Business Economics 05 Elasticity

Objectives To outline the importance of demand sensitivity analysis to the behavior of the organization To consider the factors that affect the price elasticity of demand To consider the relationship between price, demand, marginal and total revenue To develop the concepts of supply elasticity, advertising, cross-price, and income elasticity to the behavior of the organization To understand the direction of economic impact of government policy

Elasticity of demand – the degree of responsiveness of quantity demanded to a change in price . Percentage change in the Qty. Ed = demanded of Good x Percentage change in the price of Good x = %  Qdx %  Px Q 1 = Qd before  P Q 2 = Qd after  P P 1 = P before  P P 2 = P after  P

= (Q 2 – Q 1 / Q 1 ) (P 2 – P 1 / P 1 ) Illustration – Q 1 =2,000, Q 2 =2,500 P 1 = 10, P 2 = 9 then 2500 – 2000 / 2000 = - 2.5 9–10 / 10

The use of proportionate or % measures It allows comparison of changes in two qualitatively different things measured in two different types of units. It avoids the problem of what size units to use It is the only sensible way of deciding how big a change in price or quantity is. The sign (+ or -)

Point elasticity the measurement of elasticity at a point on a curve E =  Q . P  P Q In terms of calculus e = dq . P dp q dq/dp is the reciprocal of the slope of demand curve i.e. dp/dq which is constant therefore Ed depend on P/Q

Arc elasticity the measurement of elasticity between two points on a curve E =  Q . ( P 1 + P 2 )  P (Q 1 + Q 2 ) Relative responsiveness of quantity demanded to a discrete change in price, and its intention is to provide a measure of the elasticity of demand over a range of prices.

Exercise If P1=5, P2=4, Q1=200, Q2=260 then measure point elasticity and arc elasticity.

Types/degrees of price elasticity Perfectly elastic Perfectly inelastic Unity elastic Relatively elastic Relatively inelastic

E = -1 At midpoint on demand curve Qdx = A + BP x if Q = 0 then P = - A/B or if P = 0 then Q = A Slope of linear demand curve =  P  Q B Is reciprocal of the slope of demand curve Qdx = A +  Qdx . P x  Px As E =  Qdx . P x  Px Q x Then Qdx = A + E.Qx Dividing both sides by Q x 1 = A + E Qx Solving for E E = (Qx – A) / Q x

Mid point on D is at A/2, substituting this in above equation gives E = -1 Q < A/2  E > -1 Q > A/2  E < -1 Q A E = -  P O -  > E > -1 E = -1 -1 > E > 0 E = 0 -A / B A / 2

Total revenue and elasticity (Qd X = 80 – 2Px) Price of Software (P x ) Quantity of Software Sold (Q x ) Own Price Elasticity (E QxPx ) Total Revenue (P X Q X ) A 0 80 0.00 0 B 5 70 -0.14 350 C 10 60 -0.33 600 D 15 50 -0.60 750 E 20 40 -1.00 800 F 25 30 -1.66 750 G 30 20 -3.00 600 H 35 10 -7.00 350 I 40 0 -  0

Elasticity and revenue Total revenue test – if demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in tr. If demand is inelastic, an increase (decrease) in price will lead to a increase (decrease) in total revenue. Finally, tr is maximized at the point where demand is unitary elastic. Various types of revenues TR, AR, MR, incremental revenue

Demand, elasticity and total revenue

Q TR 0 TR Q A E = -  P O -  > E > -1 E = -1 -1 > E > 0 E = 0 -A / B A / 2

Relationship between ed, MR and TR when ed>1, MR is positive and TR rises as price falls when ed=1, MR=0, TR=max when ed<1, MR is negative and TR falls as price falls Relationship between ed and TR elasticity price increases price decreases e > 1 TR falls TR rises e = 1 TR constant TR constant e < 1 TR rises TR falls

TR, MR, AR AND E MR = d(TR) = d(PQ) = P + Q dP dQ dQ dQ MR = P (1 + Q dP ) P dQ Since Q . dP = 1 P dQ E MR = P (1 + 1 ) E MR = f (E), If E = -1 Then MR = P (1 + 1 ) = 0 -1

Using price elasticity of demand: Application to Phillip Morris In 1993, Phillip Morris cut cigarette prices by 18%, Others including R J Raynolds matched it In 1994, demand increased by 12.5% but profit declined by 25% due to bad pricing strategy All this happened because price was cut when demand was inelastic (-0.694)

Exercise ‘ Cut price and make it up in volume’ E = -1.7 e = %  Q Price cut = 5% %  P Will sale increase enough to increase TR due to price cut?

Exercise Given: the demand equation is P = 81 – 9Q 1. What is the equation for MR 2. At what output is MR = 0 3. At what output TR is maximum 4.Determine the price elasticity of demand at the output where TR is maximum.

G Gasoline price and consumer response in US 555 8,700 15.7 1.31 1981 638 9,300 14.5 0.86 1979 25% 680 9,600 14.1 0.62 1977 685 9,400 13.7 0.57 1975 736 7% 9,800 13.3 $ 0.40 1973 Avg. Fuel consumption (gallons) Avg. Miles driven per vehicle per Year Avg. Miles per gallon Avg. Price of gasoline Year

Estimates of price elasticity (US – 1975) Good or service Estimated price elasticity Electricity -0.13 SR Electricity -1.89 LR Water -0.14 LR Motion pictures -3.69 LR Gasoline -0.15 SR Gasoline -0.78 LR Foreign travel -4.10 LR

Determinants of price elasticity ?

Determinants of price elasticity Nature of the commodity (less elastic for broadly defined products) Range of substitutes Proportion of income spent Time period Durability of a commodity Extent of use Income level Urgency of demand

Income elasticity of demand – the responsiveness of demand to a change in consumer’s income Point Ey = %  Q =  Q . Y %  Y  Y Q Arc Ey = Q 2 -Q 1 - Y 2 + Y 1 Y 2 -Y 1 Q 2 +Q 1 Example Demand for auto = f(per capita Y) Q=50,000+5(Y) Y1=10,000 then Q1=100,000, Y2=11,000 then Q2=105,000 Ey(Arc)= 105,000-100,000 11,000+10,000 = =0.512 11,000-10,000 105,000+100,00 Ey(Point) = 5. 10,000 = 0.5 ( dq = 5) 100,000 dy

Business Economics 05 Elasticity

Income elasticity and decision making Inferior goods(Ey<0), normal goods(1>Ey>0), superior goods(Ey>1) In different stages of business cycle International trade Engel’s law and the plight of the farmer (1940 US farmer to feed 11 people, now he feeds 80 people)

Income elasticity of demand, selected commodities, global Good Elasticity Good Elasticity Grain(China) -0.12 to 0.15 Cream (US) 1.72 Potatoes(UK) -0.32 Eggs (UK) -0.21 Potatoes(US) 0.15 Eggs (US) 0.57 Oranges (US) 0.83 Break (UK) -0.17 Apples (US) 1.32 Other cereal products (UK) 0.18 Lettuce (US) 0.88 Domestic cars (US) 1.62 Meat (China) 0.1 to1.2 European cars (US) 1.93 Milk (UK) 0.05 Asian cars (US) 1.65 Milk (US) 0.50

Income elasticity of selected commodities in India 1960 -76 Commodity Rural Urban Minor cereals -0.83 -1.32 Major cereals 0.55 0.12 Handloom cloth -0.12 0.21 Mill made cloth 0.66 0.70 Bidi tobacco 0.64 -0.19 Cigarette tobacco 1.51 1.17 NCAER, 1964

NSSO Survey 2011 ToI 25 July 2011 1999-2009 Rural Urban Food 70% 78% Education 378% 345% Overall expenditure 8% 20% Medical care 152% 136%

Cross-price elasticity of demand The responsiveness of demand for one good to a change in the price of another. Cross elasticity provides a measure of substitution and complementarities between two products Exy = %  Qx %  Py Exy =  Qx . Py  Py Qx Qx = 100+0.5Py , at Py = 20 and Qx = 110 Exy = 0.5 . 20/110 = 0.09 ARC Exy = Qx 2 - Qx 1 . Py 1 + Py 2 Py 2 - Py 1 Qx 1 + Qx 2 = 150-125 . 100+50 = 0.27 100-50 150+125 Exy >0 for substitutes and Exy<0 for complementary products Exy may not be symmetrical Usefulness – pricing strategy, boundaries between industries

Trade elasticities in India 1960-91 Country Foreign Ey for India’s Exports India’s Ey for imports Exy for India’s exports Exy for India’s imports ROW 0.49 1.02 -0.94 -0.26 Australia 0.53 1.21 - -0.11 Belgium 1.53 3.91 - -0.83 Canada 0.18 0.43 -0.34 -0.37 France 1.76 2.08 - - Germany 1.42 1.08 -0.18 -1.01

Trade elasticities in India 1960-91 cont. Country Foreign Ey for India’s Exports India’s Ey for imports Exy for India’s exports Exy for India’s imports Italy 0.76 1.70 -1.78 -0.53 Japan 0.49 2.00 -0.05 -1.88 Netherlands 1.24 1.35 -0.28 -0.64 Switzerland 1.52 2.32 - -0.01 UK 0.55 1.68 -0.09 -1.79 USA 1.13 0.39 - -0.46

Reference - Gupta G S and Keshava H, 1994, Income and Price Elasticities in India’s Trade, Vikalpa , Vol. 19, No. 2, pp 13-19.

Advertisement and its effect on demand 1. Shift DD to right 2. Make it less price elastic Elasticity of advertisement – responsiveness of sales to changes in advertising expenditures E A = %  Q sales %  adv.exp. =  Qx . Ax  Ax Qx ARC E A = Qx 2 - Qx 1 . Ax 1 + Ax 2 Ax 2 - Ax 1 Qx 1 + Qx 2

The objectives of an advertising Create awareness Inform customers Create the desired perception Create a preference Persuade customer to purchase Advertisement response curve Factors determining e a Type of commodity Market share Rival’s reactions State of economy

Price elasticity of supply The responsiveness of supply to a change in the price E S = %  Q S %  P Determinants of E S

Determinants of E S Es>1 when less additional cost spare capacity easy supply of raw material ready transformation time period

Degrees of elasticity of supply Perfectly elastic- Es = infinity Perfectly inelastic- Es = 0 Unity elastic- Es = 1 Relatively elastic- Es > 1 Relatively inelastic- Es < 1

Unit elastic supply curve 6 5 4 3 1 2 0 1 2 3 4 5 6 b c S 1 a f S 2 S 3 e d g P Q

Elasticity of supply for self-consumption of own product Hicks in Value and Capital explained that supply becomes backward bending due to self consumption (Ref.: Kothari, V N, 1999, Elasticity of demand for self-consumption of own product, Indian Economic Journal, 46(2), pp 140-142)

Exercise After a careful statistical analysis, Raynolds company concludes that the demand function for its product is Q = 500 -3P + 2Po + 0.1I Where Q is the quantity demanded for its product, Po is the price of its rival’s product, and I is per capita disposable income($). At present, P=$10, Po= $20, and I= $6,000. Calculate price, income, and cross elasticity of demand. What is the implicit assumption regarding the population in the market?

Elasticity in managerial decisions Point and arc elasticity Identification problem of other factors Quick and easy method Bridge the gap of pricing in theory and pricing in practice Plays role in organization’s ability to discriminate between markets Incidence of tax

Five commodities emerge top performers in April '05 exports G. Srinivasan New Delhi , July 12 FIVE commodities, both conventional and non-conventional, accounting for close to 39 per cent of the country's aggregate exports, have emerged as the top performers in exports during the inaugural month of 2005-06. They are transport equipment, cotton readymade garment, including accessories, drugs, pharmaceuticals and fine chemicals, gems and jewellery and petroleum products. According to provisional figures of disaggregated trade figures compiled by the Directorate General of Commercial Intelligence and Statistics, transport equipment with a weight of 5.18 per cent logged a growth of 114.39 per cent during April 2005 at $347.61 million, against $162.14 million in April 2004. RMG cotton including accessories (6.31 per cent) posted a growth of 20.74 per cent at $422.87 million ($350.24 million). Drugs, pharmaceuticals and fine chemicals, with a weight of 4.65 per cent, registered a growth of 15.45 per cent at $311.98 million ($270.23 million), while petroleum comprising, crude and products exports (9.15 per cent), notched a growth of 9.17 per cent at $613.66 million, against $562.12 million. Traditional items such as gems and jewellery (14.67 per cent) grew 11.80 per cent at $983.65 million in April 2005, against $879.86 million in the corresponding month of April 2004. Unclassified exports, accounting for a meagre 3.77 per cent, posted a robust 36.46 per cent growth at $252.64 million ($185.13 million). Exports of agriculture and allied products (7.72) suffered a decline of - 2.49 per cent during the first month of the current fiscal at $517.42 million ($530.63 million), while plantation (0.88 per cent) posted a wholesome 42.08 per cent growth at $59.07 million, against $41.57 million. On the whole, exports during the first month of the current fiscal logged a growth of 19.67 per cent at $6,706.26 million ($5,603.96 million). Among the top 15 countries for exports, South Africa recorded the highest growth of 146 per cent, followed by South Korea at 76 per cent, France (72 per cent), the UK (53 per cent), Singapore (32 per cent) and China (31 per cent). Exports to the United Arab Emirates recorded negative growth rates. On the import front, the top five commodities of imports accounting for a share of 63 per cent in total imports are pearls, precious, semi-precious stones, machinery except electrical and electronic, petroleum, crude and products, electronic goods and gold. Petroleum, crude and products, with a weight of 30.18 per cent in total imports grew 30.10 per cent in April 2005 at $3036.73 million, against $2334.11 million in the corresponding month of April 2004, partly fuelled by the flare-up in global crude prices. Gold, with a weight of 11.50 per cent in the country's import basket, logged a growth of 21.09 per cent at $1156.62 million ($955.20 million), which is in keeping with the trend of 2004-05 when such imports crossed $10 billion. Import of electronic goods (7.53) per cent posted a robust growth of 28.17 per cent at $757.48 million ($590.99 million), while machinery, except electrical and electronic (6.15 per cent), grew 97.14 per cent at $618.99 million ($313.998 million). Import of pearls, precious and semi-precious stones (7.70 per cent) grew a whopping 116.47 per cent at $775.08 million ($358.05 million). Bulk imports with a weight of 40.54 per cent in aggregate imports also posted a relatively robust 35.66 per cent growth at $4088.07 million ($3,013.36 million). On the whole, imports during April 2005 at $10,060.44 million were 45.80 per cent higher than $6,900.15 million in the previous corresponding period. Among the top 15 countries for imports, the highest growth was recorded by South Africa at 93 per cent, followed by Germany (86 per cent), Belgium (85 per cent), Malaysia (83 per cent), Hong Kong and the UK Kingdom at 79 per cent each, Switzerland and Singapore at 77 per cent each, the US (62 per cent), South Korea (48 per cent) and China (47 per cent).

Business Economics 05 Elasticity

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