Economic Analysis for Business

Session IV: Elasticity and its Application-1 ApplicationInstructor

Sandeep Basnyat 9841892281 Sandeep_basnyat@yahoo.com

A scenario
You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opp. cost of your time), so youre thinking of raising the price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?

Elasticity
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Basic idea: Elasticity measures how much one variable responds to changes in another variable.
One type of elasticity measures how much demand for your websites will fall if you raise your price.

Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants. y Elastic and Inelastic demand and supply.
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Price Elasticity of Demand

Price elasticity of demand
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Percentage change in Qd
=

Percentage change in P

Price elasticity of demand measures how much Qd responds to a change in P.

Price Elasticity of Demand

Price elasticity of demand Percentage change in Qd
=

Percentage change in P
P P rises P2 by 10% P1 D Q2 Q1 Q

Example:
Price elasticity of demand equals 15% = 1.5 10%

Q falls by 15% What does elasticity = 1.5 mean?

Calculating Percentage Changes

Calculate Price Elasticity of Demand
P $250 $200 B A D 8 12 Q

Standard method of computing the percentage (%) change: end value start value x 100% start value

Calculating Percentage Changes

Demand for your websites

P $250 $200 B A D 8 12 Q

Problem: From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 From B to A, P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50

How to solve this confusion?

Calculating Percentage Changes

y

So, we instead use the midpoint method:

end value start value x 100% midpoint

 The midpoint is the number halfway between

the start & end values, also the average of those values.

 It doesnt matter which value you use as the

start and which as the end you get the same answer either way!
What is PED using midpoint method?

Calculating Percentage Changes

y

Using the midpoint method, the % change in P equals

$250 $200 x 100% = 22.2% $225

 The % change in Q equals

12 8 x 100% = 40.0% 10

 The price elasticity of demand equals

40/22.2 = 1.8

ACTIVE LEARNING

1:

Calculate an elasticity
Use the following information to calculate the price elasticity of demand for hotel rooms using midpoint method: if P = $70, Qd = 5000 if P = $90, Qd = 3000

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ACTIVE LEARNING

1:

Answers

Use midpoint method to calculate % change in Qd (5000 3000)/4000 = 50% % change in P ($90 $70)/$80 = 25% The price elasticity of demand equals
50% = 2.0 25%
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Calculating Price Elasticity of Demand

Two Ways: Arc elasticity Calculation and Point Elasticity Calculation
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Arc Elasticity:

Important Note: Along a D curve, P and Q move in opposite directions, which would make price elasticity negative most of the cases. (E <0)

(Q %(Q Q (Q p I! ! ! %(p (p (p Q p
where ( indicates change.
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Example
If a 1% increase in price results in a 3% decrease in quantity demanded, the elasticity of demand is I = -3%/1% = -3.

Calculating Price Elasticity of Demand

Point Elasticity: Elasticity at a particular point (price)
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Use of derivative: dQ/dP : denotes rate at which quantity changes with respect to Price: similar to: (Q

(p
So, replace by dQ /dP in the Arc elasticity formula, So the elasticity of demand is:

p (Q p I! ! ( dQ / dP) (p Q Q
Note: The derivative of Qn = nQn-1

Calculating Price Elasticity of Demand

y

The estimated linear demand function for pork is: Q = 286 -20p
where Q is the quantity of pork demanded in million kg per year and p is the price of pork in $ per year. At the equilibrium point of p = $3.30 and Q = 220 Find the elasticity of demand for pork:

Calculating Price Elasticity of Demand

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The estimated linear demand function for pork is: Q = 286 -20p
where Q is the quantity of pork demanded in million kg per year and p is the price of pork in $ per year. At the equilibrium point of p = $3.30 and Q = 220 the elasticity of demand for pork:

p 3.30 I ! (dQ / dP) ! 20 v ! 0.3 Q 220

Numerical example Consider a competitive market for which the quantities demanded and supplied (per year) at various prices are given as follows: Price($) Demand (millions) Supply (millions) 60 22 14 80 20 16 100 18 18 120 16 20 Calculate the price elasticity of demand when the price is $80. When the price is $100.
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Solution to Numerical example

(Q D QD P (Q D ED ! ! . (P QD (P P
From the above question, with each price increase of $20, the quantity demanded decreases by 2. Therefore,

(Q D  2  (P  ! 20 ! 0.1.
At P = 80, quantity demanded equals 20 and

80  ED !   0.1 ! 0.40. 20

Similarly, at P = 100, quantity demanded equals 18 and

100  ED !   0.1 ! 0.56.  18

NonNon-linear demand function-Numerical Example functiony

Consider the following non-linear demand function: Q=P If the value of = -2, is the demand Price elastic or inelastic?

NonNon-linear demand function-Numerical Example functionConsider the following non-linear demand function: Q = P . Find price elasticity of demand for this function. Solution: Differentiating Q = P dQ/dP = P -1 Therefore, E = P -1 (P /Q) = ( P -1+1) / Q = ( P ) / Q Since, Q = P
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E=

What determines the Elasticity of Demand? EXAMPLE 1: Wai Wai vs. Yogurt or curd
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The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

Wai Wai has lots of close substitutes (e.g., Rum Pum, Mayoz etc.), so buyers can easily switch if the price rises. Yogurt has no close substitutes, so consumers would probably not buy much less if its price rises.
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Lesson: Price elasticity is higher when close substitutes are available.

EXAMPLE 2:

Blue Jeans vs. Clothing

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The prices of both goods rise by 20%. For which good does Qd drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos, or even cotton pant).

There are fewer substitutes available for broadly defined goods. (Can you think of a substitute for clothing, other than living in a nudist colony?)
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Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

EXAMPLE 3:

Insulin vs. Caribbean Cruises

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The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities.

EXAMPLE 4:

Gasoline in the Short Run vs. Gasoline in the Long Run

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The price of gasoline rises 20%. Does Qd drop more in the short run or the long run? Why?

Theres not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run.

The Determinants of Price Elasticity: A Summary

The price elasticity of demand depends on:

 the extent to which close substitutes are available  whether the good is a necessity or a luxury  how broadly or narrowly the good is defined  the time horizon: elasticity is higher in the long run than the short run.

The Variety of Demand Curves

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Economists classify demand curves according to their elasticity. The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. The next 5 slides present the different classifications, from least to most elastic.

Perfectly inelastic demand (one extreme case)

0% % change in Q Price elasticity = = of demand % change in P 10%

=0

D curve: vertical Consumers price sensitivity: 0 Elasticity: 0

P falls by 10% P1

P2 Q

Q1 Q changes by 0%

Inelastic demand
% change in Q < 10% Price elasticity = = of demand % change in P 10%

<1

D curve: relatively steep Consumers price sensitivity: relatively low Elasticity: <1
P falls by 10% P1

P2 D Q1 Q2 Q rises less than 10% Q

Unit elastic demand

10% % change in Q Price elasticity = = of demand 10% % change in P

=1

D curve: intermediate slope Consumers price sensitivity: intermediate Elasticity: 1

P falls by 10% P1

P2

D Q1 Q2 Q

Q rises by 10%

Elastic demand
% change in Q > 10% Price elasticity = = of demand 10% % change in P

>1

D curve: relatively flat Consumers price sensitivity: relatively high Elasticity: >1
P falls by 10% P1

P2

D Q

Q1

Q2

Q rises more than 10%

Perfectly elastic demand (the other extreme)

any % % change in Q Price elasticity = = of demand 0% % change in P

= infinity

D curve: horizontal Consumers price sensitivity: extreme Elasticity: infinity

P2 = P1

P D

P changes by 0%

Q1

Q2

Q changes by any %

Elasticity of a Linear Demand Curve

P

$30 20 10 $0

200% E = = 5.0 40% 67% E = = 1.0 67% 40% E = = 0.2 200% 0 20 40 60

Q

The slope of a linear demand curve is constant, but its elasticity is not.

Price Elasticity and Total Revenue

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Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand.

Price Elasticity and Total Revenue

Price elasticity = of demand Percentage change in Q Percentage change in P

Revenue = P x Q
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If demand is elastic, then

price elast. of demand > 1 % change in Q > % change in P

The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls.

Price Elasticity and Total Revenue

Elastic demand (elasticity = 1.8) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 8 and revenue = $2000.
P increased Demand for revenue due your websites lost to higher P revenue due to lower Q D

$250 $200

When D is elastic, a price increase causes revenue to fall.

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Price Elasticity and Total Revenue

Price elasticity = of demand
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Percentage change in Q Percentage change in P

Revenue = P x Q If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250.

Price Elasticity and Total Revenue

Now, demand is inelastic: elasticity = 0.82 If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 10 and revenue = $2500.
P increased Demand for revenue websites your due lost to higher P revenue due to lower Q

$250 $200

D Q

When D is inelastic, a price increase causes revenue to rise.

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ACTIVE LEARNING

2:

Answers
A.

Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? Expenditure = P x Q Since demand is inelastic, Q will fall less than 10%, so expenditure rises.

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ACTIVE LEARNING

2:

Answers
B. As a result of a fare war, the price of a luxury cruise

falls 20%. Does luxury cruise companies total revenue rise or fall? Revenue = P x Q The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger? Since demand is elastic, Q will increase more than 20%, so revenue rises.
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Thank you