MANAGERIAL ECONOMICS

PGP I, Term I, June - August 2016

LECTURE 4
ELASTICITY OF
DEMAND & SUPPLY
Prof. D. Tripati Rao
Indian Institute of Management Lucknow
tripati@iiml.ac.in, June 29, 2016

Review Questions ..!

DD function & DD curve
Movement along the DD/SS curve
Shift of the DD/SS curve
Change in Quantity of DD/SS vs. change in DD/SS

Surplus/shortage & market clearing/adjustment

mechanism
Rationing vs. Allocation Role of Price
Shifts in SS/DD:
Change in Equilibrium (P*& Q*)

What Happens to Price & Quantity

When Demand & Supply Shifts?
No Change An Increase
in SS
in SS
P down
Q up

A Decrease
in SS

No Change
in DD

P same
Q same

P up
Q down

An Increase
in DD

P up
Q up

P ambiguous
P up
Q up
Q ambiguous

A Decrease
in DD

P down
Q down

P down
P ambiguous
Q ambiguous
Q down

One Demand Curve

Drawn on Two Different Scales

Elasticity of Demand: The Concept

Elasticity of Demand
the responsiveness of QD of a commodity/product
with respect to the change in factors affecting it
measured in percentage terms
Useful for Decision Making
Price Elasticity: own
Income Elasticity: QD
Cross Elasticity: (substitutes/complements)

Note
consumer expenditure is sensitive to Px, Yc & Py
price sensitivity is different for different goods

PRICE ELASTICITY OF DEMAND (PeD)

PeD: percent change in QD to a small/unit change in price
Quantities bought are sensitive to producers price change

P = % change in QX / % change in PX
P = (QX/QX*100)/(PX/PX*100)
P = (PX/QX )* (QX/ PX)
Recall Qx = A + B1PX & PX = a + bQX
QX/PX = B1
or, reciprocal of B1 = b = slope of DD curve

Price Elasticity of Demand

PeD () is reciprocal of the slope of DD curve
weighted by the ratio of PX to QX
Along the linear DD curve slope is constant
QX/PX is constant
But PX to QX vary along the DD
PeD () will vary along the linear DD curve
higher the point lower is the ratio
Infinity to Zero
PeD is NEGATIVE
since either QX or PX is negative
PeD is 1 at the midpoint on the DD

P
4
3
2
1

= Infinity
>1
=1
<1
=0

Q
0
1
2
3
4
slope & elasticity are not the same thing
all points on the DD curve have the same slope
Above-, Exactly-, Below- Midpoint
demand is elastic, unit-elastic & inelastic

A Simple Number Crunching!

DD Curve
Px = 5 0.625 Qx
Px = 5 when Qx = 0
Qx = 8 when Px = 0
Px/ Qx = slope = 0.625 = 5/8
vertical/ horizontal intercept
We know that
= Px/Qx * Qx/ Px
for PeD() equal to 1 & given Qx/ Px = 8/5, the
price/quantity (P/Q) ratio should be equal to 5/8
reciprocal of 5/8 enters the equation making = 1

P
5

= Qx/ Px * Px/Qx = - 8/5*2.5/4 = -1

2.5

Qx

Price elasticity equals 1 at the midpoint of the DD Curve

Elastic Zones
Only possible combination is when PX = 2.5 & QX = 4
Observation: for a linear DD curve, has range from
1 to infinity => above the midpoint
1 to zero => below the midpoint
conventional use
|| > 1 elastic
< 1 inelastic
= 1 unit elastic
Inference
elastic DD curve => the QX is very responsive
P decreases by 1 percent => QX increases more
think elasticity as responsiveness of the QX to PX

Relationship between Price & QD

Impact on Total Sales & Revenue
Price QD (Units)
10
9
8
7
6
5
4
3
2
1

TR (PQ) (Rs.)

MR (Rs.)

1000
10000
-2000
18000
8
3000
24000
6
4000
28000
4
5000
30000
2
6000
30000
0
7000
28000
-2
8000
24000
-4
9000
18000
-6
10000
10000
-8
Revenue Implications of Law of Demand

Inelastic Demand: Change in Total

Revenue when Price Changes
leads to an increase in Total Revenue
from INR10,000 to INR24,000

Price

Price

An increase in price from

INR100 to INR300

300

Revenue = 24,000

100

Revenue = 10,000
0

Demand
100

Quantity

Demand
0

80

Quantity

An increase in price from

INR400 to INR 500

Price

Price

Elastic Demand: Change in Total

Revenue when Price Changes
leads to a decrease in Total Revenue
from INR20,000 to INR10,000

500
400

Demand

Demand

Revenue =
20,000

Revenue =
10,000

50

Quantity

20

Quantity

Note: that with each price increase, the Law of Demand still holds
an increase in price leads to a decrease in the QD.
It is the change in TR that varies!

Price & Marginal Revenue

Consider TR
price & quantity
TRx = Px * Qx
Px = a + bQx
TR = aQx + bQx2
What is MR?
MR = Change in TR for one unit change in Qx
first derivative with respect to Qx
d (TR)/d (Qx) = a + 2bQx = MR
intercept a is the intercept of the Px equation
slope is TWICE of the earlier

Conditions for MAXIMIMA & MINIMA

Y

Maxima y = f (x)
1st Order Condition = 0
dy/dx
=0
2nd Order Condition = Negative
d2y/dx2
=
-
or

Minima
=0
=0
= Positive
+

Price & Marginal Revenue

Total Revenue (TRx) = f (P, Qx)
Let TRx = Px * Qx
Where Px = a + bQx
TR = aQx + bQx2
An Example:
Px = 11 0.001Qx
TRx = 11Qx 0.001Qx2
d (TR)/d (Qx) = 11 0.002Qx
setting MR = 0 & finding d2TRx/dQx2
11 0.002Qx = 0 or Qx = 5.5 (in 000)
2nd order derivative d2TRx/dQx2 = 0.002
Negative > At Qx = 5.5 TRx is at its MAXIMUM

Relationship between DD, MR & TR

Px = 11 0.001QX

DD
Quantity (000)

MR

TR

P => TR
Reaches a Maximum & Declines
MR < P at Each Output Level
MR Falls to ZERO
When TR is Maximum

Quantity (000)

Revenue Implications
Relationship between Price Elasticity & Total Revenue

Decision Tree
Elasticity
Price Rise
Infinity > || > 1 TR Falls
TR Constant
|| = 1
0 < || < 1 TR Rises

Price Decrease
TR Rises
TR Constant
TR Falls

PeD & MR
MR is NEGATIVE when elasticity is less than 1
DD drops a LOT when P increases, then TR falls
DD drops a LITTLE when P decreases, then TR rises

lot of implications for the decision making process

Point Elasticity
refers to a situation when the changes in
price & quantity are infinitesimally small
elasticity associated with a point on the DD curve
point elasticity = dQX/dPX * PX/QX
(slope of the DD curve)1* PX/ QX
Example
slope of the DD curve = 0.2627, PX = 8, & QX = 22879

at this point = (1/0.2627) *(8/22879) = 1.33

Note
small price changes are unlikely to attract consumer
discrete change in P & Q are more relevant

10

ARC Elasticity
responsiveness of QD to a discrete change in price
approximation to average price/quantity changes

arc = (Q1 Q2/ P1 P2 )* (P1+P2/Q1+Q2)

Price
8
7

QD
32
44

arc = (32 44 / 8 7 )* (8+7/32+44) = 2.368

arc lies between two values of point elasticity

Determinants of Elasticity
What determines elasticity?
Is there a RULE OF THUMB?
Demand is inelastic for => Necessities
Demand is elastic for => Luxuries
an ambiguous/amorphous dichotomy
for ex: one persons luxury is anothers necessary
Substitutability of the Product
more substitutes (stronger) greater is the price
elasticity
The relative expense on the product
lower the percent of income spent on a product lower
price elasticity is expected

11

Factors Affecting Demand Elasticity

ease of substitution (+)

proportion of total expenditure (+)
durability/postponing purchase (+)
possibility of repair (+)
used product market (+)
length of the time period (+)

12