Lecture-3: Elasticity

Abdul Quadir
XLRI

June 27, 2023

Readings

Chapter 2 the Textbook

Introduction

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

▶ We have analyzed qualitatively how the demand is affected by changes in px , py
and m.
▶ However, we do not have any clue about their magnitude
▶ 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 do our sales change if the incomes of households fall by 10% because of
Covid?
Introduction

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

▶ We have analyzed qualitatively how the demand is affected by changes in px , py
and m.
▶ However, we do not have any clue about their magnitude
▶ 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 do our sales change if the incomes of households fall by 10% because of
Covid?
The Concept of Elasticity

▶ The answer to the above or related questions lies in the magnitude of market
responsiveness
▶ Economists commonly measure responsiveness using the concept of elasticity
▶ Elasticity is a general concept that can be used to quantify the response in one
variable when another variable changes
▶ 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

▶ Price elasticity of demand

▶ Cross price elasticity of demand
▶ Income elasticity
▶ Supply elasticity
Slope of The Demand Curve
▶ Recall that cetres paribus there is a negative relationship between quantity
demanded and its own price
▶ 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

▶ What are the slopes of both the demand curves?

▶ 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
▶ D1 ’s unit of quantity demanded is kilogram and D2 ’s unit of quantity demanded is
grams
▶ Converting this change into a percentage will solve the problem
Slope of The Demand Curve

▶ What are the slopes of both the demand curves?

▶ 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
▶ D1 ’s unit of quantity demanded is kilogram and D2 ’s unit of quantity demanded is
grams
▶ Converting this change into a percentage will solve the problem
Price Elasticity of Demand
▶ Price elasticity of demand: The ratio of the percentage change in quantity
demanded to the percentage change in price
▶ It measures the responsiveness of demand to changes in price
▶ Mathematically,

% change in quantity demanded

price elasticity of demand =
% change in price
%∆q
=
%∆p
∆q p
Eq,p = ·
∆p q
dq p
= · Calculus Formula
dp q
▶ This is called point elasticity of demand
Price Elasticity of Demand
▶ Price elasticity of demand: The ratio of the percentage change in quantity
demanded to the percentage change in price
▶ It measures the responsiveness of demand to changes in price
▶ Mathematically,

% change in quantity demanded

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

▶ 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

▶ 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

▶ Inelastic demand: Demand that responds somewhat, but not a great deal, to
changes in price
– Inelastic demand always has a numerical value between zero and −1.
▶ Unitary elastic: A demand relationship in which the percentage change in
quantity demanded of a product is the same as the percentage change in price in
absolute value (a demand elasticity of -1)
▶ 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).
▶ 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 the 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 1: ∆p = 5.75 − 5 = −0.75 and 800 − 1000 = −200

∆q p 200 5 4
EQ,P = =− = − ≈ −1.33
∆p q 0.75 1000 3
Solution 2:
∆q p 200 5.75 23
EQ,P = =− = − ≈ −1.92
∆p q 0.75 800 12
Example
Suppose the 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 1: ∆p = 5.75 − 5 = −0.75 and 800 − 1000 = −200

∆q p 200 5 4
EQ,P = =− = − ≈ −1.33
∆p q 0.75 1000 3
Solution 2:
∆q p 200 5.75 23
EQ,P = =− = − ≈ −1.92
∆p q 0.75 800 12
Arc Elasticity

▶ Arc elasticity of demand is calculated over a range of prices.

▶ Choose average price and quantity
▶ The formula is given by

∆q p̄
Arc elasticity of demand : Eq,p = ·
∆p q̄

p1 +p2
– p̄ = 2
q1 +q2
– q̄ = 2
Elasticity Along a Demand Curve

▶ Consider a linear demand curve q = a − bp

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

▶ Consider a linear demand curve q = a − bp

▶ The linear inverse demand curve: p = ba − b1 q
▶ Choke Price: Price at which demand falls to zero. Thus, here a
b is a choke price.
▶ What is the price elasticity for the linear demand curve?
▶ Eq,p = −b qp
▶ 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
Eq,p = −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

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

▶ What is Eq,p for this demand?
▶ Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
▶ Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
▶ 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

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

▶ What is Eq,p for this demand?
▶ Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
▶ Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
▶ 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

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

▶ What is Eq,p for this demand?
▶ Eq,p = −b
dq p p −abp −b
Eq,p = = −abp −b−1 = = −b
dp q q ap −b
1
▶ Suppose a constant elasticity demand curve is given by the formula q = 200p − 2 .
What is the price elasticity of demand?
▶ 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

▶ Managers use price elasticity of demand frequently

▶ Will an increase in prices necessarily increase the revenue of a product?
▶ For some it could be the case but for some, it could not be
▶ How can we decide that a reduction in quantity or an increase in price will result
in generating more revenue?
Total Revenue and Price Elasticity

▶ Managers use price elasticity of demand frequently

▶ Will an increase in prices necessarily increase the revenue of a product?
▶ For some it could be the case but for some, it could not be
▶ How can we decide that a reduction in quantity or an 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

▶ TR increases when |Eq,p | < 1, decreases when |Eq,p | > 1 and attains maximum
when |Eq,p | = 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

▶ TR increases when |Eq,p | < 1, decreases when |Eq,p | > 1 and attains maximum
when |Eq,p | = 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

▶ TR increases when |Eq,p | < 1, decreases when |Eq,p | > 1 and attains maximum
when |Eq,p | = 1
TR and Eq,p
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 Eq,p

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

▶ Consider total revenue R ′ at price p + ∆p and quantity q + ∆q

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

▶ Denote the change in revenue by ∆R

∆R = R ′ − R = p∆q + q∆p + ∆p∆q.

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

∆R = p∆q + q∆p
TR and Eq,p

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

∆q p ∆q p ∆q
q+p >0 =⇒ 1 + >0 =⇒ > −1 =⇒ Eq,p > −1
∆p q ∆p q ∆p
▶ Thus, we have |Eq,p | < 1.
▶ Revenue will increase in case of a 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

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

statistical techniques
▶ Some factors that provide ideas about 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 the demand for a particular product in the category (a 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 consumers see the product 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
▶ 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
▶ 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
demanded of one good 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
= Calculus Formula
dpx qy
▶ Eqy ,px > 0 implies that the goods are substitutes
▶ Eqy ,px < 0 implies that the goods are complements
Revenue Management and Cross Price Elasticity

▶ Suppose you are a manager responsible for revenue management with a shoe
retail firm.
▶ Your firm is selling two kinds of shoes: branded and locally produced
▶ You have the following data:
– cross price elasticity between branded and local shoes is 0.4
– own price elasticity of branded shoes is −1.5
– revenue from the sale of branded shoes is Rs. 200 million
– revenue from the sale of local shoes is Rs. 100 million
▶ What will be the change in revenue if you decrease the price of branded shoes by
6%?
Revenue Management and Cross Price Elasticity
▶ We can use the following formula for discrete case assuming x = branded shoes
and y = local shoes:
 
∆R = Rx (1 + EQx ,px ) + Ry EQy ,px %∆px

Derivation: Let us take R = Rx + Ry where Rx = px Qx (x, y ) and Ry = py Qy (x, y )

dR ∂Qx ∂Qy
= Qx + px + py
dpx ∂px ∂px
 
∂Qx px ∂Qy 1
= Qx 1 + + py Qy
∂px Qx ∂px Qy
 
dR ∂Qx px ∂Qy px
px = px Qx 1 + + py Qy
dpx ∂px Qx ∂px Qy
  dpx
dR = Rx (1 + EQx ,px ) + Ry EQy ,px ×
px
Revenue Management and Cross Price Elasticity
▶ We can use the following formula for discrete case assuming x = branded shoes
and y = local shoes:
 
∆R = Rx (1 + EQx ,px ) + Ry EQy ,px %∆px

Derivation: Let us take R = Rx + Ry where Rx = px Qx (x, y ) and Ry = py Qy (x, y )

dR ∂Qx ∂Qy
= Qx + px + py
dpx ∂px ∂px
 
∂Qx px ∂Qy 1
= Qx 1 + + py Qy
∂px Qx ∂px Qy
 
dR ∂Qx px ∂Qy px
px = px Qx 1 + + py Qy
dpx ∂px Qx ∂px Qy
  dpx
dR = Rx (1 + EQx ,px ) + Ry EQy ,px ×
px
Cross Price Elasticity of Demand

▶ The cross-price elasticity of demand helps managers to predict the effect of

competitors’ pricing strategies on the demand for their own product.
▶ The competition authorities use the cross-price elasticity of demand to determine
the likely effect of mergers on the degree of competition in an industry:
– If two goods are good substitutes: a merger could significantly reduce competition in
the industry.
– If two goods are strong complements: a merger could give the merged firm excessive
control over the supply chain.
Elasticity of Supply

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

a change in the 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
▶ Likely to be positive in output markets.
Estimation of Demand Curve

▶ To estimate the demand curve, one has to collect data and use statistical
techniques to estimate the parameters of the demand curve
▶ Another method is an indirect way of calculating the demand curve just using
price, quantity and estimated elasticities
▶ This methods is known as back-of the envelope calculations
▶ Let us calculate the parameters a and b in the linear demand curve q = a − bp
using this methods
Estimation of Demand Curve

▶ To estimate the demand curve, one has to collect data and use statistical
techniques to estimate the parameters of the demand curve
▶ Another method is an indirect way of calculating the demand curve just using
price, quantity and estimated elasticities
▶ This methods is known as back-of the envelope calculations
▶ Let us calculate the parameters a and b in the linear demand curve q = a − bp
using this methods
Estimation of Demand Curve
▶ Let q ∗ and p ∗ be the known values of quantity and price in the market
▶ Calculation for b:
p∗
Eq,p = −b
q∗
q∗
b = −Eq,p
p∗
▶ 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

▶ 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.
▶ Demand for milk is relatively price inelastic, with estimates in the range of −0.5
to −0.6
▶ Calculate the demand function
▶ Take average elasticity, i.e., -0.55
∗
▶ b = −Eq,p pq∗ = −(−0.55) × 70 20
= 0.16
▶ a = (1 − Eq,p )q ∗ = (1 − (−0.55))70 = 108.5
▶ q = 108.5 − 0.16p
Example: Estimation of Demand Curve

▶ 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.
▶ Demand for milk is relatively price inelastic, with estimates in the range of −0.5
to −0.6
▶ Calculate the demand function
▶ Take average elasticity, i.e., -0.55
∗
▶ b = −Eq,p qp∗ = −(−0.55) × 70 20
= 0.16
▶ a = (1 − Eq,p )q ∗ = (1 − (−0.55))70 = 108.5
▶ 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, 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?