Download Price elasticity of demand

10 : Theory of Demand
1
Recap from last session
Change in Demand
Supply, Law of Supply
Market Equilibrium
Change in Equilibrium
Prof. Trupti Mishra, School of Management, IIT Bombay
2
A Shift in Both Supply and Demand
Price of
Ice-Cream
Cone
Large increase
in demand
New
equilibrium
S2
S1
P2
Small
decrease in
supply
P1
D2
Initial equilibrium
D1
0
Q1
Q2
Prof. Trupti Mishra, School of Management, IIT Bombay
Quantity of
Ice-Cream
Cone
3
A Shift in Both Supply and Demand
Price of
Ice-Cream
Cone
Small increase
in demand
S2
New
equilibrium
S1
P2
Large
decrease in
supply
P1
Initial
equilibrium
D2
D1
0
Q2
Q1
Prof. Trupti Mishra, School of Management, IIT Bombay
Quantity of
Ice-Cream
Cone
4
Simultaneous Shifts
 When demand & supply shift simultaneously
 Can predict either the direction in which price changes or
the direction in which quantity changes, but not both
 The change in equilibrium price or quantity is said to be
indeterminate when the direction of change depends on
the relative magnitudes by which demand & supply shift
Prof. Trupti Mishra, School of Management, IIT Bombay
5
What Happens to Price and Quantity when Supply or
Demand Shifts?
Prof. Trupti Mishra, School of Management, IIT Bombay
6
Session Summary
• The demand curve shows how the quantity of a good depends
upon the price.
– According to the law of demand, as the price of a good falls, the
quantity demanded rises. Therefore, the demand curve slopes
downward.
Prof. Trupti Mishra, School of Management, IIT Bombay
7
Session Summary
– In addition to price, other determinants of how much
consumers want to buy include income, the prices of
complements and substitutes, tastes, expectations,
and the number of buyers.
– If one of these factors changes, the demand curve
shifts.
Prof. Trupti Mishra, School of Management, IIT Bombay
8
Session Summary
• The supply curve shows how the quantity of a good
supplied depends upon the price.
• According to the law of supply, as the price of a good
rises, the quantity supplied rises.
supply curve slopes upward.
Therefore, the
Prof. Trupti Mishra, School of Management, IIT Bombay
9
Session Summary
• In addition to price, other determinants of how much
producers want to sell include input prices, technology,
expectations, and the number of sellers.
• If one of these factors changes, the supply curve shifts.
Prof. Trupti Mishra, School of Management, IIT Bombay
10
Session Summary
• Market equilibrium is determined by the intersection of
the supply and demand curves.
• At the equilibrium price, the quantity demanded equals
the quantity supplied.
• The behavior of buyers and sellers naturally drives
markets toward their equilibrium.
Prof. Trupti Mishra, School of Management, IIT Bombay
11
Elasticity of Demand
• From the managerial point of view, the knowledge of the
nature of relationship between
• product’s demand and its determinants is not sufficient. What
is more important is the degree of responsiveness of demand
to changes in its determinants.
Prof. Trupti Mishra, School of Management, IIT Bombay
12
Elasticity of Demand
• It allows us to analyze demand with greater precision.
• It is a measure of how much buyers and sellers respond to
changes in market conditions
Prof. Trupti Mishra, School of Management, IIT Bombay
13
Elasticity of Demand measures the degree of responsiveness
of the quantity demanded of a commodity to a given change in
any of the determinants of demand.
Prof. Trupti Mishra, School of Management, IIT Bombay
Types of Elasticity of Demand
Price elasticity of Demand
Income Elasticity of Demand
Cross Elasticity of Demand
Prof. Trupti Mishra, School of Management, IIT Bombay
Price elasticity of demand is a measure of how much the
quantity demanded of a good responds to a change in the
price of that good.
Percentage change in quantity demanded given a percent
change in the price.
Prof. Trupti Mishra, School of Management, IIT Bombay
Price Elasticity of Demand
% Q
% P
P & Q are inversely related by the law of demand so E is
always negative.
E
The larger the absolute value of E, the more sensitive buyers
are to a change in price
Prof. Trupti Mishra, School of Management, IIT Bombay
Degree of Price Elasticity of Demand
Inelastic Demand
Quantity demanded does not respond strongly to price
changes.
Elastic Demand
Quantity demanded responds strongly to changes in price.
Prof. Trupti Mishra, School of Management, IIT Bombay
Degree of Price Elasticity of Demand
Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in
price.
Unit Elastic
Quantity demanded changes by the same percentage as the
price.
Prof. Trupti Mishra, School of Management, IIT Bombay
Degree of Price Elasticity of Demand
Price
Price
D
D
Quantity
Perfectly Elastic
E =∞
Quantity
Perfectly Inelastic
Ep = 0
Prof. Trupti Mishra, School of Management, IIT Bombay
Inelastic Demand
Price
Demand
E<1
5.00
4.00
1. A 25%
increase in
price…
0
90
100
Quantity
2. … Leads to a 10% decrease in quantity demanded.
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21
Unit Elastic Demand
E=1
Price
Demand
5.00
4.00
1. A 25%
increase in
price…
0
75
100
Quantity
2. … Leads to a 25% decrease in quantity demanded.
Prof. Trupti Mishra, School of Management, IIT Bombay
22
Elastic Demand
E>1
Price
Demand
5.00
4.00
1. A 25%
increase in
price…
0
50
100
Quantity
2. … Leads to a 50% decrease in quantity demanded.
Prof. Trupti Mishra, School of Management, IIT Bombay
23
The own-price elasticity can be measured between two
points on a demand curve (for arc elasticity) or on a
point ( for point elasticity)
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24
Measurement of Price Elasticity of Demand
Point Elasticity of Demand
E
% Q
% P
Q
Q
P
P
100
100
Q
P
P
Q
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ARC Elasticity of Demand
E
Q
P
Average P
Average Q
Total Revenue and Price Elasticity of Demand
Price
4.00
P x Q = 400
(revenue)
Demand
0
100
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Quantity
27
How Total Revenue Changes When Prices Changes: Inelastic
Demand
Price
3.00
P x Q = 240
(revenue)
1.00
P x Q = 100
(revenue)
0
Demand
80
100
Prof. Trupti Mishra, School of Management, IIT Bombay
Quantity
28
How Total Revenue Changes When Prices Changes: Elastic
Demand
Price
Change in Total Revenue when Price Changes
5.00
4.00
Demand
Revenue = 200
Revenue = 100
0
20
50
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Quantity
29
A Linear Demand Curve
Price
Elasticity
is larger
than 1.
7
6
5
4
Elasticity
is smaller
than 1.
3
2
1
0
2
4
6
8
10
12
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14
Quantity
30
Price Elasticity & Total Revenue
Elastic
Unitary elastic
Inelastic
Q-effect dominates
No dominant effect
P-effect dominates
% Q
% P
% Q
% P
% Q
% P
Price
rises
TR falls
No change in TR
TR rises
Price
falls
TR rises
No change in TR
TR falls
Prof. Trupti Mishra, School of Management, IIT Bombay
31
Determinants of Price Elasticity of Demand
Nature of Commodity :
The demand for luxury goods is more price-elastic than the
demand for necessities and comforts.
The demand for necessity goods is price-inelastic.
Comforts have more elastic demand than necessities, and less
elastic demand than luxuries.
Prof. Trupti Mishra, School of Management, IIT Bombay
Determinants of Price Elasticity of Demand
Availability and proximity of Substitutes : The higher the degree
of closeness between the commodity and its substitutes, the
greater the price-elasticity of demand for the commodity.
Prof. Trupti Mishra, School of Management, IIT Bombay
Determinants of Price Elasticity of Demand
Proportion of Income Spent on the Commodity: The larger the
proportion of income spent on a commodity, the greater will be
the elasticity of demand for such commodity, and vice versa.
Prof. Trupti Mishra, School of Management, IIT Bombay
Determinants of Price Elasticity of Demand
Time: The longer the adjustment time, the greater the priceelasticity of demand
Prof. Trupti Mishra, School of Management, IIT Bombay
Determinants of Price Elasticity of Demand
Durability of the Commodity
Items of addiction
Prof. Trupti Mishra, School of Management, IIT Bombay
Income Elasticity of Demand
Income elasticity (EM) measures the responsiveness of quantity
demanded to changes in income, holding the price of the good &
all other demand determinants constant.
EM
% Qd
% M
Qd
M
M
Qd
Prof. Trupti Mishra, School of Management, IIT Bombay
Income Elasticity of Demand
Positive for a normal good
Negative for an inferior good
Zero for a neutral goods
Prof. Trupti Mishra, School of Management, IIT Bombay
Income Elasticity of Demand
If Em > 1, Luxury good
If Em < 1, Necessity Goods
If Em = 1, Semi Luxury goods
Prof. Trupti Mishra, School of Management, IIT Bombay
Cross-Price Elasticity of demand
Cross-price elasticity of demand
(EXY) measures the
responsiveness of quantity demanded of good X to changes in
the price of related good Y, holding the price of good X & all
other demand determinants for good X constant
Prof. Trupti Mishra, School of Management, IIT Bombay
40
Cross-Price Elasticity of demand
E XY
% QX
% PY
QX
PY
PY
QX
 Positive when the two goods are substitutes
 Negative when the two goods are complements
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41
Promotional/ Advertising Elasticity of Demand
 It measures the response of quantity demanded to change in
the expenditure on advertising and other sales promotion
activities.
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42
Promotional/ Advertising Elasticity of Demand
Ea = ∂Q/∂A.A/Q
Q= quantity of goods sold
A= unit of advertising expenditure on goods
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43
Session References
Managerial Economics; D N Dwivedi, 7th Edition
Managerial economics – Christopher R Thomas, S Charles
Maurice and Sumit Sarkar
Managerial economics – Geetika, Piyali Ghosh and Purba Roy
Choudhury
Managerial economics- Paul G Keat, Philip K Y Young and
Sreejata Banerjee
Micro Economics : ICFAI University Press
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44
Numericals
Demand Schedule
Price
Quantity Demanded
3
20
4
15
5
11
6
9
7
7
Compute point price elasticity of demand for decrease in price from Rs 6 to 5.
Compute point price elasticity of Demand for a increase in price from Rs 5 to 6.
45
Price
Quantity Demanded
10
30
11
25
12
21
13
18
The current price is Rs 12 per kg. Compute E using arc method for an
increase in price by one rupee per kg.
Prof. Trupti Mishra, School of Management, IIT Bombay
46