Managerial Economics Thomas

ninth edition Maurice

Chapter 6

Elasticity and Demand

McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 Managerial Economics

Price Elasticity of Demand (E)

• Measures responsiveness or sensitivity
of consumers to changes in the price of
a good
%Q
• E
%P
• P & Q are inversely related by the law of
demand so E is always negative
• The larger the absolute value of E, the more
sensitive buyers are to a change in price
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 Managerial Economics

Price Elasticity of Demand (E)

Table 6.1
Elasticity Responsiveness E
Elastic %Q%P E 1
Unitary Elastic %Q%P E 1
Inelastic %Q%P E 1

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 Managerial Economics

Price Elasticity of Demand (E)

• Percentage change in quantity
demanded can be predicted for a given
percentage change in price as:
• %Qd = %P x E
• Percentage change in price required for
a given change in quantity demanded
can be predicted as:
• %P = %Qd ÷ E

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 Managerial Economics

Price Elasticity & Total Revenue

Table 6.2
Elastic Unitary elastic Inelastic
%Q%P %Q%P %Q%P
Quantity-effect No dominant Price-effect
dominates effect dominates
Price
TR falls No change in TR TR rises
rises
Price
TR rises No change in TR TR falls
falls

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 Managerial Economics
Factors Affecting Price Elasticity
of Demand
• Availability of substitutes
• The better & more numerous the
substitutes for a good, the more elastic is
demand
• Percentage of consumer’s budget
• The greater the percentage of the
consumer’s budget spent on the good, the
more elastic is demand
• Time period of adjustment
• The longer the time period consumers have
to adjust to price changes, the more elastic
is demand
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 Managerial Economics
Calculating Price Elasticity of
Demand
• Price elasticity can be calculated
by multiplying the slope of demand
(Q/P) times the ratio of price to
quantity (P/Q)
Q
 100
%Q Q Q P
E   
%P P P Q
 100
P
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 Managerial Economics
Computation of Elasticity at a
Point
• When calculating price elasticity at a
point on demand, multiply the slope of
demand (Q/P), computed at the point
of measure, times the ratio P/Q, using
the values of P and Q at the point of
measure
• Method of measuring point elasticity
depends on whether demand is linear or
curvilinear

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 Managerial Economics
Point Elasticity When Demand is
Linear
 Given Q  a  bP  cM  dPR , let income &
price of the related good take specific
values M ˆ and Pˆ , respectively
R

 Then express demand as Q  a'  bP , where

ˆ  dPˆ and the slope parameter
a'  a  cM R
is b  Q P

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 Managerial Economics
Point Elasticity When Demand is
Linear
• Compute elasticity using either of the two
formulas below which give the same value
for E
P P
E b or E 
Q PA

Where P and Q are values of price and quantity demanded

at the point of measure along demand, and A (  a'/ b )
is the price-intercept of demand

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 Managerial Economics

Marginal Revenue
• Marginal revenue (MR) is the change
in total revenue per unit change in
output
• Since MR measures the rate of
change in total revenue as quantity
changes, MR is the slope of the total
revenue (TR) curve
TR
MR 
Q
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 Managerial Economics

Demand & Marginal Revenue

(Table 6.3)
Unit sales (Q) Price TR = P  Q MR = TR/Q
0 $4.50 $ 0 --

1 4.00 $4.00 $4.00

2 3.50 $7.00 $3.00
3 3.10 $9.30 $2.30
4 2.80 $11.20 $1.90
5 2.40 $12.00 $0.80
6 2.00 $12.00 $0
7 1.50 $10.50 $-1.50
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 Managerial Economics

Income Elasticity
• Income elasticity (EM) measures the
responsiveness of quantity demanded
to changes in income, holding the price
of the good & all other demand
determinants constant
• Positive for a normal good
• Negative for an inferior good

%Qd Qd M
EM   
%M M Qd
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 Managerial Economics

Cross-Price Elasticity
• Cross-price elasticity (EXY) measures the
responsiveness of quantity demanded of
good X to changes in the price of related
good Y, holding the price of good X & all
other demand determinants for good X
constant
• Positive when the two goods are substitutes
• Negative when the two goods are complements
%QX QX PY
E XY   
%PY PY QX
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 Managerial Economics

Point Elasticity Measures

 For the linear demand function
QX  a  bPX  cM  dPY , point
measures of income & cross-price
elasticities can be calculated as
M
EM c
Q

PR
E XR d
Q
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 Managerial Economics
Price Elasticities of Demand in
the US

Commodity Short Run Long Run

Clothing .90 2.90
HH Natural Gas 1.40 2.10
Tobacco Products 0.45 1.89
Electricity 0.13 1.89
Wine 0.88 1.17
Jewelry 0.41 0.67
Gasoline 0.20 0.60

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 Managerial Economics
Income Elasticities of Demand for
Selected Commodities in the US

Commodity Income Elasticity

Wine 2.59
Electricity 1.94
Beef 1.06
Cigarettes 0.50
Beer 0.46
Chicken 0.28
Flour -0.36

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 Managerial Economics
Cross Elasticities of Demand for
Selected Commodities in the US
Commodity Cross Price Cross
Elasticity with Price
Respect to Elasticity
Margarine Butter 1.53
Natural Gas Electricity 0.80
Pork Beef 0.40
Chicken Pork 0.29
Clothing Food -0.18
Entertainment Food -0.72
Cereals Fresh Fish -0.87

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 Managerial Economics

Using Elasticity in Managerial Decisions

Suppose the Tasty Company markets coffee brand X and
estimated the following regression of the demand for its brand
of coffee
Qx = 1.5-3.0Px+0.8I+2.0Py-0.6Ps+1.2A where
Px = Price of coffee brand X
I = personal disposable income in millions of dollars
Py= price of competitive brand
Ps = price of sugar
A = Adverstising expenditures in hundreds of thousands
Suppose Px=2, I=2.5 , Py = 1.8, Ps=0.50, A=1
Suppose %change in P = 5% , %change in advertising = 12% ;
%change in income = 4%; percentage change in price of Y=7%
; price of sugar falls by 8%

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 Managerial Economics

Suppose that GM’s Smith estimated the following regression

equation for Chevrolet automobiles:
Qc=100,000-100Pc+2,000N+50I+30Pf-1,000Pg+3A+40,000PI
Where:
Qc = qty demanded for Chevrolet
Pc=Price of Chevrolet
N= population of US in millions
I = per capita disposable income
Pf = price of Ford
Pg= real price of gasoline in cents per gallon
A= advertising in dollars per year
Pi = credit incentive to purchase Chevrolet

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