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FINC304

Quantitative Demand Analysis

Session 4– Elasticity

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS


Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
Session Overview
• In Session 2, we looked at the qualitative relationship
between demand and the factors that influence demand. The
relationship we studied just gave the direction in which
demand will change when the factors of demand change.
What managers are interested in more is the magnitude by
which the demand for their products will change when any of
the factors change. This is useful in making predictions for the
firm. Again, when managers change the price of their
products, it has repercussions for their revenue. It is
important for managers to identify how the demand for their
products will respond to changes in the price of their product
as this has repercussions for their revenue. This session seeks
to address all these issues.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2


Session Outline
The key topics to be covered in the session are as follows:
• Price Elasticity of Demand
• Relationship between Price Elasticity of Demand and Total
Revenue
• Income Elasticity of Demand
• Cross Price Elasticity of Demand

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3


Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4


Elasticity of Demand
• Elasticity: Measures the Responsiveness of one
variable to a change in another variable
• Relationships established between two variables
make it easy for elasticity to be calculated
• Usually expressed as a ratio of percentage changes
• Elasticity of Demand: responsiveness of demand to
changes in the factors that influence demand
• Several elasticities then: goods own price, cross
price elasticity and income elasticity

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5


Elasticity of Demand
• We commonly study three main elasticities
Own price elasticity, income elasticity and cross price
elasticity
• Own price elasticity: responsiveness of quantity
demanded to changes in the own price of a good
• Cross price elasticity: responsiveness of quantity
demanded to changes in the price of related products
• Income elasticity: responsiveness of quantity demanded
to changes in the income of the consumer

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6


Own Price Elasticity of Demand
• Mathematically expressed as %change in quantity
divided by the % change in price of the own product
• Always negative because of the law of demand which
shows a negative relationship between price and
quantity
• To make interpretation easier, use absolute values
• If ED > 1 elastic
• If ED < 1 inelastic
• If ED = 1 unit elastic
• If ED = ∞ perfectly elastic
• If ED = 0 perfectly inelastic

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7


Elasticity and Total Revenue Test
• Revenue=Price*Quantity
• If Demand is elastic, %change in quantity>%change
in price.
• Meaning quantity effect is bigger than price effect
which means the direction of quantity will dominate
total effect
• Hence, if price rises, and quantity falls, Total revenue
will fall
• Using the same principle, total revenue will rise if
price rises when demand is inelastic.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 8


Application on Total Revenue Test
• A phone company operates in two markets. In
market one, research suggests that the price
elasticity is -0.5 and on the other market -1.4. The
company has decided to revise fares upwards on
both markets by 10% this year. Comment on the
decision. What alternative pricing strategy would you
suggest?

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 9


Answer
• It is a good decision on market 1 but not on the
other market. From the total revenue test, when
demand is price elastic, price and total revenue move
in the opposite direction and when demand is price
inelastic, total revenue and price move the same
direction. Since demand is price inelastic on market
1, raising prices would increase sales. For the other
market, demand is price elastic so a better strategy
would be to decrease prices.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10


Review of Last Class
Elasticity
Quantitative Demand Analysis

Determinants of Price Elasticity of Demand

Availability of substitutes
If a good has more substitutes PED will be higher
There are more substitutes for Coca-Cola than there are for
soft drinks

Slide 11
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Determinants of Price Elasticity of Demand

Availability of substitutes
If a good has more substitutes PED will be higher
There are more substitutes for Coca-Cola than there are for
soft drinks
Expenditure share
If a commodity makes a higher fraction of his budget on a
good, the demand tends to be price-elastic

Slide 12
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Determinants of Price Elasticity of Demand

Availability of substitutes
If a good has more substitutes PED will be higher
There are more substitutes for Coca-Cola than there are for
soft drinks
Expenditure share
If a commodity makes a higher fraction of his budget on a
good, the demand tends to be price-elastic
Time
The more time that passes (since price changes), the higher
the price elasticity of demand for the good will be; the less
time that passes, the lower the price elasticity of demand for
the good.

Slide 13
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Cross-Price elasticity of demand

Shows the responsiveness of the demand for a good to


changes in the price of a related good
%�Q xd ∂ Qxd P
Ex,y = %�Py = ∂ Py ∗Q dyx

Slide 14
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Cross-Price elasticity of demand

Shows the responsiveness of the demand for a good to


changes in the price of a related good
%�Q xd ∂ Qxd P
Ex,y = %�Py = ∂ Py ∗Q dyx
Sign contains useful information about the relationship
between good x and good y
If Ex,y > 0 goods x and y are substitutes
If Ex,y < 0 goods x and y are complements

Slide 15
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand


Cross-price elasticity of demand is useful for pricing related
commodities
especially firms that sell multiple products

Slide 16
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand


Cross-price elasticity of demand is useful for pricing related
commodities
especially firms that sell multiple products
If goods X and Y are related, we can show the overall impact
of a small change in the price of X on total sales from X and
Y as follows:
D.R = [Rx (1 + Exx ) + Ry Ey,x ] ∗%D.Px
Where R is total revenue, Rx , Ry are total revenues from X and
Y respectively, and Exx is the own price elasticity of demand for
X

Slide 17
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand


Cross-price elasticity of demand is useful for pricing related
commodities
especially firms that sell multiple products
If goods X and Y are related, we can show the overall impact
of a small change in the price of X on total sales from X and
Y as follows:
D.R = [Rx (1 + Exx ) + Ry Ey,x ] ∗%D.Px
Where R is total revenue, Rx , Ry are total revenues from X and
Y respectively, and Exx is the own price elasticity of demand for
X
Suppose a kenkey seller’s sales typically includes 800 from
kenkey and 1,500 from fish
if the own price elasticity of demand for -1.3 and the cross-price
elasticity is -3.5, by how much will the kenkey seller’s revenue
change if she decreases the price of her kenkey by 5%
Slide 18
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand

Plugging the values into the formula, we have: Cross-price


elasticity of demand is useful for pricing related commodities
D.R = [Rx (1 + Exx ) + Ry Ey,x ] ∗%D.Px =
[800(1 − 1.30) + 1500 ∗ −3.5] ∗ −5%
D.R = 2745

Slide 19
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand

Plugging the values into the formula, we have: Cross-price


elasticity of demand is useful for pricing related commodities
D.R = [Rx (1 + Exx ) + Ry Ey,x ] ∗%D.Px =
[800(1 − 1.30) + 1500 ∗ −3.5] ∗ −5%
D.R = 2745
In other words, reducing the price of kenkey by 5% will
increase her total revenue by GHC 2745

Slide 20
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Application of Cross-Price elasticity of demand

Plugging the values into the formula, we have: Cross-price


elasticity of demand is useful for pricing related commodities
Change in R = [Rx (1 + Exx ) + Ry Ey,x ] ∗
%change in .Px = [800(1 − 1.30) + 1500 ∗
−3.5] ∗ −5%
D.R = 2745
In other words, reducing the price of kenkey by 5% will
increase her total revenue by GHC 2745
What is the intuition behind this?

Slide 21
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Income elasticity of demand

Measures the responsiveness of demand to changes in income


%�Q x d ∂ Qxd
Em= %�m = ∂m ∗Qmxd

Slide 22
Agyapomaa Gyeke-Dako(PhD) 4/27/2018
Review of Last Class
Elasticity
Quantitative Demand Analysis

Income elasticity of demand

Measures the responsiveness of demand to changes in income


%�Q x d ∂ Qxd
Em= %�m = ∂m ∗Qmxd
Sign contains useful information about the type of good X is
If Em> 0 X is a normal good
If Em< 0 X is an inferior

Slide 23
Agyapomaa Gyeke-Dako(PhD) 4/27/2018