Lecture-3: Elasticity

Abdul Quadir
XLRI

July 14, 2021

Readings

Chapter 2 the Textbook

Introduction

I Recall that quantity demanded of a product: qxd = f (px , py , m, h)

I We have analyzed qualitatively how the demand is affected by changes in px , py
and m.
I However, we do not have any clue about their magnitude
I In fact, can we answer the following questions:
– How much do we have to cut our price to achieve 4.5% sales growth?
– If we cut prices by 5%, how many more units will we sell?
– If not, do we have enough personnel to increase production?
– How much revenue and cash flows will change because of this decision?
– How much our sales change if rivals cut their prices by 3%?
– How much our sales change if incomes of households falls by 10% because of Covid?
Introduction

I Recall that quantity demanded of a product: qxd = f (px , py , m, h)

I We have analyzed qualitatively how the demand is affected by changes in px , py
and m.
I However, we do not have any clue about their magnitude
I In fact, can we answer the following questions:
– How much do we have to cut our price to achieve 4.5% sales growth?
– If we cut prices by 5%, how many more units will we sell?
– If not, do we have enough personnel to increase production?
– How much revenue and cash flows will change because of this decision?
– How much our sales change if rivals cut their prices by 3%?
– How much our sales change if incomes of households falls by 10% because of Covid?
The Concept of Elasticity

I The answer of the above or related questions lies in the magnitude of market
responsiveness
I Economists commonly measure responsiveness using the concept of elasticity
I Elasticity is a general concept that can be used to quantify the response in one
variable when another variable changes
I For instance, if some variable A changes in response to changes in another
variable B,

percentage change in A
elasticity of A with respect to B =
percentage change in B
%∆A
=
%∆B
Different Elasticities

I Price elasticity of demand

I Cross price elasticity of demand
I Income elasticity
I Supply elasticity
Slope of The Demand Curve
I Recall that cetris paribus there is a negative relationship between quantity demand
and its own price
I This is depicted in the following graph:
p p

p1 = 3 3

p2 = 2 2

D1 D2

q1 = 5 q2 = 8 q 5000 8000 q
Slope of The Demand Curve

I What is the slopes of both the demand curves?

I Their slopes are

∆Y p2 − p1 1
Slope of D1 = = =−
∆X q2 − q1 3
∆Y p2 − p1 1
Slope of D1 = = =−
∆X q2 − q1 3000
I D1 ’s unit of quantity demanded is kilogram and D2 ’s unit of quantity demanded is
grams
I Converting this change into percentage will solve the problem
Slope of The Demand Curve

I What is the slopes of both the demand curves?

I Their slopes are

∆Y p2 − p1 1
Slope of D1 = = =−
∆X q2 − q1 3
∆Y p2 − p1 1
Slope of D1 = = =−
∆X q2 − q1 3000
I D1 ’s unit of quantity demanded is kilogram and D2 ’s unit of quantity demanded is
grams
I Converting this change into percentage will solve the problem
Price Elasticity of Demand
I Price elasticity of demand: The ratio of the percentage change in quantity
demanded to the percentage change in price
I It measures the responsiveness of demand to changes in price
I Mathematically,

% change in quantity demanded

price elasticity of demand =
% change in price
%∆q
=
%∆p
∆q p
Ep,q = ·
∆p q
dq p
= · Calculus Formula
dp q
I This is called point elasticity of demand
Types of Elasticities

I Look at the following table and compute their price elasticities:

product %∆p %∆q
insulin 10% 0%
Mobile service 10% -1%
Chicken 10% -10%
Bananas 10% -30%

product %∆p %∆q Elasticity Type

insulin 10% 0% 0 perfectly inelastic
Mobile service 10% -1% -0.1 inelastic
Chicken 10% -10% -1 unitary elastic
Bananas 10% -30% -3.0 elastic
Types of Elasticities

I Look at the following table and compute their price elasticities:

product %∆p %∆q
insulin 10% 0%
Mobile service 10% -1%
Chicken 10% -10%
Bananas 10% -30%

product %∆p %∆q Elasticity Type

insulin 10% 0% 0 perfectly inelastic
Mobile service 10% -1% -0.1 inelastic
Chicken 10% -10% -1 unitary elastic
Bananas 10% -30% -3.0 elastic
Types of Elasticities

I Inelastic demand: Demand that responds somewhat, but not a great deal, to
changes in price
I Inelastic demand always has a numerical value between zero and −1
I Unitary elasticity: A demand relationship in which the percentage change in
quantity of a product demanded is the same as the percentage change in price in
absolute value (a demand elasticity of -1)
I Elastic demand: A demand relationship in which the percentage change in
quantity demanded is larger in absolute value than the percentage change in price
(a demand elasticity with an absolute value greater than 1).
I Perfectly elastic demand Demand in which quantity drops to zero at the
slightest increase in price
Relationship Between Demand Curves

p ∆p
p is same for both D1 and D2
∆q2 ∆q1
q > q
Flatter demands are more elastic

A
p D3
D2

D1 q
Example
p p

p1 = 3 3

p2 = 2 2

D1 D2

q1 = 5 q2 = 8 q 5000 8000 q

3
D1 : %∆q = × 100 = 60%
5
3000
D2 : %∆q = × 100 = 60%
5000
Example
p p

p1 = 3 3

p2 = 2 2

D1 D2

q1 = 5 q2 = 8 q 5000 8000 q

3
D1 : %∆q = × 100 = 60%
5
3000
D2 : %∆q = × 100 = 60%
5000
Example

Suppose price is initially Rs. 5, and the corresponding quantity demanded is 1,000
units. Suppose, too, that if the price rises to Rs. 5.75, the quantity demanded will fall
to 800 units.

What is the price elasticity of demand over this region of the demand curve? Is
demand elastic or inelastic?

Solution: ∆p = 5.75 − 5 = −0.75 and 800 − 1000 = −200

∆q p 200 5 4
EQ,P = =− =−
∆p q 0.75 1000 3
Example

Suppose price is initially Rs. 5, and the corresponding quantity demanded is 1,000
units. Suppose, too, that if the price rises to Rs. 5.75, the quantity demanded will fall
to 800 units.

What is the price elasticity of demand over this region of the demand curve? Is
demand elastic or inelastic?

Solution: ∆p = 5.75 − 5 = −0.75 and 800 − 1000 = −200

∆q p 200 5 4
EQ,P = =− =−
∆p q 0.75 1000 3
Elasticity Along a Demand Curve

I Consider a linear demand curve q = a − bp

I The linear inverse demand curve: p = ba − b1 q
I Choke Price: Price at which demand falls to zero. Thus, here a
b is a choke price.
I What is the price elasticity for the linear demand curve?
I Eq,p = −b qp
I Calculate the range of Eq,p at midpoint of the linear demand curve.
Elasticity Along a Demand Curve

I Consider a linear demand curve q = a − bp

I The linear inverse demand curve: p = ba − b1 q
I Choke Price: Price at which demand falls to zero. Thus, here a
b is a choke price.
I What is the price elasticity for the linear demand curve?
I Eq,p = −b qp
I Calculate the range of Eq,p at midpoint of the linear demand curve.
Elasticity Along a Demand Curve
p

a
b Eq,p = −∞
|Eq,p | > 1

a
2b Eq,p = −1
|Eq,p | < 1

Eq,p = 0
a
a q
2
Price Elasticity Along a Demand Curve
p

66.7
Ep,q = −40 = −1.67
A
p1 = 5
B
p2 = 4

C
2
D
1
D1
2 4 8 10 q
q1 q2
Constant Elasticity Demand Curve

I The constant elasticity demand curve: q = ap −b

I What is Eq,p for this demand?
I Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
I Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
I Suppose a linear demand curve is given by the formula q = 400 − 10p. What is
the price elasticity of demand at p = 30? At p = 10?
Constant Elasticity Demand Curve

I The constant elasticity demand curve: q = ap −b

I What is Eq,p for this demand?
I Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
I Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
I Suppose a linear demand curve is given by the formula q = 400 − 10p. What is
the price elasticity of demand at p = 30? At p = 10?
Constant Elasticity Demand Curve

I The constant elasticity demand curve: q = ap −b

I What is Eq,p for this demand?
I Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
I Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
I Suppose a linear demand curve is given by the formula q = 400 − 10p. What is
the price elasticity of demand at p = 30? At p = 10?
Total Revenue and Price Elasticity

I managers use price elasticity of demand frequently

I Will increase in prices necessarily increase the revenue of a product?
I For some it could be the case but for some it could not be
I How can we decide that reduction in quantity or increase in price will result in
generating more revenue?
Total Revenue and Price Elasticity
Consider the demand function given by qxd = 80 − 2px

p q TR p q Eq,p TR
0 80 0 0 80 0.00 0 A
5 70 350 5 70 -0.14 350 B
10 60 600 10 60 -0.33 600 C
15 50 750 15 50 -0.60 750 D
20 40 800 20 40 -1.06 800 E
25 30 750 25 30 -1.67 750 F
30 20 600 30 20 -3.0 600 G
35 10 350 35 -7.0 10 350 H
40 0 0 40 0 -∞ 0 I

I TR increases when |Ep,q | < 1, decreases when |Ep,q | > 1 and attains maximum
when |Ep,q | = 1
Total Revenue and Price Elasticity
Consider the demand function given by qxd = 80 − 2px

p q TR p q Eq,p TR
0 80 0 0 80 0.00 0 A
5 70 350 5 70 -0.14 350 B
10 60 600 10 60 -0.33 600 C
15 50 750 15 50 -0.60 750 D
20 40 800 20 40 -1.06 800 E
25 30 750 25 30 -1.67 750 F
30 20 600 30 20 -3.0 600 G
35 10 350 35 -7.0 10 350 H
40 0 0 40 0 -∞ 0 I

I TR increases when |Ep,q | < 1, decreases when |Ep,q | > 1 and attains maximum
when |Ep,q | = 1
Total Revenue and Price Elasticity
Consider the demand function given by qxd = 80 − 2px

p q TR p q Eq,p TR
0 80 0 0 80 0.00 0 A
5 70 350 5 70 -0.14 350 B
10 60 600 10 60 -0.33 600 C
15 50 750 15 50 -0.60 750 D
20 40 800 20 40 -1.06 800 E
25 30 750 25 30 -1.67 750 F
30 20 600 30 20 -3.0 600 G
35 10 350 35 -7.0 10 350 H
40 0 0 40 0 -∞ 0 I

I TR increases when |Ep,q | < 1, decreases when |Ep,q | > 1 and attains maximum
when |Ep,q | = 1
TR and Ep,q
p

40 I
H
35
G
30
F
25
E
20
D
15
C
10
B
5
A
10 20 30 40 50 60 70 80 q
TR and Ep,q

I Consider total revenue R at price p and quantity q: R = pq

I Consider total revenue R 0 at price p + ∆p and quantity q + ∆q

R 0 = (p + ∆p)(q + ∆q)
= pq + p∆q + q∆p + ∆p∆q

I Consider change in revenue ∆R

∆R = R 0 − R = p∆q + q∆p + ∆p∆q.

I Ignore ∆p∆q for small change in p and q, then

∆R = R 0 − R = p∆q + q∆p
TR and Ep,q

I Divide ∆R by ∆p
∆R ∆q
=q+p
∆p ∆p
I Thus, ∆R ∆q
∆p > 0 when q + p ∆p > 0.
I Therefore,

∆q p ∆q p ∆q
q+p >0 =⇒ 1 + >0 =⇒ > −1
∆p q ∆p q ∆p
Eq,p > −1

I Thus, we have |Ep,q | < 1.

I Revenue will increase in case of price rise iff demand is inelastic.
TR and Ep,q

p (q + ∆q)∆p

∆p∆q

p + ∆p

p p∆q

q + ∆q q q
Intuitive Factors which Affect Own Price Elasticity

I In practice, economists calculate the price elasticities of various goods using

statistical techniques
I Some factors that provide idea of elasticities:
1. Availability of direct or indirect substitutes.
– The fewer substitutes are available, the less elastic the demand.
– The demand for the product category (cigarettes as a whole) will be relatively less
elastic than demand for particular product in category (particular brand of cigarettes).
2. Demand tends to be more price elastic when a consumer’s expenditure on the
product is large
3. Demand tends to be less price elastic when the product is seen by consumers as
being a necessity
4. Buyer’s prior commitments
– buyer of a particular car/software becomes a captive customer/locked in for spare
parts/future upgrades.
Income Elasticity of Demand
I Income elasticity of demand: Measures the responsiveness of demand to
changes in income

% change in quantity demanded

income elasticity of demand =
% change in income
%∆q
=
%∆m
∆q m
Eq,m = ·
∆m q
dq m
= Calculus Formula
dm q
I Eq,m > 0 implies that the good is a normal good
I Eq,m < 0 implies that the good is an inferior good
Cross Price Elasticity of Demand
I Cross-price elasticity of demand A measure of the response of the quantity of
one good demanded to a change in the price of another good

% change in quantity of qy demanded

Cross price elasticity of demand =
% change in price of x
%∆qy
=
%∆px
∆qy px
Eqy ,px = ·
∆px qy
dqy
= px qy Calculus Formula
dpx
I Eqy ,px > 0 implies that the goods are substitutes
I Eqy ,px < 0 implies that the goods are complements
Elasticity of Supply

I Elasticity of supply: A measure of the response of quantity of a good supplied to

a change in price of that good:

% change in quantity of supplied

elasticity of supply =
% change in price
%∆q
=
%∆p
∆q s p
Eqs ,px = ·
∆p q s
dq s p
= · Calculus Formula
dp q s
I Likely to be positive in output markets.
Estimation of Demand Curve

I One way to estimate the demand curve is to collect data and use statistical
techniques to estimate the parameters of the demand curve
I Another method is indirect way of calculating the demand curve just using price,
quantity and estimated elasticities
I This methods is known as back-of the envelope calculations
I Calculate the parameters a and b in the linear demand curve q = a − bp from this
methods
Estimation of Demand Curve
I Let q ∗ and p ∗ be the known values of quantity and price in the market
I Calculation for b:
p∗
Eq,p = −b
q∗
q∗
b = −Eq,p
p∗
I Calculation for a: Note that p ∗ and q ∗ must lie on the demand curve

q ∗ = a − bp ∗
q∗ ∗
 
∗ ∗ ∗
a = q + bp = q + − Eq,p ∗ p
p
a = (1 − Eq,p )q ∗
Example: Estimation of Demand Curve

I Suppose the per capita consumption of Milk in India is about 70 litres per person
per year, while the average inflation-adjusted retail price of milk is about Rs. 20
per litre
I Demand for milk is relatively price inelastic, with estimates in the range of −0.5
to −0.6
I Calculate the demand function
I Take average elasticity, i.e., -0.55
∗
I b = −Eq,p pq∗ = −(−0.55) × 70 20
= 0.16
I a = (1 − Eq,p )q ∗ = (1 − (−0.55))70 = 108.5
I q = 108.5 − 0.16p
Example: Estimation of Demand Curve

I Suppose the per capita consumption of Milk in India is about 70 litres per person
per year, while the average inflation-adjusted retail price of milk is about Rs. 20
per litre
I Demand for milk is relatively price inelastic, with estimates in the range of −0.5
to −0.6
I Calculate the demand function
I Take average elasticity, i.e., -0.55
∗
I b = −Eq,p qp∗ = −(−0.55) × 70 20
= 0.16
I a = (1 − Eq,p )q ∗ = (1 − (−0.55))70 = 108.5
I q = 108.5 − 0.16p
Exercise
At a major French food retailer, the own-price elasticities of the demand for various
brands of pasta were: −1.36 for national brands, −2.16 for private labels, and −1.85
for low-price brands. At the same retailer, the own-price elasticities of the demand for
various brands of biscuits were: −1.00 for national brands, −1.14 for private labels,
and −0.50 for low-price brands. (Source: Fabian Berges, Daniel Hassan, and Sylvette
Monier-Dilhan, “Are consumers more loyal to national brands than to private labels?”
Bulletin of Economic Research, Vol. 65, 2013.)
1. Compare the elasticities of the demand for national brands vis-a-vis private labels
of pasta. Does the difference make sense?
2. Do national brands or private labels or low-price brands command more brand
loyalty? (Hint: Interpret brand loyalty by the own-price elasticity.)
3. Which is more elastic? The demand for pasta or biscuits?
4. Based on the own-price elasticities, can you make any recommendations on
pricing?