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Session 4– Elasticity

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.

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

Reading List

• Baye Michael and Price Jeffery: Managerial

Economics and Business Strategy, 8th Edition

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

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

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

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.

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?

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.

Review of Last Class

Elasticity

Quantitative Demand Analysis

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

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

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

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

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

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

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

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

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

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

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

%�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

%�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

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