Lecture - 3: Elasticity

Abdul Quadir
XLRI

September 3, 2020
Readings

Chapter 2 of the Textbook

Introduction
I Recall that we have seen that quantity demanded of a product
is
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:
I How much do we have to cut our price to achieve 4.5% sales
growth?
I If we cut prices by 5%, how many more units will we sell?
I If not, do we have enough personnel to increase production?
I How much revenue and cash flows will change because of this
decision?
I How much our sales change if rivals cut their prices by 3%?
I 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 The only difference between these two demands are that 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 this problem
Price Elasticity of Demand

I Price elasticity of demand: The ratio of the percentage of

change in quantity demanded to the percentage of 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
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 the 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 ba is a choke price.
I What is the elasticity for the linear demand curve?
I Eq,p = −b pq
I Calculate the range of Eq,p , Ep,q at midpoint of the linear
demand curve.
Elasticity Along a Demand Curve

I Consider the 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 ba is a choke price.
I What is the elasticity for the linear demand curve?
I Eq,p = −b pq
I Calculate the range of Eq,p , Ep,q 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

I Suppose a constant elasticity demand curve is given by the

1
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

I Suppose a constant elasticity demand curve is given by the

1
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

I Suppose a constant elasticity demand curve is given by the

1
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 Business use price elasticity of demand a lot

I Will increment 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

R = pq total revenue at price p and quantity q

0
R = (p + ∆p)(q + ∆q) TR at new p + ∆, q + ∆qp
= pq + p∆q + q∆p + ∆p∆q

∆R = R 0 − R = p∆q + q∆p + ∆p∆q.

Ignore ∆p∆q for small change in p and q.
∆R ∆q
=q+p .
∆p ∆p
∆R
∆p > 0 implies q + p ∆q
∆p > 0. Thus,
∆q p ∆q p ∆q
q+p >0 ⇒1+ >0 ⇒ > −1
∆p q ∆p q ∆p
Eq,p > −1
Thus, we have |Ep,q | < 1. Revenue will increase iff demand is
inelastic.
TR and Ep,q
p

(q + ∆q)∆p

∆p∆q

p + ∆p

p p∆q

q + ∆q q q
Determinants of 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. Substitute goods: demand tends to be more price elastic when
there are good substitutes for a product
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
Income Elasticity of Demand

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
Eq,m > 0 implies that the good is a normal good
Eq,m < 0 implies that the good is an inferior good
Cross Price Elasticity of Demand

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

I Eqy ,px > 0 implies that the goods are substitutes

I Eqy ,px < 0 implies that the goods are complements
Elasticity of Supply

Elasticity of supply: A measure of the response of quantity of a

good supplied to a change in price of that good. Likely to be
positive in output markets.

% change in quantity of supplied

elasticity of supply =
% change in price
%∆q
=
%∆p
∆q s p
Eqs ,px = ·
∆p q s
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 pounds litres per person, 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 −0.6.22
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 pounds litres per person, 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 −0.6.22
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