Chapter 4: Quantitative Demand Analysis: Elasticity of Demand in Managerial Economics

Elasticity of demand is a fundamental concept in managerial economics that plays a crucial role in business decision-making. It provides
insights into how consumers respond to various economic changes, allowing businesses to make informed pricing and marketing
strategies. At its core, elasticity of demand measures the responsiveness of the quantity demanded of a product or service to changes in
price, income levels, or the prices of related goods.

Understanding elasticity is essential for businesses as it helps predict revenue fluctuations, assess the potential impact of price changes,
and optimize product positioning in the market. A product with high elasticity experiences significant demand shifts when prices change,
while a product with low elasticity maintains stable demand regardless of price fluctuations. This concept extends beyond pricing; it
also aids in demand forecasting, market segmentation, and competitive analysis.

By analyzing different types of demand elasticity—such as price elasticity, income elasticity, and cross-price elasticity—businesses can
strategically adjust their operations to maximize profitability and remain competitive in dynamic market conditions.

Types of Elasticity of Demand

Elasticity of demand can be classified into:

1. Price Elasticity of Demand (PED) – Effect of price changes on quantity demanded.

2. Income Elasticity of Demand (YED) – Effect of income changes on demand.
3. Cross-Price Elasticity of Demand (XED) – Effect of the price of one good on the demand for another.
4. Total Revenue and Elasticity – Relationship between price changes, elasticity, and revenue.

1. Price Elasticity of Demand (PED)

Price Elasticity of Demand (PED) measures how much quantity demanded changes in response to a change in price.

Formula:

Example 1: Elastic Demand (PED > 1)

Scenario:
The price of a smartphone decreases from €1000 to €900. As a result, the quantity demanded increases from 500 units to 700 units.
Interpretation:
Since |PED| = 4 > 1, demand is elastic (a small price decrease leads to a large increase in quantity demanded).

Example 2: Inelastic Demand (PED < 1)

Scenario:
The price of petrol increases from €1.50 to €1.65 per liter, but the quantity demanded drops only slightly from 1000 liters to 950
liters.

Interpretation:

Since |PED| = 0.5 < 1, demand is inelastic (price changes significantly, but demand changes only slightly).

Example 3: Unit Elastic Demand (PED = 1)

Scenario:
A concert ticket price increases from €50 to €55,
and as a result, ticket sales drop from 2000 to
1800.
Interpretation:

Since |PED| = 1, demand is unit elastic, meaning the percentage change in price is equal to the percentage change in quantity
demanded.

Example 4: Perfectly Inelastic Demand (PED = 0)

Scenario:
A life-saving medicine's price increases from €20 to €30, but the quantity demanded remains at 500 units.

Interpretation:

Since PED = 0, demand is perfectly inelastic—no matter how the price changes, demand remains constant.

Example 5: Perfectly Elastic Demand (PED = ∞)

Scenario:
In a highly competitive market, a seller sells oranges at €1 per kg. If they increase the price to €1.10, all customers switch to
competitors, and quantity demanded drops to zero.

Interpretation:

Since PED = ∞, demand is perfectly elastic—a tiny price increase causes demand to drop to zero.

Interpreting PED Values

• PED > 1 (Elastic Demand): A small price change causes a large quantity change.
• PED < 1 (Inelastic Demand): A large price change causes a small change in quantity.
 • PED = 1 (Unit Elastic Demand): % change in price = % change in quantity.
• PED = 0 (Perfectly Inelastic Demand): No change in demand despite price changes (e.g., life-saving drugs).
• PED = ∞ (Perfectly Elastic Demand): Even a tiny price increase eliminates demand (e.g., pure competition).

Examples of PED

Product PED Value Explanation

Luxury Cars (e.g., If the price increases, demand drops significantly because consumers can delay
Highly Elastic (PED > 1)
Ferrari) purchases or buy alternatives.

Even with price hikes, demand remains stable because people need fuel for
Gasoline Inelastic (PED < 1)
commuting.

Perfectly Inelastic (PED

Salt Consumers buy the same amount regardless of price changes.
= 0)

Airline Tickets (Budget

Elastic (PED > 1) If prices increase, travelers switch to alternative airlines or travel less.
Airlines)

Electricity Inelastic (PED < 1) Even if prices rise, consumers still use electricity for daily needs.

Managerial Implications of PED

1. Pricing Strategy
o If demand is elastic, lowering prices can increase total revenue.
o If demand is inelastic, raising prices can increase revenue.
2. Revenue Forecasting
o Elasticity helps predict how total sales and revenue will change when prices fluctuate.
3. Market Positioning
o Products with inelastic demand (e.g., medicine) can sustain higher prices, maximizing profit margins.
o Businesses in competitive markets (elastic demand) should focus on pricing strategies and differentiation.

2. Income Elasticity of Demand (YED)

Definition

Income Elasticity of Demand (YED) measures the sensitivity of demand to changes in consumer income.

Formula:

Interpreting YED Values

• YED > 1 (Luxury Goods): Demand rises faster than income (e.g., luxury watches, designer clothing).
• 0 < YED < 1 (Necessities): Demand rises slightly with income (e.g., rice, electricity).
• YED < 0 (Inferior Goods): Demand decreases as income rises (e.g., second-hand clothes, public transport).

Example 1: Luxury Goods (YED > 1)

Scenario:
A person’s income increases from €50,000 to €60,000 per year. As a result, the demand for luxury watches increases from 100 to 150
units.
Interpretation:

Since YED > 1, luxury watches are a luxury good—demand increases significantly when income rises.

Example 2: Necessities (0 < YED < 1)

Scenario:
A person's income increases from €30,000 to €33,000 per year. As a result, demand for milk increases from 500 to 525 liters.

Interpretation:
Since 0 < YED < 1, milk is a necessity—demand increases with income but at a slower rate.

Example 3: Inferior Goods (YED < 0)

Scenario:
A person's income increases from €20,000 to
€25,000 per year. As a result, demand for instant
noodles drops from 300 to 250 packs.

Interpretation:

Since YED < 0, instant noodles are an inferior

good—demand decreases as income rises because
people switch to higher-quality food.
 Examples of YED

Product YED Value Explanation

Rolex Watches YED > 1 As income rises, demand for luxury watches increases significantly.

Milk 0 < YED < 1 Demand increases with income, but at a slower rate.

Instant Noodles YED < 0 Demand declines as income rises, as consumers prefer higher-quality food.

Managerial Implications of YED

1. Luxury brands target customers with higher disposable income.

2. Inferior goods see a drop in demand as the economy grows.
3. Normal goods (necessities) remain stable across economic conditions.

3. Cross-Price Elasticity of Demand (XED)

Cross-Price Elasticity of Demand (XED) measures how the demand for one good changes when the price of a related good changes.

Formula:

Interpreting XED Values

• XED > 0 (Substitutes): Price increase in one good increases demand for the other (e.g., Pepsi and Coke).
• XED < 0 (Complements): Price increase in one good decreases demand for the other (e.g., cars and petrol).
• XED = 0 (Unrelated Goods): No relationship between products (e.g., books and washing machines).

Example 1: Substitutes (Coke and Pepsi)

• Old Price of Coke: €1.50

• New Price of Coke: €1.80
• Old Demand for Pepsi: 500 cans
• New Demand for Pepsi: 550 cans
Interpretation:

Since XED > 0, Coke and Pepsi are substitutes. A price increase in Coke leads to higher demand for Pepsi.

Example 2: Complements (Coffee and Sugar)

• Old Price of Coffee: €3.00

• New Price of Coffee: €3.60
• Old Demand for Sugar: 100 kg
• New Demand for Sugar: 80 kg

Interpretation:

Since XED < 0, coffee and sugar are complements. A price increase in coffee leads to a lower demand for sugar.

Example 3: Unrelated Goods (Shoes and Laptops)

• Old Price of Laptops: €1,000

• New Price of Laptops: €1,200
• Old Demand for Shoes: 300 pairs
• New Demand for Shoes: 300 pairs (no change)

Interpretation:

Since XED = 0, shoes and laptops are unrelated products. A price change in laptops does not affect the demand for shoes.
Examples of XED

Product A Product B XED Value Explanation

Coke Pepsi Positive Price increase in Coke leads to more demand for Pepsi.
Coffee Sugar Negative Price increase in coffee leads to lower sugar demand.
Shoes Laptops Zero Unrelated products, so no impact.

Managerial Implications of XED

1. Competitive Pricing: Businesses must monitor substitutes' pricing.

2. Product Bundling: Firms selling complements can bundle them (e.g., fast food meals).

4. Total Revenue and Elasticity

Definition

Total Revenue (TR) = Price × Quantity Sold

The relationship between elasticity and revenue determines profitability.

Key Relationships

Demand Type Price Increase Price Decrease

Elastic (PED > 1) Total Revenue ↓ Total Revenue ↑

Inelastic (PED < 1) Total Revenue ↑ Total Revenue ↓

Unit Elastic (PED = 1) No Change No Change

Case 1: Elastic Demand (PED > 1)

• Old Price: €10

• New Price: €12 (Price Increase of 20%)
• Old Quantity Sold: 100 units
• New Quantity Sold: 80 units (Demand drops by 20%)

Step 1: Calculate Total Revenue Before and After the Price Change

Interpretation:
• Since Total Revenue decreased after the price increase, demand is elastic.
• Managerial Decision: Lowering the price would increase revenue.

Case 2: Inelastic Demand (PED < 1)

• Old Price: €10

• New Price: €12 (Price Increase of 20%)
• Old Quantity Sold: 100 units
• New Quantity Sold: 95 units (Demand drops by only 5%)

Step 1: Calculate Total Revenue Before and After the Price Change
Interpretation:

• Since Total Revenue increased after the price increase, demand is inelastic.
• Managerial Decision: Raising the price can maximize revenue.

Case 3: Unit Elastic Demand (PED = 1)

• Old Price: €10

• New Price: €12 (Price Increase of 20%)
• Old Quantity Sold: 100 units
• New Quantity Sold: 83.33 units (Demand decreases proportionally by 20%)

Step 1: Calculate Total Revenue Before and After the Price Change

Interpretation:

• Total Revenue remains unchanged, confirming unit elasticity.

• Managerial Decision: Price changes do not affect revenue.

Managerial Implications

1. Elastic Demand → Lower price to increase revenue.

2. Inelastic Demand → Raise prices to maximize revenue.
3. Unit Elastic Demand → Price changes have no effect on revenue.

Elasticity analysis is critical in pricing, marketing, and revenue forecasting. Managers use elasticity data to decide on pricing
strategies, product positioning, and market segmentation. Understanding demand elasticity helps businesses maximize profits
and stay competitive.

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The Role of Elasticity in Business Decision-Making

Elasticity of demand is a vital tool for businesses in:

• Pricing Strategy → Determining optimal prices for maximum revenue.

• Revenue Forecasting → Predicting how total sales change with price shifts.
• Product Differentiation → Positioning products as necessities or luxuries.
• Market Segmentation → Identifying which customer groups are more responsive to price or income changes.

Real-World Business Case Studies on Elasticity

Case Study 1: Apple Inc. and Price Elasticity of Demand

Apple is known for its premium pricing strategy, but are its products elastic or inelastic?
Analysis

• When Apple increased iPhone prices by 10%, demand only dropped by 5%.

• Since PED < 1, iPhones have inelastic demand → Apple can raise prices without losing too many customers.

• Apple can increase prices and still increase revenue, thanks to strong brand loyalty and differentiation.

McDonald's competes with Burger King, but its demand also depends on complementary goods (e.g., fries & ketchup).

Scenario 1: McDonald's vs. Burger King (Substitutes)

• If Burger King increases its prices, McDonald’s sees an increase in demand.

XED>0

• McDonald's attracts price-sensitive customers from Burger King.

Scenario 2: McDonald's Fries & Ketchup (Complements)

• If McDonald's increases the price of fries, demand for ketchup drops.

XED<0

• The products are complements, meaning McDonald's must consider bundle pricing to maximize sales.

• For substitutes → Competitive pricing is essential.

• For complements → Bundling products can increase total sales.

Case Study 3: Tesla and Income Elasticity (YED)

Tesla's electric vehicles (EVs) are luxury goods, making them highly income elastic.

Scenario:

• As consumer incomes rise by 20%, Tesla's sales increase by 40%.

• Since YED > 1, Tesla cars are luxury goods.

• Tesla should target high-income segments and expand during economic booms.

Advanced Computations & Graphical Analysis

Let’s now compute real-world elasticity scenarios with graphs.

Scenario 1: Total Revenue and Elasticity

A company sells 1000 units at $50 per unit. What happens to total revenue if price increases to $60?

Price ($) Quantity Demanded Total Revenue ($)

50 1000 50,000

60 800 (elastic) 48,000 (revenue ↓)

60 950 (inelastic) 57,000 (revenue ↑)

• If demand is elastic (PED > 1) → Total revenue decreases when price increases.
• If demand is inelastic (PED < 1) → Total revenue increases when price increases.

Revenue vs. Price graph to visualize this.

Graph Analysis: Total Revenue and Price Elasticity

• Elastic Demand (PED > 1) → As price increases from $50 to $60, total revenue decreases.
• Inelastic Demand (PED < 1) → As price increases from $50 to $60, total revenue increases.

• If demand is elastic, lower prices to increase revenue.

• If demand is inelastic, increase prices to maximize revenue.

Elastic vs. Inelastic Demand in Different Industries

Industry Elastic or Inelastic? Why?

Airlines Elastic Consumers can switch to trains or budget airlines.
Pharmaceuticals Inelastic Medicine is a necessity; people buy it regardless of price.
Fast Food Elastic Many alternatives (e.g., McDonald's vs. KFC).
Luxury Watches Elastic People buy luxury items only if affordable.
Utilities (Electricity, Water) Inelastic People need these daily, so price changes don’t affect demand much.

Key Business Strategies Based on Elasticity

1. Inelastic Products → Price increases can be used to increase total revenue.

2. Elastic Products → Discounts and promotions drive higher sales.
3. Cross-Elasticity Awareness → Businesses must monitor substitutes & complements to optimize pricing.