Sessions 7 & 8

Sessions 7 & 8 Elasticity and Its Applications (With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 5)

Session Objectives: 

What is elasticity? What kinds of issues can elasticity help us understand?



What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure?



What are the income and cross-price elasticities of demand? [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

An Example 

You design websites for local businesses.



You charge Rs.50,000 per website, and currently design 12 websites per month, so that your total revenue is Rs. 6,oo,ooo. Earlier you were designing 15 websites per month @ Rs.30,000 per website



Your costs are rising (including the opportunity cost of your time), so you’re thinking of raising the price to Rs. 80,000.



The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? What will be the impact on your revenue? [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Elasticity of Demand 

Basic idea: Elasticity measures how much one variable responds to changes in another variable.



In the given example, elasticity measures how much demand for your websites will fall if you raise your price



Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as Price elasticity of demand =% change in Qd / % change in P



Loosely speaking, it measures the price-sensitivity of buyers’ demand [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Elasticity of Demand Price elasticity of demand = 15% / 10%

P

Price rises by 10% Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Demand falls by 15%

Q

Elasticity of Demand P

In our example, demand falls from 15 to 12 websites per month 80,000 Compute price elasticity of demand from A to B. Find the quantity demanded when price rises to Rs. 80,000

C B

50,000

A

30,000

Anything striking?

?

12

15

Suppose the market demand for burgers is given by the equation Qd = 60,000,000 – 1,000,000P For a price increase from Rs. 30 to Rs. 40 per burger, what is the price elasticity demand? [MBA of - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Q

Elasticity of Demand 

Use the following information to calculate the price elasticity of demand for hotel rooms: P = Rs. 700, Qd = 300; P =Rs. 900, Qd = 200



Problem: The standard method gives different answers depending on where you start.



The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.

Quick Activity: 

(Q2  Q1 ) /[(Q2  Q1 ) / 2] Price elasticity of demand = ( P2  P1 ) /[( P2  P1 ) / 2]

What will be the price elasticity of demand for websites using midpoint method? [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Determinants of Price Elasticity Example 1:



Consider two commodities fish and salt. Suppose prices of both these goods rises by 20%. For which good demand drops the most?



Fish, since it has close substitutes in the form of veg and other non-veg food items; while salt has no close substitutes. Lesson 1: Price elasticity is higher, when close substitutes are available [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Determinants of Price Elasticity Example 2:



Consider the example “blue-jeans” vs. “clothing”. Suppose prices of both these goods rises by 20%. For which good demand drops the most?



For narrowly defined goods such as blue-jeans there are many close substitutes, whereas for broadly defined goods like clothing, there are fewer (here no) substitutes. Lesson 2: Price elasticity is higher for narrowly defined goods than broadly defined ones.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Determinants of Price Elasticity Example 3:



Consider the combination “insulin” vs. “Goa Cruises”. Suppose prices of both of these rises by 20%. For which good demand drops the most?



To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson 3: Price elasticity is higher for luxuries, than for necessities.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Determinants of Price Elasticity Example 4:



Suppose price of petrol rises by 20%. Does demand drop more in the short run or in the long run?



There’s not much people can do in the short run, other than ride the bus, but options are limited. In the long run, people can change into smaller, fuel-efficient cars or can arrange for a carpool or even live closer to where they work. Lesson 4: Price elasticity is higher in the long run, than in the short run

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Determinants of Price Elasticity The price elasticity of demand depends on: 

the extent to which close substitutes are available



whether the good is a necessity or a luxury

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how broadly or narrowly the good is defined

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the time horizon: elasticity is higher in the long run than the short run.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

The Variety of Demand Curves 

Economists classify demand curves according to their elasticity.



The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb:



The flatter the curve, the bigger the elasticity.



The steeper the curve, the smaller the elasticity

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

The Variety of Demand Curves Inelastic Demand 

Quantity demanded does not respond strongly to price changes.



Price elasticity of demand is less than one.

Elastic Demand 

Quantity demanded responds strongly to changes in price.



Price elasticity of demand is greater than one. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

The Variety of Demand Curves Perfectly Inelastic 

Quantity demanded does not respond to price changes.



Price elasticity of demand is equal to zero

Perfectly Elastic 

Quantity demanded changes infinitely with any change in price.



Price elasticity of demand is infinite

Unit Elastic 

Quantity demanded changes by the same percentage as the price.



Price elasticity of demand is equal to one

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

The Variety of Demand Curves For a straight line demand curve, slope is constant but elasticity varies from zero to infinity. Suppose that the demand equation is as follows: Qd = 100 – 4P 

Draw the demand curve



Calculate the price elasticity of demand at P=0, 25, 12.5, 10, & 20



Interpret your results.

At any point on a linear demand curve price elasticity of demand equals the ratio of the lower to the upper portion of the demand curve. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Total, Average and Marginal Revenue 

Total revenue is the amount paid by buyers and received by sellers of a good.



Computed as the price of the good times the quantity sold, i.e., TR = P x Q.



Average revenue is the total revenue divided by the number of units sold. Average revenue curve is nothing but the demand curve.

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Marginal revenue is the extra revenue that the seller gets by offering an extra unit for sale. Thus MR = Δ TR/ΔQ. Graphically, MR at a point on TR curve is the slope of the TR curve at that point. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Total, Average and Marginal Revenue Price (Rs.)

Quantity

TR =PxQ

AR =TR/Q

MR=ΔTR/ΔQ

10

1

10

10

___

9

2

18

9

8

8

3

24

8

6

7

4

28

7

4

6

5

30

6

2

5

6

30

5

0

4

7

28

4

-2

3

8

24

3

-4

2

9

18

2

-6

10

1

-8

1

10 [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Total, Average and Marginal Revenue 

Observations: When output is zero, TR is also zero; so that TR curve starts from the origin and AR and MR curve have the same vertical intercept (for all practical purposes!!!).



TR increases as price goes from Re.1 to Rs.5 and then decreases for prices greater than Rs.6

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MR declines as quantity increases. MR is zero when TR reaches maximum at an output level of 5 units. Beyond 6 units, when TR starts decreasing, MR becomes negative. Why?



Because price and quantity are inversely related, to sell extra units, the firm must reduce the price of all the units sold. Negative MR implies that rupees received from selling the extra unit are not sufficient to compensate for the rupees lost as a result of selling all other units at a lower price.



AR declines at a rate 1 per unit, whereas MR declines at a rate of 2 per unit.[MBA This- means 2008-10]MR curve is twice as steep as a corresponding AR (or a linear demand 18.08.2008 & curve). Dr. Jaydeep Mukherjee 20.08.2008

Ravenshaw University

Total, Average and Marginal Revenue TR Quick Activity: The demand function for fountain pen is given as Qd = 40 –2P. At Q = 5 units, calculate the marginal revenue.

TR Q

6

AR MR

AR [MBA - 2008-10] 18.08.2008 & 20.08.2008

6

Dr. Jaydeep Mukherjee Ravenshaw University

MR

Q

Price Elasticity and Total Revenue 

A price increase has two effects on revenue: • Higher P means more revenue on each unit you sell. • But you sell fewer units (lower Q), due to Law of Demand.



Which of these two effects is bigger?



It depends on the price elasticity of demand.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Price Elasticity and Total Revenue A price increase will have one of the following effects, depending on the price elasticity of demand: 

TR will increase if demand is inelastic (0<ep<1)



TR will decrease if demand is elastic (ep>1)



TR will remain unchanged if demand is unitary elastic (ep=1)

Problems! 

Pharmacists raise the price of insulin by 10%. Does total revenue of pharmacists rise or fall?



As a result of a fare war, the price of air travel falls 20%. Does these companies’ total revenue rise or fall? [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 1 How much tuition for University Students? 

The Board of Trustees of a leading state University, with a current student strength of 4000, is faced with a critical financial problem. At present tuition rates, the University is losing Rs.10 lakhs per year.



The President of the Board of Trustees urges a 25% increase in tuition from the present Rs.1000 per year to tide over this financial crisis.



However an economics professor of the same University discovers a journal article that estimates the elasticity for enrollment at state Universities as 1.3 with respect to tuition changes. Should the University proceed with the proposed hike in tuition fees? [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 2 Can good news for farming be bad news for farmers? 

What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?



Because the hybrid increases the amount of wheat that can be produced on each acre of land, farmers are now willing to supply more wheat at any given price.



Supply curve shifts to the right; with an unchanged demand curve price of wheat falls from Rs.12 per kg. to Rs.10 per kg.



Empirically, it is observed that the demand for basic foodstuffs such as wheat is usually inelastic because these items are relatively inexpensive and have few close substitutes.



As such quantity of wheat sold rises only slightly, so that revenue that farmers receive by selling their crops, falls and they are worse off. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 2 2. . . . leads Price of wheat to a large fall in price . . .

1. When demand is inelastic, an increase in supply . . . S1

S2

Rs.12 Rs.10

Demand 100 110

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Quantity of wheat

3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from Rs.1200 to Rs.1100. Dr. Jaydeep Mukherjee Ravenshaw University

Application - 2 Question: If farmers are made worse off by the discovery of the new hybrid, why do they adopt it? 

Assumption of perfect competition! 

Each farmer is only a small part of the market for wheat, so that he is a price taker.



For any given price of wheat, it is better to use the new hybrid to produce and sell more wheat.



However, when all farmers do this, the supply of wheat increases, the price falls and the farmers are worse off. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 3 Does drug interdiction increase or decrease drug-related crime? 

One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.



We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime.



For simplicity, we assume the total rupee value of drug-related crime equals total expenditure on drugs.



Demand for illegal drugs is inelastic, due to addiction issues.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 3 Policy 1: Interdiction 

Interdiction reduces the supply of drugs.



Since demand for drugs is inelastic, P rises proportionally more than Q falls.



Result: an increase in total spending on drugs, and in drugrelated crime

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Application - 3 Policy 2: Education 

Education reduces the demand for drugs.



P and Q fall.



Result: a decrease in total spending on drugs, and in drugrelated crime Price

[MBA - 2008-10] 18.08.2008 & 20.08.2008

S

D2 Dr. Jaydeep Mukherjee Ravenshaw University

D1 Quantity

Income Elasticity of Demand Measure the responsiveness of demand to changes in income Income elasticity of demand =% change in Qd / % change in I 

Recall: An increase in income causes an increase in demand for a normal good.



Hence, for normal goods, income elasticity > 0.



For inferior goods, income elasticity < 0.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Income Elasticity of Demand Classification of goods 

If 0<eI<1, the goods are referred to as necessities. For such goods demand is relatively unaffected by changes in income. Example: bread. As families become more affluent, it will consume more bread, but the increase is usually not proportionate to the increase in income.



If eI>1, the goods are referred to as luxuries. For such goods change in demand is proportionately more than change in income. Example: purchase of necklace. As families become wealthier, they have more disposable income and their consumption on these luxury goods represent a larger share of their incomes. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Income Elasticity and Decision Making 

Any economy is subject to business cycles with fluctuations in income.



During periods of expansion, incomes are rising and firms selling luxury items such as electronic goods and exotic vacations will find that the demand for their products will increase at a rate faster than the rate of income growth. During recession, demand for such goods decrease rapidly.



Conversely, sellers of necessities such as fuel and basic food items will not benefit as much during periods of economic prosperity, but will also find that their markets are somewhat recession-proof. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Income Elasticity and Engel’s Law 

In 19th century, a German statistician, Ernst Engel studied the consumption patterns of a large number of households and concluded that the percentage of income spent on food decreases as incomes increase. That is, food is a necessity.



One of the implications of Engel’s law is that farmers may not prosper as much as those in other occupations during periods of economic prosperity. However, they may be somewhat recession-proof.

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Cross-Price Elasticity of Demand Measure the responsiveness of demand to changes in prices of related goods 

The cross-price elasticity of demand measures the response of demand for one good to changes in the price of another good.



Cross-price elasticity of demand = % change in Qd for good 1 / % change in price of good 2



For substitutes, cross-price elasticity > 0 



An increase in price of Pepsi causes an increase in demand for Coca Cola.

For complements, cross-price elasticity < 0 

An increase in price of ketchup causes decrease in demand for burgers. [MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University

Cross-Price Elasticity of Demand 

The price of apples rises from Rs.40.00 per kg. to Rs.50 per kg. As a result, the quantity of oranges demanded rises from 8,000 per week to 9,500. Calculate the cross-price elasticity of demand.



The following estimate is available for good X. Calculate the cross-price elasticity of demand between X and Y. Price of good X (Rs.)

Quantity demanded of good X (in units)

Price of good Y (Rs.)

20

60

25

20

40

35

30

30

30

[MBA - 2008-10] 18.08.2008 & 20.08.2008

Dr. Jaydeep Mukherjee Ravenshaw University