1. Chapter # 3 Elasticity,importance and its practical use in Managerial Economics Tahir Islam

2.  Elasticity. The term elasticity refers to extension quality of a good. For example, rubber, Spring, plastic, metals etc. And a good which has no quality of extension and contraction is known as inelasticity or inelastic good. For instance, stone, paper etc.  Demand elasticity. law of demand shows qualitative relationship between demand and price. The LOD expresses only inverse relationship b/w price and quantity demanded but it does not show quantitative relationship between demand and price that is how much quantity demand of a product is change by a one unit change in price. Only elasticity of demand makes us able to know about that how much quantity is effected by change in price. Thus demand elasticity is the degree of responsiveness of quantity demanded to change in price. it shows sensitivity of quantity demanded of a product to price change. Mathematically it is written as Meaning and concept of elasticity

3. Meaning and concept of elasticity (cont…) Ed = Or E d = %∆ in Q d %∆ in P Percentage Change in Quantity Demand Percentage Change in Price

4. Point price elasticity of demand 1 2 5 6 4 3 100 200300 400500 Midpoint, ES=1

5. Point price elasticity measures elasticity at particular point on demand curve At midpoint elasticity of demand is equal to one Below midpoint point elasticity of demand is less than one Above midpoint elasticity of demand is greater than one If we move downward from midpoint or when we decrease price point elasticity of demand became relative inelastic When we move upward from midpoint point elasticity of demand became relative elastic Point price elasticity of demand

6. Point price elasticity of demand (cont…) So two different elasticity of demand does not provide a sound base for managerial making decision So we will go for another option or elasticity of demand i.e. known as acre elasticity of demand Which provide a slid base for managerial making decision What is acre elasticity of demand Acre elasticity of demand measures elasticity between two points on demand curve

7. Acre price elasticity of demand Point price elasticity of demand provides different elasticity of demand, when a firm increase or decrease the price To avoid this, we use Acre elasticity of demand in which we use the average of two prices and average of two quantities The formula for acre elasticity of demand is ∆Q (P 2 + P 1 )/2 ∆P (Q 2 + Q 1 )/2 E P = P 2 - P 1 Q 2 - Q 1 Q 2 + Q 1 P 2 + P 1 =

8. Acre price elasticity of demand (cont…) By using the above formula we obtain a constant elasticity of demand which provide a solid base for managerial making decision

9. Price elasticity, total revenue, and marginal revenue An important relationship exist among these terms TR is equal to price times quantity, MR is the change in total revenue per unit change in out put or sales TR = P×Q MR =∆TR With decline in price,total revenue increases if demand is elastic i.e. if Ep is greater than one TR remains unchanged if demand is unitary elastic, TR is declines if demand is inelastic ∆Q

10. Price elasticity, total revenue, and marginal revenue (cont…) Reason for If demand is elastic a price decline leads to a proportionately larger increase in quantity demand or sale so total revenue increases When demand is unitary elastic, a decline in price leads to an equal proportionate increase in quantity demand or sale and so total revenue remain unchanged If demand is inelastic, a decline in price leads to a smaller proportionate increase in quantity demanded so total revenue of a firm declines

11. Demand curve is linear so elasticity of demand at midpoint is unitary, elastic above midpoint, and inelastic below the midpoint Reduction in price leads to increase in total revenue down to the midpoint of demand curve (where total revenue is maximum) and to decline thereafter MR is positive as long as TR increases; MR is zero when TR is maximum MR is negative when TR declines Price elasticity, total revenue, and marginal revenue (cont…)

12. PQ E TR=P.Q MR=∆TR/∆Q 6 0 -∞ $0- 5100 -5 500$5 4200 -2 800 3 3300 -1 900 1 2400 -0.5 800-1 1500 -0.2 500-3 0600 0 0-5 p

13. Price elasticity, total revenue, and marginal revenue (cont…) 0 1 300 600 300 2 3 4 5 6 600 TR MR E E P =1 TR P <1 E P >1 F F P,MR ($) 900

14. Price elasticity of demand for a commodity depends on availability of substitutes for a commodity Price elasticity of demand is larger if closer and greater the numbers of substitute are available in market Length of time over which the quantity response to the price change is important Demand for sugar is more price elastic than salt Substitute of sugar is (honey, saccharine) No substitute of salt More narrowly a commodity is defined the greater is its price elasticity Factors affecting the price elasticity of demand

15. Factors affecting the price elasticity of demand con Price elasticity for coke is much greater than the price elasticity of demand for soft drink Price elasticity of demand is larger the longer is the time period allowed for consumers to respond to the change in commodity price Consumers take time to learn about the availability of substitutes and to make adjustment in their purchases

16. Income elasticity of demand:  “Income elasticity of demand is the responsiveness of demand to changes in the income of the consumer.”  Income elasticity is calculated by using the following formula: E y = % change in quantity / % change in income E y = ΔQ/Q ÷ ΔY/Y E y = ΔQ/Q × Y/ΔY

17. Income elasticity of demand (cont….)  Income elasticity of demand is: a)Equal to unity i.e. when the percentage change in income is equal to percentage change in quantity demanded. E y = 1 b)It is less than unity, if percentage change in income is more than percentage change in quantity demanded. E y < 1 a)More than unity, if percentage change in income is less than percentage change in quantity demanded. E y > 1

18. Acre Income elasticity of demand: Income elasticity of demand just like point price elasticity of demand provides different results depending whether income rises or falls For policy making and for making managerial making decision we can not use point income elasticity of demand, we use acre income elasticity of demand We use average income and average quantities Acre elasticity of demand measures the average response of consumer as their income changes

19. Acre price elasticity of demand ∆Q (Y 2 + Y 1 )/2 ∆Y (Q 2 + Q 1 )/2 E Y = Y 2 - Y 1 Q 2 - Q 1 Q 2 + Q 1 Y+ Y 1 = 2

20. Income elasticity of demand (cont….) Income elasticity of demand is positive for normal goods In case of necessities Ey is positive but low (0< EY <1) Food, clothing and housing In case of luxuries EY is above 1 Such as health care, education and recreation For inferior goods income elasticity of demand is negative such as flour its demand decreases as income rises because consumers can then afford to buy prepared foods or to eat out Income elasticity of demand is use for purpose of forecasting the demand for a commodity that a firm sells under different market condition

21. Income elasticity of demand (cont….) Estimated Income Elasticity of Demand for Selected Commodities, United States CommodityIncome Elasticity Wine2.59 Electricity1.94 European Car 1.93 Asian Car1.65 Domestic Car 1.63 Beef1.06 Cigarettes0.50 Beer0.46 Chicken0.28 Pork0.14 Flour-0.36

22. Cross Elasticity of Demand Cross elasticity of demand: When the quantity demanded is responsive to change in the price of other product, the elasticity is said to be cross elasticity of demand For example, there are two products X and Y, whereas product Y is the substitute of X When the change in price of Y leads to the change in the quantity demanded of X, then quantity demanded of X is responsive to change in the price of Y Thus here the elasticity of demand for X is said to be cross elasticity of demand. Because the quantity demanded of X is changed by the change in the price of Y

23. Mathematically it can be written as: E XY = %∆ Q X %∆ P Y ∆Q X P Y ∆P Y Q X E XY =

24. Cross price elasticity of demand (cont…) For substitute goods cross elasticity of demand is always positive For complementary goods cross elasticity of demand is negative If cross elasticity of demand is greater than one, substitutability between two goods increases If cross elasticity of demand is less than one, substitutability between two goods decreases If cross elasticity of demand is equal to zero, it means that goods are independent such as books and butter

25. Cross point- price elasticity of demand (cont…) Point cross-price elasticity of demand gives different results depending on whether price of related good rises or falls So policy makers can not use this elasticity for managerial making decision To avoid this difficulty we go for another option i.e. acre cross-price elasticity of demand

26. Acre cross elasticity of demand In acre elasticity of demand we use average price and average quantity demand which we use in managerial making decision or in policy making In managerial making decision this elasticity is very useful. Firm uses this concept to measure the effect of changing the price of related good and to design its own price policy

27. Acre cross elasticity of demand (cont…) For example the General Motors Corporation can use the cross-price elasticity of demand to measures the effect of changing the price of Chevrolets on the demand for pontiacs Chevrolets and pontiacs are substitute goods If price of former decreases demand for latter decreases Similarly manufactures of both razors and razor blades uses this elasticity to measure the increase in demand for razor blades that would result if firm reduced the price of razors Cross elasticity of demand is positive and high, if products belong to same industry, for example Chevrolets and pontiacs

28. ∆Q X (P Y2 + P Y1 )/2 ∆P Y (Q X2 + Q X1 )/2 E XY = P Y2 - P Y1 Q X2 - Q X1 Q X2 + Q X1 P Y2 + P Y1 =

29. Estimated Cross-Price Elasticity of Demand Between selected Commodities, United States Commodity XCommodity Y E MargarineButter1.53 Natural GasElectricity0.80 European CarsUS domestic and Asian Car0.76 Asian Cars US domestic and European Car0.61 US domestic Car European and Asian Car0.28 Pork Beef 0.40 ChickenPork 0.29 ClothingFood -0.18 EntertainmentFood -0.72 CerealsFresh Fish -0.87 XY

30. Using elasticity's in managerial making decision The analysis of forces or variables that affect demand and numerical estimate of these variables are essential for the firm to make the best operating decision and to make a plan for its growth Some factors or variables that affect the demand are under the control of a firm Such as setting the price of its product Expenditures on advertisement Quality of its product

31. Using elasticity's in managerial making decision (cont…) Customer service Some factors are not under the control of a firm Level and growth of consumer income Consumer expectation about price Competitor price decisions Competitors expenditures on advertisement Product quality and customer service of competitor

32. Using elasticity's in managerial making decision (cont…) The firm needs these elasticity estimates in order to determine the optimal operational policies and most effective way to respond to the policies of competing firms If demand for a product is price inelastic, the firm would not decrease the price of the product, by doing so the firm would decrease the profit If elasticity of sale with respect to advertising is positive and higher than for its expenditures on product quality and customer service then firm must concentrate more on advertising rather than on product quality and customer service.

33. Using elasticity's in managerial making decision (cont…) If the firm estimated that cross elasticity of demand for its product with respect to the price of competitor’s product is very high It will be very quick to respond to the competitor price reduction,otherwise, the firm would lose a great deal of its sale However the firm would thing twice before lowering its price for fear of starting a price war

34. Using elasticity's in managerial making decision (cont…) If income elasticity of demand is very low for the firm product Management must know that firm will not benefit from rising incomes and may want to improve its product or move into new product line with more income elasticity of demand So identification of all important variables that effect the demand, and numerical estimates of these variables are important in making managerial policies