Managerial Economics

Aditya Kuvalekar
Essex

Lecture 3: Elasticity.
Recall: Demand Curve

▶ Demand curve: What quantity will be demanded at different possible market

prices?
▶ What underlies the demand curve? A consumer’s willingness to pay or
reservation price.
▶ Features of a demand curve
▶ Price on the vertical axis, Quantity on horizontal axis
▶ Downward sloping: law of demand
▶ Slope and shape depend on tastes - a consumer’s willingness to pay depends on many
factors.
▶ Inverse demand: Willingness to pay for a given quantity.
▶ Consumer surplus: difference between willingness to pay and price.
A Demand Curve
Parle G biscuits

Price (|/unit)

▶ The blue line is a “demand curve.”

A ▶ At price |10, 100, 000 units are demanded by
the market.
|10
▶ Triangle A represents the consumer surplus.
▶ The area below the demand curve and above the
market price line.

Quantity (units)
100,000

Demand Curve
Demand Elasticity

Context: You want to estimate the impact of a price change on sales (quantity and
revenue).
▶ How sensitive is demand to price?
▶ How important is the pricing of competing products?
▶ How is demand affected by consumer incomes?

Concepts: Own price elasticity, Income elasticity, cross-price elasticity

What is price elasticity of demand?

▶ Measures sensitivity of the quantity demanded to price.

▶ Approximately, elasticity answers the question: By what percentage will quantity
demanded change if the price changes by 1%?

%∆Q ∂Q/Q
ε= =
%∆P ∂P/P
What is price elasticity of demand?

▶ Measures sensitivity of the quantity demanded to price.

▶ Approximately, elasticity answers the question: By what percentage will quantity
demanded change if the price changes by 1%?

%∆Q ∂Q/Q
ε= =
%∆P ∂P/P
▶ More formally, elasticity is defined

∂Q P
ε=
∂P Q
What is price elasticity of demand?

▶ Measures sensitivity of the quantity demanded to price.

▶ Approximately, elasticity answers the question: By what percentage will quantity
demanded change if the price changes by 1%?

%∆Q ∂Q/Q
ε= =
%∆P ∂P/P
▶ More formally, elasticity is defined

∂Q P
ε=
∂P Q
▶ What can we say about ε?
What is price elasticity of demand?

▶ Measures sensitivity of the quantity demanded to price.

▶ Approximately, elasticity answers the question: By what percentage will quantity
demanded change if the price changes by 1%?

%∆Q ∂Q/Q
ε= =
%∆P ∂P/P
▶ More formally, elasticity is defined

∂Q P
ε=
∂P Q
▶ What can we say about ε?
▶ Negative valued
▶ Not the same as the slope
▶ Independent of units
▶ Depends where we are on the demand curve
Examples

PRODUCT ELASTICITY1
Milk −0.5
Cigarettes −0.5
Beer −1.3
Budweiser beer −4.19
US Luxury cars −1.9
Foreign Luxury cars −2.9
What do you think are the factors that affect elasticity?

1
Hausman, 1994
Factors affecting elasticity of demand
Factors affecting elasticity of demand

▶ Habit forming products

▶ Presence of good substitutes
▶ Size / share of expenditure
▶ Necessity
▶ Industry-level elasticity vs. brand-level elasticity
Elasticity of demand: rules of thumb

▶ Luxuries vs. Necessities

▶ Short-run vs. Long-run

▶ Brand vs. Category (Availability of substitutes)

▶ Share of expenditure
Elasticity of demand: rules of thumb

▶ Luxuries vs. Necessities

Elasticity higher (in absolute value) on luxuries.

▶ Short-run vs. Long-run

Elasticity lower (in absolute value) in the short run than in the long run. E.g.
Petrol.

Elasticity can be lower (in absolute value) in the short run for durables. E.g.,
Refrigerators

▶ Brand vs. Category (Availability of substitutes)

Elasticity higher (in absolute value) on specific products than for a category. E.g.
Skoda Slavia vs cars overall.

▶ Share of expenditure
Elasticity higher (in absolute value) on products where share of expenditure is
high. E.g. Food demand more elastic than transportation, though food seems to
be more “essential.”
Elastic vs. Inelastic

Are there any absolute standards? What are the benchmarks?

▶ Elasticity is always negative.

▶ Between 0 and −1: Inelastic demand: The percentage change in quantity is less
than the percentage change in price.
▶ Between −1 and −∞: Elastic demand: The percentage change in quantity is more
than the percentage change in price.

▶ Exactly −1: Unitary elastic

▶ Theoretical extremes: Perfectly elastic and perfectly inelastic

Elastic Demand

Price Price D

Quantity Quantity

Infinitely elastic demand Completely elastic demand

▶ Steeper curve: less elastic, flatter curve: more elastic.

Elasticity: Practice example 1
Linear demand curve

The demand curve for wheat in 1981 was

QD = 3550 − 266P

where quantity is measured in millions of bushels, and price is in USD/bushel. The

supply curve was approximately

QS = 1800 + 240P.

▶ What is the price elasticity of demand at the market clearing price? Is demand for
wheat elastic or inelastic? Why?
Elasticity: Practice example 1
Linear demand curve

The demand curve for wheat in 1981 was

QD = 3550 − 266P

where quantity is measured in millions of bushels, and price is in USD/bushel. The

supply curve was approximately

QS = 1800 + 240P.

▶ What is the price elasticity of demand at the market clearing price? Is demand for
wheat elastic or inelastic? Why?

▶ Now, suppose a drought hits some suppliers. The equilibrium supply reduces by
≈ 5% from 2630 to 2500. What is the new equilibrium price? What is the
percentage change in price from before?
What is driving grain prices?

▶ Futures trading and speculation often blamed for price rises.

▶ Suppose that you see doubling of prices for, say, bread.

▶ A friend tells you that this is the result of greedy speculators. How would you
respond?

2
Source:
[Link]
What is driving grain prices?

▶ Futures trading and speculation often blamed for price rises.

▶ Suppose that you see doubling of prices for, say, bread.

▶ A friend tells you that this is the result of greedy speculators. How would you
respond?

▶ “Let’s see this more carefully. What’s the price elasticity of demand for wheat?
Has there been a shortage of supply?”

▶ US Department of Agriculture estimates the elasticity of demand for bread to be

0.04.2

▶ What does it mean? If there’s a drop, for the quantity to drop by 1% what is the
change in price required?

2
Source:
[Link]
What is driving grain prices?

▶ Futures trading and speculation often blamed for price rises.

▶ Suppose that you see doubling of prices for, say, bread.

▶ A friend tells you that this is the result of greedy speculators. How would you
respond?

▶ “Let’s see this more carefully. What’s the price elasticity of demand for wheat?
Has there been a shortage of supply?”

▶ US Department of Agriculture estimates the elasticity of demand for bread to be

0.04.2

▶ What does it mean? If there’s a drop, for the quantity to drop by 1% what is the
change in price required?

▶ 20%. Therefore, with a mere 5% drop in production, prices can double!

2
Source:
[Link]
Elasticity: Practice example 1
Learnings from linear demand curve

▶ If you know the demand curve, use dQ P

dP Q
to compute elasticity at any point.
▶ As we move along the demand curve, the slope stays the same, but ε changes.
▶ As we increase prices, we should expect growing resistance on purchases.
▶ As we move down, we see a smaller impact of price decreases.
Practice example 2

Amazon raises Prime subscription price to $99 a year.3

▶ Price increase from $79 to $99 a year; a 25% increased.

▶ How much will quantity change?

▶ The article says:

Analysts said they expect fewer than 10% of the more than 20 million Prime members
to drop their accounts. Including additional spending by Prime members, the change
could generate between $150 million and $300 million in operating income annually,
analysts predicted.

▶ Demand elasticity: −0.4, inelastic.

3
URL: [Link]
Elasticity: Practice example 3
Two points off demand curve

The wholesale price of beer rose from $10 to $12 a case. Shipments at the two prices
were:
Price Quantity
10 10500
12 8100

▶ What is the elasticity at the original price of $10?

▶ Did revenue rise or fall?

Is there a systematic way of knowing how price changes affect revenue?

How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

 
∂R ∂Q P
=Q 1+ = Q(1 + ε).
∂P ∂P Q
How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

 
∂R ∂Q P
=Q 1+ = Q(1 + ε).
∂P ∂P Q

▶ Suppose you decrease price.

▶ Revenue rises if
▶ Revenue falls if
▶ Revenue unchanged if
How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

 
∂R ∂Q P
=Q 1+ = Q(1 + ε).
∂P ∂P Q

▶ Suppose you decrease price.

▶ Revenue rises if ε < −1 (elastic).
▶ Revenue falls if ε > −1 (inelastic).
▶ Revenue unchanged if ε = −1.
How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

 
∂R ∂Q P
=Q 1+ = Q(1 + ε).
∂P ∂P Q

▶ Suppose you decrease price.

▶ Revenue rises if ε < −1 (elastic).
▶ Revenue falls if ε > −1 (inelastic).
▶ Revenue unchanged if ε = −1.

▶ Examples:
▶ US luxury cars: if price falls by 1%,
▶ Foreign luxury cars: if price falls by 1%,
How do price changes affect revenue?

▶ Elasticity tells us how revenue will change if we change pricing.

Revenue R = P × Q.

▶ How does R change with a change in P?

 
∂R ∂Q P
=Q 1+ = Q(1 + ε).
∂P ∂P Q

▶ Suppose you decrease price.

▶ Revenue rises if ε < −1 (elastic).
▶ Revenue falls if ε > −1 (inelastic).
▶ Revenue unchanged if ε = −1.

▶ Examples:
▶ US luxury cars: if price falls by 1%, revenue rises by 0.9%.
▶ Foreign luxury cars: if price falls by 1%, revenue rises by 1.8%.
How do price changes affect revenue?

▶ What happens to revenue if

Price (|/unit)
you reduce the price?

p1

∆P
p2

100,000 Quantity

Demand Curve
How do price changes affect revenue?

▶ What happens to revenue if

Price (|/unit)
you reduce the price?
▶ Loss due to lower price, but
gain from new customers.
▶ Net increase in revenue if
gain > loss.
Loss = ∆P × Q

p1
Gain = ∆Q × P
∆P
p2

100,000 Quantity

Demand Curve
How do price changes affect revenue?

▶ What happens to revenue if

Price (|/unit)
you reduce the price?
▶ Loss due to lower price, but
gain from new customers.
▶ Net increase in revenue if
gain > loss.
Loss = ∆P × Q
Gain > Loss
p1
Gain = ∆Q × P P × ∆Q > − Q × ∆P
∆P P × ∆Q
p2 =⇒ <−1
Q × ∆P
=⇒ ε < −1

100,000 Quantity

Demand Curve
A comparison of two different demand curves
What happens to the revenue if you drop prices?

Price (|/unit) Price (|/unit)

Loss = ∆P × Q
Loss = ∆P × Q

p1 p1 Gain = ∆Q × P
Gain = ∆Q × P
∆P ∆P
p2 p2

Quantity Quantity
Other elasticities

How sensitive is demand for your product to prices of related products?

▶ Elasticity is a very general concept.
▶ We’re asking, how responsive is some variable to a shock in its price, or cost...
▶ Could as well ask, how responsive is
▶ Crime to minimum sentences
▶ Class attendance to start time
Other elasticities
Cross-price Elasticity of Demand

How sensitive is demand for your product to prices of related products?

▶ What is the percentage change in quantity demanded for butter if the price for
margarine increases by 1%?
▶ Answer lies in Cross-price elasticity
Other elasticities
Cross-price Elasticity of Demand

How sensitive is demand for your product to prices of related products?

▶ What is the percentage change in quantity demanded for butter if the price for
margarine increases by 1%?
▶ Answer lies in Cross-price elasticity
▶ Cross-price elasticity of demand for butter with respect to the price of margarine is

∆Qb /Qb Pm ∆Qb

εQb ,Pm = = .
∆Pm /Pm Qb ∆Pm
Other elasticities
Cross-price Elasticity of Demand

How sensitive is demand for your product to prices of related products?

▶ What is the percentage change in quantity demanded for butter if the price for
margarine increases by 1%?
▶ Answer lies in Cross-price elasticity
▶ Cross-price elasticity of demand for butter with respect to the price of margarine is

∆Qb /Qb Pm ∆Qb

εQb ,Pm = = .
∆Pm /Pm Qb ∆Pm
▶ Cross-price elasticity is positive:
▶ Cross-price elasticity is negative:
Other elasticities
Cross-price Elasticity of Demand

How sensitive is demand for your product to prices of related products?

▶ What is the percentage change in quantity demanded for butter if the price for
margarine increases by 1%?
▶ Answer lies in Cross-price elasticity
▶ Cross-price elasticity of demand for butter with respect to the price of margarine is

∆Qb /Qb Pm ∆Qb

εQb ,Pm = = .
∆Pm /Pm Qb ∆Pm
▶ Cross-price elasticity is positive: Goods are substitutes.
▶ Cross-price elasticity is negative: Goods are complements.
Other elasticities
Cross-price Elasticity of Demand

How sensitive is demand for your product to prices of related products?

▶ What is the percentage change in quantity demanded for butter if the price for
margarine increases by 1%?
▶ Answer lies in Cross-price elasticity
▶ Cross-price elasticity of demand for butter with respect to the price of margarine is

∆Qb /Qb Pm ∆Qb

εQb ,Pm = = .
∆Pm /Pm Qb ∆Pm
▶ Cross-price elasticity is positive: Goods are substitutes.
▶ Cross-price elasticity is negative: Goods are complements.
▶ Examples?
Other elasticities
Income Elasticity of Demand

▶ Income Elasticity of Demand: What is the percentage change in quantity

demanded resulting from a 1% increase in income?

∆Q/Q I ∆Q
εI = = .
∆I/I Q ∆I
Other elasticities
Income Elasticity of Demand

▶ Income Elasticity of Demand: What is the percentage change in quantity

demanded resulting from a 1% increase in income?

∆Q/Q I ∆Q
εI = = .
∆I/I Q ∆I
▶ Demand for most goods increases when income increases:
▶ Normal goods: εI > 0.
▶ Inferior good: εI < 0.
▶ Income elastic goods: εI > 1. Examples?
Other elasticities
Income Elasticity of Demand

▶ Income Elasticity of Demand: What is the percentage change in quantity

demanded resulting from a 1% increase in income?

∆Q/Q I ∆Q
εI = = .
∆I/I Q ∆I
▶ Demand for most goods increases when income increases:
▶ Normal goods: εI > 0.
▶ Inferior good: εI < 0.
▶ Income elastic goods: εI > 1. Examples?
▶ Do you think the demand for golf clubs is income elastic or income inelastic?
Other elasticities
Income Elasticity of Demand

▶ Income Elasticity of Demand: What is the percentage change in quantity

demanded resulting from a 1% increase in income?

∆Q/Q I ∆Q
εI = = .
∆I/I Q ∆I
▶ Demand for most goods increases when income increases:
▶ Normal goods: εI > 0.
▶ Inferior good: εI < 0.
▶ Income elastic goods: εI > 1. Examples?
▶ Do you think the demand for golf clubs is income elastic or income inelastic?

▶ Similarly we could talk about elasticities of supply.

Applying our learnings:

What do we think the income elasticity of movies will be?

Applying our learnings:

What do we think the income elasticity of movies will be?

Movies are inferior goods.

Applying our learnings:
Market for cars

Response to the change in price of:4

Model 323 Cavalier Accord Taurus Century

Mazda 323 -6.4 0.6 0.2 0.1 0
Cavalier 0 -6.4 0.2 0.1 0.1
Accord 0 0.1 -4.8 0.1 0
Taurus 0 0.1 0.2 -4.2 0
Century 0 0.1 0.2 0.1 -6.8

4
BLP, 1990
Applying our learnings:
Market for cars

▶ Why are the “own” elasticities so high?

▶ Are the Accord and Taurus complements or substitutes?

▶ If GM lowers the price of its Chevy Cavalier, does it cannibalize its Buick
Century?

▶ Suppose Honda sold 300, 000 Accords in 2001. In 2002, the price of the Accord
decreased by 2%, while the price of the Taurus decreased by 3%. What is the
likely change in Accord sales?