PG 2013 Sessions 7 & 8

ELASTICITY OF DEMAND

Elasticity of Demand
Measure 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 )

Price Elasticity (Ep)

Price Elasticity (Ep)

% change in Qd Ep= _______________ % change in Px

(Q2-Q1)/Q1 = --------------(P2-P1)/P1 Where Q1= Original quantity P1 = Old price

Q2= New quantity P2= New price

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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.
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Types of Price Elasticity

Type
Perfectly elastic

Numerical Description Shape of expression curve 0 Infinite Zero One Horizontal Vertical Rectangula r hyperbola

Perfectly inelastic

Unit elastic 1 Relatively elastic Relatively inelastic >1 <1

More than1 Flat Less than 1 Steep

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Types of Price Elasticity

Ep=
price

Ep=0

Ep=1

Ep> 1

Ep<1

price

Quantity demanded
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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.
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Elasticity
Highly Elastic ( Ep >1)

Price
Increases

Quantity Demanded
Decreases

Total Outlay
Decreases

Decreases
Unitary Elastic ( Ep=1) Increases Decreases Highly Inelastic (Ep < 1) Increases

Increases
Decreases Increases Decreases

Increases
No Change No Change Increases

Decreases

Increases

Decreases

Total Outlay Method

Unit Price (Rs) A. 10 5 B. 10 Quantity 10 25 10 TE =P*Q (Rs) 100 125 100 ep>1

5
C. 10 5

20
10 15

100
100 75

ep=1

ep<1
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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

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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.

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.
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Short and Long Run Price Elasticity in 2006-07

Commodity Butter^ Petrol ^ Electricity (household) * * ^ SR Ep 1.47 0.30 0.13 LR Ep 2.78 0.90 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?

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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.
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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
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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

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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

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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 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.

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Ec =

(Q2y-Q1y)/Q1y --------------(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.
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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
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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?
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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 Suzukis Esteem and its effect on demand for Wagon R
Used for measuring interrelationships between sectorse.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 24 growth.

Price Elasticity and Cross Elasticity for Oranges

University of Floridas 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
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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).
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Promotional Elasticity
Degree of responsiveness of demand to a change in advertising expenditure Higher the responsiveness, higher will be the firms incentive to advertise

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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: Consumers Income, competitors pricing and non pricing decisions. For these, responses can be tailored according to elasticity.

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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

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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
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Using Elasticity in Managerial Decision Making

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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.

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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 competitors 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 firms product is very low, what should be the firms strategy?
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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
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Using Elasticity in Managerial Decision Making

4. If cross elasticity with a competitors 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 firms product is very low, what should be the firms strategy?
May think of changing the product line to something more price elastic as the firm will no benefit from an increase in incomes.
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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?

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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 .

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1.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
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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

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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
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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.

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Promotional Elasticity (Ea)

Old A=12 L; New A=20L; A =8L; Ea= 1.4; Dx (Old demand)= 6000 New D =Dn Dx = D- 6000 Eq: Ea= ( Dx / A)* (A/Dx) Putting the variables in the equation we get 1.4= (Dn-6000)/8,00,000 *( 12,00,000/6000) Dn-6000= (1.4* 8,00,000 * 6000)/ 12,00,000 Dn = 5600+6000 =11600 units
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Castrol India -ET 500, 19 Dec 12

Castrol 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 companys 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
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 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 companys distribution since demand from rural India was growing strong. Castrols 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 brandbuilding exercises. To be contd for more 47 concepts

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Elasticity of supply
Ess = % change in quantity supplied / % change in price Flatter the supply curve , larger the elasticity

Managerial Economics Oxford University Press, 2006

All rights reserved

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
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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

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 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?