Chapter 4: Keat et al
Managerial Economics, Prof A.K. Waithima
Elasticity the concept
The responsiveness of one variable to changes in
another
When price rises, what happens to demand?
Demand falls
BUT!
How much does demand fall?
Managerial Economics, Prof A.K. Waithima
Elasticity the concept
If price rises by 10% - what happens to demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which demand
will change
Managerial Economics, Prof A.K. Waithima
4 basic types used
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity
Managerial Economics, Prof A.K. Waithima
Price Elasticity of Demand
The responsiveness of demand to changes in price
Where % change in demand is greater than % change in
price elastic
Where % change in demand is less than % change in
price - inelastic
Managerial Economics, Prof A.K. Waithima
Price Elasticity of Demand cont..
The Formula:
=
% Change in Quantity Demanded
___________________________
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: has sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)
Managerial Economics, Prof A.K. Waithima
Exercise
Consumers of a commodity will buy 20
units at the price of Ksh 11 and 38 units at
the price of Ksh 7 per unit. Determine how
much they will buy at the price of Ksh 18.
Determine the price elasticity of demand
Managerial Economics, Prof A.K. Waithima
Range of price elasticity
Price (Ksh)
= 0 demand is
perfectly price inelastic
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.
= demand is perfectly
price elastic
Quantity Demanded
Managerial Economics, Prof A.K. Waithima
Figure 4.5 the Point Price Elasticity of Demand
PX
A (EP = -
6
)
B (EP = 5)
C (EP = -2)
D (EP = -1)
E (EP = -0.5)
F (EP = -0.2)
G (EP = 0)
0
10
20
30
40
50
Managerial Economics, Prof A.K. Waithima
60
QX
Relationship between MR and price elasticity of
demand
=
=
+
= (1 +
)
Note:
1
= (1 + )
Managerial Economics, Prof A.K. Waithima
Elasticity
Price
Total
revenue is of
price
x
The importance
elasticity
quantity
sold. In this
is the information
it
example,
TR
=
Ksh
5 xon
provides on the effect
100,000
=
Ksh
500,000.
total revenue of changes in
price.
This value is represented by
the shaded rectangle.
Ksh 5
Total Revenue
D
100
Quantity Demanded (000s)
Managerial Economics, Prof A.K. Waithima
Elasticity
Price
If the firm decides to
decrease price to (say) Ksh
3, the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue.
Ksh 5
Ksh 3
Total Revenue
D
100
140
Quantity Demanded (000s)
Managerial Economics, Prof A.K. Waithima
Elasticity
Price (Ksh)
Producer decides to lower price to attract sales
% Price = -50%
10
% Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
Not a good move!
D
5 6
Quantity Demanded
Managerial Economics, Prof A.K. Waithima
Elasticity
Price (Ksh)
Producer decides to reduce price to increase sales
% in Price = - 30%
% in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
Quantity Demanded
Managerial Economics, Prof A.K. Waithima
20
Elasticity
If demand is price
If demand is price
elastic:
Increasing price would
reduce TR (% Qd > %
P)
Reducing price would
increase TR
(% Qd > % P)
inelastic:
Increasing price would
increase TR
(% Qd < % P)
Reducing price would
reduce TR (% Qd < %
P)
Managerial Economics, Prof A.K. Waithima
Income Elasticity of Demand
The responsiveness of demand to changes in incomes
Normal Good demand rises as income rises and vice
versa( > 0)
Inferior Good demand falls as income rises and vice
versa( < 0)
Managerial Economics, Prof A.K. Waithima
Exercise
With an income of Ksh 9000, consumers are willing
to buy 44 units of a commodity and 69 units when
the income rises to Ksh 12000. Determine and
comment on the nature of the commodity.
Managerial Economics, Prof A.K. Waithima
Elasticity
For example:
= - 0.6: Good is an inferior good but inelastic a rise in income of
3% would lead to demand falling by 1.8%
= + 0.4: Good is a normal good but inelastic a rise in incomes of
3% would lead to demand rising by 1.2%
= + 1.6: Good is a normal good and elastic a rise in incomes of
3% would lead to demand rising by 4.8%
= - 2.1: Good is an inferior good and elastic a rise in incomes of
3% would lead to a fall in demand of 6.3%
Managerial Economics, Prof A.K. Waithima
Cross elasticity of demand
The responsiveness of demand
of one good to changes in the price of a related
good either
a substitute or a complement
=
Managerial Economics, Prof A.K. Waithima
Exercise
At the price of Ksh 5 for commodity X, the demand for
X is 20 units while the demand for Y is 45. When the
price of X rises to Ksh 12, demand for X decreases to 11
units while demand for Y rises to 51 units. Determine:
A) demand function
B) Cross elasticity of demand
C) comment on the relationship between the 2
commodities
Managerial Economics, Prof A.K. Waithima
Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse
relationship between the two)
Goods which are substitutes:
Cross Elasticity will have a positive sign (positive
relationship between the two)
Managerial Economics, Prof A.K. Waithima
Elasticity
Price Elasticity of Supply:
The responsiveness of supply to changes
in price
If Pes is inelastic - it will be difficult for suppliers to
react swiftly to changes in price
If Pes is elastic supply can react quickly to changes
in price
Pes =
%
Quantity Supplied
____________________
% Price
Managerial Economics, Prof A.K. Waithima
Determinants of Elasticity
Time period the longer the time under consideration the
more elastic a good is likely to be
Number and closeness of substitutes
the greater the number of substitutes,
the more elastic
The proportion of income taken up by the product
the smaller the proportion the more inelastic
Luxury or Necessity - for example,
addictive drugs
Managerial Economics, Prof A.K. Waithima
Importance of Elasticity
Relationship between changes in price and total
revenue
Importance in determining what goods to tax (tax
revenue)
Importance in analysing time lags in production
Influences the behaviour of a firm
Impact of devaluation on imports and exports
Managerial Economics, Prof A.K. Waithima
