Managerial Economics: Theory and Applications

MANAGERIAL ECONOMICS
THEORY AND APPLICATIONS
CHAPTER-5
ELASTICITY OF DEMAND
Chapter 5 Elasticity of Demand
Learning Objectives
After completing this chapter, the student should be able to:
1. Explain the concepts and measurements of price, income, cross-price and advertising elasticity of demand and their applications in practice. 2. Trace the determinants of price-elasticity of demand. 3. Determine elasticities of demand from the linear and double-log-linear demand functions. 4. Interpret the case study results in the measurement of demand elasticity.
Himalaya Publishing House
Managerial Economics Theory and Applications Dr. D. M. Mithani
Price-Elasticity of demand Price elasticity of demand is measured as the ratio of percentage changein the quantity demanded of a product to the percentage change in its price.
Types of Price Elasticity

Unit elasticity of demand (e = 1) Elastic demand (e > 1), i.e., elasticity is greater than unity. Inelastic demand (e < 1 ), i.e., elasticity is less than unity.
Perfectly elastic demand; Perfectly inelastic demand; Relatively elastic demand; Unitary inelastic demand; and Relatively inelastic demand.
A case of perfectly inelastic demand Demand for insulin by a diabetic patient is perfectly inelastic. Total Outlay Method
Point elasticity Elasticity measured at a given point on the demand curve (function).
Arc elasticity Average elasticity measured over between a specific range (two points) of a demand curve (function).
Factors Influencing Elasticity of Demand

Nature of commodity Availability of substitutes Number of uses Consumers income Height of price and range of price change Proportion of expenditure Durability of the commodity Habit Complementary goods Time Recurrence of demand Possibility of postponement
Income Elasticity of Demand

Definition: The income elasticity is defined as a ratio percentage or proportional change in the quantity demanded to the percentage or proportional change in income.
Types of Income Elasticity

Unitary income elasticity of demand; (em = 1); Income elasticity of demand greater than unity; (em > 1); Income elasticity of demand less than unity; (em < 1); Zero income elasticity of demand; (em = 0); and Negative income elasticity of demand. (em < 0);
Applications of Income Elasticity

Long-term business planning. In the long run, demand for comforts and luxury goods may tend to be highly income elastic. Hence, prospects for long run growth in sales for these goods are very bright. The firm can plan out its business accordingly. Market strategy. Income elasticity of demand is helpful in developing market strategies. Housing development strategies. On the basis of income elasticity, housing development requirement can be predicted and construction work can be effectively launched upon.
Cross Elasticity of Demand

Cross price elasticity Positive value suggests substitute products. negative value suggests complementary products. Definition. The cross elasticity demand refers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity.
Advertising or Promotional Elasticity of Demand
Illustration: Practical Application

In practice, the price variations and differentials in several businesses such as hotels, air-lines, ferries, coaches, time to time, reflect differences in the level of demand, particularly the varying elasticity of demand at different times such as peak seasons and off-seasons over a year. A telephone company also decides its rate structure into peak rate, standard rate, discount rate etc., at different times of the day. For example, during working day 8.00 a.m. to 7.00 p.m. peak rate is charged on calls, while lower or discount rates are charged during night hours. On public holidays, discount rate is charged. In all such cases, pricing is based on demand consideration rather than the cost element.
Himalaya Publishing House Managerial Economics Theory and Applications Dr. D. M. Mithani
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MANAGERIAL ECONOMICS

THEORY AND APPLICATIONS

Chapter 5 Elasticity of Demand

Himalaya Publishing House