:A Shift in Supply

P

Q

D1

S1

P1

Q1

S2

P2

Q2

Event: New technology

reduces cost of producing

diesel cars.

STEP 3:

The shift causes priceto fall and quantity to

rise.


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25

Example3: A Shift in Both Supply and Demand

P

Q

D1

S1

P1

Q1

S2

D2

P2

Q2

Events:

price of fuel rises AND

new technology reduces

production costs

STEP 1:

Both curves shift.

STEP 2:

Both shift to the right.

STEP 3:

Q rises, but effectonPis ambiguous:

If demand increases more than

supply,Prises.


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STEP 3, cont.

P

Q

D1

S1

P1

Q1

S2

D2

P2

Q2

EVENTS:

price of fuel rises AND

new technology reduces

production costs

But if supply

increases more

than demand,

P falls.

Example3: A Shift in Both Supply and Demand


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Shifts in Supply and Demand

Use the three-step method to analyze the effects of each event on the

equilibrium price and quantity of music downloads.

Event A: A fall in the price of CDs

Event B: Sellers of music downloads negotiate a reduction in

the royalties they must pay for each song they sell.

Event C: Events A and B both occur.


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A. Fall in price of CDs

2. D shifts left

P

Q

D1

S1

P1

Q1

D2

The market for

music downloads

P2

Q2

1. D curve shifts

3. PandQboth fall.

STEPS


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B. Fall in cost of royalties

P

Q

D1

S1

P1

Q1

S2

The market for

music downloads

Q2

P2

1. Scurve shifts

2. Sshifts right

3. Pfalls,

Q rises.

STEPS

(Royalties are part ofsellers costs)

a1


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Slide 29

a1 The royalties that sellers must pay the artists are part of sellers costs of production. Typically, this royalty is a fixed amount each

time one of the artists songs is downloaded. Event B, therefore, describes a reduction in sellerscosts of production.

Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in

costs of production for sellers of music downloads. Hence, the S curve shifts to the right.

arnab, 7/7/2013


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C. Fall in price of CDs and fall in cost of

royalties

Results

Punambiguously falls.Effect on Q is ambiguous:

The fall in demand reduces Q;

The increase in supply increases Q.

a2


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Slide 30

a2 Verify the result by a graphical analysis as discussed in the class.arnab, 7/7/2013


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A Problem

In Rolling Stone magazine, several fans and rock stars, including Pearl Jam, werebemoaning the high price of concert tickets. One superstar argued, It just isnt worth $75to see me play. No one should have to pay that much to go to a concert. Assume this starsold out arenas around the country at an average ticket price of $75.

a) How would you evaluate the arguments that ticket prices are too high?

b) Suppose that due to this stars protests, ticket prices were lowered to $50. In whatsense is this price too low? Draw a diagram using supply and demand curves to

support your argument.

c) Suppose Pearl Jam really wanted to bring down ticket prices. Since the bandcontrols the supply of its services, what do you recommend they do? Explainusing a supply and demand diagram.

d) Suppose the band s next CD was a total flop. Do you think they would still have toworry about ticket prices being too high? Why or why not? Draw a supply anddemand diagram to support your argument.

e) Suppose the group announced their next tour was going to be their last. Whateffect would this likely have on the demand for and price of tickets? Illustratewith a supply and demand diagram.

31


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A Funny Exercise

Explain the story told by this image with the help of DemandSupply Tools..

32


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Market Equilibrium: Algebraic Approach

Quantity Demanded is function of price

.(1)

An inverse demand function or price function is

.(1.1)

Quantity Supplied is function of

....(2)

An inverse supply function is

..(2.1)

33

dPdQ

( ) ddd bPaPfQ -==\

sQ sP

( )

bband

baawhere

QbaQfP ddd

1,

1

==

-==\ -

( )

ddand

d

ccwhere

QdcQfP sss

1,

1

=-=

+==\ -

( ) sss dPcPfQ +==\


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Market Equilibrium: Algebraic Approach

When the market is in equilibrium, , where, is the

Equilibrium Price

where, is the Equilibrium Quantity

Since, Price cannot be negative

Alternatively, you can obtain the equilibrium price and quantity just byequating equations (1) and (2)

34

esd PPP ==

+

--=

+

-=

+=-\

db

cabaPand

db

caQ

QdcQba

e

e

ee

,

e

eQ

caf


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Example

Demand is given by QD = 620 - 10P and supply is given by QS =

100 + 3P. What is the price and quantity when the market is in

equilibrium?

Answer:In equilibrium,

QD = QS,

620 - 10P = 100 + 3P

So, the equilibrium Price is 40And the equilibrium quantity is 220.

35


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A note on Equilibrium Price

The objective of Demand supply analysis is to find a price at which the

market is clear. We know it is the equilibrium price.

Other than Market clearing explanation of equilibrium price what else

can you say about this price?

In the simplest manner, equilibrium price can be defined as the market

value of a product or service and at this value the willingness to accept

(WTA) of the sellers matches with willingness to pay (WTP) of the

buyers.

Now the question is why does equilibrium price differ across different

markets?

It was thought by the economists, that intrinsic use value of a commodityis the reason for this difference .

However, the concepts of production cost and scarcity value better

explain this difference. It should be noted that scarcity is also responsible

for increasing the production cost. The following examples help you to

understand this concept: 36

a3


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Slide 36

a3 Comments and Arguments are very much welcome...arnab, 7/11/2013


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A note on Equilibrium Price (contd.)

37

Diamond and Water Paradox

Real Diamond and Cubic Zicronium Diamond

(artificial)

Hand Written Bible and Printed Bible

Whale Oil Lubricant and Lubricant made from

Jojoba Beans


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Suggested Readings

Shuttlecock Production in Uluberia, West Bengal

(http://articles.economictimes.indiatimes.com/2012-12-

28/news/36036532_1_shuttlecocks-duck-feathers-badminton-

players)

Discovery of Jojoba Beans caused a collapse of Whale Oil

Lubricant Price ( MMH, Chapter 2, Page 29)

Depreciation of Rupee and Impact on Product Market (Thearticle sent through e-mail)

Atkins Diet and Demand for Egg (The article sent through e-mail)

38


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Elasticity

Basic idea:

Elasticity measures how much one variable responds to

changes in another variable.

One type of elasticity measures how much demand for yourwebsites 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.

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Price elasticity of demand measures how

much Qdresponds to a change inP.

Price elasticity

of demand=

Percentage change in Qd

Percentage change inP

Loosely speaking, it measures the price-sensitivity of

buyers demand.

40

Price Elasticity of Demand


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Price elasticity

of demand

equals

P

Q

D

Q2

P2

P1

Q1

P risesby 10%

Q falls

by 15%

15%10%

= 1.5

Price elasticity

of demand=

Percentage change in Qd


Example:

41



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Along aD curve,PandQ move

in opposite directions, whichwould make price elasticity

negative.

We will drop the minus sign

and report all price elasticitiesas

positive numbers.

Along aD curve,PandQ move

in opposite directions, whichwould make price elasticity

negative.

We will drop the minus sign

and report all price elasticitiesas

positive numbers.

P

Q

D

Q2

P2

P1

Q1

Price elasticityof demand

= Percentage change in Qd


42


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Calculating Percentage Changes

P

Q

D

$250

8

B

$200

12

A

Demand for

your websites

Standard methodof computing the

percentage (%) change:

end value start value

start value x 100%

Going from A to B,

the % change inPequals

($250$200)/$200 = 25%

43


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P

QD

$250

8

B

$200

12

A

Demand for

your websites

Problem:The standard method gives

different answers depending on

where you start.

From A to B,Prises 25%, Q falls 33%,

elasticity = 33/25 = 1.33

From B to A,

Pfalls 20%, Q rises 50%,

elasticity = 50/20 = 2.50

44



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So, we instead use the midpoint method:

end value start value

midpointx 100%

The midpoint is the number halfway between thestart & end values, the average of those values.

It doesnt matter which value you use as the start

and which as the endyou get the same answer

either way!

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Using the midpoint method, the % change

inPequals

$250 $200

$225x 100% = 22.2%

The % change in Q equals

12 8

10x 100% = 40.0%

The price elasticity of demand equals

40/22.2 = 1.8

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What determines price elasticity?

To learn the determinants of price elasticity, we look at a series ofexamples.

Each compares two common goods.

In each example: Suppose the prices of both goods rise by 20%.

The good for which Qd falls the most (in percent) has the

highest price elasticity of demand.

Which good is it? Why? What lesson does the example teach us about the determinants

of the price elasticity of demand?

47


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The Determinants of Price Elasticity

The price elasticity of demand depends on:

the extent to which close substitutes are available

whether the good is a necessity or a luxury how broadly or narrowly the good is defined

the time horizon elasticity is higher in the long

run than the short run

The price elasticity of demand depends on:

the extent to which close substitutes are available

whether the good is a necessity or a luxury how broadly or narrowly the good is defined

the time horizon elasticity is higher in the long

run than the short run

48


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EXAMPLE 1: Insulin vs. Caribbean Cruises

The prices of both of these goods rise by 20%.

For which good does Qd drop the most? Why?

To millions of diabetics, insulin is a necessity.

A rise in its price would cause little or no decreasein demand.

A cruise is a luxury. If the price rises,

some people will forego it.

Lesson: Price elasticity is higher for luxuries than fornecessities.


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EXAMPLE 2: Breakfast cereal vs. Sunscreen

The prices of both of these goods rise by 20%. For which

good does Qd drop the most? Why?

Breakfast cereal has close substitutes (e.g., pancakes, Eggo

waffles, leftover pizza), so buyers can easily switch if the

price rises.

Sunscreen 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.


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EXAMPLE 3: Blue Jeans vs. Clothing

The prices of both goods rise by 20%. For which good does Qd

drop the most? Why?

For a narrowly defined good such as blue jeans, there are

many substitutes (black jeans, khakis, Grey Jeans).

There are fewer substitutes available for broadly defined

goods. Actually, there is no substitutes for clothing.

Lesson: Price elasticity is higher for narrowly defined goods

than broadly defined ones.


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EXAMPLE 4: Car Fuel in the Short Run vs. Car Fuel

in the Long Run

The price of petrol rises 20%. Does Qd drop more in the short

run or the long run? Why?

Theres 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.


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53

The Variety of Demand Curves

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.

Five different classifications ofD curves.


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54

Q1

P1

D

Perfectly inelastic demand (one extreme case)

P

Q

P2

P fallsby 10%

Q changes

by 0%

0%

10% = 0Price elasticity

of demand =

% change in Q

% change inP =

Consumers

price sensitivity:

D curve:

Elasticity:

vertical

none

0

a4


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Slide 54

a4 If Q doesnt change, then the percentage change in Q equals zero, and thus elasticity equals zero.

It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently largeprice increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health

insurance.

However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling

demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate.arnab, 7/12/2013


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55

Inelastic demand

P

QQ1

P1

Q2

P2

Q rises less

than 10%

< 10%

10% < 1Price elasticity

of demand =

% change in Q

% change inP =

P fallsby 10%

Consumers

price sensitivity:

D curve:

Elasticity:

relatively steep

relatively low

< 1

a5


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Slide 55

a5 An example: Student demand for textbooks that their professors have required for their courses.

Here, its a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy theirbooks, but instead will share with a friend, or try to find them in the library, or just take copious notes in class.

Another example: Gasoline in the short run.arnab, 7/12/2013


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56

Unit elastic demand

P

QQ1

P1

Q2

P2

Q rises by 10%

10%

10% = 1

Price elasticity

of demand =

% change in Q

% change inP =

P fallsby 10%

Consumers

price sensitivity:

Elasticity:

intermediate

1

D curve:

intermediate slope


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57

Elastic demand

P

QQ1

P1

Q2

P2

Q rises more

than 10%

> 10%

10% > 1

Price elasticity

of demand =

% change in Q

% change inP =

P fallsby 10%

Consumers

price sensitivity:

D curve:

Elasticity:

relatively flat

relatively high

> 1

a6


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Slide 57

a6 A good example here would be breakfast cereal, or nearly anything with readily available substitutes.

An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve).arnab, 7/12/2013


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58

D

Perfectly elastic demand (the other extreme)

P

Q

P1

Q1Pchanges

by 0%

Q changes

by any %

Very Large

Very Low(almost 0%)= infinity

Q2

P2 =Consumers

price sensitivity:

D curve:

Elasticity:

infinity

horizontal

extreme

Price elasticity

of demand =

% change in Q

% change inP =

a7


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Slide 58

a7 Heres a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive

markets. Suppose you run a small family farm in Jodhpur. Your main crop is Bazra. The demand curve in this market is

downward-sloping, and the market demand and supply curves determine the price of Bazra. Suppose that price is Rs. 50/Kg.

Now consider the demand curve facing you, the individual Bazra farmer. If you charge a price of Rs.50, you can sell as much or as

little as you want. If you charge a price even just a little higher than Rs. 50, demand for YOUR Bazra will fall to zero: Buyers wouldnot be willing to pay you more than Rs.50 when they could get the same Bazra elsewhere for Rs. 50. Similarly, if you drop your price

below Rs. 50, then demand for YOUR Bazra will become enormous (not literally infinite, but almost infinite): if other Bazra farmers

are charging Rs.50 and you charge less, then EVERY buyer will want to buy Bazra from you.

Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes

are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a

perfect substitute for the wheat you sell.arnab, 7/12/2013


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Problem

59

Use the following

information to

calculate the

price elasticityof demand

for hotel rooms:

ifP= $70, Qd = 5000

ifP= $90, Qd = 3000


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Answers

60

Use midpoint method to calculate

% change in Qd

(5000 3000)/4000 = 50%

% change inP

($90 $70)/$80 = 25%

The price elasticity of demand equals50%

25%= 2.0


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You design websites for local businesses.

You charge $200 per website, and currently sell 12 websites per

month.

Your costs are rising (including the opportunity cost of your

time), so you consider raising the price to $250.

The law of demand says that you wont sell as many websites if

you raise your price.

How many fewer websites? How much will your revenue fall,

or might it increase?

You design websites for local businesses.

You charge $200 per website, and currently sell 12 websites per

month.

Your costs are rising (including the opportunity cost of your

time), so you consider raising the price to $250.

The law of demand says that you wont sell as many websites if

you raise your price.

How many fewer websites? How much will your revenue fall,

or might it increase?

A scenario

61


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62

Price Elasticity and Total Revenue

Continuing our scenario, if you raise your price

from $200 to $250, would your revenue rise or fall?

Revenue =Px Q

A price increase has two effects on revenue:

HigherPmeans more revenue on each unit

you sell.

But you sell fewer units (lowerQ),

due to Law of Demand.

Which of these two effects is bigger?

It depends on the price elasticity of demand.

a8


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Slide 62

a8 It should be clear that making the best possible decision would require information about the likely effects of the price increase on

revenue. That is why elasticity is so helpful, as we will now see.arnab, 7/12/2013


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63

If demand is elastic, then

price elast. of demand > 1

% change in Q > % change inP

The fall in revenue from lowerQ is greaterthan the increase in revenue from higherP,so revenue falls.

Revenue =Px Q

Price elasticity

of demand=

Percentage change in Q




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64


Elastic demand

(elasticity = 1.8) P

Q

D

$200

12

IfP= $200,

Q = 12 and revenue

= $2400.

WhenD is elastic,

a price increase

causes revenue to fall.

$250

8

IfP= $250,

Q = 8 and

revenue = $2000.

lost

revenue

due to

lowerQ

increased revenue

due to higherP

Demand foryour websites


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65


If demand is inelastic, then

price elast. of demand < 1% change in Q < % change inP

The fall in revenue from lowerQ is smaller

than the increase in revenue from higherP,

so revenue rises.

In our example, suppose that Q only falls to 10 (instead

of 8) when you raise your price to $250.

Revenue =Px Q

Price elasticityof demand =Percentage change in Q



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66


Now, demand is

inelastic:elasticity = 0.82 P

Q

D

$200

12

IfP= $200,

Q = 12 and revenue

= $2400. $250

10

IfP= $250,

Q = 10 and

revenue = $2500.

WhenD is inelastic,

a price increase

causes revenue to rise.

lost

reven

ue

due

to

lowerQ

Demand for your websites

increased revenue due tohigherP


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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?

Problem

67


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Answers

68

A. Pharmacies raise the price of insulin by 10%. Does

total expenditure on insulin rise or fall?

Expenditure =Px Q

Since demand is inelastic, Q will fall less

than 10%, so expenditure rises.


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Answers

69

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 =Px Q

The fall inPreduces revenue,

but Q increases, which increases revenue. Which

effect is bigger?

Since demand is elastic, Q will increase more than

20%, so revenue rises.


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Other Types of Elasticity of Demand

Income elasticity of demand: measures the response ofQd toa change in consumer income

Income elasticity of

demand=

Percent change in Qd

Percent change in income

Recall : An increase in income causes an increase in demand

for a normalgood.

Hence, for normal goods, income elasticity > 0. Forinferiorgoods, income elasticity < 0.

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Cross-price elasticity of demand:measures the response of demand for one good to changes in

the price of another good

Cross-price elast.

of demand

=% change in Qd for good 1

% change in price of good 2

For substitutes, cross-price elasticity > 0

(e.g., an increase in price of mutton causes an increase in

demand for chicken)

For complements, cross-price elasticity < 0

(e.g., an increase in price of computers causes decrease in

demand for software)

71

Other Types of Elasticity of Demand

Documents

Lecture 4 - Concept of Market Equilibrium, Elasticity and Its Application