Managerial Economics

CHAPTER 3: ELASTICITY

ELASTICITY change

measures how responsive or sensitive 3 explanations of the inverse relationship of

demand is to changes, such as in price. price and quantity demanded:

Types of 1. The law of demand is consistent with

Special Cases: Common Sense. - People ordinarily do buy
elasticity:
more of a product at a low price than at a
Elastic: Perfectly Elastic: high price.
Consumer Represented by a
response is horizontal demand 2. Diminishing Marginal Utility - the
greater than the curve, indicating an decreasing satisfaction a consumer gains
change. extreme sensitivity to from each additional unit of a product
consumed. This principle explains why
price changes.
Inelastic: consumers will only buy more units if the
Consumer Perfectly Inelastic: price decreases.
response is less Represented by a
3. Income effect - indicates that a lower
than the change. vertical demand curve, price increases the purchasing power of a
showing no response to buyer’s money income
Unitary:
price changes.
Consumer
3.1 Substitution effect - suggests that at a
response is equal lower price, buyers have the incentive to
to the change. substitute what is now a less expensive
product

3.1 Demand Analysis

B. Demand Curve
Demand shows various amount of goods that
consumers are willing and able to buy at a
specific period of time (day, week, month or
year). This can be represented as demand
schedule or demand table, demand curve
and demand function.

A. Demand Schedule
Determinants of Demand:
Law of demand - As the Pric Quantity
price increases, the e Demanded
0 100 1. Tastes or preferences - If consumers
quantity demanded
5 90 have favorable response regarding the good,
decreases.
10 80 demand will increase
Demand is different from 15 70
20 60 2. Number of Buyers - An increase in the
quantity demanded.
25 50 number of buyers will increase in demand

3. Income - There are two kinds of goods

Demand - the whole schedule, can change under income, normal good or superior good
when its determinants, known as the and inferior good.
determinants of demand, change. These  Normal Goods (Superior Goods): As
changes in demand are typically represented income increases, demand for normal
by shifts in the demand curve. goods also increases. This shows a
positive relationship between income
Quantity demanded - the specific amount and normal goods.
of good at a given price (i.e., at price 10  Inferior Goods: As income increases,
quantity demanded, can change with a price demand for inferior goods decreases.
 This shows a negative (inverse) Qd = 100 – 2(0) = 100 – 0 = 100
relationship between income and inferior Qd = 100 – 2(5) = 100 – 10 = 90
goods. Qd = 100 – 2(10) = 100 – 20 = 80
Qd = 100 – 2(15) = 100 – 30 = 70
4. Price of Related Goods Qd = 100 – 2(20) = 100 – 40 = 60
 Substitute Goods: If the price of a Qd = 100 – 2(25) = 100 – 50 = 50
particular good increases and the
demand for its related good increases, 3.2 Price Elasticity of
these goods are substitutes.
 Complementary Goods: If the price of Demand
a particular good increases and the The responsiveness of consumers to a price
demand for its related good decreases, change is measured by a product’s price
these goods are complementary. elasticity of demand. Graphically,

5. Expectation - Consumers' expectations 1. Flat demand curve, Elastic demand

about future price changes can affect current
demand. For example, if a typhoon is Point a = original
expected, demand will rise because price is 2 and original
consumers anticipate higher prices and lower quantity is 10
supply after the storm.
Price decreased from
These determinants are also known as non- 2 to 1 while quantity
price determinants. Any movement of one increased from 10 to
point to another point along the same 40.
demand curve is called change in quantity
demanded. The movement of one curve to The change in price is less than the change
another demand curve is called change in in quantity. Consumers’ consumption is very
demand. affected by the price change; thus, this
elasticity refers to luxury good.
C. Demand Function
2. Steep demand curve, Inelastic
Another representation of demand is a demand
function
Original price is 1
Qd =a−bP and original
quantity is 20 at
Where: point d.
Qd = Quantity Demanded
a = intercept (at price 0) Price increased
from 1 to 4 while
b = slope ( ∆∆QdP ) quantity decreased
from 20 to 10.
P = price
The change in price is greater than the
The negative slope represents the negative change in quantity. Consumers’ consumption
relationship of price and quantity demanded. is slightly affected by the price change; thus,
Intercept is the maximum amount of goods this elasticity refers to basic good. Even
that the consumers are willing and able to though there is a large change in price,
buy at price 0. Thus, Considering the given consumers cannot give up large quantity of
demand schedule earlier, we can derive its their consumption.
demand function:
∆ Qd 3. Steeper than elastic demand but
b= flatter than inelastic demand
∆P
90−100 −10
b= = Original price at 3
5−0 5
b=−2 and original
quantity is 10 at
point e.
Qd =100−2 ( P )
Price decreased
To check: substitute the P with the given from 3 to 1 while
prices from the table. quantity increased
from 10 to 30.
 Demand curve D1 in (a) represents perfectly
The change in price is equal to the change in inelastic demand. A price increase will result
quantity, thus, this elasticity is considered as in no change in quantity demanded. Thus,
unitary. the price-elasticity coefficient is zero.

The coefficient Ed which measures the price Demand is Perfectly Elastic - a small price
elasticity or inelasticity of demand can be reduction causes buyer to increase their
computed as: purchases from zero to all they can obtain,
percentage change ∈quantity demanded of product X the elasticity coefficient is infinite ( E d=∞ )
Ed =
percentage change∈ price of product X

Midpoint Formula:
change∈quantity change ∈ price
Ed = ÷
∑ of quantities /2 ∑ of prices /2
Ed =
|( Q2−Q1
Q1 +Q
2
)(P −P1
÷2 / 2
P1+ P
÷2
2
)| Demand curve D2 in (b) represents perfectly
elastic demand – a line parallel to the
The demand curve is downward sloping, horizontal axis. A price increase will cause
reflecting an inverse relationship between quantity demanded to decline from an infinite
price and quantity demanded. Thus, the price amount to zero.
elasticity coefficient (Ed) is always negative.
However, the absolute value of Ed is used to 3.2. Price Elasticity of Demand and
interpret elasticity.
1 Total Revenue Relationship
Importance of Elasticity for Firms:
Demand is Elastic – if a specific percentage
 Elasticity affects how price changes
change in price results in a larger percentage
impact total revenue (TR) and,
change in quantity demanded. Thus, Ed is
ultimately, profits (TR minus total
greater than 1 Ed >1 ¿. costs).
 Total Revenue (TR) is the total amount
Ed >1=Elastic received from product sales in a time
period and is calculated as
Demand is Inelastic - If a specific TR=PxQ
percentage change in price produces a where:
smaller percentage change in quantity P is price and
demanded This means that Ed is less than 1 ( Q is quantity demanded.
Ed <1 ¿
Total-Revenue Test:
Ed <1=Inelastic  Observing changes in total revenue
in response to price changes helps
Demand is Unit Elastic - the percentage determine elasticity:
change in price of the product is equal to the o Elastic Demand: TR changes in
change in the quantity demand (E¿¿ d=1)¿ the opposite direction of price.
o Inelastic Demand: TR changes
in the same direction as price.
Ed =1=Unit Elastic
o Unit Elastic Demand: TR
remains unchanged when price
Demand is Perfectly Inelastic – Extreme
changes.
cases where a price change results in no
change whatsoever in the quantity
Effects on Total Revenue:
 Elastic Demand: A price decrease
increases TR, as additional sales offset
the lower price.
 Inelastic Demand: A price decrease
reduces TR, as increased sales don’t
fully offset the lower price.
 Unit Elastic Demand: Price changes
leave TR unchanged, as gains or losses
demanded (E¿¿ d=0)¿ from price adjustments are exactly
balanced by the change in sales
 quantity. Types of Goods by Income Elasticity:

Normal (Superior) Goods: If Ei is positive,

demand for the good increases as income
rises. This indicates a direct relationship
between income and demand.

Inferior Goods: If Ei is negative, demand for

3.2. Cross Elasticity of Demand the good decreases as income rises. This
2 indicates an inverse relationship between
This concept measures how the demand for income and demand.
one good (X) responds to a price change in
another good (Y). The cross-elasticity 3.2. Price Elasticity and Prediction
coefficient E xy is calculated as: 4
Price elasticity of demand (Ep) measures how
percentagechange ∈quantity of product X much the quantity demanded of a product
E xy =
percentage change ∈ price of product Y change in response to a change in its price. It

( )( )
Q X 2−Q X 1 PY 2−PY 1 is calculated as:
E XY = ÷2 ÷ ÷2
Q X 1+ Q X 2 P Y 1 + PY 2
% change ∈quantity demande d
E P=
% change ∈ price
Substitute Goods: If E xy is positive,
meaning demand for X rises when the price When rearranged, the equation becomes:
of Y increases, X and Y are substitutes. ∆Q ∆P
 Example: An increase in Gatorade’s =E p ( )
Q P
price boosts demand for Polari Sweat,
where:
indicating a positive cross elasticity
and high substitutability.
∆Q
 =¿ percentage change in quantity
Q
Complementary Goods: If E xy is negative, demanded
demand for X decreases when the price of Y ∆P
 =¿percentage change in price
increases, indicating X and Y are P
complements.
 Example: A price increase for digital Example 1: Gasoline Price Elasticity
cameras reduces demand for memory For gasoline, with a short-term price elasticity
sticks, showing a negative cross of demand of -0.3:
elasticity and high complementarity.  If the price of gasoline rises by 20%
(from $2.50 to $3.00 per gallon), the
Independent Goods: If E xy is zero or near- quantity demanded will decrease by
zero, the goods are unrelated, with no effect −0.3 ×20 %=−6
on each other’s demand.  This small change in demand indicates
 Example: The price of walnuts has no gasoline is inelastic (not very
impact on the demand for plums, responsive to price changes).
indicating they are independent
goods. Example 2: Luxury Car Price Elasticity
For luxury cars, with a price elasticity of
demand of -2.1:
 A 5% increase in price would lead to a
3.2. Income Elasticity of Demand −2.1 ×5 %=−10.5 %
3  drop in sales, showing a more elastic
Measures how consumer demand for a good demand (sensitive to price changes).
change in response to income changes.
When multiple factors, such as price and
The income elasticity coefficient Ei is income, influence demand, we use both
calculated as: price elasticity (Ep) and income elasticity
percentage change∈quantity demanded (Ey). For nonbusiness air travel, given:
Ei =
percentagechange ∈income  E P=−0.38
 EY =1 .8
E I=
(
Q 2−Q1
Q1+Q 2
÷2 ÷
)(
Income2−Income 1
Income1 + Income 2
÷2
) If prices increase by 8% and incomes rise by
5%, we calculate the impact on demand by
summing the effects:
 ∆Q
Q
=E p ( )
∆P
P
+ Ey (
∆Y
Y
)
Substituting values:

∆Q
=( .0 .38 ) ( 8 % )+ (1.8 )( 5 % )=6 %
Q

Thus, sales of nonbusiness airline tickets are

expected to increase by about 6%, as the
positive effect of income growth outweighs
the negative impact of the price increase.

Demand Analysis and

3.3
Optimal Pricing
In this section, we put demand analysis to
work by examining three important
managerial decisions: (1) the special case of
revenue maximization, (2) optimal markup
pricing, and (3) price discrimination.

3.3. Price Elasticity, Revenue, and

1 Marginal Revenue
Measures how consumer demand for a good
change in response to income changes.

The income elasticity coefficient Ei is

calculated as:
percentage change∈quantity demanded
Ei =
percentagechange ∈income

E I=
( Q 2−Q1
Q1+Q 2 )(
÷2 ÷
Income2−Income 1
Income1 + Income 2
÷2
)
Types of Goods by Income Elasticity:

Normal (Superior) Goods: If Ei is positive,

demand for the good increases as income
rises. This indicates a direct relationship
between income and demand.

Inferior Goods: If Ei is negative, demand for

the good decreases as income rises. This
indicates an inverse relationship between
income and demand.