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?

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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

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 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.

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 Price Elasticity of Demand

 Price elasticity of demand is the

percentage change in quantity demanded
given a percent change in the price.

 It is a measure of how much the quantity

demanded of a good responds to a change
in the price of that good.

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Determinants of Price Elasticity of
Demand
 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 demand.
 The proportion of income taken up by the product
– the smaller the proportion the more inelastic
 Luxury or Necessity – necessary goods have
inelastic demand vs. luxury goods have elastic
demand. E.g. Salt vs. luxury cars.

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 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :

 if the good is a luxury.

 the longer the time period.
 the larger the number of close substitutes.
 If the consumer is spending large portion
of his income on the product.

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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.

The Percentage Method

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

.
 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.

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 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.

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 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
.
 Inelastic Demand
- Elasticity is less than 1
Price

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

90100 Quantity
2. ...leads to a 10% decrease in quantity.
.
 Unit Elastic Demand
- Elasticity equals 1
Price

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

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
.
 Elastic Demand
- Elasticity is greater than 1
Price

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

50 100 Quantity
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 Demand

2. At exactly 4,
consumers will
buy any quantity.

3. At a price below 4, Quantity

quantity demanded is infinite.
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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

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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.) Quantity demanded Total expenditure
4.50 4 18
4.00 4.5 18
3.00 6 18

As price falls, the quantity demanded increases,

But the total outlay remains constant.
Hence, elasticity of demand is equal to unity.

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 Demand is Elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 6 27
4 7 28
3 10 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.) Quantity demanded Total expenditure
4.50 4 18
4 4.25 17
3 5 15

As price falls, the quantity demanded increases,

but the total outlay decreases.
Hence, demand is inelastic. ( Lesser than unity)

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 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.

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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

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 Geometric Method
 At the point M,
the demand curve Price Elasticity > 1

is unit elastic. M is Elasticity = 1

the midpoint of
this linear demand
curve
 Above M, demand M
Elasticity < 1

is elastic,
 Below M, demand
is inelastic
Quantity

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 Total revenue is The importance of
price x quantity
Elasticity sold. In this
example, TR = 5 x
elasticity is the
information it
provides on the
Price 100 = 500. effect on total
This value is revenue of
represented by the changes in price.
shaded rectangle.

Total Revenue

100 Quantity Demanded

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 If the firm decides

Elasticity to decrease price

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

Total Revenue
D
100 140 Quantity Demanded

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Elasticity
Price
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded

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 Elasticity
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20

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Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
 Reducing price  Reducing price
would increase TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

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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.

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 Income elasticity of Demand

 Income elasticity of Percentage change in quatity demanded

=
demand Percentage change in income

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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

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 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
Percentage Change
in Quantit y Demanded
in Quantity of good X
Demanded
PriceElasticity
Cross Elasticity of Demand
of Demand = =
Percentage Change
in Price of good Y

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Price elasticity of Supply
 Responsiveness of supply to a given
change in the price.

Percentage Change
in Quantity Demanded
Quantity Supplied
Price Elasticity of Supply
Demand =
Percentage Change
in Price

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 Determinants of Price Elasticity of
Supply
 Number of producers: ease of entry into the market.
 Spare capacity: it is easy to increase production if
there production capacity available.
 Ease of switching: if production of goods can be
varied, supply is more elastic.
 Ease of storage: when goods can be stored easily, the
elastic response increases demand.
 Length of production period: quick production
responds to a price increase easier.

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 Time period of training: when a firm invests in
capital the supply is more elastic in its response
to price increases.
 Factor mobility: when moving resources into
the industry is easier, the supply curve is more
elastic.
 Reaction of costs: if costs rise slowly it will
stimulate an increase in quantity supplied. If
cost rise rapidly the stimulus to production will
be choked off quickly.
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Ranges of Price Elasticity of
Supply
 Perfectly inelastic Supply – Quantity supplied
does not change at all with a given change in
price.
 Relatively Inelastic Supply – Quantity supplied
does not respond strongly to a given change in
price.
 Unitary elastic supply – The change is quantity
supplied is as much as the change in price.

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Ranges of Price Elasticity of
Supply
 Relatively Elastic Supply – Quantity
supplied respond strongly to a given
change in price.
 Perfectly elastic supply - Quantity
supplied changes infinitely with a
given change in price.

.
 Perfectly Inelastic Supply
Elasticity equals 0
Price Supply

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity supplied unchanged.
.
 Inelastic Supply
Elasticity is less than 1
Price

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

100 110 Quantity

leads to a 10% increase in Supply
.
 Unit Elastic Supply
Elasticity equals 1
Price

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

100 125 Quantity

leads to a 25% increase in Supply
.
 Elastic Supply
Elasticity is greater than 1
Price

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

100 150 Quantity

Leads to a 50% increase in quantity supplied
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 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.

3. At a price below 4, Quantity

quantity supplied is zero.
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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 firm’s product.
 “Demand forecasting is an estimate of sales
during a specified future period based on
proposed marketing plan and a set of particular
uncontrollable and competitive forces.”

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Objectives of Demand Forecasting

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The criteria of a good demand forecasting method in economics:
 1. Accuracy – Closeness to the actual demand
 2. Longevity or Durability – Usability for a longer period
of time
 3. Flexibility or Scale-ability – Must anticipate the possible
changes in consumer preferences
 4. Acceptability and Simplicity – All stakeholders must be
convinced (simple / statistical methods)
 5. Availability – Data availability is the key
 6. Plausibility and Possibility – Easy for use
 7. Economy – Cost effective
 8. Yielding quick result – Fast to process and act
 9. Maintenance of timeliness – Time bound and result
oriented
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 Levels of Demand Forecasting
 Demand forecasting can be carried out at different
levels.
 Micro - When each individual production or service
organization estimate demand for their products or
services, it is called micro level demand forecasting.
 Industry - When demand as estimated for a group of
similar production or service organizations, it is called
industry level demand forecasting.
 Macro - When aggregate demand for industrial output
by the whole country is carried out, it is called macro
level demand forecasting.

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Forecasts are necessary for :
 Scheduling of the production process.
 Preparations of budgets.
 Manpower Planning.
 Setting targets of sales executives.
 Advertising & promotion decisions.
 Decisions about expansion of a firm.
 Other decisions like long term investment
plans, warehousing and inventory decisions.

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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 )

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Demand Forecasting Methods
FORECASTING METHODS

Survey Method Statistical Method

Opinion Consumers' Trend Brometric

Survey Interview projection method

Correlation
& Regression
Complete Sample End-use
enumeration survey method

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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.

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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.

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Interview and Survey approach

 Opinion polling method : Information about

the consumer’s 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.

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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.

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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.

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User’s 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 two methods :
 Correlation or regression analysis.
 Time series analysis.

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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.

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Naïve Method

Next Year’s Sales = This Year’s Sales X This Year’s Sales

Last Year’s Sales

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

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EXAMPLE OF MOVING-AVERAGE FORECAST

SALES SALES FOR THREE-YEAR

PERIOD VOLUME THREE-YEAR MOVING
PERIOD AVERAGE
1 200
2 250
3 300 750
4 350 900 300
5 450 1100 ( 3) = 366.6
6 ?
Period 6 Forecast = 366.6

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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.

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A TREND FORECAST OF SALES

O b s e rve d Sale s F o re c as t Sale s

600

500

400 Tre n d
Lin e
300
Sale s

200

100

0
1984 1985 1986 1987 1988 1989 1990
T im e

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 Barometric Techniques or Lead-Lag indicators method:
This consists in discovering a set of series of some
variables which exhibit a close association in their
movement over a period or time.
 For example, it shows the movement of agricultural
income (AY series) and the sale of tractors (ST series).
The movement of AY is similar to that of ST, but the
movement in ST takes place after a year’s time lag
compared to the movement in AY.
 Thus if one knows the direction of the movement in
agriculture income (AY), one can predict the direction
of movement of tractors’ sale (ST) for the next year.
Thus agricultural income (AY) may be used as a
barometer (a leading indicator) to help the short-term
forecast for the sale of tractors.
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