ECO 824 (MANAGERIAL

ECONOMICS)
WEEK 5 CLASS
Outline

 Elasticity of Demand
 Own-Price Elasticity
 Cross-Elasticity
 Income-Elasticity
 Advertisement-Elasticity
 Elasticity of Price Expectation
 Demand Forecasting
 The Forecasting Techniques
Elasticity of Demand
 Context
 From the managerial point of view, the knowledge of the nature of relationship
between product’s demand and its determinants is not sufficient. What is more
important is the degree of responsiveness of demand to changes in its determinants.
This degree of responsiveness of demand to changes in its determinants is referred
to as the elasticity of
demand for the product in question.
 In practical business decisions, firms would like to pass cost increases over to the
consumers through price increases. But whether increase in price as a result of
rising cost is beneficial to the firm will depend on:
 The price-elasticity of demand for the product; and,
 The price-elasticity of demand for its substitutes
Elasticity of Demand
 Thus, the starting point for a managerial decision about pricing policy of the
firm. For instance, if the firm’s objective is to raise price, such policy could
be expedient for the firm if:
 The demand for the product is less elastic; and,
 Demand for its substitute is much less elastic.
 The concepts of price-elasticities of demand mostly used in business
decisions are:
 Own- Price Elasticity
 Cross-Price Elasticity,
Own- Price Elasticity

 The own-price elasticity of demand is generally defined as the degree of

responsiveness of demand for a commodity to changes in its own price. More
precisely, it is the percentage change in quantity demanded as a result of one
percent change in the price of the commodity. The working definition is as
follows:

Where stands for own-price elasticity of demand

Own- Price Elasticity Contd.

 where Q = original quantity demand, P = original price, ∆Q = change

in quantity demanded (new quantity – original quantity), ∆P = change
in price (new price – original price)
 Note that since the term, ∆Q/∆P, is the slope of the demand function,
a minus sign (-) is generally inserted in the formula above before the
fraction with a view to making the elasticity coefficient a non-
negative value.
 The own-price elasticity can be measured between two points on a
demand curve (for arc elasticity) or on a point ( for point
elasticity).
Arc Elasticity

 An arc elasticity measures the elasticity of demand between any two finite
points on a given demand line or curve. Measure of elasticity between points
A and B in figure 3.6 below, for example, is referred to as arc elasticity.
Movement from point A to B indicates a fall in the commodity price from say,
N10/unit to N8/unit, so that ∆P = N(10 – 8) = N2. The decrease in price is
assumed to cause an increase in quantity demanded from say, 50 to 60 units,
so that ∆Q = 50 – 60 = -10 units. The elasticity from A to B can be computed
by substituting these values into the elasticity formula to get:
 ( and are original price and quantity)
 = -1 (the case of unitary elasticity)
This implies that 1 percent decrease in price of the commodity results in 1
percent increase in quantity demanded
Point Elasticity of Demand for a Linear Demand Function
 Linear Demand Function
When change in price is infinitesimally small, the measurement of elasticity for
an infinitesimally small change in price is same as measurement of elasticity at a
point. Point elasticity is measured by the following formula:
Point elasticity (ep) = (P/Q)(dQ/dP)
 Cross Elasticity of Demand: The cross-elasticity can be defined as the degree
of responsiveness of demand for a commodity to the changes in price of its
substitutes and complementary goods. The formula for measuring the cross-
elasticity of demand for a commodity, X, can be written as:

(Positive elasticity implies that the two goods are substitute while
negative implies that they are complementary goods)
Determinants of Price-elasticity of demand

 Availability of Substitutes for the product

 Nature of the Commodity
 Weightage in the Total Consumption
 Time factor in adjustment of Consumption pattern
 Range of Commodity Use
Price-Elasticity from a Linear Demand Function, Example

 Consider a linear demand function: Q = 210 – 0.1P,

the point elasticity can be measured for any price by using:

For P = N5/unit, the price-elasticity would be:

= -0.1
Q = 210 – 0.1(5) = 210 – 0.5 = 209.5
= -0.1)= -0.002
Price-Elasticity from a Non-Linear Demand Function, Example

 The computation of price elasticity from a non-linear demand function follows

the same process as that of the linear demand function. The only difference
is in the nature of the demand function. If a non-linear demand function is
given by:

 Then,
 Where = 0
 =-
From
= (Originally and -ab=-ab
== -b
This implies that price-elasticity for multiplicative demand function remains
constant, regardless of a change in the commodity price.
Income-Elasticity of Demand

 The income-elasticity of demand can be defined as the degree of

responsiveness of demand to changes in the consumer’s income. In the case of
inferior goods, the income-elasticity of demand is always negative. This is so
because the demand for inferior goods decreases with increases in consumer’s
income, and vice versa.
 The income-elasticity of demand for a commodity, say X can be computed by:

Where, ey = income-elasticity of demand; Y = consumer’s income; Qx = quantity

demanded of commodity X
As noted above, for all normal goods, the income-elasticity is positive. However,
the degree or magnitude of elasticity varies in accordance with the nature and
type of commodities. Consumer goods of the three categories: necessities,
comforts, and luxuries have different elastiticies. The general pattern of
income-elasticities of different kinds of goods for increase in income and their
effects on sales is given in table below
Magnitude of Income-Elasticity for different Categories of
Goods

Consumer Goods Coefficient of Income- Effect on Sales

Elasticity
Essential goods Less than 1 or unity () Less than proportionate
change in sale
Comforts Almost equal to unity () Almost proportionate
change in sales
Luxuries Almost equal to unity () More than proportionate
increase in sales
Advertisement- or Promotional-Elasticity of Sales

The concept of advertisement elasticity is found useful in the determination of

optimum level of advertisement expenditure. This concept assumes a greater
significance in deciding advertisement expenditure than other decision variables.
This is so especially when the government imposes restriction on advertisement
cost (as is the case in most developed economies), or there is competitive
advertising by the rival firms.

By definition, advertisement-elasticity of sales is the degree of

responsiveness of sales to changes in advertisement expenditures. It can
be computed by the formula:

where S = sales; ∆S = change in sales; A = initial advertisement cost;

and, ∆A = additional expenditure on advertisement
Interpretation of Advertisement-Elasticity of Sales

Elasticity () Interpretation
Sales do not respond to advertisement
expenditure
Increase in total Sales is less than
proportionate to the increase in
advertisement expenditure
Sales increase in proportion to the
increase in expenditure on
advertisement

Sales increase at a higher rate than the

rate of increase in advertisement
expenditure.
important factors affecting the advertisement-elasticity

 The level of total sales. As sales increase, the advertisement-elasticity of

sales decreases.
 Advertisement by rival firms. In a highly competitive market, the
effectiveness of advertisement by a firm is determined by the relative
effectiveness of advertisement by the rival firms
 Cumulative effect of past advertisements. Additional doses of
advertisement expenditures do have cumulative effect on the promotion
of sales, and this may considerably increase the advertisement-elasticity
of sales.
Elasticity of Price-Expectations

 During the period of price fluctuations, consumer’s price expectations play a

significant role in determining demand for a given commodity. The price-
expectation-elasticity refers to the expected change in future price as a
result of changes in current prices of a given product. The elasticity of price-
expectation is defined and measured by the following formula:

where Pc and Pf are current and future prices, respectively.

The coefficient ex is a measure of expected percentage change in future price
due to a 1 percent change in current price. ex > 1 implies that future change in
price will be greater than the current change in price, and vice versa. ex = 1
implies that the future change in price will be equal to the change in current
price.
Demand Forcasting
 The term demand forecasting in our context simply means predicting the
future demand for a product. Information regarding future demand is
essential for scheduling and planning production, acquisition of raw
materials, acquisition of finance, and advertising. Forecasting is most useful
where large-scale production is involved and production requires long
gestation period.
 Techniques employed in demand forecasting
 The Survey and Statistical methods.
The Survey Technique
 Survey techniques are used where the purpose is to make short-run demand
forecasts. This technique uses consumer surveys to collect information about
their intentions and future purchase plans. It involves: (i) survey of potential
consumers to elicit information on their intentions and plans; (ii) opinion
polling of experts, that is, opinion survey of market experts and sales
representatives; The methods used in conducting the survey of consumers and
experts include:
 Consumer Survey Methods (direct interview): Direct interview of the
potential consumers may be in the form of:
(a) Complete Enumeration. All consumers or users of the product in question are
contacted to ascertain their future of purchasing the product. The quantities
indicated by the consumers are added together to obtain the probable demand
for the product. If, for example, a majority of n out of m households in a given
geographical location indicate the quantity, (q) they will be willing to purchase
of a commodity, then the total probable demand (Dp) may be obtained as:

here q1, q2, q3, … n, represent demand by individual households

The Survey Technique Contd.
(b) Sample Survey. In a sample survey, only few potential consumers and
users of the products are selected as respondents from the relevant
market. The survey may take the form of either direct interview or
mailed questionnaire to the sample consumers. On the basis of
information obtained thereof, the probable demand (Dp) can be
estimated by the simple formula:

Where is the number of households indicating demand for the product

is the number of household surveyed
H is the census number of households from the relevant market.
is the average expected demand as indicated by the households
survey = total quantity of demand indicated ÷ number of households.
(c) The End-Use Method. This method of forecasting demand has a considerable theoretical and
practical importance, especially in forecasting demand for inputs. The method involves four basic
stages:
 Stage 1: This stage requires that all the possible users of the product in question be identified
and listed.
 Stage 2: The second stage involves fixing suitable technical norms of consumption, expressed in
either per unit of production of the complete product or, in some cases, per unit of investment
or per capita use.
 Stage 3: The third step is the application of the norms. This requires the knowledge of the desired
or targeted levels of output of the individual industries for the reference year, and also the likely
development in other economic activities for which the product is used.
 Stage 4: The final stage in the end-use method of demand forecasting involves the aggregation
of the product-wise or use-wise content of the item for which the demand is to be forecast.
Result of this aggregation gives the estimate of demand for the product as a whole for the
terminal year in question.
Opinion Poll Method
 These methods aim at collecting opinions of those possessing knowledge of
the market, such as the sales representatives, sales executives, professional
marketing experts, and marketing consultants. The opinion poll methods
include: (a) The Expert-Opinion method; (b) Delphi method; and, (c) Market
Studies and Experiments
(a) The Expert-Opinion method: This method involves the use of sales
representatives in the assessment of demand for the product in the areas, States
or cities they represent. The sales representatives are expected to know the
future purchasing plans of consumers they transact business with. The estimates
of demand thus obtained from the different sales representatives at different
areas, States and cities are added up to get the overall probable demand for the
product in question.
(b) Delphi method; This method of demand forecasting is an extension of the
simple expert opinion poll method. It is used to consolidate the divergent expert
opinions and to arrive at a compromise estimate of future demand.
 Market Studies and Experiments. This method requires that firms first select
some areas of representative markets, about four cities with similar features
in terms of population, income level, cultural and social background,
occupational distribution, and consumer preferences and choices. This is
followed by market experiments involving changing prices, advertisement
expenditures, and other controllable variables in the demand function, all
things being equal. These variables are changed over time, either
simultaneously in all the markets or in selected markets. Having introduced
these changes, the consequent changes in demand over a period of time are
then recorded. Based on these data, elasticity coefficients are then
computed, and these coefficients are used to assess the forecast demand for
the product.
The End

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