Economics for Business

ECON861
Week 2

Paper Coordinator &Lecturer:

Sadhana Srivastava, PhD
Lecture Hours: Tuesdays: 6-8 pm

Professional
Masters
 Week-2: Topics
• Market mechanism and equilibrium
• Elasticity of demand
• Elasticity of supply
• Types of demand elasticity
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross elasticity of demand
• Elasticity and slope
• Elasticity and revenue

Prescribed reading
Farnham (2014) Economics for Managers: chapters 2 and 3.
Professional
Masters
 Market Mechanism

• The market mechanism is the tendency in a

free market for price to change until the
market clears
• Markets clear when quantity demanded
equals quantity supplied at the prevailing price
• Market clearing price – price at which markets
clear

Professional
Masters
 Market Equilibrium: Example
Price per gallons ($) Quantity Supplied(millions Quantity Demanded(millions of
of gallons) gallons)

1.00 500 800

1.20 550 700

1.40 600 600 QS = QD

1.60 640 550

1.80 680 500

2.00 700 460

2.20 720 420

Professional
Masters
Intersecting Supply and Demand Curves: Market
Equilibrium

Professional
Masters
 Market Equilibrium: QS = QD

In equilibrium:
• There is no shortage (or excess demand)
• There is no surplus (or excess supply)
• Quantity supplied equals quantity demanded
• Anyone who wants to buy at the current price
can and all producers who want to sell at that
price can

Professional
Masters
 Market Surplus: QS>QD

A higher than equilibrium price:

• There is excess supply – surplus
• Downward pressure on price
• Quantity demanded increases and quantity
supplied decreases
• The market adjusts until equilibrium is
reached

Professional
Masters
 Market Shortage: QD > QS

A lower than equilibrium price:

• There is excess demand – shortage
• Upward pressure on prices
• Quantity demanded decreases and quantity
supplied increases
• The market adjusts until the equilibrium is
reached

Professional
Masters
 The Market Mechanism (Market Clearance)

• Supply and demand interact to determine the

market-clearing price
• When not in equilibrium, the market will
adjust to alleviate a shortage or surplus and
return the market to equilibrium
• Markets must be competitive for the
mechanism to be efficient

Professional
Masters
Finding Market Equilibrium Price &Quantity

QD = 15 -2PC = Demand function

QS = - 25 + 8 PC = Supply function
In equilibrium : QD =QS
15 -2PC = - 25 + 8 PC
40 = 10 PC
PC = 40/10 = $4 (equilibrium price)
Substitute PC = $4 into the demand equation
15-2($4) = 15 – 8 = 7 (equilibrium quantity)

Professional
Masters
 Tax and Market Equilibrium
Demand function : p = 50 – 2q
Supply function : p = 10 + 3q
Questions:
Find the equilibrium point
What would be the effect of a $5 tax?
How much revenue does the Government
collect as a result of this $5 tax?

Professional
Masters
 Market Equilibrium: Answer
Equilibrium Point:
Demand = Supply :
50 – 2q = 10 + 3q
3q + 2q = 50-10
5q = 40
q* = 40/5 = 8 = equilibrium quantity.
50-2(8) = (50 -16) = $34 = P*
P* = equilibrium price
.
Professional
Masters
What would be the effect of a $5 tax on market equilibrium?
Answer:
Demand Function: p = 50 – 2q (no change)
Supply Function : p -5 = 10 + 3q
P = 10 +5 + 3q
P = 15 +3q
New equilibrium point: 50 – 2q = 15 +3q
50 – 15 = 2q + 3 q
35 = 5q
q* = 35/5 = 7 = new equilibrium quantity
The new equilibrium price will be: 50 – 2(7) = $36.

Professional
Masters
 Tax and Market Equilibrium: Interpretation

• Notice that the original price was $34, and it

went up to $36 as a result of the tax.
• This is a $2 increase, but the tax was $5.
• This means the producer pays $3 of the tax,
while passing $2 of the tax off to the
consumer
• The consumer pays $36. Out of this, $5 is the
tax and the producer keeps $31.

Professional
Masters
How much revenue does the Government collect as a result of
this $5 tax?

Answer:
Tax per unit = $5 per unit
New equilibrium quantity = q* =7
Tax revenue = (Price × quantity)
= (5 dollars per unit)(7 units) = $35

Professional
Masters
 Changes in Market Equilibrium

• Equilibrium prices are determined by the

relative level of supply and demand
• Changes in supply and/or demand will cause
change in the equilibrium price and/or
quantity in a free market

Professional
Masters
Change in Demand with no change in Supply

Professional
Masters
Change in Supply with no change in Demand

Professional
Masters
 What is the impact of a fall in raw material prices?

Answer:
• Other things remaining the same, a fall in raw
material prices causes the supply curve to
shift to the right.
• No change in demand curve

Professional
Masters
Impact of a fall in raw material prices

Professional
Masters
 What is the possible impact of a rise in consumer income?

Answer:
• Other things remaining the same, an increase
in consumer income causes the demand curve
to shift to the right.
• No change in supply curve

Professional
Masters
Possible impact of a rise in consumer income

Professional
Masters
Income increases and raw material prices fall

Professional
Masters
 Shifts in Supply and Demand

• When supply and demand change

simultaneously, the impact on the
equilibrium price and quantity is determined
by:
• The relative size and direction of the change
• The shape of the supply and demand models

Professional
Masters 24
 Example: The Price of a University Education
• The price of a university education rose 55
percent from 1990 to 2017 (assumption)
• Increases in costs of modern classrooms and
wages increased costs of production –
decrease in supply – S. curve shifts to the left.
• Due to a larger percentage of high school
graduates attending college, demand
increased- D. curve shifts to the right.

Professional
Masters 25
 Market for a University Education

P S2017
(annual cost
in 1970 New
dollars)
equilibrium
was reached at
$3,917 $3,917 and a
S1990 quantity of 13.2
million
students

$2,530

D1990 D2017

Professional Q (millions enrolled))

8.6 13.2
Masters 26
 Exercise

1. Auckland house prices have seen a large increase in

demand and a small increase in supply. Draw a
diagram and show how the equilibrium price and
quantity of houses are likely to change

Professional
Masters
 Elasticities of Supply and Demand

• Now that we know about demand and supply, its important

to understand, how they respond to price changes, and
what it means for the manager !

• Elasticity gives a way to measure this response of price

changes on demand and supply

• The case for analysis on Chapter 3 demonstrates on the

example of Procter and Gamble Co.- how a company’s
pricing policies depend on how consumers respond to price
changes.
Professional
Masters 28
 Elasticity of Demand & Supply

Types of Elasticity
(Own) Price elasticity of demand
Income elasticity of demand
Cross-price elasticity of demand
Price elasticity of Supply

Professional
Masters
Why should we be interested in elasticity of demand?
• Own-price elasticity helps firms understand
the impact that price changes will have on
their revenue.
• Income elasticity can help firms understand
what income groups to target their products
to.
• Cross-price elasticity can help firms
understand who their closest competitors are.

Professional
Masters 30
 The elasticity of demand
• Price elasticity of demand measures how much the
quantity demanded of a good responds to a change
in the price of that good.

• Price elasticity of demand is the percentage change

in quantity demanded divided by the percentage
change in price.

Professional
Masters
 The relevance
• Suppose the electronics store you manage wants
to offer a discount price to attract customers.
How can you make sure that this will bring in
more revenue ?

• You need to know if you discount prices by 10%,

will your customers demand increase by same
amount, go down or remain the same ?

Professional
Masters
 Measuring Price Elasticity of Demand
• Measures the response of quantity demanded
to price changes.
• Measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price

%QD
E  D

%P
P

Professional
Masters 33
 Price Elasticity of Demand: Formula
• The percentage change in a variable is the
absolute change in the variable divided by the
original level of the variable
• Therefore, elasticity can also be written as:

Q Q P Q
E 
D

P P Q P
P

Professional
Masters 34
 Elastic and Inelastic Distinction
• Usually a negative number, so we take the
absolute value.
1. As price increases, quantity decreases
2. As price decreases, quantity increases
• When |EP| > 1, the good is price elastic
– |%Q| > |%P|
• When |EP| < 1, the good is price inelastic
– |%Q| < |% P|

Professional
Masters 35
 Determinant of Price Elasticity of Demand

• The primary determinant of price elasticity of

demand is the availability of substitutes

• Many substitutes, demand is price elastic (can

easily move to another good with a price
increase) (Coffee prices rise, switch to Tea !)

• Few substitutes, demand is price inelastic

(Disney)
Professional
Masters 36
 Point Price Elasticity
• Point Price Elasticity of Demand: A measurement of
the price elasticity of demand calculated as a point
on the demand curve.
Q Q P Q
E  D

P P Q P
P

• Calculating point elasticity with a demand function:

QD = 4,000 – 400P
• -400 = coefficient of variable P = ∆Q/∆P = shows how
much Q is going to change given a 1 unit change in P.
Professional
Masters
 Point Price Elasticity Calculation with a Demand Function
Question:
With a demand function : QD = 4000 – 400 P, what is
point price elasticity at a price of $8?
Answer.
• ∆Q/∆P = - 400 = coefficient of P
• Quantity demand at a price of $8 = 4000 - 400(8) =
4000 – 3200 = 800units.
• Point price elasticity (∆Q/∆P) (P/Q) = -400(8/800) =
-400 (0.01) = - 4
• Point price elasticity = Absolute value of -4 = 4

Professional
Masters
 Price Elasticity of Demand

• Looking at a linear demand curve, as we move

along the curve Q/P is constant, but P and
Q will change
• Price elasticity of demand must therefore be
measured at a particular point on the demand
curve
• Elasticity will change along the demand curve
in a particular way

Professional
Masters 39
 Price Elasticity of Demand
• Given a linear demand curve

• Elasticity depends on slope and on the values

of P and Q
The top portion of demand curve is elastic
• Price is high and quantity small
The bottom portion of demand curve is inelastic
• Price is low and quantity high

Professional
Masters 40
 Price Elasticity of Demand

Price EP = -
Demand Curve
4
Q = 8 – 2P
Elastic

2 Ep = -1

Inelastic

Ep = 0
Professional 4 8 Q
Masters 41
 Price Elasticity of Demand

• The steeper the demand curve, the more

inelastic the demand for the good becomes

• The flatter the demand curve, the more elastic

the demand for the good becomes

• Two extreme cases of demand curves

Completely inelastic demand – vertical
Infinitely elastic demand – horizontal

Professional
Masters 42
 Steeper and Flatter Demand Curves
• Steeper demand curve : More inelastic (D1)
• Flatter demand curve: More elastic (D2)

Professional
Masters
 Infinitely Elastic Demand

Price

EP = 

P* D

Professional Quantity
Masters 44
 Completely Inelastic Demand

Price
D

EP = 0

Professional Q* Quantity
Masters 45
Elasticity of Different Demand Curves

Professional
Masters
 Total revenue and the price
elasticity of demand
Total revenue TR calculated as

• amount paid by • price of the good

buyers multiplied by
• amount received • quantity of good
by sellers. sold
• TR = P x Q.

Professional
Masters
 Total revenue

Professional
Masters
Elasticity and total revenue along a
linear demand curve
With inelastic
Increase in price
demand curve

Proportionally
Total revenue
smaller decrease
increases
in quantity

Professional
Masters
How total revenue changes:
Inelastic demand

Professional
Masters
Elasticity and total revenue along a
linear demand curve
With elastic Increase in
demand curve price

Proportionally
Total revenue
larger decrease
decreases
in quantity

Professional
Masters
 Quiz Time !!
• If businesses aim to increase revenue through a price
discount, which of these goods or services it is more
likely to be successful, based on elasticity estimates?

i) Mobile phones, where there are close substitutes

ii) Disneyland theme park tickets

iii)Potatoes
Professional
Masters
TABLE 3.1 Values of Price Elasticity of Demand Coefficients and relationship with total revenue
TABLE 3.2 Numerical Example of Demand, Total Revenue, Average Revenue, and Marginal Revenue
Functions
TABLE 3.5 Relationships for a Linear Downward Sloping Demand Curve
 Income Elasticity of Demand
• Income Elasticity of Demand
Measures how much quantity demanded changes
with a change in income

Q/Q I Q
EI  
I/I Q I

Professional
Masters 56
 Income elasticity

Income increases

Quantity demanded Quantity demanded

increases decreases

Good is normal
Professional Good is inferior
Masters
 Income elasticity
• Can take positive and negative values; if its positive,
good is normal

• If its value is greater than 0 but less than 1, it is regarded

as necessities, and tend to be income inelastic.

• Its value is greater than 1, regard as luxuries , and tend

to be income elastic

• If its negative, good is inferior

Professional
Masters
 Income elasticity
• necessities.
– Examples: food, fuel, clothing, utilities and
medical services.
• luxuries.
– Examples: sports cars, furs and expensive
foods.

Professional
Masters
 Quiz Time !!
• Why does spending on restaurant meals declines more
during economic downturns than does spending on food to
be eaten at home ? Does elasticity have anything to do with
it ?

• Suppose a second hand car dealer tells you that he noticed

that demand for his cars have increased only by 1%, while
its known that incomes have increased by 2% over that
period, what does this tell the dealer about the income
elasticity and the type of good he is selling ?

Professional
Masters
 Cross Elasticity of Demand
• Cross-Price Elasticity of Demand
Measures the percentage change in the quantity
demanded of one good that results from a one
percent change in the price of another good

Qb Qb Pm Qb
EQb Pm  
Pm Pm Qb Pm

Professional
Masters 61
 Cross-price elasticity

Price of good m increases

Quantity demanded Quantity demanded

for good b increases for good b decreases

Goods are Goods are

substitutes
Professional complements
Masters
 Complements, Substitutes and Elasticity
• Complements: Cars and Tires
Cross-price elasticity of demand is negative
• Price of cars increases, quantity demanded of tires
decreases
• Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
• Price of butter increases, quantity of margarine
demanded increases

Professional
Masters 63
 Price Elasticity of Supply

• Measures the sensitivity of quantity supplied

given a change in price
Measures the percentage change in quantity
supplied resulting from a 1 percent change in price

% Q S
E S

%P
P

Professional
Masters 64
The price elasticity of supply

(a) Perfectly inelastic supply: elasticity equals 0

Professional
Masters
The price elasticity of supply

(b) Inelastic supply: elasticity is less than 1

Professional
Masters
The price elasticity of supply

(c) Unit elastic supply: elasticity equals 1

Professional
Masters
The price elasticity of supply

(d) Elastic supply: elasticity is greater than 1

Professional
Masters
The price elasticity of supply

(e) Perfectly elastic supply: elasticity equals infinity

Professional
Masters
 Determinants of elasticity
of supply
• Ability of sellers to change the amount of
the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.
• Time period.
– Supply is more elastic in the long run.

Professional
Masters
Application of supply, demand and
elasticity
• Examine whether the supply or demand curve
shifts.
• Determine the direction of the shift of the curve.
• Use the supply-and-demand diagram to see how
the market equilibrium changes.

Professional
Masters
 An increase in supply:
wheat market

Professional
Masters
 Exercises
Supply Function: QS = 1800 + 240P
Demand Function: QD = 3550 – 266P
Questions
Q1: Find equilibrium price and quantity

Q2: Find price elasticity of demand and supply

at the equilibrium price and quantity

Q3: Find price elasticity of demand at price

$4.00

Professional
Masters 73
 Answer (Q1)

QS = QD
1800 + 240P = 3550 – 266P
506P = 1750
PE = $3.46 per bushel = Equilibrium Price
Substitute the value of P either in supply or
demand functions to get quantity
QE = 1800 + (240)(3.46) = 2630 million bushels =
Equilibrium Quantity

Professional
Masters 74
 Answer (Q2)

We can find the elasticities of demand and

supply at these points
P QD 3.46
E 
D
 (266)  0.35
Q P
P
2, 630

P QS 3.46
E 
S
 (240)  0.32
Q P
P
2, 630

Professional
Masters 75
 Answer (Q3)

• Assume the price of wheat is $4.00/bushel

due to decrease in supply

QD  3,550  (266)(4.00)  2, 486

4.00
E 
D
P (266)  0.43
2, 486

Professional
Masters 76
 Summary

• We have looked at the underlying theory that can

help us better understand how different market
participants respond to change through elasticities of
demand and supply

• We now move on to analyse the decisions regarding

production and costs from the perspective of a
manager, applying relevant economic theory

Professional
Masters
 Next topic….

• Read chapters 5 & 6 from Farnham(2014)

Economics for Managers, 3rd edition

Professional
Masters