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Elasticity of Demand and Supply

- Prof. Rama Deshmukh

- Concept
- Definition
- 4 types and
- 3 methods of measurement
- Determinants of price elasticity

- Elasticity is degree of responsiveness
- Concepts
- 1) Price elasticity of demand
- 2) Income elasticity of demand
- 3) Cross elasticity of demand
- 4) Promotional elasticity of demand

3 methods of measurement

- 1 ) Percentage or proportionate method
- e change in demand / change in price. The

formula is e P/Q. d Q /d P - This formula is biased, therefore a better

formula is e d Q / (Q1 Q2 / 2) - --------------------------

- d P /( P1 P2 / 2)

Given the demand schedule, calculate the e

- When price change from 5 to 3
- e 2

Price Qty

6 0

5 20

4 40

3 60

2 80

1 100

2) Point elasticity method

- On a linear demand curve e lower segment upon

upper segment of a curve - On a non-linear demand curve first a tangent

needs to be drawn before deciding value of e.

E8

egt1

E1

Elt1

E0

3) Total outlay method

- Total revenue or outlay remains unchanged if e 1

Reason if e 1 then d D would be same as d

P and TR P.Q . IF price rises demand would

contract proportionately keeping TR unaltered. - If e lt 1 what will happen to TR when P rises or

falls ? - increase
- If e gt1 what will happen to TR when P rises or

falls? - decrease

Relation between AR, MR and Price elasticity

- TR PQ
- AR PQ/QP
- MR dTR/dQ
- MR P (dQ/dQ)Q(dP/dQ) PQ(dP/dQ) P

1Q/PdP/dQ - e (P/Q)(dQ/dP)
- MR AR-(AR/IeI)

TR

AR

MR

- Let us consider the demand function as Q120-P.

Estimate quantity when price is 120, 100, 60, 20.

Also find the value of MR when P 100 - TR (120-Q)Q 120Q-Q2
- MR 120-2Q
- When P100, MR 80

5 types of Price elasticity of demand

- E 1 ,here demand curve is straight line or

rectangular hyperbola. - A relatively elastic demand curve is to the right

and flatter or gently falling. - Whereas relatively inelastic curve is steeply

falling and to the left.

Perfectly elastic and inelastic demand

- einfinity
- The demand curve is parallel to X axis

- e 0
- Demand curve is parallel to Y axis.

- 1) Price elasticity of demand (dQ/dP) P/Q
- 2) Income elasticity of demand
- 3) Cross elasticity of demand
- 4) Promotional elasticity of demand

- The demand function for mutton for Ravi is given

as Q 5850-6Pm2Pc0.15Y where Y8000, Pm125,

Pc70. Calculate income elasticity and cross

elasticity - ey(dQ/dY)(Y/Q)
- Q 5850-(6125)(270)(0.158000) 6440
- ey 0.15(8000/6440) 0.186

Determinants of price elasticity

- Nature of commodity
- Availability of substitutes
- Weightage in the consumption
- Time factor in the adjustment of the consumption

pattern - Range of commodity use

Cross Elasticity of Demand

- Cross elasticity of demand is the ratio of

percentage change in the quantity demanded - For one product to a percentage change in the

price of another related product, other factors

remaining constant. - If the two products are good substitutes, the

value of cross elasticity will be positive. - If the two products are good complementary, the

value of cross elasticity will be negative.

Application of cross elasticity of demand

- The knowledge of cross elasticity of demand is

very important in managerial decision making for

developing an appropriate price strategy. Firms

selling multiple products use cross elasticity of

demand to analyze the effect of change in the

price of on product to the demand of others. - Firms producing similar kinds of product and

services operating in same industry having a

positive cross elasticity of demand. - Eg- PG and HLL are having a positive cross

elasticity - Of demand between each other in fabric and home

care - products. Hence, if HLL plans to increase the

price of - Surf, a washing detergent, the demand for P

Gs - similar products like Ariel and Tide will

increase.

Determinants of promotional elasticity

- Level of total sales
- Advertisement of the rival firms
- Cumulative effect of the past advt.
- Other factors

Quiz

The demand for the commodity is said to be

elastic if the total amount spent on the

commodity is -

- Less when the price is low then when the price is

high - Same whether the price is high or low
- More when the price is low than when the price is

high

Prices can be increased to shift the excise duty

to consumer if the product subjected to duty is --

- In relatively inelastic demand
- In relatively elastic supply
- Perishable good
- Widely used
- Luxury item

How would you indicate relatively elastic demand?

- E 0
- E lt 1
- E gt 1
- E 1

A fall in the price of a commodity leads to

- Shift in the demand
- Fall in the demand
- Rise in the consumers real income
- Fall in the consumers real income

When the demand is elastic, a price reduction --

- Will increase total revenue
- Will decrease total revenue
- Will not affect total revenue

Which of the following statements are true?

- Elasticity of demand is determined by

substitution possibilities - If the demand is inelastic, a change in the price

will not affect the quantity sold - If total revenue falls when the price increases,

demand is elastic

If the income elasticity of demand is greater

than unity, the commodity is --

- Necessity
- Luxury
- Normal good
- Non-related good