Managerial Economics L4

Dr. Rashmi Ahuja

 Quantitative Demand Analysis
 Till now….focus on qualitative analysis…but detailed quantitative analysis is
also important…
 How much do we have to cut our price to achieve 3.2 percent sales growth?
 If we cut prices by 6.5 percent, how many more units will we sell? Do we
have sufficient inventories on hand to accommodate this increase in sales?
If not, do we have enough personnel to increase production? How much
will our revenues and cash flows change as a result of this price cut?
 How much will our sales change if rivals cut their prices by 2 percent or a
recession hits and household incomes decline by 2.5 percent?
 Elasticity

… allows us to analyze supply and demand with greater

precision.

… is a measure of how much buyers and sellers respond to

changes in market conditions
The Elasticity Concept

 How responsive is variable “G” to a change in variable “S”

% G
EG , S 
% S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.

If EG,S = 0, then S and G are unrelated.

The Elasticity Concept Using Calculus
 An alternative way to measure the elasticity of a function G = f(S) is

dG S
EG , S 
dS G

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.

If EG,S = 0, then S and G are unrelated.

 Own Price Elasticity of Demand

d
% Q X
EQX , PX 
%PX
 Negative according to the “law of demand.”

Elastic: EQX , PX  1
Inelastic: EQX , PX  1
Unitary: EQX , PX  1
Example
 Suppose the quantity demanded of a stick increases from 5 to 10 when the price of stick
decreases from $3 to $2. Calculate the price elasticity of demand.
 Examples
 Suppose a 10 percent price decrease (%ΔP = -10%) causes consumers to
increase their purchases by 30 percent (%ΔQ = 30%).

The price elasticity is equal to -3 .

In contrast, if the 10 percent decrease in price causes only a 5 percent increase in

sales, the price elasticity would equal -0.5.
Mid point Formula

(Q2  Q1 ) /[(Q2  Q1 ) / 2]
Price elasticity of demand =
( P2  P1 ) /[( P2  P1 ) / 2]
Example
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, using the midpoint formula,
would be calculated as:
 Perfectly Elastic & Inelastic Demand

Price Price
D

Quantity Quantity

Perfectly Elastic ( EQX ,PX  ) Perfectly Inelastic ( EQX , PX  0)

 Most products have elasticities in between
these two extremes…..
 Elastic |E| >1 …. Demand in which percentage change in qty demanded is greater then
percentage change in prices

 Inelastic |E|< 1… Demand that responds somewhat, but not a great deal, to changes in
price.

 Unitary elastic demand |E|=1

 PRICE ELASTICITY AND TOTAL REVENUE
 price and quantity demanded move in opposite directions along a demand curve:

TR = P X Q
 Two kinds of Effects

 Price Effect
 Quantity Effect

The price and quantity effects always push total revenue in opposite directions. Total revenue moves in the
direction of the stronger of the two effects. If the two effects are equally strong, no change in total revenue can
occur.

From where you will get to know which effect is stronger ?????
 IF |E| > 1  percentage change in Qty demanded is greater than the percentage change in price  Quantity effect
dominates the Price Effect .

TR = P X Q

TR = P X Q

If demand curve is elastic, then price incr.  decrease in TR

If demand curve is elastic then price decr.  increase in TR.
 Can you derive the effect on revenue when the demand
is inelastic ????
 If |E| < 1 then demand is inelastic which means that percentage change in quantity demanded is less than the
percentage change in price ; then price effect is stronger than the quantity effect.

TR = P X Q

TR = P X Q

If demand curve is inelastic, then price incr.  increase in TR

If demand curve is inelastic then price decr.  decrease in TR.
 Own-Price Elasticity
and Total Revenue
Elastic (Qty Unitary Elastic Inelastic (Price Effect
effect dominates)
dominates)
Price rises TR falls No change in TR TR rises

Price falls TR rises No change in TR TR falls

Elasticity of a Linear Demand Curve
 Figure 4 Elasticity of a Linear Demand Curve
Demand is elastic; demand When price increases from $4
Price is responsive to changes in to $5, TR declines from $24 to
price. $20.
$7

6 Elasticity is > 1 in this range.

5

4
Elasticity is < 1 in this range.
Demand is inelastic; demand is not
3
very responsive to changes in price.
2 When price increases from $2
to $3, TR increases from $20
1
to $24.

0 2 4 6 8 10 12 14
Quantity
 Elasticity, Total Revenue and Linear Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q
 Elasticity, Total Revenue and Linear Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 Elasticity, Total Revenue and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
Factors Affecting Own Price Elasticity
 Availability of close Substitutes

 Time Horizon : Long run vs Short run

 Expenditure share : The importance of being unimportant

 Luxuries vs Necessities
Cross Price Elasticity of Demand

d
%QX
EQX , PY 
%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQ < 0, then X and Y are complements.

X,PY
Income Elasticity

d
% Q X
EQX , M 
% M

If EQ > 0, then X is a normal good.

X,M

If EQX,M < 0, then X is a inferior good.

 Income Elasticity
 Goods consumers regard as necessities tend to be income inelastic
 Examples include food, fuel, clothing, utilities, and medical services.

 Goods consumers regard as luxuries tend to be income elastic.

 Examples include sports cars and expensive Swiss Watches.
 Uses of Elasticities

 Pricing.
 Managing cash flows.
 Impact of changes in competitors’ prices.
 Impact of advertising campaigns.
 And lots more!
Example 1: Pricing and Cash Flows

 According to an FTC Report by Michael Ward, AT&T’s own price elasticity of

demand for long distance services is -8.64.
 AT&T needs to boost revenues in order to meet it’s marketing goals.
 To accomplish this goal, should AT&T raise or lower it’s price?
Answer: Lower price!

 Since demand is elastic, a reduction in price will increase quantity demanded

by a greater percentage than the price decline, resulting in more revenues for
AT&T.
Example 2: Quantifying the Change

 If AT&T lowered price by 3 percent, what would happen to the volume of long
distance telephone calls routed through AT&T?
Answer
• Calls would increase by 25.92 percent!
d
%QX
EQX , PX  8.64 
%PX
d
% Q X
 8.64 
 3%
 3%    8.64   %QX
d

d
%QX  25.92%
Example 3: Impact of a change in a
competitor’s price

 According to an FTC Report by Michael Ward, AT&T’s cross price elasticity of demand
for long distance services is 9.06.
 If competitors reduced their prices by 4 percent, what would happen to the demand for
AT&T services?
Answer
• AT&T’s demand would fall by 36.24 percent!

d
%QX
EQX , PY  9.06 
%PY
d
%QX
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%