Elasticity and Its Application

Elasticity The concept

The responsiveness of one variable to changes in another When price rises what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity The concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity . . .
is a measure of how much buyers and sellers respond to changes in market conditions

allows us to analyze supply and demand with greater precision.

Price Elasticity of Demand

Price

elasticity of demand is the percentage change in quantity demanded given a percent change in the price.
is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

It

Determinants of Elasticity

Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, salt & luxury cars

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Percentage Change
in Quantity Demanded Price Elasticity of Demand = Percentage Change in Price

The Percentage Method

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Computing the Price Elasticity of Demand

Price elasticity of demand Percentage change in quatity demanded Percentage change in price

Example: If the price of an ice cream cone increases from 2.00 to 2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

(10 8 ) 100 20 percent 10 2 ( 2.20 2.00 ) 100 10 percent 2.00

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Ranges of Elasticity
Perfectly

Inelastic

Quantity demanded does not respond to price changes.

Inelastic Demand
Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one.
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Ranges of Elasticity
Unit

Elastic

Quantity demanded changes by the same percentage as the price.

Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.
Perfectly

Elastic

Quantity demanded changes infinitely with any change in price.

A Variety of Demand Curves

Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

Perfectly Inelastic Demand

- Elasticity equals 0
Price

Demand

5 1. An increase in price... 4

Quantity 100 2. ...leaves the quantity demanded unchanged.

.

Inelastic Demand
- Elasticity is less than 1
Price 5

1. A 25% increase in price... 4

Quantity 90100 2. ...leads to a 10% decrease in quantity.

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Unit Elastic Demand

- Elasticity equals 1
Price

1. A 25% 5 increase in price... 4

Quantity 75 100 2. ...leads to a 25% decrease in quantity.

.

Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% 5 increase in price... 4

Quantity 50 100 2. ...leads to a 50% decrease in quantity.

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Perfectly Elastic Demand

- Elasticity equals infinity
Price 1. At any price above 4, quantity demanded is zero. 4 2. At exactly 4, consumers will buy any quantity. 3. At a price below 4, quantity demanded is infinite.
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Demand

Quantity

Computing the Price Elasticity of Demand ( Other methods)

Price elasticity of demand can also be calculated by a few other methods. These methods are : Total Outlay Method Midpoint Formula Geometric Method

Total Outlay Method

This method, measures the change on expenditure on commodities due to a change in price. If a given change does not cause any change in the total amount spent on the commodity, the demand is said to be unitary elastic. If the total expenditure increases due to fall in price, the demand is said to be elastic and vice versa.
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Demand is Unitary elastic

Price ( in Rs.) 4.50 Quantity demanded 4 Total expenditure 18

4.00 3.00

4.5 6

18 18

As price falls, the quantity demanded increases, But the total outlay remains constant. Hence, elasticity of demand is equal to unity.

Demand is Elastic
Price ( in Rs.) 4.50 Quantity demanded 6 Total expenditure 27

4 3

7 10

28 30

As price falls, the quantity demanded increases, And the total outlay also increases. Hence, demand is elastic. ( Greater than unity)

Demand is inelastic
Price ( in Rs.) 4.50 Quantity demanded 4 Total expenditure 18

4 3

4.25 5

17 15

As price falls, the quantity demanded increases, but the total outlay decreases. Hence, demand is inelastic. ( Lesser than unity)

Midpoint Formula
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.
(Q2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]
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Computing the Price Elasticity of Demand

(Q2 Q1 )/[(Q 2 Q1 )/2] Price Elasticity of Demand = (P2 P1 )/[(P2 P1 )/2]
Example: If the price of an ice cream cone increases from 2.00 to 2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8) 22 percent (10 8) / 2 2.32 ( 2.20 2.00) 9.5 percent ( 2.20 2.00) / 2
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Geometric method

Elasticity at a point on a straight line demand curve can be calculated as follows : e= Length of the lower segment -------------------------------------------------Length of the upper segment

At the midpoint of the demand curve e = 1 At all points above the midpoint e >1 At all points below the midpoint e < 1

Geometric Method

At the point M, the demand curve is unit elastic. M is the midpoint of this linear demand curve Above M, demand is elastic, Below M, demand is inelastic

Price

Elasticity > 1 Elasticity = 1

Elasticity < 1

Quantity

Perfectly Inelastic Supply

- Elasticity equals 0
Price

Supply

5 1. An increase in price... 4

Quantity 100 2. ...leaves the quantity supplied unchanged.

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Inelastic Supply
- Elasticity is less than 1
Price 5

1. A 25% increase in price... 4

Quantity 90 100 leads to a 10% increase in Supply

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Unit Elastic Supply

- Elasticity equals 1
Price

1. A 25% 5 increase in price... 4

75 100 leads to a 25% increase in Supply

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Quantity

Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% increase in price...

5 4

Quantity 75 Leads to a 50% increase in quantity supplied

.

50

Perfectly Elastic Supply

Elasticity equals infinity
Price 1. At any price above 4, quantity supplied is infinite. 4

Supply
2. At exactly 4, Producers will sell any quantity. Quantity

3. At a price below 4, quantity supplied is zero.

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Income elasticity of Demand

Income elasticity of demand =

Percentagechange in quatity demanded Percentagechange in income

Income elasticity of Demand

Income Elasticity of Demand:

The responsiveness of demand to changes in incomes.

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Cross Elasticity of Demand

Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
__% in Qd of Good T_ Xed =
% Price of good y

Elasticity
Price

Total revenue is price x quantity sold. In this example, TR = 5 x 100 = 500.

This value is represented by the shaded rectangle.

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

Total Revenue

D 100 Quantity Demanded

Elasticity
Price

If the firm decides to decrease price to (say) 3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Total Revenue

D
100 140 Quantity Demanded

Elasticity
Price 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

Not a good move!

D
5 6
Quantity Demanded

Elasticity
Price ()

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
D

10 7

Quantity Demanded

20

Elasticity

If demand is price elastic: Increasing price would reduce TR (% Qd > % P) Reducing price would increase TR (% Qd > % P)

If demand is price inelastic: Increasing price would increase TR (% Qd < % P) Reducing price would reduce TR (% Qd < % P)

Importance of Elasticity
Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

Importance of Elasticity Concepts

For a Businessman : If a businessman finds that the demand is inelastic, he is free to increase prices. In case if the demand is elastic, by slightly reducing the price, the demand will increase sharply and hence the total revenue will also increase. The better a company can assess future demand, the better it can plan its resources. Each company is exposed to three types of factors influencing demand: company, competitive and macroeconomic factors.
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Demand Forecasting
A forecast is a prediction or anticipation of any event which is likely to happen in future. Demand forecast is the prediction of the future demand for a firms product. It can either be made through experience or by statistical methods.

Forecasts are necessary for :

Fulfillment of the objectives. Preparations of budgets. Stabilization of employment and production. Decisions about expansion of a firm. Other decisions like long term investment plans, warehousing and inventory decisions.

A forecast is important for at least five reasons:

1. A forecast becomes a basis for setting and maintaining a production schedule manufacturing. 2. It determines the quantity and timing of needs for labor, equipment, tools, parts, and raw materials purchasing, personnel. 3. It influences the amount of borrowed capital needed to finance the production and the necessary cash flow to operate the business controller. 4. It provides a basis for sales quota assignments to various segments of the sales force sales management.

5. It is the overall base that determines the companys business and marketing plans, which are further broken down into specific goals marketing offer.
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Methods of Demand forecasting

There are two different sets of methods for demand forecasting : Interview & survey methods ( for short term forecasts ) Projection Approach ( for long term forecasts )

Interview and Survey approach

To anticipate the demand for a product, information needs to be collected about the expected expenditure patterns of consumers. Depending on the various approaches to collect this information, different sub methods are formulated. We will study them one by one.

Interview and Survey approach

Executive Opinion : In small companies, usually the owner takes the responsibility of forecasting. As a result of the experience and knowledge he is expected to have, he can predict what would be the course of activities in future and plan his own activities accordingly.

Interview and Survey approach

Opinion polling method : Information about the consumers expenditure can be collected either by the market research department or through the wholesalers and retailers. As a result of technological advancements, it is now possible to collect this information by the means of internet.

Interview and Survey approach

Collective opinion method :

Jury is a group of individuals, usually the top bosses or sales, production, marketing managers having experience in different fields. The advantage of this method is that instead of basing the forecast on the opinion of one single individual, a more accurate forecast can be drawn.

Interview and Survey approach

Sample survey method : The total number of customers of a company is called as its population. When this number is more, it is not possible to collect information for all the customers. When only a few customers are contacted, it is called as a Sample Survey.

Users Expectations

Consumer and industrial companies often poll their actual or potential customers. Some Industrial manufacturers ask about the quantities of products their customers may purchase in future and take this as their forecast.
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Delphi Method
Administering a series of questionnaires to panels of experts. This method gathers information from all experts and the opinion of all the experts is shared by all other experts. In case if an expert finds that his own forecast is unrealistic, after going through the opinion of other experts, there is a chance for corrections.
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Projection Approach
In this method, the past experience is projected for the future. This can be done by tow methods : Correlation or regression analysis. Time series analysis.

Classical approach to time series analysis:

Past sales can be used to forecast future demand. Past sales are viewed from the angles of trends, various cycles of business, seasonality and then a forecast is drawn after checking the possibility of the same treads, cycles and seasonality factors. This method is easy to use, it is based on past behavior and does not include new company, competitor or macroeconomic developments.

Nave Method
Next Years Sales = This Years Sales X This Years Sales Last Years Sales

Moving Average
Moving averages are used to allow for marketplace factors changing at different rates and at different times.

EXAMPLE OF MOVING-AVERAGE FORECAST

PERIOD 1 2 3 4 5 6

SALES VOLUME 200 250 300 350 450 ?

SALES FOR THREE-YEAR PERIOD

THREE-YEAR MOVING AVERAGE

750 900 1100 ( 3) = 300 366.6

Period 6 Forecast = 366.6

Trend Projections Least Squares

Eyeball fitting is simply a plot of the data with a line drawn through them that the forecaster feels most accurately fits the linear trend of the data.

A TREND FORECAST OF SALES

Observed Sales 600 500 400 Trend Line

Forecast Sales

Sales

300 200 100 0 1984 1985

1986

1987 Time

1988

1989

1990