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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

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Other Elasticities

Supply elasticity

Advertising and cross

advertising elasticity

Conjectural price elasticity

Imports and exports elasticities

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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 = A Q X P

AP % AP/P A P Q

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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

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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 A P Q2+Q1

Average P (P2+P1)/2

Price

Quantity

demanded 0 Q1 Q2

P1

P2

A P

AQ

C

A

B

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Elasticity along a linear demand curve

Qd 0

Ed = 00 : Perfect elastic

Ed > 1 : Elastic range

Ed = 1 : Point of unitary elasticity

Ed < 1 : Inelastic range

Ed = 0 : Perfect inelastic

P

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Graphical Representation of Elasticity

1. Unitary Elasticity

Qd

P2

P1

Q1 Q2 0

D P

D

5%

5%

P up 5% Qd 5%

down

P down 5% Qd 5%

up

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2. Inelastic situation

(relative)

P up 20% Qd 5%

down

P

P2

Q1 Q2

D

P1

0

D1

20%

5% D Qd

Large range of price changes but

Small changes of quantity of demand

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3. Elastic situation

(relative)

P up 5% Qd 20%

Down

P

P2

Q1 Q2

D

P1

0

20%

5%

D

Qd

Small range of price changes but

massive changes of quantity of demand

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4. Perfect Inelastic situation

P

P3

Q1

P1

0

D

Qd

P2

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5. Perfect Elastic situation

P

P

Q1 Q2 0

D

Qd

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

% change in price of another product

Complements and Substitutes

Cross Ed < 0 (-)

“Complements”

e.g.1. DVD demand rises as

price of DVD machines

declines

e.g.2. Demand for flights to

Canary Isles over Y2K fall as

price of accommodation rises

Cross Ed > 0 (+)

“Substitutes”

e.g.1. Rise in price of petrol

increases demand for public

transport

e.g.2. Fall in price of mobile

phones decreases demand for

BT lines

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EY = AQ . Y

AY Q

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.

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 and interest rates, etc.

Ey = % change in quantity demanded

% change in disposable Y

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Income and Elasticity - Relationship

Income Income

Elasticity < 0

Income Elasticity = 0

Income Elasticity>0

Demand 0

A

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

Y

Qd

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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)

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The effect on revenue of a price

change

at point y, Ed = 1

between x and y, Ed > 1

between y and z, Ed < 1

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)

quantity

pri

ce (

£)

quantity

tota

l re

ven

ue

(£) 0

0

MR

AR

x

y p*

z

q*

Elastic Range

Unitary

Inelastic Range

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Income Elasticity – Examples (Looking at this coefficient name which

good is Normal and inferior)

Good Category Consumers’ expenditure

(£M, 1985)

change in expenditure

(%)

Income elasticity of

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% source : Pass & Lowes (1994)

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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

Es > 1,

Elastic

Es < 1, Inelastic

S

S

S

Es =1, Unitary

S

S

Es = 00 Es = 0 perfect elastic Perfect inelastic

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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.

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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)

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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.

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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

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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.

Sal

es (

un

its

sold

)

Time 0

Launch Growth Maturity

(saturation) Decline

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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

Segmentation is the process of slicing a market for a particular product or service into a

number of different segments. The segments are usually based on factors such as

demographics, beliefs or the occasion of use of the product.

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.

The internet promises to provide new opportunities for segmentation. It offers

continuous opportunities to capture information about customer behaviour.

Consumers identify themselves and their characteristics by their electronic

participation in particular interest groups, and by their general online behaviour.

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Market Segmentation : Mobile Internet Access

Access to www

No access to www

Not portable

Mobile

phones

Desktop

PCs

Laptop

computers

Highly portable

WAP

Phones

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Segmentation Example 1 : Beer

Beer Category

49%

51%

Ales Lagers

• Which are the growing product

segments through the 1990s?

• In which product segments are

branding and advertising most

important?

Product Format

29%

71%

Draught Packaged

Retail Outlet

80%

20%

On-sale Off-sale

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Segmentation Example 2 : Paint

Specialised

Paint

Decorative paint Industrial paint

Overall market

Broad sectors

Major users DIY Professional

Decorators

General

Industrial

Product group Primer Matt Gloss Special

Purpose

etc.

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

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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.

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.

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