AME – Session 3

Dr. Prema Basargekar

Session Plan
• Define and measure elasticity
• Apply concepts of price elasticity, cross-
elasticity, and income elasticity of Demand
• Understand determinants of elasticity
• Show how elasticity affects revenue
• Elasticity of Supply
Concept of Elasticity
• Elasticity is a measure of responsiveness of one
variable to change in another variable
• It is a percentage change in one variable that arises
due to a given percentage change in another variable.
• Eg. 1) % change in student’s grade due to % change
in time spent on studding
• 2) % change in tax revenue due to change in tax rate
• 3) % change in total production due to change in
wage rate
• Elasticity: the percentage change in dependent
variable relative to a percentage change in
independent variable.

percent change in A
Coefficien t of Elasticity 
percent change in B
Importance of Elasticity Concept
Elasticity of demand measures the degree of
responsiveness of demand to the changes in its
determinants.
1. It helps in taking crucial decisions regarding
manoeuvring of prices with a view to making larger
profits
2. Due to the increase in input price, increase in
excise duty, sales tax, the firm wants to raise price
and pass on the same to the consumer. Can it do so.
The answer lies with the price elasticity of the
product.
Price Elasticity of Demand
 Elasticity
– Responsiveness
 Price elasticity of demand
– Consumers’ responsiveness to a
change in price
– Percentage change in quantity
demanded divided by percentage
change in price
Cross Elasticity
• Cross elasticity of demand: The percentage
change in quantity demanded caused by a 1
percent change in price of the related commodity
i.e. substitute or complementary.

• Ec = %  Quantity X
• %  in Price of Y
Income Elasticity of Demand:

• The percentage change in quantity demanded

caused by a 1 percent change in income.

%Q
EY 
%Y
Price Elasticity of Demand
 Demand Curve for Tacos
If the price of tacos drops from
$1.10 to $0.90, the quantity
demanded increases from
$1.10 a
95,000 to 105,000.
b
0.90
Price per taco

0 95 105 Thousands per day

Elasticity - Taco
• Avg of $ 1.10 & $ 0.90 = $ 1
• Percentage change in Price = -20/1 = 20 %

• Avg of Qd = 95,000 + 105000 = 100000

• Percentage change in Qd = 10000/ 100000
= 10 %

• Ed = 10 % / -20 % = - 0.5
Graphical Measurement
• Linear Demand curve:

• Ep= Lower segment / Upper segment of the D

curve

• Non linear D curve : A tangent is drawn

through a chosen pt Slope of the demand
curve at that pt is same as the slope of a
tangent.
The Price Elasticity of Demand

• Elasticity differs
along a linear
demand curve.
The Price Elasticity of Demand
• Point elasticity: Elasticity measured at a given
point of a demand curve.

dQ P1
εP = x
dP Q1
Example
• If Qx = 50 – 0.5Px
• And if Px = Rs. 10, then find out Ep.

• Qx = 50 – (0.5*10)
• Qx = 50 – 5
• Qx = 45
• Ep = 0.5*(10/45) = -0.23
 Elasticity and Total Revenue
 Total revenue = price * quantity demanded
at this price
 TR= p * q
 As p decreases
 If D elastic, TR increases
 If D inelastic, TR decreases
 If D unit elastic, TR unchanged
Price Elasticity and the Linear D Curve

 Linear D curve
– Constant slope
– Different elasticity
– D becomes less elastic as we move
downward
 D upper half: elastic
 D lower half: inelastic
 D midpoint: unit elastic
 $100
90
(a) Demand and price elasticity
Demand, Price
a
80 Elastic, ED >1
Elasticity, and
Price per unit

70 b
60 Unit elastic, ED =1 Total Revenue
50
40 c Inelastic, ED <1 Where D is elastic, a
30 lower P increases TR
20
d Where D is inelastic, a
10 e D lower P decreases TR

0 100 200 500 800 900 1,000 Quantity per period

(b) Total revenue

25,000
TR reaches a
Total
maximum at the rate
revenue
Total revenue

of output where D is
unit elastic

0 500 1,000 Quantity per period

Explaining graph
• Elasticity of demand between points a & b is =
• = % change in price = 10/ 85 = 12 %
• = % change in Qd = 100/150 = 67 %
• = Ed = 67/12 = 5.6 %

• Elasticity between points d & e is =

• = % change in price = 10/15 = 67 %
• = % change in Qd = 100/850 = 12 %
• = Ed = 12/67 = 0.2
Elasticity and Total Revenue

• Total Revenue – the amount of money a firm

collects through sales
• TR = Price * Quantity
• How is Total Revenue related to Elasticity?
• Recall that a lower price leads to an increase in
quantity demanded…
• Whether Total Revenue increases due to a fall in
price will depend on whether the percentage
increase in the quantity demanded is less than or
greater than the price decrease
 P Elastic
Unit Elastic

Inelastic

Q
TR

Q
What Does this Graph Show?
Should you increase or decrease price to
increase Total Revenue?
In the elastic portion of the demand curve, the %
change in quantity demanded is greater than the
% change in price, so you should decrease price
in order to increase total revenue
In the inelastic portion of the demand curve, the
% change in quantity demanded is less than the
% change in price, so you should increase price
in order to increase total revenue
Total revenue is maximized at the unit elastic
point
Price Elasticity of Demand

• Price Elasticity and Total Revenue

▫ Price cut increases TR if │εP│> 1.

▫ TR remains constant if │εP│= 1.
▫ Price cut decreases TR if │εP│< 1.
Price Elasticity and Marginal Revenue
• Price Elasticity and Price Changes

▫ MR > 0 if │εP│> 1.
▫ MR = 0 if │εP│= 1.
▫ MR < 0 if │εP│< 1.
Marginal Revenue and Price Elasticity of Demand

PX EP  1
EP  1

EP  1

MRX
QX
Marginal Revenue, Total Revenue, and Price Elasticity

MR>0 MR<0

EP  1 EP  1
TR

1
EP MR=0

QX
Constant-Elasticity Demand Curves

 Perfectly elastic D curve

– Horizontal; ED = ∞
– Consumers don’t tolerate P increases
 Perfectly inelastic D curve
– Vertical; ED = 0
– ‘Price is no object’
 Unit-elastic D curve
– %∆p causes an exact opposite %∆q
 Constant-Elasticity Demand Curves
(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

Price per unit

Price per unit
Price per unit

D’

ED ’’ = 1
ED’’ = 0
ED = ∞ $10 a
p D
b
6
D’’

0 Quantity per period0 Q 0

Quantity 60 100 Quantity
per period per period
Consumers demand all quantity
offered for sale at p, but demand Consumers demand Q Total revenue is the same
nothing at a price above p regardless of price for each p-q combination
 Summary of Price Elasticity of Demand
Effects of a 10 Percent Increase in Price
Determinants of Elasticity
1- Availability of substitutes.
Higher the degree of closeness of substitutes
the greater the elasticity of demand for the commodity.
Ex-Pepsi & Coca cola

2-Nature of the commodity

Luxury goods demand more elastic as their demand can be postponed
when price is high as against necessities.
Demand for durables is more elastic than non durables.

3 – Broad category
The elasticity of products defined broadly is less as compared with the
products which are defined narrowly. As it has few substitutes
Determinants of Elasticity
4- Weightage in the total consumption
The more the weightage in total expenditure, the higher is the
value of elasticity

5- Time factor in adjustment of consumption pattern.

In the long run the elasticity is high as more substitutes/
alternatives become available.

6- Range of commodity use-

Wider the range of uses of a commodity, higher is the elasticity of
demand. Ex- milk, elect. for reduction in prices.
For the increase in price, the commodity has a lower elasticity
because the consumption of normal goods cannot be cut down
substantially beyond a point.
 Demand Becomes More Elastic over Time

Dw: one week after the price increase

Price per unit

$1.25 Dm: one month after the price increase

Dy: one year after the price increase

1.00 e

Dy
Dw Dm

0 50 75 95 100 Quantity per day

Dy is more elastic than Dm , which is more elastic than Dw
Selected Price Elasticities of Demand (Absolute
Values)
Class activity
• Will elasticity of demand for Bajaj Pulzer more
or less for elasticity of motorcycles? Explain.

• Why do Amusement parks charge lower price to

children and higher price to adults even though
the service is exactly same?

• If Ep > 1, and if price fall down the TR will

_____ (rise/ fall)
Class activity
• Daily demand for Bata shoes is estimated to be
• Qdx = 100 -3Px +4Py – 0.01M + 2Ax
• Where Px = $25; Py = $ 35; M = $ 20,000
• The company utilizes 50 units of advertising.
• Calculate and interprete price , income and cross
elasticities.
Answer
• Qx = 100 – 3(25) + 4(35) – 0.1(20,000) + 2 (50) = 65
units
• Epx = -3(25/65) = -1.15
• The demand for shoes is price elastic. Thus fall in price
will increase total revenue.
• Epy = 4(35/65) = 2.15
• Cross price elasticity is positive. Thus product ‘Y’ is a
substitute.
• Em = -0.01(20,000/65) = - 3.08
• Income elasticity is negative. Thus product is inferior and
rise in income will reduce the demand.
 Price Elasticity of Supply

 Elasticity
– Responsiveness
 Price elasticity of supply
– Producers’ responsiveness to a change in price
– Percentage change in quantity supplied divided
by percentage change in price
 Price Elasticity of Supply

%q
ES 
%p
q p
ES  
(q  q' ) / 2 ( p  p' ) / 2
 Law of supply
 ES positive
 Price Elasticity of Supply
S
Price per unit

If the price increases from p

p’ to p’, the quantity supplied
increases from q to q’.
Price and quantity supplied
p move in the same direction,
so the price elasticity of
supply is a positive number.

0 q q’ Quantity per period

 Categories of ES

 If %∆q < %∆p

– ES between 0 and 1
– Inelastic S
 If %∆q > %∆p
– ES greater than 1
– Elastic S
 If %∆q = %∆p
– ES = 1
– Unit elastic S
Constant-Elasticity Supply Curves

 Perfectly elastic S curve

– Horizontal; ES = ∞
– Producers supply 0 at a price below P
 Perfectly inelastic S curve
– Vertical; ES = 0
– Goods in fixed supply
 Unit-elastic S curve
– %∆p causes an exact opposite %∆q
– S curve is a ray from the origin
 Constant-Elasticity Supply Curves
(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

Price per unit

Price per unit
Price per unit

S’
S’’
ES’’ = 1

ES’ = 0
ES = ∞ $10
p S
5

0 0
Quantity Q 0
Quantity 10 20 Quantity
per period per period per period
Firms supply any amount of
output demanded at p, but Quantity supplied is Any %∆p results in the
supply 0 at prices below p. independent of the price same %∆q supplied.
 Determinants of Supply Elasticity

 ES is greater:
– If the marginal cost rises
slowly as output expands
– The longer the period of
adjustment (time)
 Supply Becomes More Elastic over Time
Sw Sm
Sw: one week after the
Sy
price increase
$1.25
Sm: one month after the
Price per unit

price increase
1.00
Sy: one year after the
price increase

0 100 110 140 200 Quantity per day

Sw is less elastic than Sm, which is less elastic than Sy

Income Elasticity of Demand
 Demand responsiveness to a change in
consumer income
 Percentage change in demand divided by the
percentage change in income that caused it
 Inferior goods
– Negative income elasticity
 Normal goods
– Positive income elasticity
Example of Income Elasticity
• If income elasticity of demand for ‘Ganesh’
brand of notebooks is – 1.94 and if you expect
consumer incomes to rise by 10%, how will this
forecast affect the demand for ‘Ganesh’
notebooks? What is the nature of this good?

• -1.94 = % change Qd(G) / 10

• = -19.4
• Inferior product
Income Elasticity of Demand

 Normal goods
– Income inelastic
• Elasticity between 0 and 1
• Necessities
– Income elastic
• Elasticity > 1
• Luxuries
Selected Income Elasticities of Demand
Cross-Price Elasticity of Demand

 Responsiveness of D for one good to

changes in P of another good
 %∆ in demand for one good divided by %∆
in price of another good
– If positive: substitutes
– If negative: complements
– If zero: unrelated
Cross-price Elasticity of Demand
• Cross-price elasticity shows demand sensitivity to changes in
other prices.
▫ εPX = ∂QY/QY ÷ ∂PX/PX.

• Substitutes have εPX > 0.

▫ E.g., Coke demand and Pepsi prices.

• Complements have εPX < 0.

▫ E.g., Coke demand and Lay’s prices.
Two products are considered good substitutes or complements
when the coefficient is larger than 0.5.

• Independent goods have εPX = 0.

▫ E.g., Coke demand and Car prices.
Example of Cross Elasticity
• If cross price elasticity of demand for Harry
potter books and Harry potter Movies is found
out to be 0.15. And if price of Harry Potter books
is likely to rise by 15%, how will this affect the sale
of Harry Potter movies? Find out whether Books
and Movies are substitute or complementary.

• 0.15 = % change in Qd(m)/15

• = % change in Qd(m) = 2.25
Using Elasticity for Managerial Decisions

The firm can identify all the factors which affect

the demand for the product.

The firm can use relevant information to estimate

the elasticity for each variable & can arrive at
optimum result.

1. Price elasticity
2. Cross elasticity
3. Income elasticity
4. Advertisement elasticity
Class Activity
• How will you use ‘Elasticity’ in business?
• 1. You are working for Maruti Udyog where Zen and Alto
are substitute to each other.
• 2. You are working for HP where Laptop and Printers are
complements to each other.
• 3. You are working for a diamond factory which requires
a specially trained and skilled workforce.
• 4. You have to decide the advertisement budget for the
new hair colour your company is going to launch.
• 5. You are working for Pepsi and you come to know that
Coca cola is planning to reduce its price by 10 %
Use and application of concept of price
elasticity
• A firm can reduce the price so as to maximise TR
till price elasticity is greater than one.
• A firm can increase the price so as to maximise
TR till the price elasticity is less than one.
• When price elasticity is equal to one, TR is
maximum.
Use and application of the concept of
income elasticity
• In a market economy, income and employment do not
increase steadily. They fluctuate as per business cycles in the
economy. Income elasticity helps in finding out to what
extent the demand for the product will rise or reduce as per
the changes in PCI in the country.
• In expansionary phase, if Ey >1, the demand wd rise more
than proportionate rise in Y; if Ey > 0 but <1; the demand
would rise less than proportionate rise in Y; if Ey < 0, the
demand wd fall with rise in Y.
• It has a greater significance in production planning &
management in the long run. It can be useful in forecasting
demand, in avoiding over or under production.
Use and application of the concept of cross
elasticity
• It helps a firm to understand which other products are
its close substitute or close complements and
understand their impact on its own product’s sale.
• It helps in planning for production, marketing and
pricing policies.
• It helps in understanding the impact of change in price
of one product on demand for another product when a
firm is producing two complementary products or two
substitute products.
• It also helps in determining the borderline between
different industries.
Use and application of concept of elasticity
in decision making
• Advertisement elasticity: useful in determining
optimal level of advertisement expenditure.
• Tax elasticity – useful for determining the
rational tax rate
• Labour elasticity – useful for determining
incentives and wage rate
• Price, income and cross elasticity- useful for
understanding gains from trade in
understanding International trade
• Supply elasticity- useful for designing incentive
policies for the government for firms.
 Some examples of Elasticity
• Price elasticity of demand - cars:
▫ BMW 735i = -9.376
▫ Honda Accord = -51.637
▫ Ford Escort = -106.497

• Cross-price elasticity of demand - cars:

▫ BMW 735i & Lexus LS400 = 0.336
▫ BMW 735i & Honda Accord = 0.203
▫ BMW 735i & Ford Escort = 0.009

• Which cars are close substitutes? Which

consumers are most price sensitive?
Elasticity of Soft Drinks

• Price elasticity of demand:

▫ Coke (2-liter bottle) = -3.89
▫ 7-Up (2-liter bottle) = -4.25
▫ Mountain Dew (2-liter bottle) = -3.75

• Cross-price elasticity of demand:

▫ Coke & Pepsi = 0.63
▫ Coke & Mountain Dew = 0.12
▫ Coke & Diet Coke = 0.81
Questions to think about?

• Why is the price elasticity of the Ford Escort

higher than the BMW?

• Why is the price elasticity of soft drinks less

than the price elasticity of cars?

• Why is the cross-price elasticity of BMW and

Ford Escort lesser than cross elasticity of
BMW and Lexus?
In-Class Problem to Solve
• Last year, Mahesh had an income of Rs. 40,000 from his
job at the XYZ Chemical Plant. At that level of income,
Mahesh consumed 15 units of Good X. This year,
Mahesh received a Rs. 15,000 raise. After his raise, he
consumed 18 units of Good X.
a. Using the above information, please calculate
Mahesh’s income elasticity of demand.
b. Is Good X a normal or inferior good?
c. If Mahesh’s boss gave him an additional 10% raise,
what would happen to Mahesh’s consumption of
Good X?
Solutions
q new  qold I new  I old
EI  
 qnew  qold  / 2  I new  I old  / 2
18  15 55,000  40,000
 
18  15 / 2 (55,000  40,000) / 2
3 15,000
   0.1875  0.3158
16.5 47,500
 0.59

• Normal good => EI > 0

% change in consumptio n
EI 
% change in income
?
 0.59   ?  5.9
10
Concepts learnt
• Elasticity
• Elasticity of demand
• Price, income, cross and advertisement elasticity
• Measurement of elasticity – ratio, arc, graphical, and
point elasticity
• Categories of elasticity of demand
• Determinants of elasticity of demand
• Elasticity of supply
• Determinants of elasticity of supply
• Use and application of concept of elasticity in managerial
decision making