Chapter # 3
Elasticity ,importance and its
practical use in Managerial
Economics
Tahir Islam
Meaning and concept of
elasticity
 Elasticity . The term elasticity refers to extension
quality of a good. For
example, rubber, Spring, plastic, metals etc. And a good which has no
quality of extension and contraction is known as inelasticity or inelastic
good. For instance, stone, paper etc.
 Demand elasticity. law of demand shows qualitative
relationship between demand and price. The LOD expresses only
inverse relationship b/w price and quantity demanded but it does not show
quantitative relationship between demand and price that is how much
quantity demand of a product is change by a one unit change in price. Only
elasticity of demand makes us able to know about that how much quantity is
effected by change in price.
Thus demand elasticity is the degree of responsiveness of quantity
demanded to change in price. it shows sensitivity of quantity demanded of a
product to price change. Mathematically it is written as
Meaning and concept of elasticity
(cont…)
Percentage Change in Quantity Demand
Ed =
Percentage Change in Price
Or
Ed
=
%∆ in Qd
%∆ in P
Point price elasticity of demand
6
5
4
3
Midpoint, ES=1
2
1
100
200
300
300
400
500
Point price elasticity of demand
• Point price elasticity measures elasticity at
particular point on demand curve
• At midpoint elasticity of demand is equal to one
• Below midpoint point elasticity of demand is less
than one
• Above midpoint elasticity of demand is greater
than one
• If we move downward from midpoint or when we
decrease price point elasticity of demand
became relative inelastic
• When we move upward from midpoint point
elasticity of demand became relative elastic
Point price elasticity of demand (cont…)
• So two different elasticity of demand does not provide a
sound base for managerial making decision
• So we will go for another option or elasticity of demand
i.e. known as acre elasticity of demand
• Which provide a slid base for managerial making
decision
• What is acre elasticity of demand
• Acre elasticity of demand measures elasticity between
two points on demand curve
•
Acre price elasticity of demand
• Point price elasticity of demand provides different
elasticity of demand, when a firm increase or decrease
the price
• To avoid this, we use Acre elasticity of demand in which
we use the average of two prices and average of two
quantities
• The formula for acre elasticity of demand is
EP =
∆Q (P2 + P1)/2
∆P (Q2 + Q1)/2
=
Q2 - Q1
P2 - P1
P2 + P1
Q 2 + Q1
Acre price elasticity of demand (cont…)
• By using the above formula we obtain a constant
elasticity of demand which provide a solid base for
managerial making decision
Price elasticity, total revenue, and marginal
revenue
• An important relationship exist among these terms
• TR is equal to price times quantity,
• MR is the change in total revenue per unit change in out
put or sales
• TR = P×Q
• MR =∆TR
∆Q
• With decline in price ,total revenue increases if demand
is elastic i.e. if Ep is greater than one
• TR remains unchanged if demand is unitary elastic,
• TR is declines if demand is inelastic
Price elasticity, total revenue, and marginal
revenue (cont…)
Reason for
• If demand is elastic a price decline leads to a
proportionately larger increase in quantity demand or
sale so total revenue increases
• When demand is unitary elastic, a decline in price leads
to an equal proportionate increase in quantity demand or
sale and so total revenue remain unchanged
• If demand is inelastic, a decline in price leads to a
smaller proportionate increase in quantity demanded so
total revenue of a firm declines
Price elasticity, total revenue, and marginal
revenue (cont…)
• Demand curve is linear so elasticity of demand at midpoint
is unitary, elastic above midpoint, and inelastic below the
midpoint
• Reduction in price leads to increase in total revenue down
to the midpoint of demand curve (where total revenue is
maximum) and to decline thereafter
• MR is positive as long as TR increases;
• MR is zero when TR is maximum
• MR is negative when TR declines
Price elasticity, total revenue, and marginal
revenue (cont…)
P
6
5
4
3
2
1
0
Q
0
100
200
300
400
500
600
Ep
-∞
-5
-2
-1
-0.5
-0.2
0
TR=P.Q
$0
500
800
900
800
500
0
MR=∆TR/∆Q
$5
3
1
-1
-3
-5
Price elasticity, total revenue, and marginal revenue
F
(cont…)
900
TR
TR
P,MR ($)
600
300
6
E >1
5
P
4
E
3
F
P
=1
2
E
P
<1
1
0
300
MR
600
Factors affecting the price elasticity of demand
• Price elasticity of demand for a commodity depends on
availability of substitutes for a commodity
• Price elasticity of demand is larger if closer and greater the
numbers of substitute are available in market
• Length of time over which the quantity response to the price
change is important
• Demand for sugar is more price elastic than salt
• Substitute of sugar is (honey, saccharine)
• No substitute of salt
• More narrowly a commodity is defined the greater is its price
elasticity
•
Factors affecting the price elasticity of
demand con
• Price elasticity for coke is much greater than the price
elasticity of demand for soft drink
• Price elasticity of demand is larger the longer is the time
period allowed for consumers to respond to the change
in commodity price
• Consumers take time to learn about the availability of
substitutes and to make adjustment in their purchases
Income elasticity of demand:
• Income elasticity of demand:
 “Income elasticity of demand is the responsiveness
of demand to changes in the income of the
consumer.”
 Income elasticity is calculated by using the following
formula:
Ey = % change in quantity / % change in income
Ey = ΔQ/Q ÷ ΔY/Y
Ey = ΔQ/Q × Y/ΔY
Income elasticity of demand (cont….)
 Income elasticity of demand is:
a) Equal to unity i.e. when the percentage change in income is
equal to percentage change in quantity demanded.
Ey = 1
b) It is less than unity, if percentage change in income is more
than percentage change in quantity demanded.
Ey < 1
a) More than unity, if percentage change in income is less than
percentage change in quantity demanded.
Ey > 1
Acre Income elasticity of demand:
• Income elasticity of demand just like point price elasticity
of demand provides different results depending whether
income rises or falls
• For policy making and for making managerial making
decision we can not use point income elasticity of
demand, we use acre income elasticity of demand
• We use average income and average quantities
• Acre elasticity of demand measures the average
response of consumer as their income changes
Q2 - Q1
∆Q (Y2 + Y1)/2
EY =
=
∆Y (Q2 + Q1)/2
Y2 - Y1
Y+
Y1
2
Q 2 + Q1
Income elasticity of demand (cont….)
•
•
•
•
•
•
Income elasticity of demand is positive for normal goods
In case of necessities Ey is positive but low (0<EY<1)
Food, clothing and housing
In case of luxuries EY is above 1
Such as health care, education and recreation
For inferior goods income elasticity of demand is
negative such as flour its demand decreases as income
rises because consumers can then afford to buy
prepared foods or to eat out
• Income elasticity of demand is use for purpose of
forecasting the demand for a commodity that a firm sells
under different market condition
Income elasticity of demand (cont….)
Estimated Income Elasticity of Demand for Selected Commodities,
United States
Commodity
Income Elasticity
Wine
2.59
Electricity
1.94
European Car
1.93
Asian Car
1.65
Domestic Car
1.63
Beef
1.06
Cigarettes
0.50
Beer
0.46
Chicken
0.28
Pork
0.14
Flour
-0.36
Cross Elasticity of Demand
• Cross elasticity of demand: When the quantity demanded
is responsive to change in the price of other product, the
elasticity is said to be cross elasticity of demand
• For example, there are two products X and Y, whereas
product Y is the substitute of X
• When the change in price of Y leads to the change in the
quantity demanded of X, then quantity demanded of X is
responsive to change in the price of Y
• Thus here the elasticity of demand for X is said to be
cross elasticity of demand.
• Because the quantity demanded of X is changed by the
change in the price of Y
• Mathematically it can be written as:
EXY = %∆ QX
%∆ PY
∆QX PY
EXY =
∆PY QX
Cross price elasticity of demand (cont…)
• For substitute goods cross elasticity of demand is always
positive
• For complementary goods cross elasticity of demand is
negative
• If cross elasticity of demand is greater than one,
substitutability between two goods increases
• If cross elasticity of demand is less than one,
substitutability between two goods decreases
• If cross elasticity of demand is equal to zero, it means
that goods are independent such as books and butter
•
Cross point- price elasticity of demand
(cont…)
• Point cross-price elasticity of demand gives different
results depending on whether price of related good rises
or falls
• So policy makers can not use this elasticity for
managerial making decision
• To avoid this difficulty we go for another option i.e. acre
cross-price elasticity of demand
Acre cross elasticity of demand
• In acre elasticity of demand we use average price and
average quantity demand which we use in managerial
making decision or in policy making
• In managerial making decision this elasticity is very
useful.
• Firm uses this concept to measure the effect of changing
the price of related good and to design its own price
policy
•
Acre cross elasticity of demand (cont…)
• For example the General Motors Corporation can use
the cross-price elasticity of demand to measures the
effect of changing the price of Chevrolets on the demand
for pontiacs
• Chevrolets and pontiacs are substitute goods
• If price of former decreases demand for latter decreases
• Similarly manufactures of both razors and razor blades
uses this elasticity to measure the increase in demand
for razor blades that would result if firm reduced the price
of razors
• Cross elasticity of demand is positive and high, if
products belong to same industry, for example
Chevrolets and pontiacs
∆QX (PY2 + PY1)/2 QX2 - QX1 PY2+ PY1
EXY =
=
∆PY (QX2 + QX1)/2 PY2 - PY1 QX2 + QX1
Estimated Cross-Price Elasticity of Demand
Between selected Commodities, United States
Commodity X
Commodity Y
E
XY
Margarine
Natural Gas
European Cars
Asian Cars
US domestic Car
Pork
Chicken
Clothing
Entertainment
Cereals
Butter
Electricity
US domestic and Asian Car
US domestic and European Car
European and Asian Car
Beef
Pork
Food
Food
Fresh Fish
1.53
0.80
0.76
0.61
0.28
0.40
0.29
-0.18
-0.72
-0.87
Using elasticity's in managerial making
decision
• The analysis of forces or variables that affect demand
and numerical estimate of these variables are essential
for the firm to make the best operating decision and to
make a plan for its growth
• Some factors or variables that affect the demand are
under the control of a firm
• Such as setting the price of its product
• Expenditures on advertisement
• Quality of its product
•
Using elasticity's in managerial making
decision (cont…)
•
•
•
•
•
•
•
•
Customer service
Some factors are not under the control of a firm
Level and growth of consumer income
Consumer expectation about price
Competitor price decisions
Competitors expenditures on advertisement
Product quality and customer service of competitor
Using elasticity's in managerial making
decision (cont…)
• The firm needs these elasticity estimates in order to
determine the optimal operational policies and most
effective way to respond to the policies of competing
firms
• If demand for a product is price inelastic, the firm would
not decrease the price of the product, by doing so the
firm would decrease the profit
• If elasticity of sale with respect to advertising is positive
and higher than for its expenditures on product quality
and customer service then firm must concentrate more
on advertising rather than on product quality and
customer service.
Using elasticity's in managerial making
decision (cont…)
• If the firm estimated that cross elasticity of demand for
its product with respect to the price of competitor’s
product is very high
• It will be very quick to respond to the competitor price
reduction ,otherwise, the firm would lose a great deal of
its sale
• However the firm would thing twice before lowering its
price for fear of starting a price war
Using elasticity's in managerial making
decision (cont…)
• If income elasticity of demand is very low for the firm
product
• Management must know that firm will not benefit from
rising incomes and may want to improve its product or
move into new product line with more income elasticity of
demand
• So identification of all important variables that effect the
demand, and numerical estimates of these variables are
important in making managerial policies