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BUSINESS
ECONOMICS

Micro Economics Analysis
3: Elasticity of Demand

TABLE OF CONTENTS
1
...
Introduction
3
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Why is Elasticity important for us?
Total Revenue and Price Elasticity of Demand
Marginal revenue, demand and Price Elasticity
5
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Summary

Learning Outcomes
After studying this module, you shall be able to learn and understand the
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Concepts of Elasticity of Demand and Price Elasticity of Demand
Factors effecting Price elasticity of Demand
Methods to compute elasticity
Relationship between total revenue, marginal revenue and Price elasticity
Income elasticity of Demand
Cross Price Elasticity of Demand

2
...
When an amusement park owner decided to raise ticket prices, the price hike
caused attendance at the amusement park to fall
...
But this is not always the case
...
For example: when a beverage company A increases the price of a
certain cold drink but other rival producers leave their prices unchanged
...
The reduced
amount of cold drinks sold, more than offset the higher price hence leading to reduction in
revenue
...

Firms recognize that price and demand are inversely related
...
This
information is not directly given by the Law of Demand
...
There is a substantial difference in the effect on the total sales
revenue of a firm between these two responses to a change in price
...
By what degree does it respond
also depends on the nature of good
...
All these concepts will be discussed in this chapter
...


This unit is devoted to the concept of price elasticity of demand, which will be defined in the next
section along with other concepts of elasticities
...


3
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In other words, as price increases (decreases), the quantity
demanded by consumers will decrease (increase)
...
Another definition says (in percentage terms), the price elasticity of
demand (ε) shows the percentage change in the quantity of a good q demanded resulting from a
1% increase in its price p
...
Another way to write
the formula is:
ε = (dq/q)
(dp/p)
This can be written as:

ε = p
...
In some
contexts, it is common to introduce a minus sign in this formula to make this quantity positive
...
With linear demand curves, elasticity
changes along the demand curve (see figure1), however its slope does not
...
The slope of the curve is
concerned with values of the respective variables at each position along the curve (i
...
, its' shape
and direction)
...
The opposite situation, relatively inelastic demand, indicates that there has been a less
than proportionate change in quantity demanded – a weak response to price change
...

Another case is when we have a perfectly vertical demand curve, which indicates that the quantity
demanded will be exactly the same, regardless of price
...
A perfectly horizontal demand curve indicates
that consumers will have almost any quantity demanded, but only at that price
...
There is another type of
demand curve which is non-linear rectangular hyperbola
...
It is also called constant elasticity demand curve
...


Availability of Substitutes
This is the most important factor which influences the price elasticity of demand
...
When there is a upward change in the price, then consumers substantially reduce

the consumption of that good if close substitutes are available and hence consumers will be more
responsive to a price rise
...
For example: suppose there is an airline G, which captures a
significant share of the market but has good substitutes in the form of other airlines available,
then if the producer increases the price of air tickets by 20%, consumers may respond by shifting
to some other airline service which has lower price
...

Therefore, if close substitutes are available, then the good would be relatively more elastic and on
the other hand, if poor or no substitutes are available, then the good would be relatively inelastic
...
This implies the demand for a car is probably more elastic than
the demand for milk because the expenditure required to purchase a car would make up a larger
proportion of the budget of a typical consumer
...
The length of the time period affects the magnitude of price
elasticity
...
Elasticity if measured
immediately after the price change, it would appear to be relatively inelastic
...
They try to look for substitute with
same nutritional value like eggs, cheese etc
...
Hence, given a
longer time period, higher is the price elasticity of a good
...
4 (hence demand is relatively inelastic)
(∆P) Q
5 3000
This is also known as point elasticity of demand
...

There is another method to calculate elasticity between 2 different points on an interval on a
demand curve (Linear or Non-linear), which is known as interval elasticity or arc elasticity
...
Instead of taking
P/Q, we take Average P/Average Q (i
...
average of prices and average of quantities at two
points)
...
Moving along a linear
demand curve doesn’t change slope but the second component of the elasticity formula
(P/Q) varies as we move from one point to another, thereby, leading to change in the total
value of elasticity
...
Similarly if we move up the curve, P/Q increases leading to
increase in the absolute value of ε
...
However, there is no relation between P
and ε as such
...
the value of b can be greater than, less than or equal to 1
...


4
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Change in TR = Marginal Revenue2 = Output effect + Price effect
Both effects move in the opposite direction
...
This is dependent on the elasticity of the product
...

When a producer increases prices (P), this would increase the total revenue (TR) if the quantity
sold remains constant
...
This effect on TR of a price change is called price effect
...
It moves in the opposite direction of price and pulls
TR along with it
...
Hence when there is a change in price, both effects work and TR moves in
the direction of the stronger effect
...

Then TR = P*Q remains same
...

Case2) Magnitude of Price effect > Magnitude of quantity effect
This will pull TR =P*Q in the direction of change in P as price effect is dominant
...
e
...

Total impact on TR: it will go in the direction of Price change
Case3) Magnitude of Price effect < Magnitude of quantity effect
This will pull TR =P*Q in the direction of change in Q as quantity effect is dominant
...
e
...


2

Marginal revenue is defined as the change in total revenue due to one additional unit sold
...
It is defined as the addition to total revenue due to selling one additional unit
...
MR is related to price elasticity because MR like price elasticity involves
changes in TR caused by movements along a demand curve
...
However, there is a relation between
marginal revenue and price elasticity; hence we discuss this relation in the present chapter
...
So additional revenue is less than the price itself
...
now as price falls, it falls for every unit sold, hence
additional revenue earned is less than price
...
Looking at figure 5, the same relation is depicted
graphically
...
This implies MR is twice steep as demand curve as shown in
the illustration below
...
We see that till MR>0, TR rises as P falls, which implies ε >1
...
After that, at the point MR=0, TR is
maximum and it does not change when quantity changes, so ε=1, which means the good is unitary
elastic
...
e
...

This relation can be summarized in the following table:

5
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In other
words, we need to know how a consumer’s demand for good (Q x) changes, when there is a
change in his/her income
...

Income elasticity (Em) can be defined as the percentage change in the quantity demanded for the
good (Qx) in response to percentage change in income (M)
...
Thus if the good is normal, Em is always
positive (Em>0)
...

On the other hand if the change in quantity responds less than proportionately to change
in income, then 0b) If the good is inferior, which means as income increases, quantity demanded decreases,
then the sign of ∆Qx/∆M will be negative
...

The relationship between income and quantity demanded is given by Engel’s Curve
...


Cross Price Elasticity of Demand
A change in the price of related goods also affects the quantity demanded for any good Qx
...
Impact of their price change on the
quantity demanded of the good is given by cross elasticity of demand (Exr)
...
For example, the quantity demanded of Coca-Cola to changes in the
price of Pepsi
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For example, as the price of coke increases, then consumers may
purchase proportionately more Pepsi products
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The mathematical formula for cross price elasticity of demand is:

Exr =

(∆𝑸𝒙/𝑸𝒙)
(∆𝑷𝒓 /𝑷𝒓)

Where Pr is the price of the related good
...

a) If the goods are substitutes, then ∆Qx/∆Pr> 0
...

Example: if we consider Pepsi as a perfect substitute for Coke, then Exr would be positive infinity
...
This implies Exr<0
Example: Pen and refills are complementary goods
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Table 4: Other demand Elasticities
Income elasticity
Em
Type of Good
0Normal Good
Greater than 0
Em>1: Elastic
Inferior Good
Less than 0
Cross Price Elasticity
Exr
Type of relation
Exr>0
Substitute
Exr= Positive
Infinity, if Perfect
substitutes
Exr<0
Complement

5
...

The price elasticity of demand (ε) shows the percentage change in the quantity of a good
q demanded resulting from a 1% increase in its price p
...
The exception is when a demand curve is a rectangular hyperbola
...
When demand is elastic,
then TR moves in the direction of Price
...
When demand is inelastic, then TR remains unchanged
...
When demand is elastic, MR is
positive
...

Income elasticity Em measures the percentage change in the quantity demanded in
response to percentage change in income
...
Em < 0 for inferior
goods
...
E xr > 0 for substitutes and
Exr< 0 for complements

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Title: business eco - micro eco analysis elasticity of demand
Description: Microeconomic analysis is the study of economic behavior at the individual or small group level. Utility refers to the satisfaction or pleasure that a consumer derives from consuming a good or service. In microeconomic analysis, utility is used to explain how consumers make choices among goods and services in order to maximize their satisfaction, subject to budget constraints. Utility can be measured in different ways, but the most common method is through the use of utility functions, which assign a numerical value to each level of satisfaction. These functions are used to analyze how changes in prices, income, and other factors affect consumer behavior and market outcomes.

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