PG 2013 Sessions 7 & 8

ELASTICITY OF DEMAND

1

2

Elasticity of DemandMeasure of sensitiveness of demand.

Responsiveness of demand to

- Change in price (Ep)

- Change in income (Ey)

- Change in price of a related commodity (Ec)

- Change in advertising expenditure (Ea )

3

Price Elasticity (Ep) Price Elasticity (Ep)

% change in Qd Ep= _______________ % change in Px

(Q2-Q1)/Q1

= --------------- (P2-P1)/P1

Where Q1= Original quantity Q2= New quantity P1 = Old price P2= New price

4

Price Elasticity (Ep)

When P1 = Rs. 10, Q1 = 2000 . When price changes, P2=9 , Q2= 2500. Find the price elasticity of demand.

Ep = (2500-2000) /2000 / (9-10)/10 = - 2.5

Interpretation: A 10% reduction in price will result in a 2.5% increase in quantity demanded.

5

Types of Price ElasticityType Numerical

expressionDescription Shape of

curve

∞ Infinite Horizontal

Perfectly inelastic

0 Zero Vertical

Unit elastic 1 One Rectangular hyperbola

Relatively elastic

>1 More than1 Flat

Relatively inelastic

<1 Less than 1 Steep

Perfectly elastic

6

Types of Price Elasticity

Ep= ∞ Ep=0

Ep=1

Ep> 1Ep<1

Quantity demanded

pric

epr

ice

7

Total Outlay/ Revenue Method of Measuring Elasticity

It is possible to find out the elasticity through the Total Outlay Method. Here, elasticity is measured by comparing total expenditure before and after a change in price

Ep=1: Unit elastic when there is no change in the total revenue as a result of a rise or fall in price- Revenue remains constant

Ep>1: Relatively elastic when total revenue rises with a fall in price and falls with a rise in price.

Ep<1 : Relatively inelastic when total revenue rises with a rise in price and falls with a fall in price.

Total Outlay Method

Elasticity

Price Quantity Demanded

Total Outlay

Highly Elastic ( Ep >1)

Increases Decreases Decreases

Decreases Increases Increases

Unitary Elastic ( Ep=1)

Increases Decreases No Change

Decreases Increases No Change

Highly Inelastic (Ep < 1) Increases Decreases Increases

Decreases Increases Decreases

8

9

Total Outlay Method

Unit Price (Rs) Quantity TE =P*Q (Rs)

A. 10 10 100

5 25 125 ep>1

B. 10 10 100

5 20 100 ep=1

C. 10 10 100

5 15 75 ep<1

10

Factors Determining Price Elasticity• Nature of commodities: Necessities- inelastic• Variety of uses: If commodity has a variety of uses,

more elastic demand• Availability and closeness of substitutes: More the

substitutes, more elasticity• Income level: Richer people are less affected by price

rise• Proportion of income spent on commodity: Where it

is small, less the elasticity• Urgency of Demand: The more urgent the demand, the

less elastic

Determinants of Price Elasticity of Demand

• Durability of a commodity: The more durable and reparable a commodity, higher the elasticity; Perishable goods have lower elasticity

• ADDICTION: Less elasticity• Defining the Product: The demand for a commodity

will be less price elastic if it is more broadly defined. The demand for a commodity will be more price elastic if it is more narrowly defined.

12

Factors Determining Price Elasticity

Time: Demand for a product is more price elastic in the longer run by when the consumer gets the time to make the adjustment and more able to respond to a change in price.

E.g., when gasoline prices increased sharply in 1974, elasticity of demand was very low in the period that followed immediately. But over many years, Ep increased as consumers shifted to more fuel-efficient cars, car pools, public transport and other measures to reduce gasoline consumption.

Short and Long Run Price Elasticity in 2006-07

Commodity SR Ep LR Ep

Butter^ 1.47 2.78

Petrol ^ 0.30 0.90

Electricity (household) * 0.13 1.89

* Refers to USA

^ Refers to urban India• SR Ep : Short run Price elasticity• LR Ep : Long run Price elasticity

What does the Table tell you?14

Short and Long Run Price Elasticity in Urban India, 2006-07

Commodity SR Ep LR Ep

Butter 1.47 2.78

Petrol 0.3 0.9

Electricity (household) * 0.13 1.89

1.1% rise in butter price leads to 1.47% reduction in demand in SR and 2.8% fall in LR.

2.Short run Ep is lower than long run PE for all goods

3. For petrol , demand is highly inelastic in the SR. (1% rise in price leads to 0.3% fall in demand), but in the long run elasticity is higher.

15

16

Price Elasticity (Ep)

Identify which commodity has a more elastic demand in the following pairs:

- Penicillin and sugar

- Car and tyre

- Ice cream and vanilla ice cream

- Coke and soft drinks

- Demand of the firm and demand of the industry

Ey = % change in Quantity demanded (Q) / % change in income of consumer (y)

Q2-Q1/Q1

Y2-Y1/Y1• Positive Ey : When income increases, consumer buys

more of the good e.g., Normal goods- clothes, food

• Zero Ey : No change in demand when there is a change in income- Neutral goods- salt, matchbox

• Negative Ey : When income increases, consumer buys less of the good – Inferior goods

17

Managerial Application of Income Elasticity

• Helps in forecasting demand for a commodity under different economic conditions- Demand for a commodity with low income elasticity will not be affected during boom or recession

• Helps a firm in identifying which type of consumer is most likely to buy its product.

• Helps identify most suitable media for advertising

18

Cross Elasticity

Responsiveness of the demand of one good to the change in the price of a related good, ceteris paribus

Ec = % change in Quantity demanded of X (Qdx) / % change in price of a related commodity, Y (Py)

Related goods may be complementary (joint demand) or substitutes

Positive Ec : Quantity demanded of X moves in the same direction as the price of Y

Case of Substitutes – E.g., Coke and Pepsi

Negative Ec : Quantity demanded of X moves in the opposite direction as the price of Y

Case of Complements – Tea and sugar, car and petrol

19

Consider 2 goods X and Y. There was no change in the price of Y but its demand fell from 6000 to 5500 units. On analysis it was found that the price of a related good X had risen to Rs. 250 from 225. Find the cross elasticity and the relationship between the two goods.

20

(Q2y-Q1y)/Q1y

Ec = --------------- (P2x-P1x)/P1x

(5500- 6000) / 6000

= ----------------------

(250 – 225) / 225

Cross elasticity = - 0.75

The negative cross elasticity indicates that X and Y are complementary goods.

21

22

Cross Elasticity

Given cross elasticity, identify nature of relationship and give logical reasoning:

Commodity Ec wrt P of: Ec

1. Dalda Butter 1.55

2. Natural gas Electricity 0.80

3. Clothing Food - 0 .18

4. Entertainment Food - 0.72

23

Cross Elasticity

1.Dalda & Butter 1.55

Means 1% increase in price of butter leads to a 1.55% increase in demand for margarine. Thus, the two goods are substitutes.

4. Entertainment & Food -0.72

Means 1% increase in price of food leads to a decrease in demand for entertainment by 0.72%. Why?

Using Cross Elasticity in Managerial Decision Making

• To estimate the potential loss for firm A when there is a threat of its competitor (Firm B) reducing its price.

• Firms use this concept to measure the effect of changing the price of a product they sell on the DD of other related products that the firm also sells. Changing the price of Maruti Suzuki’s Esteem and its effect on demand for Wagon R

• Used for measuring interrelationships between sectors- e.g. in an agrarian economy, knowledge of cross elasticity between demand for industrial products with respect to agricultural prices would indicate the extent to which farmers’ prosperity is the cause of industrial growth.

24

Price Elasticity and Cross Elasticity for Oranges

University of Florida’s Market Experiment• 9 super markets in Michigan• Each day for 31 consecutive days (short enough

as would be no change in population, taste, weather etc, but long enough to collect adequate data)

• Price changed by 4 cents, up to 16 cents• 9250 dozen of oranges were sold in the 9

supermarkets during the experiment

25

Interpretation

• Price elasticity of all three types of oranges was quite high (Bold face numbers- diagonal)

• Cross-price elasicities of demand between the two types of Florida oranges were higher than 1 (+1.16 and +1.56), indicating that they were close substitutes.

• Cross-price elasicities of demand between the two types of Florida and California oranges were close to zero (0.18,0 .09, 0.01, 0.14), indicating that California oranges were not viewed as substitutes to Florida oranges.

• So while pricing, the producers of Florida oranges should carefully consider the price of other Florida oranges, but need not be much concerned about price of California oranges.

Price Elasticity and Cross Elasticity for Oranges- Interpretation

Price Elasticity:

1.An 1% rise in the price of Flo Indian river results in a -3.07% fall in demand (and so on for other 2 varieties)

2.Both the Florida oranges have higher price elasticity

(Means Californian ones are less price elastic).

28

Promotional Elasticity

• Degree of responsiveness of demand to a change in advertising expenditure

• Higher the responsiveness, higher will be the firm’s incentive to advertise

29

30

Using Elasticity in Managerial Decision Making

Some factors that affect demand are within the control of the firm and others, outside.

Within control: Price, advertising, non price like quality and customer service. These can be decided according to elasticity

Outside Control: Consumer’s Income, competitor’s pricing and non pricing decisions. For these, responses can be tailored according to elasticity.

Using Elasticity in Managerial Decision Making

• Deciding on Price- Products with elastic demand should be sold at a lower price, while those with highly inelastic demand should be sold at a higher price to maximise revenue

• Advertising Expenditure Determination: Increase ad expenditure if elasticity is

high; otherwise wasteful to spend money on advertising. So explore alternatives

31

Using Elasticity in Managerial Decision Making

• Price discrimination- Higher prices for segments with inelastic demand and lower price for segments with elastic demand

• Determining Rewards for Factors of Production- Factors with inelastic demand are rewarded more than factors with relatively elastic demand. Hence low wages for laborers and high rewards for specialists

32

Using Elasticity in Managerial Decision Making

33

Using Elasticity in Managerial Decision Making

Globalisation and Elasticity:

• High cross elasticity between domestic and foreign goods because of high substitutability between domestic and foreign goods and services

• Expected to increase even further.

34

Using Elasticity in Managerial Decision Making

1.When an economy is growing at a high rate, leading to increased employment and consumer incomes, what type of goods are likely to face an increase in demand?

2. Should the manager lower the price of a good if its demand is inelastic? Why?

3.If advertising elasticity is highly inelastic, should the manager spend money on sales promotion or improving product quality? Why?

4. If cross elasticity with a competitor’s product is high, how should a manager respond to a price reduction by the competitor?

5.In a growing economy, if income elasticity for a firm’s product is very low, what should be the firm’s strategy?

35

Using Elasticity in Managerial Decision Making

1.When an economy is growing at a high rate, resulting in increased employment and consumer incomes, what type of goods are likely to face an increase in demand? Luxury goods

2.Should the manager lower the price of a good if its demand is inelastic? Why?

No, he will lose revenue

3.If advertising elasticity is highly inelastic, should the manager spend money on sales promotion or improving product quality?

Advertising wont increase revenue, so he should concentrate on product quality

36

Using Elasticity in Managerial Decision Making

4. If cross elasticity with a competitor’s product is high, how should a manager respond to a price reduction by the competitor?

Quickly reduce price; otherwise competitor will take away his customers (But should not start a price war)

5.In a growing economy, if income elasticity for a firm’s product is very low, what should be the firm’s strategy?

May think of changing the product line to something more price elastic as the firm will no benefit from an increase in incomes.

37

Using Elasticity in Managerial Decision Making

6. A Study by Venkatram and Deodhar in 1999 showed that DD for coffee in India is inelastic. So, what should be the coffee producers’ strategy?

38

6. Inelastic demand means , coffee demand is not very responsive to price. So authors proposed that the Coffee Board should focus attention on non-price factors rather than price incentives in its campaign to promote coffee .

39

Knowledge Testing1.Items of joint consumption will have --------

cross elasticity

2. When Ea is -------- than 1, the firm can incur heavy promotional expenditure.

3. When Ea is low, it means the firm should incur ________ expenditure on advertising its product.

4. A negative Ec between two goods implies that the two goods are -----------

5. A higher positive Ec implies ________ substitutability between two items

6.Income elasticity of demand for diamonds would be:

A)=1 B) =0 C) >1 D) <1 40

Knowledge Testing

1. Items of joint consumption will have negative

cross elasticity

2. When Ea is greater than 1, the firm can incur heavy promotional expenditure.

3. When Ea is low, it means the firm should incur less expenditure on advertising its product.

4. A negative Ec between two goods implies that the two goods are complements.

5. A higher positive Ec implies greater substitutability between two items

6.Income elasticity of demand for diamonds would be: C) >1

41

True of False• Alcohol is relatively price elastic.

• Governments impose higher taxes on goods with inelastic demand.

• The flatter the demand curve, the higher is the price elasticity.

• Distinguish between normal and inferior goods in terms of income elasticity of demand

42

43

Sums in Elasticity

Compute the relevant elasticities of demand when the demand for a product increases from 100 to 150 units (when all other things remain constant) when

i) Price of product decreases from Rs. 8 per unit to Rs. 6 per unit

ii) Income of consumer increases from Rs. 1000 to Rs. 4500

iii) Price of a related good increases from Rs. 8 to Rs. 10 per unit. Also, state the relationship

44

Promotional Elasticity (Ea)

A company presently sells 6000 units of shoe polish at a price of Rs. 30 per unit. Suppose it decides to increase its advertising expenditure from Rs. 12 lakh to Rs. 20 lakh. If the promotional elasticity for shoe polish is 1.4, find out the new demand for shoe polish.

45

Promotional Elasticity (Ea)

Old A=12 L; New A=20L; Δ A =8L;Ea= 1.4; Dx (Old demand)= 6000 New D =Dn

Δ Dx = D- 6000Eq: Ea= (Δ Dx / Δ A)* (A/Dx)Putting the variables in the equation we get1.4= (Dn-6000)/8,00,000 *( 12,00,000/6000)Dn-6000= (1.4* 8,00,000 * 6000)/ 12,00,000Dn = 5600+6000

=11600 units

Castrol India -ET 500, 19 Dec 12Castrol India felt in 2011 that something was

amiss.2 things happened in 2011: the economy which was growing at close to 8.5% in FY 11 slowed down to 6 to 6.5% in FY12. Secondly, the cost of base oil, which is the company’s principal ingredient, increased dramatically by almost 30%.

According to Ravi Kripalani, CEO, Castrol India: The slowdown taught us that it was not enough to bank on our existing advantages. There are 3 other things that we needed to focus on: affordability, advocacy and availability

46

• This meant a lot of research on price elastcity of demand for its products and how much cost increases could be passed on to consumers. The management also decided to strengthen the company’s distribution since demand from rural India was growing strong.

• Castrol’s efforts to stay ahead of the technology curve by launching newer and better products consistently has also helped. It chose not to apply brakes on its advertising and brand-building exercises. To be contd for more concepts

47

48

Managerial Economics ©Oxford University Press, 2006

All rights reserved

Elasticity of supply

• Ess = % change in quantity supplied / % change in price

• Flatter the supply curve , larger the elasticity

Summary• Responsiveness of quantity demanded to a

change in Price, Income, price of related good or promotional expenditure.

• Price elasticity of demand measures % change in quantity demanded in response to a change in price.

• Degrees of price elasticity- diagrammatic representation

• Measuring Price elasticity• Factors influencing Ep

50

Summary

• Income elasticity : Most goods are normal (Ei >0); for inferior goods Ei < 0; Normal goods with Ei >1 are called luxuries, while Normal goods with Ei between 0 and 1 are called necessities

• Cross elasticity: measures the response of demand of good X for a change in the price of a related good Y. Goods X and Y are substitutes if Ec is positive and complementary if Ec is negative

• Promotional Elasticity measures response of demand to a change in advertising expenditure

• Importance and use of the Concept in managerial decision making

51

• Retail sales of diesel have soared up to 20% in some regions in the past week as bulk buyers are making a beeline for cheaper fuel available at petrol pumps after the recent change in pricing norms.

The surge has further distorted the retail market, which has already seen a massive shift of consumers to diesel cars as petrol prices are significantly higher. A sharp increase in CNG prices has added to the demand for diesel, which rose 22% in Delhi in the December quarter and continues to grow at the same scorching pace this month. Petrol sales in large cities such as Delhi have dropped 3% in recent months.

ET, 30 Jan 2013

• Bulk buyers, who normally purchase diesel in tankers directly from oil companies, now have to pay about 20% more than the price at retail pumps since the government allowed market pricing for big customers and promised to gradually raise retail prices to market levels in a year. This has triggered a rush of big buyers to petrol pumps where they find diesel about Rs 10 cheaper.

The surge is bad news for state firms such as IOC,HPCL and  BPCL which were hoping bigger margins from big customers would offset the revenue loss from retail sales at state-set prices.

• It is difficult to prevent malpractices. In the last few days, we have seen higher demand for diesel at retail outlets. In some markets, sales have risen 5%, in some cases 15%, and there are areas where sales have gone up even 20%," said a senior executive in IndianOil's marketing division.

Sales have increased in Gujarat, where state roadways buses have started filling their tanks with diesel from petrol pumps.

Other states also have similar plans, industry officials said.

"In some places they have already shifted to petrol pumps and in other places they are making plans. The price differential is very high," an IOC executive said.

• In Andhra Pradesh, retail sales at several pumps have risen 20% as industrial users are buying cheaper fuel at pumps, said Rajiv Amaram, joint secretary of the Confederation of Indian Petroleum Dealers, which represents 4,000 pumps in the state.

"Fuel buyers, whether general or industrial users, normally go to bunks where they get relatively cheaper fuel. Anybody, whether retail or industrial user, is entitled to 2,000 litre of fuel purchase at retail pumps, and we cannot stop them from such purchases as long as they are under the prescribed limit per transaction," he told ET.

1. Identify the elasicity issues here

2. What are the micro-macro links implied?