Economics for Managers

Market Equilibrium
Price Elasticity of
Demand, Income and
cross price elasticities
of Demand
Re-cap of Session 1

 Important to define what business a firm is in

 Do note define a business from the firm’s
perspective; define from a consumer’s
perspective
 Therefore business is not defined by what a
firm produces but by what need of the
consumer it meets
What business are you in?

 Amazon: not electronics, books, technology. But “a

marketplace that provides value beyond price”
 Railways: not a. transportation on rails, b. not terrestrial
transportation, c. not even transportation, but ‘mobility’
 HELPS IN DEFINING COMPETITION
 So for railways: a. competition is not another rail company, b.
not even roadways, c. not even airlines, but even Zoom!
And therefore …

 What business is, for eg, Salad Days into?

– Even the owner might not get it right!!!.
Learning Objective Sessions 2,3

 At the end of this session, you should be able

to:
– Compute price elasticity of demand
– Analyze and evaluate the impact on total revenue
of price elasticity for various businesses
– Design simple strategies to influence price
elasticity
– Income and cross price elasticity
Equilibrium Analysis

 Equilibrium Analysis
We go deeper!
Equilibrium

 Demand, Supply & Prices

– And: sensitivity of demand to prices
ELASTICITIES OF DEMAND
 Demand Functions

 Slopes?
Comments?

12

Price /kg
Price /kg

12 12
Price /kg

10 10 10

Quantity (kgs) Quantity (kgs) Quantity (kgs)

A B C
 Demand Functions

 Nature of good Slope of C the least; of B the most

Now comments on nature of good?
Does this seem odd?

12

Price /kg
Price /kg

12 12
Price /kg

10 10 10

Quantity (kgs) Quantity (kgs) Quantity (kgs)

A B C
 Examples?

 Examples of goods like A, B and C?

12

Price /kg
Price /kg

12 12
Price /kg

10 10 10

Quantity (kgs) Quantity (kgs) Quantity (kgs)

A B C
Interpretation of slope

 P1 Rs 10.00 per Kg Q 100 Kgs

 P2 Rs 10.25 per Kg Q 90 Kgs
Slope?
Interpretation of slope

 P1 Rs 10.00 per Kg Q 100 Kgs

 P2 Rs 10.25 per Kg Q 90 Kgs
– Slope = dy/dx = - .25/10
– 1/ Slope = demand sensitivity=-10/ .25 = -40
Demand Sensitivity

 Sensitivity of demand to changes in price

 Measured by:

ΔQ/ΔP
Interpretation of slope/sensitivity

 P1 Rs 10.00 per Kg Q 100 Kgs

 P2 Rs 10.25 per Kg Q 90 Kgs
1/Slope =demand sensitivity= -10/ .25 = -
40

 P1 Rs 10.00 Q 100,000 gms

 P2 Rs 10.25 Q 90,000 gms
1/Slope?
Interpretation of slope/sensitivity

 P1 Rs 10.00 per Kg Q 100 Kgs

 P2 Rs 10.25 per Kg Q 90 Kgs
1/Slope = -10/ .25 = -40

 P1 Rs 10.00 Q 100,000 gms

 P2 Rs 10.25 Q 90,000 gms
1/Slope = -10000/.25 = -40000
Demand Sensitivity

 Sensitivity of demand to changes in price

 Measured by:

ΔQ/ΔP
 BUT THERE SEEMS TO BE A PROBLEM OF
COMPARISON, BECAUSE OF DIFFERENCE IN UNITS OF
MEASUREMENT!!
Elasticity of Demand

 So, the need for a proportionate unit-free

measure
– So how do we fix it?
Price Elasticity of Demand

 So, the need for a proportionate unit-free

measure

 PRICE ELASTICITY OF DEMAND

– It measures the proportionate change in
demand to a proportionate change in
price
Price Elasticity of Demand

 A proportionate unit-free measure

 PRICE ELASTICITY OF DEMAND

– It measures the proportionate change in
demand to a proportionate change in
price
= (∆Q/Q)/ (∆P/P)
Remember the
= (∆Q/ ∆P) * (P/Q) values will be
negative, but we
ignore it
Example

P Q
10 200 (∆Q/Q)/ (∆P/P)

or
12 192
(∆Q/ ∆P) * (P/Q)

COMPUTE!
Price elasticity of demand:
Computation

P Q
10 200
12 192

 ∆Q/Q = ??

 ∆P/P = ??

 Therefore Price elasticity = ∆Q/Q / ∆P/P =??

Price elasticity of demand:
Computation

P Q
10 200
12 192

 ∆Q/Q = -8/200 = -0.04

 ∆P/P = 2/10 = 0.2

 Price elasticity = ∆Q/Q / ∆P/P = -.04/.2 = -.2

Confusion !

 ∆Q/Q = -8/200 = -0.04

 ∆P/P = 2/10 = 0.2

 Price elasticity = -0.04/0.2 = -0.2

 Which Q and which P to take?

Confusion!

 ∆Q/Q = -8/200 = -0.04

 ∆P/P = 2/10 = 0.2 With initial Q,P
 Price elasticity = -0.04/0.2 = -0.2
 Which Q and which P to take?
– Original Q of 200 and original P of 10 or
– New Q of 192 and new P of 12?
 ∆Q/Q = -8/192 = ??
 ∆P/P = 2/12 = ?? With final Q,P
 Price elasticity = ??
Confusion!
 ∆Q/Q = -8/200 = -0.04
 ∆P/P = 2/10 = 0.2 With initial Q,P
 Price elasticity = -0.04/0.2 = -0.2
 Which Q and which P to take?
– Original Q of 200 and original P of 10 or
– New Q of 192 and new P of 12?
 ∆Q/Q = -8/192 = -0.041667
 ∆P/P = 2/12 = 0.166667 With final Q,P
 Price elasticity = -0.25
Problem Again!! Both are right But which is right?!!!
Think of a solution!!
Arc Elasticity

 ∆Q/Q = -8/200 = -0.04

 ∆P/P = 2/10 = 0.2
 Price elasticity = -0.04/0.2 = -0.2

 Which Q and which P to take?

 Take the average Q and the average P.

 This is the Arc elasticity measure. Compute!

Arc Elasticity Computation

 Average Q = (200+192)/2 = 196

 Average P = (10+12)/2 = 11

 Therefore ∆Q/Q = -8/196 = -0.040816

 And ∆P/P = 2/11 = 0.181818

 And so Arc Price elasticity = -

0.040816/0.181818 = -0.22449
Let us go back to our original
demand slope examples

 Look at the excel template

 What do you think the new Q
will be for markets A (Beverages)
 B (Petrol)
 and C (Jewellery)?
Slopes

 What do you think the new Q will be for

markets A, B and C?
 Now compute the slopes and inverse
slopes
Slopes

 What do you think the new Q will be for

markets A, B and C?
 Now compute the slopes/ inverse?

Notice something
about the slopes?
Elasticities

 What do you think the new Q will be for

markets A, B and C?
 Now compute the slopes
 Now compute the elasticities
Elasticities

 What do you think the new Q will be for

markets A, B and C?
 Now compute the slopes
 Now compute the elasticities using initial/
final Q?
Elasticities

 What do you think the new Q will be for

markets A, B and C?
 Now compute the slopes
 Now compute the elasticities using initial/
final Q?
 Now, finally, compute the arc elasticity!
From Arc Elasticity to …

 Point Elasticity
 As the changes in Q and P become smaller
and smaller, the arc comes closer to be a
point; therefore we can define ‘point
elasticity’ - at a particular Q and at a
particular P-

 Replace discrete ∆ with continuous ‘d’ and

then we have:
 Point Elasticity = dQ/dP * P/Q
Price elasticity: Business
Relevance

 Why should Varun Madan, for example, be

concerned about price elasticity?
Price elasticity: Business
Relevance

 Why should Varun Madan, for example, be

concerned about price elasticity?
– If, for example, he were to be contemplating an
increase in prices for his salads, how should he
go around analyzing the decision? What would be
the effects, and on what?
Price elasticity: Business
Relevance

 Why should Varun Madan, for example, be

concerned about price elasticity?
– If, for example, he were to be contemplating an
increase in prices for his salads, how should he go
around analyzing the decision? What would be the
effects, and on what?
– Demand would go down (this would be true for all
‘normal goods’)
– But ….
Price elasticity: Business
Relevance

 Why should Varun Madan, for example, be

concerned about price elasticity?
– If, for example, he were to be contemplating an increase
in prices for his salads, how should he go around
analyzing the decision? What would be the effects, and
on what?
– Demand would go down (this would be true for all
‘normal goods’)
– But ….total revenue may or may not go up depending
on …
Price elasticity: Business
Relevance

 Why should Varun Madan, for example, be

concerned about price elasticity?
– If, for example, he were to be contemplating an increase
in prices for his salads, how should he go around
analyzing the decision? What would be the effects, and
on what?
– Demand would go down (this would be true for all
‘normal goods’)
– But ….total revenue may or may not go up depending
on increase in price and price elasticity
Price elasticity and Total Revenue

 Note: Total Revenue (TR) = Q * P. So:

 If mod of price elasticity is < 1 , TR will increase with an
increase in price, and decrease with a decrease in
price
– Example: If P increases by 10 percent, and Q falls by 8
percent, TR = 1.1 * .92 = 1.012, indicating that TR increases
by 1.2 percent
 If mod of price elasticity is > 1, then TR will decrease
with an increase in price, and increase with a decrease
in price
Price elasticity and Total Revenue
 Note: Total Revenue (TR) = Q * P. So:
 If mod of price elasticity is < 1 , TR will increase with an
increase in price, and decrease with a decrease in
price
 If mod of price elasticity is > 1, then TR will decrease
with an increase in price, and increase with a decrease
in price
 Example: If P increases by 10 percent, and Q falls by 12
percent, TR = 1.1 * .88 = 0.968, indicating that TR decreases by
3.2 percent
Technical Terms!
 If mod of price elasticity is < 1 , we say it is
price inelastic
 If mod of price elasticity is > 1, we say it is
price elastic
 If mod of price elasticity is = 1, we say it is
unit elastic
Therefore…..

 So important for a manager, for an

entrepreneur, to understand price elasticity
 And, obviously, would you prefer a high
price- elasticity or a low price-elasticity?
– What factors, then, might affect price elasticity?
What sort of businesses will have high/ low
elasticity? Would you have control over the price
elasticity?
Factors affecting Price Elasticity

 Number of Substitutes: Brand-specific

elasticity and product-specific elasticity
 Necessities vs luxuries
 Share of exp on the commodity in the total
budget
 Time period: Short run and long run
Elasticity in the short and long run

 Is it higher in the short run relative to the long run?

– ………… or is it the other way?
 Read Pindyck and Rubinfeld pages 62 only the
part on price elasticity
Point Price Elasticity

 Arc elasticity is : over a range of prices.

 Point elasticity is at a price or over a very

small range- so small that the range tends to
zero.
 So ‘∆’ becomes ‘d’.
dQ /dP * P/Q
Numerical, from book

 Page 61
 Demand Function for Wheat: Q = 3550-
266P
 Current P = $3.46 Find Price Elasticity
Numerical, from book

 Page 61
 Demand Function for Wheat: Q = 3550-
266P
 Current P = $3.46 Find Price Elasticity
 Q = 2630
 (P/Q)*(dQ/dP) = (3.46/2630)*-266 = -.35
 Interpret!
Learning Objective

 At the end of this session you should be able

to:
– Compute price elasticity of demand
– Analyze and evaluate the impact on total revenue
of price elasticity for various businesses
– Design simple strategies to influence price
elasticity
OK?
Before the next class …..

 1. Read Sections 2.1, 2.2, 2.4 and 2.5

focusing only on demand, that is, till p.67
 2. How sensitive do you think demand for
Salad Days is, to price?
 3. Apart from price are there any other
factors that will affect the demand for Salad
Days?