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LECTURE 4
ELASTICITY OF
DEMAND & SUPPLY
Prof. D. Tripati Rao
Indian Institute of Management Lucknow
tripati@iiml.ac.in, June 29, 2016
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
Note
consumer expenditure is sensitive to Px, Yc & Py
price sensitivity is different for different goods
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
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
P
5
Qx
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
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
Price
Price
300
Revenue = 24,000
100
Revenue = 10,000
0
Demand
100
Quantity
Demand
0
80
Quantity
Price
Price
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!
Maxima y = f (x)
1st Order Condition = 0
dy/dx
=0
2nd Order Condition = Negative
d2y/dx2
=
-
or
Minima
=0
=0
= Positive
+
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
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
10
ARC Elasticity
responsiveness of QD to a discrete change in price
approximation to average price/quantity changes
QD
32
44
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
12