ID 2301 – INDUSTRIAL MANAGEMENT 1

ECONOMICS MANAGEMENT

Lecture 06 for E20 Batch

DR.U.FAROOK, [email protected], 0763230144

FORMERLY, HEAD OF THE DEPARTMENT OF MECHANICAL ENGINEERING,
FACULTY OF ENGINEERING,
SOUTH EASTERN UNIVERSITY OF SRI LANKA
DETERMINATION OF MARKET PRICE IN
PERFECT COMPETION

Elasticity, Cross Elasticity

Effect of Demand and supply in perfect competion
Elasticity of demand
Elasticity of Demand refers to the degree of responsiveness of quantity
demanded to the changes in the determinants of demand.
There are mainly three quantifiable determinants of demand:-

Price of the Good

Income of the Consumer
Price of the Related Goods

Types of Elasticity of Demand

As we have seen above there are three quantifiable determinants of demand,

Hence, elasticity of demand can be of three types

Price Elasticity of Demand

Income Elasticity of Demand
Cross Elasticity of Demand
Concept of elasticity of demand

Alfred Marshall introduced the concept of elasticity in

1890 to measure the magnitude of percentage change
in the quantity demanded of a commodity to a certain
percentage change in its price or the income of the
buyer or in the prices of related goods.
Price elasticity of demand

Definition
Price Elasticity of demand is the degree of
responsiveness of demand to a change in its price. In
technical terms it is the ratio of the percentage
change in demand to the percentage change in
price.
Price elasticity of demand
Ep = Percentage change in quantity demanded/Percentage change in
price

In mathematical terms it can be represented as: Ep =(∆q/∆p) (p/q); From the

definition it follows that
When percentage change in quantity demanded is greater than the
percentage change in price then, price elasticity will be greater than one
and in this case demand is said to be elastic.

When percentage change in quantity demanded is less than the percentage

change in price then, price elasticity will be less than one and in this case
demand is said to be inelastic.

When percentage change in quantity demanded is equal to the percentage

change in price then price elasticity will be equal to one and in this case
demand is said to be unit elastic.
Numerical example
Let us consider a situation where Price of a cup of tea has increased from Rs.40 to Rs.45
and as a result of this demand for cups of tea has declined from 50 cups to 48 cups.

Percentage change in demand = (New demand – Old demand)/ Old demand

= (48-50)x100 /50 = -2 x100 /50 = -0.04 = -4 %

Percentage change in price = (45-40)x 100/40 = 5x100 /40 = 500/40 = 12.5 %

Price elasticity of demand = -4/12.5 = -0.32

Since the Elasticity of Demand is less than one Demand is inelastic . In other
words, we can say that for a 12.5% increase in price, demand has declined only
by 4% . The negative sign indicates the inverse relationship between demand
and price.
Diagrammatic representation of Price Elasticity of Demand
Determinants of price elasticity of demand

There are number of factors which determine the price elasticity of demand. Let
us consider some of these factors.
Firstly, if close substitutes are available then there is a tendency to shift from one
product to another when the price increases and demand is said to be elastic.
For example, demand for two brands of tea. If the price of one brand A increases
then the demand for the other brand B increases. In other words greater the
possibility of substitution greater the elasticity.
Secondly, how much of the income is spent on a commodity by the consumer.
Greater the proportion of income spent on the commodity greater will be the
elasticity.
Thirdly, the number of uses to which the commodity can be put is important
factor determining elasticity. If the commodity can be put to many uses then the
elasticity will be greater.
Determinants of price elasticity of demand

Fourthly, if two commodities are consumed jointly then increase in the price of
one will reduce the demand for both.
Fifthly, time element has an important role to play in determining the elasticity of
demand . Demand is more elastic if time involved is long. In the short run , it is
difficult to substitute one commodity for another.
Sixthly, Cost of switching between different products and services. There may be
significant transaction costs involved in switching. In this case demand tends to
be relatively in-elastic. For example ,mobile phone service providers may include
penalty clauses in their contracts.
Seventhly, Who makes the payment, Where the purchaser does not directly pay
for the good they consume, such as perks enjoyed by employees, demand is
likely to be more inelastic.
Finally, Brand Loyalty, An attachment to a certain brand either out of tradition or
because of propriety barriers can override sensitivity to price changes, resulting in
more inelastic demand.
Income elasticity of demand

Definition
In economics, income elasticity of demand measures
the responsiveness of the quantity demanded for a
good or service to a change in the income of the
people demanding the good.
Numerical example

It is calculated as the ratio of the percentage

change in quantity demanded to the percentage
change in income. For example, if in response to a
10% increase in income, the quantity demanded
for a good increased by 20%, the income elasticity
of demand would be 20%/10% = 2.
Interpretation

Inferior goods' demand falls as consumer income increases as

shown in the figure.
A negative income elasticity of demand is associated with inferior
goods; an increase in income will lead to a fall in the demand and
may lead to changes to more luxurious substitutes.
A positive income elasticity of demand is associated with normal
goods; an increase in income will lead to a rise in demand. If
income elasticity of demand of a commodity is less than 1, it is
a necessity good. If the elasticity of demand is greater than 1, it is
a luxury good or a superior good.
.
 Interpretation
Income elasticity of demand can be used as an indicator of industry
health, future consumption patterns and as a guide to firms investment
decisions. For example, an increasing portion of consumer's budgets
will be devoted to purchasing automobiles and restaurant meals and
a smaller share to tobacco and margarine.
Income elasticities are closely related to the population income
distribution and the fraction of the product's sales attributable to
buyers from different income brackets. Specifically when a buyer in a
certain income bracket experiences an income increase, their
purchase of a product changes to match that of individuals in their
new income bracket.
Types of income elasticity of demand

There are five possible income demand curves:

1. High income elasticity of demand:

In this case increase in income is accompanied by relatively larger
increase in quantity demanded. Here the value of coefficient Ey is
greater than unity (Ey>1). E.g.: 20% increase in quantity demanded
due to 10% increase in income.

2. Unitary income elasticity of demand:

In this case increase in income is accompanied by same
proportionate increase in quantity demanded. Here the value of
coefficient Ey is equal to unity (Ey=1). E.g.: 10% increase in quantity
demanded due to 10% increase in income.
Types of income elasticity of demand
3. Low income elasticity of demand:
In this case proportionate increase in income is accompanied by less than
increase in quantity demanded. Here the value of coefficient Ey is less than unity
(Ey<1). E.g.: 5% increase in quantity demanded due to 10% increase in income.

4. Zero income elasticity of demand:

This shows that quantity bought is constant regardless of changes in income.
Here the value of coefficient Ey is equal to zero (Ey=0). E.g.: No change in
quantity demanded even 10% increase in income.

5. Negative income elasticity of demand:

In this case increase in income is accompanied by decrease in quantity
demanded. Here the value of coefficient Ey is less than zero/negative (Ey<0).
E.g.: 5% decrease in quantity demanded due to 10% increase in income.
Cross elasticity of demand

Definition
Cross elasticity of demand (XED) is the responsiveness
of demand for one product to a change in the price
of another product. Many products are related, and
XED indicates just how they are related.
Numerical example

Cross Elasticity of Demand

= XRD

= % change in the quantity of good B/ % change in price of good A

Numerical example
Substitutes
When XED is positive, the related goods are substitutes. For example, if the price of Coca
Cola increases from 50p to 60p per can, and the demand for Pepsi Cola increases from 1m
litres to 2m litres per year, the XED between the two products is:

+100/+20 = (+) 5
The positive sign means that the two goods are substitutes, and because the coefficient is
greater than one, they are regarded as close substitutes.

Complements
When XED is negative, the goods are complementary products. The equation is the same
as for substitutes.
For example, if the price of Cinema Tickets increases from £5.00 to £7.50, and the demand
for Popcorn decreases from 1000 tubs to 700, the XED between the two products will be:

-30/+50 = (-) 0.6

The negative sign means that the two goods are complements, and the coefficient is less
than one, indicating that they are not particularly complementary.
Why does a firm want to know XED?

Knowing the XED of its own and other related products enables
the firm to map out its market. Mapping allows a firm to calculate
how many rivals it has, and how close they are. It also allows the
firm to measure how important its complementary products are to
its own products.

This knowledge allows the firm to develop strategies to reduce its

exposure to the risks associated with price changes by other firms,
such as a rise in the price of a complement or a fall in the price of
a substitute.

Risks also can be reduced in a number of ways.

Thank you