elasticity lecture

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Elasticity of Demand

Elasticity means the measurement of responsiveness of one variable to other variable.

X =f (Y), X = dependent variable, Y = Independent variable (If Y change how it is going to affect for X - elasticity measure it)

An elasticity of demand = (% change in the demand for good A)/% change in an independent variable

Main Demand Elasticities Price elasticity of demand Cross price elasticity of demand Income elasticity of demand

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Other Elasticities Supply elasticity Advertising and cross advertising elasticityConjectural price elasticityImports and exports elasticities

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Price elasticity of demand (the percentage change in the quantity of a good demanded divided by the corresponding percentage change in its price. This is related with the movement along the demand curve)

Point elasticity = AQ% = AQ/Q = A Q X P AP % AP/P A P Q

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Elasticity measure gives two pieces of information:

• It shows sign of the relationship between changes in the relevant variables.

• It measures the extent to which quantity responds to a change in price.

Generally price elasticity can be in three ranges:

1. Price inelastic ( 0 - 1), Ed < 1

2. Unitary (1), Ed = 1

3. Price elastic (1 and infinity), Ed > 1

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Arc elasticity allows you to calculate elasticity in two price and two quantity combinations

Change in Q Q2-Q1 Average Q = (Q2+Q1)/2 = A Q . P2+P1

Change in P P2-P1 A P Q2+Q1 Average P (P2+P1)/2

Price

Quantity demanded 0 Q1 Q2

P1

P2

A P

AQ

C

A

B

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Elasticity along a linear demand curve

Qd0

Ed = 00 : Perfect elastic

Ed > 1 : Elastic range

Ed = 1 : Point of unitary elasticity

Ed < 1 : Inelastic range

Ed = 0 : Perfect inelastic

P

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Graphical Representation of Elasticity

1. Unitary Elasticity

Qd

P2

P1

Q1 Q20

DP

D

5%

5%

P up 5% Qd 5% down

P down 5% Qd 5% up

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2. Inelastic situation (relative)

P up 20% Qd 5% down

P

P2

Q1 Q2

D

P1

0

D1

20%

5% DQd

Large range of price changes butSmall changes of quantity of demand

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3. Elastic situation (relative)

P up 5% Qd 20% Down

P

P2

Q1 Q2

D

P1

0

20%

5%

D

Qd

Small range of price changes butmassive changes of quantity of demand

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4. Perfect Inelastic situation

P

P3

Q1

P1

0

D

Qd

P2

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5. Perfect Elastic situation

P

P

Q1 Q20

D

Qd

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Factors affect for the price elasticity

Time period (more time lesser elasticity)

addictive nature for good/services (more addiction lesser elasticity)

availability of substitutes and their quality

price range, and the necessity of the goods

share of income spent on good

consumers ability to change his environment

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Importance of price elasticity • to determine pricing policies/strategy

• to select inputs

• to select markets

• to maximize revenue

• to government taxation policies

Firm and the market elasticity(Depends on the market structure: Monopoly – same, other markets – different)

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Cross elasticity of DemandThis is related with the shift in demand curve. It can be defined as the responsiveness of demand for one product to changes in prices of other product.

Ex = (% change in quantity demanded of good A)/(% change in price of B)

Epx = AQy . Px

APx Py

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Importance to check the impact of prices of other goods to

the good concerned to formulate a good pricing strategy to analyse risks associated with the goods check the effectiveness of advertising to create a

brand loyalty to measure interrelationship between industries identify the boundaries of market in differentiated

products

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Nature of Cross Price Elasticity

1) Cross price elasticity for substitute goods are positive

2) Cross price elasticity for complement goods are negative

3) Cross price elasticity for independent goods are zero

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Cross-Price Ed = % change in demand for own product % change in price of another product

Complements and Substitutes

Cross Ed < 0 (-)“Complements”

e.g.1. DVD demand rises as price of DVD machines declines

e.g.2. Demand for flights to Canary Isles over Y2K fall as price of accommodation rises

Cross Ed > 0 (+)“Substitutes”

e.g.1. Rise in price of petrol increases demand for public

transport e.g.2. Fall in price of mobile

phones decreases demand for land lines

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EY = AQ . Y

AY Q

Income Elasticity of demandThis measures the responsiveness of quantity demanded to change in income, holding other factors are constant.

This related with the shift in demand curve due to changes in income.

For normal goods this is positive and for inferior goods this is negative

Importance (to check future demand, decisions on investment, policy decisions in international trade, effects of changes in real income)

Elasticity can be measure for other variables such as advertising and interest rates, etc.

Ey = % change in quantity demanded % change in disposable Y

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Income and Elasticity - Relationship

Income Income Elasticity < 0

Income Elasticity = 0

Income Elasticity>0 Demand

0

A

O – A = Normal good, A - Y = Inferior good

Y

Qd

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Relationship between TR, AR and MR

Total Revenue = TR = P . Q

Average Revenue: TR/Q = P . Q/Q = AR = P

Marginal Revenue: d(TR)/d(Q) = MR

Angel’s Law

The proportions of expenditure on all necessities (foods) declines as incomes rise and in contrast the proportionate expenditure on luxuries (durable) would increase. (this is related with the consumer’s bahaviour with income increases)

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The effect on revenue of a price change

at point y, Ed = 1between x and y, Ed > 1between y and z, Ed < 1

between x and y, TR increases (i.e. MR is +ve)

at y TR is at its maximum (i.e. MR = 0)

between y and z, TR decreases (i.e. MR is -ve)

quantity

pric

e (£

)

quantity

tota

l rev

enue

(£) 0

0

MR

AR

x

yp*

z

q*

Elastic Range

UnitaryInelastic Range

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Income Elasticity – Examples (Looking at this coefficient name which good is Normal and inferior)

Good Category Consumers’ expenditure (£M, 1985)

change in expenditure

(%)

Income elasticity of

demand

1981 1991

Cars & other vehicles 7,754 10,657 37.44 1.25

Furniture & Floor coverings 4,031 4,893 21.38 0.72

Food 30,217 33,409 10.56 0.35

Beer 8,561 8,211 -4.09 -0.14

Other alcoholic drink 6,363 7,616 19.69 0.66

Tobacco 8,167 6,569 -19.57 -0.66

Clothing 9,563 14,410 50.21 1.68

Footwear 2,195 2,895 31.89 1.07

Energy products 17,319 21,331 23.16 0.78

note : In the same period, real national disposable income rose by 29.86%source : Pass & Lowes (1994)

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Supply ElasticityThis always should go with lag: If price changes it takes sometime to respond supply to price changes in some sectors.Es = % change in quantity supplied/% change in price

Es > 1, Elastic

Es < 1, Inelastic

SS

S

Es =1, Unitary

SS

Es = 00 Es = 0 perfect elastic Perfect inelastic

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Advertising ElasticityA measure of the effect of a change in advertising upon the sales of a given good.

Ea = (% change in quantity demanded of good A)/(% change in expenditure on advertising good A)If Ea >1: Inelastic (large amount of expenditure needed to increase demand).If Ea<1: Elastic (small amount of expenditure needed to increase demand).

Cross Advertising ElasticityA measure of the responsiveness of the quantity of demand of one good to a change in the expenditure upon advertising on another good. Positive for complements and negative for substitutes.

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Conjectural Price Elasticity

This measures interdependence between firms and a good measure to forecast price changes in retaliation specially in oligopolistic markets. This will help to firm’s pricing decision making strategy.

Ec = (Expected % change in the price charged by firm B)/(Actual % change in price charged by firm A)

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Exports and Imports ElasticityPrice elasticity of demand for exports = (% change in the demand for exports in country x/% change in price of exports in country A)

Income elasticity of demand for exports = (% change in the demand for exports in country x/% change in disposable income abroad)

Price elasticity of demand for imports = (% change in the demand for imports in country x/% change in price of imports in country A)

Income elasticity of demand for imports = (% change in the demand for imports in country x/% change in disposable income aboard)These elasticities are important to policy decisions in external trade and devaluation.

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Demand Estimation

Identification of firm’s real demand curve helps to determine

the correct price, inputs requirements profit maximising output

Identification of demand

Consumer interviews Consumer surveys Consumer clinics and focus groups Market studies Market experiments in test stores

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Statistical Estimation of Demand

Regression technique (Identification of variables, obtain data on variables, equation specification, estimation of regressionparameters, interpretation of regression results: coefficient of determination, F and t statistics, SE, problems of regression:Auto correlation, multi-collinearity, heteroscedasticity).

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Demand Forecasting Methods• Deterministic Time Series Analysis (secular trend,

cyclical fluctuation, seasonal variation and random influences).

• Trend projection, extrapolation or curve fitting • Barometric or lag or lead indicator methods.• Econometric models (Single, multiple, lag, structural

model…etc).• Input-output analysis (interrelationships).• Opinion polling and survey techniques (future plans).

Techniques selection depends on the forecasting distance, complexity of the forecasting problem, lead time, accuracy, relationship, resources and time availability, etc.

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Product Life CycleThis shows four stages of demand for a product. Introduction phase - demand increases slowly.Growth phase - demand increases rapidly.Maturity phase - demand increases less slowly.Decline phase - demand decreases.

Sale

s (u

nits

sol

d)

Time0

Launch Growth Maturity(saturation) Decline

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Characteristics Approach to Demand

This says that consumers are demanded goods because of their characteristics rather than consumers own sake.

Therefore, managers should learn how to incorporate the consumer desired characteristics to products and services.

This can show by using indifference curve analysis.

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Market Segmentation

Segmentation is the process of slicing a market for a particular product or service into a number of different segments. The segments are usually based on factors such as demographics, beliefs or the occasion of use of the product.

Market segments or niches are groups of consumers with similar tastes and preference patterns. Maximum number of market segments will not exceed the number of potential customers.

Market can be segmented according to product characteristics, consumer income level, age and geographic area. Elasticities can help to identify market segments.Segmentation can aid in: identifying competitors, new product development, targeting advertising expenditure, branding and exploiting market niches.

The internet promises to provide new opportunities for segmentation. It offers continuous opportunities to capture information about customer behaviour. Consumers identify themselves and their characteristics by their electronic participation in particular interest groups, and by their general online behaviour.

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Market Segmentation : Mobile Internet Access

Access to www

No access to www

Not portable

Mobile phones

Desktop PCs

Laptop computers

Highly portable

WAP Phones

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Segmentation Example 1 : Beer

Beer Category

49%

51%

Ales Lagers

• Which are the growing product segments through the 1990s?• In which product segments are branding and advertising most important?

Product Format

29%

71%Draught Packaged

Retail Outlet

80%

20%

On-sale Off-sale

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Segmentation Example 2 : Paint

Specialised

Paint

Decorative paint Industrial paint

Overall market

Broad sectors

Major users DIY ProfessionalDecorators

General Industrial

Product group Primer Matt Gloss SpecialPurpose

etc.

Product line Basic De Luxe Super de luxe

Colour range White Blue Red etc.

Packaging Can/brush Aerosol Tray/roller

Distribution outlets Wholesaler Retailer

Geographical cover Local Regional National International

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Criticism about demand theory

1) Consumers rationality is unpractical.

2) Demand not always behave as it is stated in the law.

3) Price is not the main concern of consumer. They concern about quality, reliability, design, after sales services, brand names, recommendations from friends, previous experience, consumer guides, advertisements, etc.

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1) Self -Study Demand Estimation

1) Specify the demand function for the following products.2) How do you estimate market demand for the following products?

1) a new version of Microsoft Office?2) a new brand of toothpaste?3) internet bank accounts?4) car exhaust systems?5) theatre performances? 6) a new toll road?7) electricity supply?8) Sri Lankan tourist sector/Sri Lankan airline9) Sri Lankan seaports 10) Sri Lankan professionals

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Questions to discussExplain market mechanism (demand, supply functions

and equilibrium price) with an example.Distinguish between movement along the supply curve

and shift in demand curve.Explain demand estimation techniques.Explain demand forecasting techniques.Distinguish between consumer and producer surplus.Explain main demand elasticity concepts with

examples.Distinguish point elasticity and arc elasticity.Distinguish between cross price and income elasticity. Explain why elasticity is so important to managers to

take business decisions.

References

Chapter 3 and 4 in McGuigan R.J, Moyer, R.C and Harris F.H (2005), Managerial Economics, Applications, strategy and Tactics, ISBN: 0-324-05881-0.

Chapter 3 in Worthington.I, Britton.C and Reese. A (2001), Economics for Business: Blending Theory and Practice, ISBN: 0273632450, Publisher: Financial Times/Prentice Hall.

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