Elasticity of Demand

1. Elasticity of Demand • Elasticity means the measurement of responsiveness of one variable to other variable. • X =f (Y), X = dependent variable, Y = Independent variable (If Y change how it is going to affect for X - elasticity measure it) • An elasticity of demand = (% change in the demand for good A)/% change in an independent variable Main Demand Elasticities • Price elasticity of demand • Cross price elasticity of demand • Income elasticity of demand

2. Other Elasticities • Supply elasticity • Advertising and cross advertising elasticity • Conjectural price elasticity • Imports and exports elasticities

3. Price elasticity of demand (the percentage change in the quantity of a good demanded divided by the corresponding percentage change in its price. This is related with the movement along the demand curve) Point elasticity = AQ% = AQ/Q = A Q X P AP % AP/P A P Q

4. Elasticity measure gives two pieces of information: • It shows sign of the relationship between changes in the relevant variables. • It measures the extent to which quantity responds to a change in price. • Generally price elasticity can be in three ranges: • Price inelastic ( 0 - 1), Ed < 1 • Unitary (1), Ed = 1 • Price elastic (1 and infinity), Ed > 1

5. Arc elasticity allows you to calculate elasticity in two price and two quantity combinations Change in Q Q2-Q1 Average Q = (Q2+Q1)/2 = A Q . P2+P1 Change in P P2-P1 A P Q2+Q1 Average P (P2+P1)/2 Price A P2 C A P B P1 AQ Quantity demanded 0 Q1 Q2

6. Elasticity along a linear demand curve Ed = 00 : Perfect elastic P Ed > 1 : Elastic range Ed = 1 : Point of unitary elasticity Ed < 1 : Inelastic range Ed = 0 : Perfect inelastic 0 Qd

7. Graphical Representation of Elasticity 1. Unitary Elasticity D P P up 5% Qd 5% down P down 5% Qd 5% up P2 5% P1 5% D Qd 0 Q1 Q2

8. 2. Inelastic situation (relative) P D P up 20% Qd 5% down D1 P2 20% P1 5% D Qd 0 Q1 Q2 Large range of price changes but Small changes of quantity of demand

9. 3. Elastic situation (relative) P P up 5% Qd 20% Down D P2 5% P1 D 20% Qd 0 Q1 Q2 Small range of price changes but massive changes of quantity of demand

10. 4. Perfect Inelastic situation D P P3 P2 P1 Qd 0 Q1

11. 5. Perfect Elastic situation P D P Qd 0 Q1 Q2

12. Factors affect for the price elasticity • Time period • addictive nature for good/services • availability of substitutes their quality • price range, and the necessity of the goods • share of income spent on good • consumers ability to change his environment

13. Importance of price elasticity • to determine pricing policies/strategy • to select inputs • to select markets • to maximize revenue • to government taxation policies • Firm and the market elasticity • (Depends on the market structure: Monopoly – same, other markets – different)

14. Cross elasticity of Demand This is related with the shift in demand curve. It can be defined as the responsiveness of demand for one product to changes in prices of other product. Ex = (% change in quantity demanded of good A)/(% change in price of B) • Epx = AQy . Px • APx Py

15. Importance • to check the impact of prices of other goods to the good concerned • to formulate a good pricing strategy • to analyse risks associated with the goods • check the effectiveness of advertising to create a brand loyalty • to measure interrelationship between industries • identify the boundaries of market in differentiated products

16. Nature of Cross Price Elasticity • Cross price elasticity for substitute goods are positive • 2) Cross price elasticity for complement goods are negative • 3) Cross price elasticity for independent goods are zero

17. Income Elasticity of demand This measures the responsiveness of quantity demanded to change in income, holding other factors are constant. This related with the shift in demand curve due to changes in income. EY = AQ . Y AY Q Ey = % change in quantity demanded % change in disposable Y For normal goods this is positive and for inferior goods this is negative Importance (to check future demand, decisions on investment, policy decisions in international trade, effects of changes in real income) Elasticity can be measure for other variables such as advertising and interest rates, etc.

18. Income and Elasticity - Relationship Income Income Elasticity < 0 Y Income Elasticity = 0 A Income Elasticity>0 Demand 0 Qd O – A = Normal good, A - Y = Inferior good

19. Relationship between TR, AR and MR Total Revenue = TR = P . Q Average Revenue: TR/Q = P . Q/Q = AR = P Marginal Revenue: d(TR)/d(Q) = MR Angel’s Law The proportions of expenditure on all necessities (foods) declines as incomes rise and in contrast the proportionate expenditure on luxuries (durable) would increase. (this is related with the consumer’s bahaviour with income increases)

20. price (£) x y p* AR z 0 quantity MR total revenue (£) 0 q* quantity The effect on revenue of a price change Elastic Range • at point y, Ed = 1 • between x and y, Ed > 1 • between y and z, Ed < 1 • between x and y, TR increases (i.e. MR is +ve) • at y TR is at its maximum (i.e. MR = 0) • between y and z, TR decreases (i.e. MR is -ve) Unitary Inelastic Range

21. Income Elasticity – Examples (Looking at this coefficient name which good is Normal and inferior) note : In the same period, real national disposable income rose by 29.86% source : Pass & Lowes (1994)

22. Supply Elasticity This always should go with lag: If price changes it takes sometime to respond supply to price changes in some sectors. Es = % change in quantity supplied/% change in price S S Es < 1, Inelastic Es > 1, Elastic S S S Es = 0 Es = 00 Es =1, Unitary Perfect inelastic perfect elastic

23. Advertising Elasticity A measure of the effect of a change in advertising upon the sales of a given good. Ea = (% change in quantity demanded of good A)/(% change in expenditure on advertising good A) If Ea >1: Inelastic (large amount of expenditure needed to increase demand). If Ea<1: Elastic (small amount of expenditure needed to increase demand). Cross Advertising Elasticity A measure of the responsiveness of the quantity of demand of one good to a change in the expenditure upon advertising on another good. Positive for complements and negative for substitutes.

24. Conjectural Price Elasticity This measures interdependence between firms and a good measure to forecast price changes in retaliation specially in oligopolistic markets. This will help to firm’s pricing decision making strategy. Ec = (Expected % change in the price charged by firm B)/(Actual % change in price charged by firm A)

25. Exports and Imports Elasticity Price elasticity of demand for exports = (% change in the demand for exports in country x/% change in price of exports in country A) Income elasticity of demand for exports = (% change in the demand for exports in country x/% change in disposable income abroad) Price elasticity of demand for imports = (% change in the demand for imports in country x/% change in price of imports in country A) Income elasticity of demand for imports = (% change in the demand for imports in country x/% change in disposable income aboard) These elasticities are important to policy decisions in external trade and devaluation.

26. Demand Estimation • Identification of firm’s real demand curve helps to determine • the correct price, • inputs requirements • profit maximising output • Identification of demand • Consumer interviews • Consumer surveys • Consumer clinics and focus groups • Market studies • Market experiments in test stores

27. Statistical Estimation of Demand Regression technique (Identification of variables, obtain data on variables, equation specification, estimation of regression parameters, interpretation of regression results: coefficient of determination, F and t statistics, SE, problems of regression: Auto correlation, multi-collinearity, heteroscedasticity).

28. Demand Forecasting Methods • Deterministic Time Series Analysis (secular trend, cyclical fluctuation, seasonal variation and random influences). • Trend projection, extrapolation or curve fitting • Barometric or lag or lead indicator methods. • Econometric models (Single, multiple, lag, structural model…etc). • Input-output analysis (interrelationships). • Opinion polling and survey techniques (future plans). • Techniques selection depends on the forecasting distance, complexity of the forecasting problem, lead time, accuracy, relationship, resources and time availability, etc.

29. Product Life Cycle This shows four stages of demand for a product. Introduction phase - demand increases slowly. Growth phase - demand increases rapidly. Maturity phase - demand increases less slowly. Decline phase - demand decreases. Maturity (saturation) Launch Growth Decline Sales (units sold) 0 Time

30. Market SegmentationMarket segments or niches are groups of consumers with similar tastes and preference patterns. Maximum number of market segments will not exceed the number of potential customers. Market can be segmented according to product characteristics, consumer income level, age and geographic area. Elasticities can help to identify market segments. Segmentation can aid in: identifying competitors, new product development, targeting advertising expenditure, branding and exploiting market niches.

31. Paint Overall market Decorative paint Industrial paint Broad sectors DIY Professional Decorators General Industrial Specialised Major users Primer Matt Gloss Special Purpose etc. Product group Basic De Luxe Super de luxe Product line White Blue Red etc. Colour range Can/brush Aerosol Tray/roller Packaging Wholesaler Retailer Distribution outlets Local Regional National International Geographical cover Segmentation Example : Paint

32. Criticism about demand theory 1) Consumers rationality is unpractical. 2) Demand not always behave as it is stated in the law. 3) Price is not the main concern of consumer. They concern about quality, reliability, design, after sales services, brand names, recommendations from friends, previous experience, consumer guides, advertisements, etc.

33. Class Group Exercise: Demand Estimation 1) Specify the demand function for the following products. 2) How do you estimate market demand for the following products? 1) a new version of Microsoft Office? 2) a new brand of toothpaste? 3) internet bank accounts? 4) car exhaust systems? 5) theatre performances? 6) a new toll road? 7) electricity supply? 8) Sri Lankan tourist sector/Sri Lankan airline 9) Sri Lankan seaports 10) Sri Lankan professionals

34. Questions to discuss • Explain market mechanism (demand, supply functions and equilibrium price) with an example. • Distinguish between movement along the supply curve and shift in demand curve. • Explain demand estimation techniques. • Explain demand forecasting techniques. • Distinguish between consumer and producer surplus. • Explain main demand elasticity concepts with examples. • Distinguish point elasticity and arc elasticity. • Distinguish between cross price and income elasticity. • Explain why elasticity is so important to engineering managers to take business decisions. • Explain the graduate unemployment problem and control price for rice by using market mechanism. • Explain oil price increase by using market mechanism.