1. Elasticity….
Elasticity and
its managerial
applications
By Prof. Ravi Kumar
Faculty of Finance and Economics, The IIPM,AMITY,MANIPAL

2. In this discussion you
will…
• Learn the meaning of the
elasticity of demand.
• Examine what determines the
elasticity of demand.
• Learn the meaning of the
elasticity of supply.
• Examine what determines the
elasticity of supply.
• Apply the concept of elasticity
in different markets.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

3. THE ELASTICITY OF DEMAND
• … 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 Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

4. Price Elasticity of Demand
• Price elasticity of demand is a measure
of how much the quantity demanded of a
good responds to a change in the price
of that good.
• Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

5. The Price Elasticity of Demand and
Its Determinants
• Availability of Close Substitutes
• Necessities versus Luxuries
• Definition of the Market
• Time Horizon
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

6. The Price Elasticity of Demand and
Its Determinants
• Demand tends to be more elastic:
– the larger the number of close
substitutes.
– if the good is a ‘luxury’.
– the more narrowly defined the
market.
– the longer the time period.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

7. 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 Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

8. The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• 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) / [(Q2 + Q1) / 2]
Price elasticity of demand =
(P2 - P1) / [(P2 + P1) / 2]
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

9. The Midpoint Method: A Better Way to
Calculate Percentage Changes and Elasticities
• Point A: Price = $4 Quantity = 120
• Point B: Price = $6 Quantity = 80
• From Point A to Point B: Price rise = 50% and Quantity fall = 33%
• From Point B to Point A: Price fall = 33% and Quantity rise = 50%
(80 - 120) / [(80 + 120)/ 2]
Price elasticity of demand =
(6 - 4) / [(6 + 4)/ 2]
Mid point method
= 1
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

10. A Variety of Demand Curves
• Inelastic Demand
– Quantity demanded does not
respond strongly to price
changes.
– Price elasticity of demand is
less than one.
• Elastic Demand
– Quantity demanded responds
strongly to changes in price.
– Price elasticity of demand is
greater than one.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

11. A Variety of Demand Curves
• Perfectly Inelastic
– Quantity demanded does not
respond to price changes.
• Perfectly Elastic
– Quantity demanded changes
infinitely with any change in
price.
• Unit Elastic
– Quantity demanded changes by the
same percentage as the price.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

12. Perfectly Inelastic Demand
Price
Demand E=0
$5.00
$4.00
1. An increase
in price…
0 100 Quantity
2. …leaves the quantity demanded unchanged.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

13. Inelastic Demand
Price
Demand E<1
$5.00
$4.00
1. A 25%
increase in
price…
0 90 100 Quantity
2. … Leads to a 10% decrease in quantity demanded.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

14. Unit Elastic Demand
Price E=1
Demand
$5.00
$4.00
1. A 25%
increase in
price…
0 80 100 Quantity
2. … Leads to a 25% decrease in quantity demanded.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

15. Elastic Demand
Price E>1
Demand
$5.00
$4.00
1. A 25%
increase in
price…
0 50 100 Quantity
2. … Leads to a 50% decrease in quantity demanded.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

16. Perfectly Elastic Demand
Price E=∞
1. At any price above $4, quantity
demanded is zero.
$4.00 Demand
2. At exactly $4, consumers will buy any quantity.
3. At any price below $4, quantity demanded is
infinite.
0
Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

17. Total Revenue and the Price
Elasticity of Demand
• Total revenue is the amount paid
by buyers and received by sellers
of a good.
• Computed as the price of the good
times the quantity sold.
TR = P x Q
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

18. Total Revenue
Price
$4.00
P x Q = $400
(revenue)
Demand
0 100 Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

19. How Total Revenue Changes When
Prices Changes: Inelastic Demand
Price
$3.00
P x Q = $400
(revenue)
$1.00
P x Q = $100
(revenue) Demand
0 80 100 Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

20. How Total Revenue Changes When
Prices Changes: Elastic Demand
Price
Change in Total Revenue when Price Changes
$5.00
$4.00
Demand
Revenue = $200
Revenue = $100
0 20 50 Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

21. Elasticity and Total Revenue along a Linear
Demand Curve
• With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

22. Table 5-1. Elasticity and Total Revenue
along a Linear Demand Curve
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

23. Figure 5-5: A Linear Demand Curve
Price
7 Elasticity
is larger
than 1.
6
5
4
Elasticity
is smaller
3 than 1.
2
1
0 4 14 Quantity
2 6 8 10 12
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

24. Other Demand Elasticities
• Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in consumers’
income.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

25. Other Demand Elasticities
• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

26. Other Demand Elasticities
• 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, furs, and
expensive foods.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

27. Other Demand Elasticities
• Cross-Price elasticity of demand
measures how much the quantity
demanded of a good responds to a change
in the price of another good.
• It is computed as the percentage change
in the quantity demanded divided by the
percentage change in the price of the
second good.
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in the price of
good 2.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

28. PRICE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.
• Price elasticity of supply is the percentage
change in quantity supplied given a
percent change in the price.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

29. The Price Elasticity of Supply and Its
Determinants
• Ability of sellers to change the amount of
the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.
• Time period.
– Supply is more elastic in the long run.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

30. Computing the Price Elasticity of Supply
• The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.
P e rc e n ta g e c h a n g e
in q u a n tity s u p p lie d
P ric e e la s tic ity o f s u p p ly =
P e rc e n ta g e c h a n g e in p ric e
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

31. Computing the Price Elasticity of Supply
• Suppose an increase in the price of milk from $1.90 to $2.10 a litre
raises the amount that dairy farmers produce from 9000 to 11 000
L per month…
• … using the midpoint method, we calculate the percent change in
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
• Similarly, we calculate the percent change in the quantity supplied
as (11 000 - 9000) / 10 000 x 100 = 20%
20%
Price elasticity of supply = = 2.0
10%
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

32. Figure 5-6 a): Perfectly Inelastic Supply
Price
Supply E=0
$5.00
$4.00
1. An increase
in price…
0 100 Quantity
2. …leaves the quantity supplied unchanged.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

33. Figure 5-6 b): Inelastic Supply
Price E<0
Supply
$5.00
$4.00
1. A 22%
increase in
price…
0 100 110 Quantity
2. …leads to a 10% increase in quantity
supplied.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

34. Figure 5-6 c): Unit Elastic Supply
Price E=1
Supply
$5.00
$4.00
1. A 22%
increase in
price…
0 100 125 Quantity
2. …leads to a 22% increase in quantity
supplied.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

35. Figure 5-6 d): Elastic Supply
Price E>1
Supply
$5.00
$4.00
1. A 22%
increase in
price…
0 100 200 Quantity
2. …leads to a 67% increase in quantity
supplied.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

36. Figure 5-6 e): Perfectly Elastic Supply
Price E=∞
1. At any price above $4, quantity
supplied is infinite.
$4.00 Supply
2. At exactly $4, producers will supply any quantity.
3. At any price below $4, quantity supplied is zero.
0
Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

37. Figure 5-7: How the price elasticity of supply
can vary
Price
$15
Elasticity is less
than 1
$12
Elasticity is
greater than 1
$4
$3
0 100 200 500
525 Quantity
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

38. THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
• Good news bad news for farmers
• OPEC
• Drugs and crime
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

39. Figure 5-8: An Increase in Supply in the
Market for Wheat
Price of
Wheat Increase in Supply
1. When demand is inelastic, an
increase in supply… S1
S2
$3
$2
2. … leads
to a fall in
price…
Demand
100 110 Quantity of Wheat
3. …and a proportionately smaller increase in quantity sold. As a result revenue
falls from $300 to $220.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

40. Figure 5-9: A Reduction in Supply in the
World Market for Oil
(a) Oil Market in the Short Run (b) Oil Market in the Long Run
Price Price
of Oil 1. In the short run, when supply of Oil
and demand are inelastic, a shift
in supply… S2 1. In the long run, when supply
and demand are elastic, a shift in
supply…
S1
S2
S1
P2 P2
P1
P1
2. … leads
Demand
2. … leads to a small
to a large increase in
increase in price…
price…
Demand
Quantity of Oil Quantity of Oil
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

41. Figure 5-10: Policies to Reduce the of Illegal
Drugs (a) Drug Interdiction (b) Drug Education
Price of Price of
Drugs 1. Drug interdiction reduces the
Drugs
supply of drugs… 1. Drug education reduces the
S2 demand for drugs…
S1
Supply
P2
P1
P2
P1
D1
2. … which
2. … which reduces the
raises the price…
price…
D2
Demand
Q2 Q1 Quantity of Drugs Q2 Q1 Quantity of Drugs
3. … and reduces the 3. … and reduces the quantity
quantity sold. sold.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

42. Summary
• Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
• Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

43. Summary
• The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
• The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU

44. Summary
• In most markets, supply is more elastic in the
long run than in the short run.
• The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price.
• The tools of supply and demand can be applied in
many different types of markets.
The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU