Elasticity and its Applications

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Sessions 4 & 5
Elasticity and Its
y
Applications

Readings


Hirschey: Economics for Managers, 2009 (Fifth Indian
Reprint), South-Western Cengage Learning – Chapter 5



Hubbard & O’Brian: Microeconomics (First Edition), Pearson Education India – Chapter 6



Mansfield, Allen,
Mansfield Allen Doherty and Weigelt: Managerial
Economics: Theory, Applications and Cases (Fifth Edition), W. W. Norton and Company – Chapter 3



Thomas and Maurice: Managerial Economics: Concepts and
Applications (Eighth Edition), Tata McGraw-Hill – Chapter 6

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 is the price elasticity of supply? How is it
related to the supply curve?



What are the income and cross-price elasticities of
demand?

An Example


You design websites for local businesses.



You charge Rs 50 000 per website, and currently
Rs.50,000
website
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
Rs.30,000



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



The law of demand says that you won’t sell as many
won t
websites if you raise your price. How many fewer
websites? What will be the impact on your revenue?

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
good,
Price elasticity of demand =% change in Qd / % change in P



Loosely speaking it measures the price sensitivity of buyers’ speaking,
price-sensitivity
buyers
demand

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
negative.
We will drop the minus sign and report
all price elasticities as positive numbers

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
Anything striking?

C
B

50,000

A

30,000

?

12

15

Suppose the market demand for burgers is given by the equation Qd = 6,000,000 – 1,000,000P
For a price increase from Rs. 30 to Rs. 40 per burger, what is the price elasticity of demand?

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:
k


(Q2  Q1 ) /[(Q2  Q1 ) / 2]
Price elasticity of demand =
( P2  P ) /[( P2  P ) / 2]
(
]
1
1

What will be the price elasticity of demand for websites using midpoint method?

Determinants of Price Elasticity
Example 1:



Consider two commodities fish and salt Suppose
salt.
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
substitutes.
Lesson 1:
Price elasticity is higher, when close substitutes...
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