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Free Video Lectures for MCA

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Demand and Elasticity

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Consider the following cases:


Making Sales Targets
A Public Transportation Problem:

Can the daily ridership fluctuations be controlled


through a pricing strategy?
The Airliners Pricing Problem:

How can an airliner fill its plains while


maximizing its profit?

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TR 0 = 220 x 120 = 26,400


TR1 = 180 x 140 = 25,200
D2

TR2 = 180 x 200 = 36,000

D1

220

180

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Q
120

140

200

Note: Slope and Scale

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Elasticity
A general definition:
Elasticity is a (standard) measure of the
degree of sensitivity ( or responsiveness) of one
variable to changes in another variable.
The price elasticity of Demand
The (self) price elasticity of demand is a
measure of the degree of sensitivity of demand
to changes in the (self) price, ceteris paribus.

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Determining Price Elasticity


Percentage Change in Quantity

Ep =
Percentage Change in Price

Change in Quantity
Quantity
Ep =
Change in Price
Price
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P
a

10

4
2

d
8

18

80

90

Ep (a --- b) = (10/8)/(-2/10) = -6.25


Ep (c ---d ) = (10/80)/(-2/4) = -.25

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What does the elasticity


measure really measure?
The elasticity measure is a ratio between

two percentage measures: the percentage


change in one variable over the percentage
change in another variable
A price elasticity of -6.25 means that for
each one percent change in price the
quantity demanded will change by 6.25
percent.

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Arc (Price) Elasticity


Note that if we increased
P
the price,
(from 8 to 10 or 2 to 4)
the original P and Q would 10
8
be 2 and 8 and 18 and
90, respectively.
Ep = (-10/18)/(2/8) = -2.22

a
b

c
4

Ep = (-10/90)/(2/2) = -.11

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18

80 90

D
Q

Arc Elasticity
To get the average elasticity between two
points on a demand curve we take the
average of the two end points (for both
price and quantity) and use it as the initial
value:
Q2-Q1

10

(Q1+Q2)

8+18

Ea =
P2-P1
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(P1+P2)

= -3.49
-2
10+8

Elasticity and the Price Level


P
Along a linear demand curve as
the price goes up, |elasticity |
increases.

Note that between points "a" and


"b" the (arc) elasticity of the
above demand curve is -3.49,
whereas between "c" and "d" it is
-.17.

10
8

Elastic

| Ep | < 1 :

Inelastic

| Ep | = 1 :

Unit-elastic

a E =-3.49
b

c E = -.17
d

4
2

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| Ep | > 1 :

18

80 90

Point Elasticity
Q
--------Q1+Q2
Q
P1+P2
Q
P
E = ------------ = ------- . ------- = ------- . -----P
P Q1+Q2
P
Q
--------P1+P2
dQ
P
Or,
= ------ . ----Q
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P,MR

Q = C - b P
|E|=1

C
1
P = ----- - ----- Q
b
b
D
MR
Q

0
TR

C
2
MR = ------ - ------ Q
b
b

Note:
In the demand equation
dQ/dP = -b
That means

0
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P
E p = -b ----Q

A note about marginal revenue:


Recall: TR = P.Q ;
P = f (Q )
Marginal Revenue = Change in TR resulting from
producing (selling) one additional unit of output.
TR
(P.Q) d P
dQ
MR = ------ = -------- = ------ .Q + ------ .P
Q
Q
dQ
dQ
dP Q
P
1
= ( -----. ----- + ------ ).P = P. ( ------- + 1 )
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dQ P
P
E

dQ P
P
E = ----- . ----- = -b . -----dp
Q
Q

Q = C - b P
dQ
---- = - b
dp

P, MR

1
MR = P. ( 1 + ---- )
E

Slope= -1/b
Slope=-2/b
MR
0

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D
Q
C

Special Cases
P

Infinitely (price) elastic

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Infinitely price inelastic

Important Observations
When demand is elastic, a decrease in price
will result is an increase in the revenue
(sales).
When demand is inelastic, a decrease in
price will result is a decrease in the revenue
(sales).
When demand is unit-elastic, an increase
(or a decrease) in price will not change the
revenue (sales).

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What Determines Elasticity


Necessities versus luxuries

Eating at restaurants
Groceries
Availability of substitutes
Chicken versus beef
How much of our income a good takes
Salt versus Nike sneakers
The passage of time

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Elasticity and Passage of Time


P
D3

D2

Do

D1

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Q3

Q2

Q1 Qo Qo

Other Elasticity Measures


Recall: Elasticity is a (standard) measure of
the degree of sensitivity ( or responsiveness) of
one variable to changes in another variable.
Income Elasticity: a measure of the degree of
sensitivity of demand for a good (or service) to
changes in consumers (buyers) income
Cross Price Elasticity: a measure of the degree
of sensitivity of demand for a good (or service)
to changes in the price of another good or
service

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Income Elasticity of Demand


A measure of the degree of responsiveness
of demand (for a good) to a change in
income, ceteris paribus.
(Shift of the demand curve)
Q2-Q1
Q2+Q1

EI =
I2-I1
I1+I2

d Q
I
= or = ------ . -----d I
Q

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Cross (Price) Elasticity


A measure of the degree of responsiveness
of the demand for one good (X) to a change
in the price of another good (Y):
(Shift of demand curve)
Qx2- Qx1
Qx2+Qx1

Ec =

or =
Py2- Py1
Py1+Py2

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d Qx
Py
----------- . ------d Py
Qx