Managerial Economics

Session 3-4
Elasticity
Introduction

• Our analysis of the impact of changes in prices and income on

consumer demand has been qualitative rather than quantitative
• The successful manager is also adept at providing “detailed”
quantitative answers to questions like :
• How much do we have to cut our price to achieve 3.2 percent sales
growth?
• If we cut prices by 6.5 percent, how many more units will we sell?
• Do we have sufficient inventories on hand to accommodate this increase in
sales? If not, do we have enough personnel to increase production?
• How much will our revenues and cash flows change as a result of this price
cut?
• How much will our sales change if rivals cut their prices by 2 percent or a
recession hits and household incomes decline by 2.5 percent?
A Scenario

• You design websites for local businesses.

• You charge $200 per website, and currently sell 12 websites
per month.

• Your costs are rising (including the opportunity cost of

your time)
• You consider raising the price to $250.

• The law of demand: you won’t sell as many websites if

you raise your price.
• How many fewer websites?
• How much will your revenue fall, or might it increase?

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Elasticity
A general definition:
“Elasticity” is a measure of the degree of sensitivity ( or
responsiveness) of one variable to changes in another
variable.

The price elasticity of Demand

The price elasticity of demand is a measure of the
degree of sensitivity of demand to changes in the (self)
price, ceteris paribus.
The percentage change in quantity demanded given a
percent change in the price
Price Elasticity of Demand

percentage change in Q d
P 
percentage change in P
15%
P rises P2  1.5
by 10% P1 10%

D
Q For each one percent change in
Q2 Q1 price the quantity demanded will
Q falls change by 1.5 percent.
by 15%
The Price Elasticity of Demand

• Determinants of price elasticity of demand

• We look at a series of examples comparing two
common goods

• In each example:
• Suppose prices of both goods rise by 20%
• Which good has the highest price elasticity of
demand? Why?
• What lesson we learn about the determinants of
price elasticity of demand?

6
The Price Elasticity of Demand
Example 1: Breakfast cereal vs. Sunscreen

• Prices of both of these goods rise by 20%.

• For which good does Qd drop the most? Why?
• Breakfast cereal has close substitutes, so
buyers can easily switch if the price rises
• Sunscreen has less close substitutes, so a
price increase would not affect demand very
much
• Price elasticity is higher when close substitutes
are available
The Price Elasticity of Demand
Example 2: Blue Jeans vs. Clothing

• Prices of both of these goods rise by 20%.

• For which good does Qd drop the most? Why?
• For a narrowly defined good, blue jeans, there
are many substitutes
• There are fewer substitutes available for
broadly defined goods (clothing)

Price elasticity is higher for narrowly defined goods

than for broadly defined ones.
The Price Elasticity of Demand
Example 3: Insulin vs. Yachts
• Prices of both of these goods rise by 20%.
• For which good does Qd drop the most?
Why?
• Insulin is a necessity to diabetics. A rise in price
would cause little or no decrease in demand
• A yacht is a luxury. If the price rises, some
people will forego it.
• Price elasticity is higher for luxuries than for
necessities.
The Price Elasticity of Demand
Example 4: Gasoline in the Short Run vs. Gasoline in the
Long Run

• The price of gasoline rises 20%.

• Does Qd drop more in the short run or the long run?
Why?
• There’s not much people can do in the
short run, other than ride the bus or carpool.
• In the long run, people can buy smaller cars
or live closer to work.
• Price elasticity is higher in the long run
Ranges of Elasticity

Inelastic Demand
• Percentage change in price is greater than percentage
change in quantity demanded.
• Price elasticity of demand is less than one.

Elastic Demand
• Percentage change in quantity demanded is greater
than percentage change in price.
• Price elasticity of demand is greater than one.
The Price Elasticity of Demand

• Variety of demand curves

• Demand is perfectly inelastic
• Price elasticity of demand = 0
• Demand curve is vertical
• Demand is relatively inelastic
• Price elasticity of demand < 1
• Demand has unit elasticity
• Price elasticity of demand = 1
• Demand is relatively elastic
• Price elasticity of demand > 1
• Demand is perfectly elastic
• Price elasticity of demand = infinity
• Demand curve is horizontal

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Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5 Necessities with no close substitutes

such as life-saving prescription drugs
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price Commodities such as wheat or gold, for which
above $4, quantity there are many substitutes and no brand loyalty
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
Arc Elasticity of Demand

• Limitation of point elasticity: 2 different estimates of

elasticity when price moves from A to B and B to A.
• Arc elasticity - Price elasticity calculated over a range of
prices
• We use an average of the initial and final price and quantity
demanded
PE (ΔQ ΔP )(P Q )
Arc elasticity of demand =
• For example: if the price of a product is expected to move
from Rs.8 to Rs.10 and QD to fall from 6 to 4 units.
• Ep = (-2/$2)($9/5) = -1.8

18
The market for wheat
• Dry
Weather
• Heavy
Rains
• Increased
Export
Demand
The market for wheat – Demand , Supply,
Equilibrium
• To understand what happened, let’s examine the behavior of supply and
demand beginning in 1981.
Supply: QS = 1800 + 240P; Demand: QD = 3550 – 266P
By setting the quantity supplied equal to the quantity demanded, we can
determine the market-clearing price of wheat for 1981:
QS = QD
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Substituting into the supply curve equation, we get market-clearing quantity
Q = 1800 + (240)*(3.46) = 2630 million bushels
The market for wheat – Demand , Supply,
Equilibrium
We find the price elasticity of demand as follows:

P ΔQD 3.46
EPD = = (  266)=  0.35 Thus, demand is inelastic.
Q ΔP 2630
We can likewise calculate the price elasticity of supply

P ΔQS 3.46
EPS = = (240)=0.36
Q ΔP 2630

• Suppose that a drought caused the supply curve to shift far enough to the
left to push the price up to $4.00 per bushel. In this case, the quantity
demanded would fall to 3550 – (266) (4.0) = 2486 million bushels.
• At this price and quantity, the elasticity of demand would be

4.00
EPD = (  266)=  0.43
2480
The market for wheat – Demand , Supply,
Equilibrium
In 2007, demand and supply were:Demand :QD 2900  125P
Supply :Qs =1460+115P
The market-clearing (nominal) price and quantity are:
1460 115P 2900  125P
P = $ 6.00 per bushel
Q 1460  (115)(6) 2150 million bushels

• Why prices skyrocketed?

• Dry weather and heavy rains
• increased export demand caused the price to rise considerably.

At the 2007 price and quantity, the price elasticity of demand was -0.35 and the
price elasticity of supply 0.32. Given these low elasticities, it is not surprising
that the price of wheat rose so sharply.
Gasoline: Short-run and Long-run Demand
Curves
• In the short run:
• an increase in price has Price DSR
only a small effect on the
quantity of gasoline DLR
demanded.

• In the longer run:

• however, because they
will shift to smaller and
more fuel-efficient cars.

Quantity
Automobiles: Short-run and Long-run Demand
Curves
• If price increases:
• consumers initially defer Price DLR
buying new cars; thus
annual quantity DSR
demanded falls sharply.
• In the longer run:
• however, old cars wear
out and must be
replaced; thus annual
quantity demanded picks
up.

Quantity
Income elasticity – Short vs Long run

• For most goods and services—foods, beverages, fuel,

entertainment, and so on
• the income elasticity of demand is larger in the long run than in the short run.

• For a durable good,

• the opposite is true. The short-run income elasticity of demand will be much
larger than the long-run elasticity.
Income Elasticity
• Short-run changes in
income affects the
demand for durable
goods sharply

• Only durable goods tend

to magnify the changes
in GDP with changes in
non-durables remaining
the same as GDP
Price Elasticity of Supply – Short run Vs. Long
run
Primary Copper SSR
Price
• The supply is more
elastic in the long SLR
run.
• If price increases, firms
would like to produce
more but are limited by
capacity constraints in
the short run.
• In the longer run, they
can add to capacity
and produce more.

Quantity
Price Elasticity of Supply – Short run Vs. Long
run
Secondary Copper SLR
Price
• The supply is more
elastic in the short SSR
run.
• If the price increases,
there is a greater
incentive to convert
scrap copper into new
supply. Initially,
therefore, supply from
scrap increases
sharply.
• But later, as the stock
of scrap falls, Quantity
secondary supply
contracts.
Price Elasticity of Supply – Short run Vs. Long
run

PRICE ELASTICITY SHORT-RUN LONG-RUN

Primary supply 0.20 1.60

Secondary supply 0.43 0.31

Total supply 0.25 1.50

Copper Prices, 1965-2011

• Early 1970s through mid-

1980s Prices fell as demand
fell
• During 1988–1990, prices
rose due to supply disruptions
and later fell
• During 1996–2002 prices
declined again but then
increased sharply starting in
2005.
• By 2010 producers started
worrying that prices would
decline again
• What would a decline of 20%
demand do to the price of
copper?
 S

Price (per unit)

P1 A
P2
B

D0

D1
Q2 Q1
Quantity demanded
Understanding and Predicting the Effects of
Changing Market Conditions
Demand: Q = a - bP
Supply: Q = c + dP
Recall Price Elasticity:
E = (P/Q) (ΔQ/ΔP)
Thus, ΔQ/ΔP for demand is -b; and
For supply, it is d
Thus, Ed = -b(P*/Q*) and
Es = d(P*/Q*)

We have data for P*, Q*, Ed, and Es

We solve for only b and d
Understanding and Predicting the Effects of
Changing Market Conditions
Example: Long-run Supply and Demand for world Copper Market

Quantity (Q*) = 18 million metric tonnes per year

Price (P*) = $3.00 per pound
Long-run Price Elasticity of Supply (Es) = 1.5
Long-run Price Elasticity of Demand (Ed) = -0.5

Note: The price of copper has fluctuated during the past few decades
between $0.60 and more than $4.00, but $3.00 is a reasonable average
price for 2008-2011)
Understanding and Predicting the Effects of
Changing Market Conditions
Example: Long-run Supply and Demand for world Copper Market

Substitute the values into Es equation:

Es = d(P*/Q*) => 1.5 = d(3/18) => 1.5 = d/6 => d = 9

Substitute d = 9 into Supply function: Q = c + dP

=> 18 = c + (9)(3.0) => 18 = c + 27 => c = 18-27 = -9

Thus, our Supply function is Q = -9 + 9P

Similarly following the same steps, our Demand function is Q = 27 – 3P
Equating the two should give us the same P* and Q*
Understanding and Predicting the Effects of
Changing Market Conditions
Example: Long-run Supply and Demand for world Copper Market

Similarly, if we believe that demand also depends on income in addition to

price, the Demand function becomes: Q = a – bP + fI
Here I is an index of aggregate income or GDP. We assume I = 1.0 in the
base year and long-run income elasticity of demand to be 1.3.

Calculating f: E = (I/Q) (ΔQ/ΔI). Thus,

1.3 = (1.0/18) (f) => f = (1.3)(18)/(1.0) = 23.4
Substitute the values b=3, f=23.4, P*=3.0, and Q*=18 into Q = a – bP + fI
We find that a = 3.6
Question: What would a decline of 20% in demand do to the price of
copper?

Demand Function: Q = 27 – 3P
Þ Q = (0.8) (27 - 3P)
Þ Q = 21.6 – 2.4P
Supply Function: Q = -9 + 9P
Equating Demand and Supply Function:
-9 + 9P = 21.6 – 2.4P
P = 30.6/11.4 = $2.68 per pound
A 10.7 percent decline in price
Why did OPEC fail to keep oil prices high in the
Long-run?
Short-run
• Supply and
Price D S1 S0 demand of oil are
inelastic
• The quantity of
P1 E1 known oil reserves
and oil extraction
capacity cant be
changed
P0 E0

Q1 Q0 Quantity
Why did OPEC fail to keep oil prices high in the
Long-run?
Long-run
• Supply and
Price demand of oil is
relatively elastic
S1 • Non-OPEC
producers increase
E1 S0 their supply
P1
• Consumers
P0 decrease their
E0 D consumption

Q1 Q0 Quantity
Apple iTunes Price Change

• Apple charged 99¢ for each song at the launch of iTunes

• Apple wanted to reconsider its pricing strategy

• Music producers wanted Apple to charge more
• However, Apple lowered its price owing to competition from rivals such as Amazon

• New pricing scheme: 69¢ a song for the older catalog, 99¢ for most new
songs, and $1.29 for the most popular tracks.

• In June 2015, Apple introduced a streaming audio service, Apple Music

• allowing customers to play as many songs as they want for $9.99 per month.
• However, they kept a price of $1.29 for hit songs
Cross-Price Elasticity of Demand

• Measures the percentage change in the quantity demanded of one good

that results from a one percent change in the price of another good

Qb Qb Pm Qb
EQb Pm  
Pm Pm Qb Pm
• Complements Vs. Substitutes??
Cross-Price Elasticities to Guide Strategies in
Digital Markets
Consumers around the globe choose not just among competing firms
offering subscription packages, but typically can also find some or all of the
same content for free within an illegal (pirate) market.

How much does the illegal digital market compete with the legal one?

• In Peru, the cross-price elasticity between Telefonica (the largest

television subscription firm in Peru) and illegal providers is 0.39.
• 10 percent increase in the Telefonica’s price translates into a 3.9 percent increase
in the quantity demanded for illegal content.
• The cross-price elasticity between Telefonica and America Movil, its top
legal competitor, is 0.42.
Price Elasticity and Total Revenue

• Elastic
• Increase (a decrease) in price leads to a decrease (an
increase) in total revenue.
• Inelastic
• Increase (a decrease) in price leads to an increase (a
decrease) in total revenue.
• Unitary
• Total revenue is maximized at the point where demand is
unitary elastic.
 3-43

Elasticity, Total Revenue and Linear

Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-44

Elasticity, Total Revenue and Linear

Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-45

Elasticity, Total Revenue and Linear

Demand

P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-46

Elasticity, Total Revenue and Linear

Demand

P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-47

Elasticity, Total Revenue and Linear

Demand

P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-48

Elasticity, Total Revenue and Linear

Demand

P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 3-49

Elasticity, Total Revenue and Linear

Demand

P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-50

Elasticity, Total Revenue and Linear

Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
The Total Revenue Test for Elasticity
Increase in Decrease in
Total Revenue Total Revenue

Increase in INELASTIC ELASTIC

Price DEMAND DEMAND

Decrease in ELASTIC INELASTIC

Price DEMAND DEMAND
Real World Price Elasticity of Demand

Commodity Elasticity – Short Run Elasticity – Long Run

Clothing 0.90 2.90
Tobacco Products 0.46 1.89
Jewellery and Watches 0.41 0.67
Beer 1.72 2.17
Cheese 1.36 -
Wine 0.88 1.17
Household Natural Gas 1.40 2.10
Electricity – Households 0.13 1.89
Public Transport 0.51 0.69
Gasoline 0.25 0.92
Real World Income Elasticity of Demand

Commodity Elasticity
Wine 2.59
Beef 1.06
Cheese 0.37
Chicken 0.28
Potatoes -0.32
Flour -0.36
Electricity – Household 1.94
Cars 1.63
Gasoline 1.20
Cigarettes 0.50
Petrol 2.682
Milk 0.820
Real World Cross-Price Elasticity of Demand

Commodity X Commodity Y Elasticity – Long Run

Margarine Butter 1.53
Pork Beef 0.40
Natural Gas Electricity 0.80
Coal Oil 0.70
Entertainment Food -0.72
Automobile Bus Transportation 0.07
European Cars US Domestic and Asian 0.76
Cars
A Few Elasticities from the Real
World

55