me- unit-2 elasticity & its applications

7/24/2019 ME- Unit-2 Elasticity & Its Applications

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Elasticity and ItsApplication


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Learning Objectives

By the end of these sessions, students shouldunderstand:

The types of the elasticity of demand and its

arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

app ca on n us ness ec s on The types of the elasticity of supply and its

application in business decision

Elasticity & its applications


3/52

Question: If business want to generate more


of product or decrease the price of

product?



4/52

Elasticity . . .

is a measure of how much buyers

and sellers respond to changes in market


con ons

allows us to analyze supply and

demand with greater precision.



5/52

Recall the law of demand, which shows the inverse relationbetween price of a commodity and its quantity demanded.

You know that when price of a commodity increases(decreases),

its quantity demanded fall (or rise).

But this knowledge can not answer a simple question that if price

increases by one unit, by what proportion will quantity demanded


decrease.

In order to ascertain this proportion, you need to know another

concept, that is elasticity of demand.



6/52

Elasticity of Demand

In fact, why only price? A firm needs to know about the

responsiveness or sensitivity of demand for the commodity itproduces to changes in all the independent variables

(determinants of demand) that influence its demand.


Elasticity of demand measures the degree of responsivenessof the quantity demanded of a commodity to a given change in

any of the determinants of demand.



7/52

Let us now explain the different types of elasticity of

demand:Note here that there can be as many types of elasticities of

demand, as the number of determinants of demand.

However, we would restrict ourselves to only four types of

elasticity, namely price elasticity, income elasticity, cross elasticity

and advertising (or promotional) elasticity.


As you know that demand is a function of multiple variables and

each of these variables independently affects demand in a

different manner; therefore in order to assess the impact of one

variable, we assume other variables as constant (ceteris paribus).



8/52

Price Elasticity of Demand

Price elasticity of demand is thepercentage change in quantity

demanded iven a ercent chan e in


the price.

It is a measure of how much thequantity demanded of a good responds

to a change in the price of that good.



9/52

Computing the Price Elasticity

of DemandThe price elasticity of demand is computed as

the percentage change in the quantitydemanded divided by the percentage change in

price.

P e r c e n ta g e C h a n g e

P e r c e n ta g e C h a n g e


P r ic e E la s t ic ity o f D e m a n d =

P e r c e n ta g e C h a n g ein P r ic e

P r ic e E la s t ic ity o f D e m a n d =

P e r c e n ta g e C h a n g ein P r ic e

ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )

Where Q1 = original quantity demanded , Q2 = new quantity demanded

. P1 = initial price level, P2 = new price level.

ep = (Q/Q) / (P/P ) (Q/ P) (P/Q)



10/52

Computing the Price Elasticityof Demand

priceinchangePercentagedemandedquatityinchangePercentagedemandofelasticityPrice =

Example: If the price of an ice cream cone increases


from $2.00 to $2.20 and the amount you buy falls from10 to 8 cones then your elasticity of demand would be

calculated as:

210

20

100

00.2

)00.220.2(

10010

)108(=

=

percent

percent



11/52

Determinants of Price Elasticity of Demand

Nature of commodity (i.e. Luxurious and necessity)

Availability of Close Substitutes

Alternative use of the Commodity(i.e. electricity, Bottle of water

Proportion of income spent on the commodity (i.e. Match

box & Salt).


Definition of the Market (More elastic in more narrow market because it is easy tofind substitute i.e. Ice cream is a narrower category where as food is broad category)

Time Horizon (More elastic in long run i.e. a shift from petrol driven

vehicle to CNG driven one)

Items of Addiction



12/52

Computing the Price Elasticity of

Demand Using the Midpoint Formula

The midpoint formula is preferable when

calculating the price elasticity of demand

because it gives the same answer regardless of


e rec on o e c ange.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=SupplyofElasticityPrice

1212

1212

+

+



13/52

Ranges (or degree) of Elasticity

Relatively Inelastic DemandQuantity demanded does not respondstrongly to

price in changes.


Price elasticity of demand is less than one (Ed< 1 ).

More Elastic Demand

Quantity demanded responds strongly to changes in

price.

Price elasticity of demand isgreater than one(Ed> 1 ).



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Ranges (or degree )ofElasticity

Perfectly InelasticQuantity demanded does not respond to pricechanges(Ed= 0).


er ec y as c

Quantity demanded changes infinitely with any

change in price (Ed= ).

Unit ElasticQuantity demanded changes by the same

percentage as the price (Ed= 1).



15/52

A Variety of Demand Curves

Because the price elasticity of demandmeasures how much quantity demanded

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

,

to the slope of the demand curve.

Economists classify demand curves

according to their elasticity.



16/52

Perfectly Inelastic Demand- Elasticity equals 0

Price

$5

Demand

1. An


Quantity

4

1002. ...leaves the quantity demanded unchanged.

in price...



17/52

Relatively Inelastic Demand(Elasticity is less than

1)

Price

4

$51. A 22%increase

in price...

Demand


Quantity100902. ...leads to a 11% decrease in quantity.

Calculate the elasticity of demand, using the midpoint

formula.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Ep

1212

1212

+

+



18/52

Unit Elastic Demand- Elasticity equals 1

Price

$51. A 22%


Quantity

4in price...

Demand

100802. ...leads to a 22% decrease in quantity.



19/52

Elastic Demand

- Elasticity is greater than 1

Price

$51. A 22%


Quantity

4in price...

Demand

100502. ...leads to a 67% decrease in quantity.



20/52

Perfectly Elastic Demand- Elasticity equals infinity

Price

1. At any priceabove $4, quantitydemanded is zero.


Quantity

Demand$4

2. At exactly $4,consumers will

buy any quantity.

3. At a price below $4,

quantity demanded is infinite.Elasticity & its applications


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Elasticity and Total Revenue

Total revenue is the amount paid bybuyers and received by sellers of a good.


multiple by quantity sold of the same

good.

TR = P x Q



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$4

Price



Demand

Quantity

P

0

P xQ = $400(total revenue)

100Q



23/52


With an relatively inelastic demand curve,an increase in price leads to a decrease in


.

Thus, total revenue increases.



24/52

Elasticity and Total Revenue:Relatively Inelastic Demand

PricePrice

An increase in price

from $1 to $3...

leads to an increasein total revenue

from$100 to $240


$3

Quantity0 80

Revenue = $240 Demand$1 Demand

Quantity0

Revenue = $100

100



25/52


With an elastic demand curve, anincrease in the price leads to a


is proportionately larger. Thus, total

revenue decreases.



26/52

Elasticity and Total Revenue:Elastic Demand

Price PriceAn increase in price

from $4 to $5...

leads to a decreasein total revenue

from$200 to $100


Demand

Quantity0

$4

50

Demand

Quantity0

Revenue = $100

$5

20

Revenue = $200



27/52

Income Elasticity ofDemand

Income elasticity of demand measures

how much the quantity demanded of a

good responds to a change in


consumers income.It is computed as the percentage change

in the quantity demanded divided by the

percentage change in income.



28/52

Computing Income Elasticity

Income Elasticity

of Demand

Percentage Changein Quantity Demanded

Percentage Changein Income

=


ey= (Q2- Q1/Q1) / (Y2- Y1/ Y1)

Where Q1 = original quantity demanded, Q2 = new quantity demanded

Where Y1= initial level of income, Y2 = new level of income



29/52

Income elasticity of demand also has similar degree

of elasticity like price elasticity of demand:

Perfectly Elastic Ey= Relatively Elastic Ey> 1

Unit Elastic Ey= 1


Relatively Inelastic Ey< 1

Perfectly Inelastic Ey= 0

The value of income elasticity can be either negative or positive,

depending upon nature of product.



30/52

Income Elasticity and types of Goods

-Normal Goods: Higher income raises the

quantity demanded for normal goods such

as, sports cars, mobile, and expensive

foods, etc.

Inferior Goods:Higher income lowers the


quantity demanded for inferior goodssuch as, bread , and jawar etc.

Neutral Goods:Higher income does not

affect the quantity demanded for neutral

goods such as, match box, salt, postcard and

needles, etc.Elasticity & its applications


31/52

If a consumers income rises from Rs. 300 to Rs. 350, his

purchase of a good X increases from 25 units per day to 35 units,find income elasticity of demand for X.

Solution:

ey= (Q2- Q1/Q1) / (Y2- Y1/ Y1)


= (10/25) / (50/300)

= 0.4 / 0.1666

= 2.4



32/52

Cross Elasticity of DemandThe cross elasticity of demand, which explains theresponsiveness of demand for one good to the change in

price of anothergood (ceteris paribus).

Expressed in ratio form, cross elasticity (eC) is defined as:

Proportionate change in quantity demanded of commodity X

eC =


eC= (QX2- QX1/QX1) / (PY2- PY1/ PY1)

Where QX1 = original quantity for commodity X, QX2 = new quantity for commodity X

Where PY1= initial price level of commodity Y, PY

2 = new price level of commodity Y

In case of substitutes good, the value of eC would be positive, and in case of complements,

it would be negative.Elasticit & its a lications


33/52

Class exercise: 1. Consider two goods X and Y. There was no change in price of

X. but its demand was seen to fall from 6000 units to 5500 units. On analysis itwas found that price of another commodity Y has decreased 250 to 225. Find out

the cross elasticity between X and Y and the relationship between the two goods.

2. Consider two goods X and Y. There was no change in price of X, but its

demand increased from 5500 units to 6000 units. On analysis it was found thatprice of another commodity Y had decreased from 250 to 225. Find out the cross

elasticity between X and Y and the relationship between the two goods.


o ut on- :

eC = (5500-6000/6000) / (225-250/250)

Since elasticity is positive, it concluded that X and Y are substitute.

Solution-2:eC = ( 6000-5500/5500) / (225-250/250)

Since elasticity is negative, it can be concluded hat X and Y are complements.

=(-500/6000) / (-25/250)= -0.08333 / -0.1 = 0.8333

=(500/5500) / (-25/250)= 0.0909 / -0.1 = -0.9090



34/52

Promotional or advertising elasticityPromotional elasticity of demand measures the degree of

responsiveness of demand to a given change in advertising

expenditure (ceteris paribus).

In ratio from ea can be expressed as:

Proportionate change in quantity demanded of commodity XProportionate change in advertising expenditure of X

ea =


a=

2-

1 1

2-

1

1

Where Q1 = original quantity demanded, Q2 = new quantity demanded

A1 = initial level of advertising expenditure, A2 = new level of advertising expenditure

Here also degree of elasticity are similar to those discussed in context of price.

When ea > 1, a firm should go for heavy expenditure on advertisement.

When , ea < 1 a firm should not spend too much on advertisement.

As for example, you find advertisements for generators, inverters, etc., but would

not find advertisements for electricity, petrol or diesel.Elasticit & its a lications


35/52

Methods of Measuring Elasticity

1. Ratio (or Percentage) Method:

In ratio method price elasticity of demand is expressed as the

ratio of proportionate change in quantity demanded and

proportionate change in the price of the commodity.

Proportionate change in quantity demanded of commodity X


Proportionate change in price of X

p

ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )

Where Q1 = original quantity demanded , Q2 = new quantity demanded .P1 = initial price level, P2 = new price level.

ep = (Q/Q) / (P/P ) = (Q/ P) (P/Q)



36/52

2. Arc Elasticity Method

Arc elasticity measures elasticity at the midpointof an arcbetween any two points on a demand curve.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Ep

1212

1212

+

+

Where Q1 = original quantity demanded , Q2 = new quantity demanded


This method finds particular application when we want to

calculate price elasticity of demand between any two points on the

demand curve.

This method finds wider applications, as it reflects a movementalong a portion (arc) of demand curve.

The basic assumption of this method is that elasticity is the same

over the range of the value of the variables under consideration.

.

P1 = initial price level, P2 = new price level.



37/52

Example: If the price of an ice cream cone increases from

$2.00 to $2.20 and the amount you buy falls from 10 to 8

cones. Q. calculate the elasticity of demand, using the

midpoint formula?.

)/2]P)/[(PP(P)/2]Q)/[(QQ(Q=Ep

1212

1212

+

+


32.2

5.9

22

2/)00.220.2()00.220.2(

2/)108(

)108(

=

=

+

+

percent

percent



38/52

Q. Calculate the elasticity of demand, using the

midpoint formula?.

$5

Price

5.00)/2(4.005.00)-(4.00

50)/2(100

50)-(100

ED

+

+=


Demand is price elastic

4 Demand

Quantity1000 50

-3percent22-

percent67 ==



39/52

Importance of elasticity of demand

1. Determination of price

2. Basis of price discrimination. (eg. Basis on place, time, use etc.)

3. Government policies of taxation (eg. Excise duties).


4. To the trade unions.

5. To international trading transactions.



40/52

Price Elasticity of Supply

Price elasticity of supply is thepercentage change in quantity supplied

resultin from a ercent chan e in


price.It is a measure of how much the

quantity supplied of a good responds to

a change in the price of that good.



41/52

Computing the Price Elasticity of Supply

Elasticity of Supply =

Percentage Change inQuantity Supplied

Percentage Changein Price

Elasticity of Supply =

Percentage Change inQuantity Supplied

Percentage Changein Price

ES


Where P = initial price level, P = Change in price level.

Q = initial quantity supplied, Q = Change in quantity supplied.


ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )Where Q1 = original quantity supplied, Q2 = new quantity supplied .

P1 = initial price level, P2 = new price level.


42/52

Firm XYZ supplied 2000 pens at price of Rs. 8 per pen.

When price increases to Rs.10 per pen. The supply of XYZincreases to 3000 pens. Find the elasticity of supply of

pens?

P = Rs. 8, P = Rs. 10 Rs. 8 = Rs. 2

Solution:


Q = 2000 pens, Q = 3000-2000 = 1000 pens

ES



43/52


44/52

Ranges of Elasticity

Perfectly Elastic

ES=


ES> 1

Unit Elastic

ES= 1



45/52

Ranges of Elasticity

Relatively Inelastic

ES< 1

P rf l In l i


ES= 0



46/52

Perfectly Inelastic Supply

- Elasticity equals 0

Price

$5

Supply

1. An


Quantity

4

1002. ...leaves the quantity supplied unchanged.

in price...


Relatively inelastic Supply (Elasticity is less than 1


47/52

y pp y ( y

Price

4

$51. A 22%increase

in price...

Supply


Quantity1101002. ...leads to a 10% increase in quantity.

Calculate the elasticity of supply, using the midpoint formula.

)/2]P)/[(PP(P

)/2]Q)/[(QQ(Q=Es

1212

1212

+

+



48/52

Unit Elastic Supply

- Elasticity equals 1

Price

$51. A 22%

Supply


Quantity

4in price...

1251002. ...leads to a 22% increase in quantity.


S


49/52

Elastic Supply

- Elasticity is greater than 1

Price

$51. A 22%

Supply


Quantity

4in price...

2001002. ...leads to a 67% increase in quantity.


P f tl El ti S l


50/52

Perfectly Elastic Supply

- Elasticity equals infinity

Price

1. At any priceabove $4, quantitysupplied is infinite.


Quantity

Supply$4

2. At exactly $4,producers will

supply any quantity.

3. At a price below $4,quantity supplied is zero.



51/52

Determinants of Elasticity of Supply

1. Ability of sellers to change the amount of the good they

produce. Beach-front land is inelastic.

Books, cars, or manufactured goods are elastic.

2. Time period: (Market period, Short period-inelastic and Long period-elastic)


3. Nature of Production (eg. Art works like painting is inelastic)4. Mobility of factors (immobility has inelastic supply)

5. Availability of input ( greater availability-more elastic)

6. Size of firm and the number of products produced(more-elastic and less- inelastic)


U li i d S I d i h i 2006 h


52/52

Unlimited Storage Income, determines that in year 2006 the

demand curve for its removable storage media (pen drive) is: P=2000-50Q, where P is the price of a pen drive, and Q is the number

of pen drives sold per month.

1. What price would the company have to charge to sell 20 pen

drives per month?2. If it sets a price of Rs. 500 for a pen drive, how many pen drives

will it sell per month?


Solution:

1). P = 2000 (50 X 20 ) = Rs. 1000

2). 500=2000- 50Q

50Q = 2000-500Q = 1500/50

Q= 30


me- unit-2 elasticity & its applications

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