Managerial Economics– Chapter 3-Empirical methods for demand

analysis
Session 2

Dr.Dimple Pandey
 Learning Objectives

 Concept of Elasticity
 Types of elasticities
 Importance of elasticity of demand
 Calculation of elasticity of demand
 Forecasting
 Elasticity of Demand

The elasticity of demand is a degree of change in the quantity demanded of a product in response
to its determinants, such as the price of the product, income of consumers, price of
substitutes/complements and change in advertisement expenses.

Price Elasticity of
Demand

Income Elasticity of
Demand

Cross-Elasticity of
Demand

Advertisement elasticity
of demand
 Price Elasticity of Demand

• Price elasticity of demand is a measure of a change in the quantity demanded of a product due
to change in the price of the product in the market.

PercentageChange in theQuantity Demanded

Price elasticity of demand 
PercentageChange in Price
 Price Elasticity of Demand

• Assume that a business firm sells a product at the price of ₹ 450. The firm has decided to
reduce the price of the product to ₹350. Consequently, the demand for the product is raised
from 25,000 units to 35,000 units. Calculate price elasticity of demand.
 Price Elasticity of Demand

• Assume that a business firm sells a product at the price of ₹ 450. The firm has decided to
reduce the price of the product to ₹350. Consequently, the demand for the product is raised
from 25,000 units to 35,000 units. Calculate price elasticity of demand.

PercentageChange in theQuantity Demanded

Price elasticity of demand 
PercentageChange in Price

• Price Elasticity of demand= (35000-25000)/25000 = 1.8

(350-450)/450
 Different Types of Price Elasticity
Based on the rate of change, the price elasticity of
demand is grouped into five main categories:

Perfectly Elastic Demand

Perfectly Inelastic demand

Relatively Elastic Demand

Relatively Inelastic Demand

Unitary Elastic Demand

The (-) sign with a value of ep is ignored because it is
indicator of negative relationship between price and
demand.
 Different Types Of Price Elasticity

Perfectly Elastic Demand

• This is one extreme of the elasticity range, when
Elasticity of Demand =∞. In this case, even a
negligible increase in price would result in zero
quantity demanded and vice versa.
• One reason is that consumers view this good as
identical to another good and do not care which one
they buy.
 Different Types Of Price Elasticity

Perfectly Inelastic Demand

When a change (rise or fall) in the price of a product
does not bring any change (fall or rise) in the quantity
demanded, the demand is called perfectly inelastic
demand. In this case, the elasticity of demand is zero
and represented as ep = 0.

A demand curve is vertical for essential goods—goods

that people feel they must have and will pay anything to
get it. Eg- Food, water, electricity etc
 Different Types Of Price Elasticity

Relatively Elastic Demand

When a proportionate or percentage change in price results in
greater than the proportionate or percentage change in
quantity demanded, the demand is said to be relatively elastic
demand. The demand curve of relatively elastic demand is
gradually sloping.
For example, air-travel for vacationers is very sensitive to
price. An increase in the air fare will lead the vacationer to
choose another mode of transportation like car or lead him to
postpone the vacation plan for the time being. Thus for a rise
in air fare for the vacationers we will see a relatively more
drastic reduction in quantity demanded and hence high price
elasticity of demand.
 Different Types Of Price Elasticity
Relatively Inelastic Demand
When a percentage or proportionate change in price results in
less than the percentage or proportionate change in demand, the
demand is said to be relatively inelastic demand. In other words,
a change in demand is less than the change in price. Therefore,
the elasticity of demand is less than 1 and represented as ep < 1.
The demand curve of relatively inelastic demand is rapidly
sloping. The most common example of relatively inelastic
demand is for gasoline. As the price of gasoline increases, the
quantity demanded does not decrease significantly.
 Different Types Of Price Elasticity
Unitary Elastic Demand
Unitary elastic demand occurs when a change (rise or
fall) in price results in equivalent change (fall or rise) in
demand. The numerical value for unitary elastic
demand is equal to one, i.e., ep =1. The demand curve
for unitary elastic demand is a rectangular hyperbola.
The price of digital cameras increases by 10%, the
quantity of digital cameras demanded decreases by
10%. If Sandy raises the price of her famous oatmeal
raisin cookies by $1.00, the unit elastic demand for that
$1.00 increase would result in a decrease in the quantity
demanded by one unit.
 Measurement Of Price Elasticity

Percentage method: It is also known as the ratio method. Using this method, a ratio of
proportionate change in quantity demanded to the price of the product is calculated to determine
the price elasticity.
PercentageChange in theQuantity Demanded
Price elasticity of demand 
PercentageChange in Price
Eg- Suppose there is a change in demand of plastic bottles from 700 units to 1000 units as a result
of fall of price from Rs 15 to Rs 10. Calculate the price elasticity of demand of plastic bottles.

Ans: -1.29(Relatively Elastic)

In this example, the value of the denominator is negative. However, price and demand are
inversely related and move in opposing directions. Therefore, the negative sign is ignored. Thus,
the elasticity is greater than one (ep > 1).
 Measurement Of Price Elasticity

Arc elasticity method: This method is used to calculate the elasticity of demand at the midpoint
of an arc on the demand curve. In this method, the average of prices and quantities are calculated
for finding elasticity. It is assumed that the elasticity would be same over a range of values of
variables considered. The formula of the arc elasticity method is:
 Measurement Of Price Elasticity

Arc elasticity method: Assume that at the price of Rs 50, the demand for the product is 200 units.
If the price of the product increases to Rs 80, the demand decreases to 150 units. Calculate the
price elasticity. Ep= -0.62
 Factors Influencing Price Elasticity of Demand

The price elasticity differs for different products as it depends on various factors.

Nature of Commodity

Availability of Substitute Goods

Impact of Income

Time under Consideration

Perishability of the Product

Addiction
 Factors Influencing Price Elasticity of Demand

• Nature of Commodity: Whether the commodity is a necessity or a luxury. The need of every
individual is not the same for the same product. A product that is luxury for an individual may
be a necessity for another person.
• Availability of substitute goods: Availability of substitutes has major impact on the demand
for a product. If substitutes are easily available at relatively low prices, the demand for the
product would be more elastic and vice versa.
• Impact of income: The amount of income that consumers spend on purchasing a particular
product also influences the price elasticity of demand. If consumers spend a large sum on a
product, the demand for the product would be elastic.
 Factors Influencing Price Elasticity of Demand

• Time under consideration: It majorly influences the price elasticity of demand. Demand for
a product remains inelastic in the short run due to failure to postpone demand.
• Perishability of the product: If products are perishable in nature, the demand for such
products would be inelastic as their consumption cannot be postponed.
• Addiction: Some products, such as cigarettes and other tobacco-based products, have inelastic
demand.
Significance of Price Elasticity of Demand

Price Determination

Formulation of Taxation Policies

International Trade

Formulation of Agricultural Policies

 Significance of Price Elasticity of Demand

• Price determination- According to market conditions, an organisation sets different prices

for elastic and inelastic. Products having elastic demand should be sold at lower price while
those having inelastic demand should be sold at high prices in order to maximise revenue.

• Formulation of taxation policies: Government can impose higher taxes on goods with
inelastic demand, whereas, low rates of taxes are imposed on commodities with elastic
demand.
 Significance of Price Elasticity of Demand

• International trade: The concept of price elasticity has a significant role in international
trade. This is because successful trade transactions between two countries are dependent on
the price elasticity of demand. Price elasticity of demand is used in deciding the level of
imports and exports. For instance, if the demand for the product is inelastic in the
international market, the seller country will have an upper hand in exports.
• Formulation of agricultural policies: The price elasticity of demand also helps the
government in formulating agricultural policies by providing insight into the paradox of
poverty. The prices of farm products whose demand is inelastic fall due to large supplies as a
result of bumper crops. This results in a fall in prices, which leads to low income for farmers.
Consequently, poverty among farmers increases
 Income Elasticity of Demand

Income elasticity of demand is a measure of a change in the quantity

demanded of a product due to change in the income of the customer.

PercentageChange in theQuantity Demanded

Income elasticity of demand 
PercentageChange in Income
 Income Elasticity of Demand

Suppose the monthly income of an individual increases from Rs5,000 to Rs15,000. Now,
his demand for clothes increases from 35 units to 70 units. Calculate the income
elasticity of demand.
 Income Elasticity of Demand

Suppose the monthly income of an individual increases from Rs5,000 to Rs15,000. Now,
his demand for clothes increases from 35 units to 70 units. Calculate the income
elasticity of demand.

PercentageChange in theQuantity Demanded

Income elasticity of demand 
PercentageChange in Income

Ei= [(70-35)/35]/[(15000-5000)/5000] = 0.5

 Types of Income Elasticity of Demand

• Positive income elasticity of demand: When a proportionate change in the income of a

consumer increases the demand for a product and vice versa, income elasticity of demand is
said to be positive. Eg- Clothes
 Types of Income Elasticity of Demand

• Negative income elasticity of demand: When a proportionate change in the income of a

consumer results in a fall in the demand for a product and vice versa, the income elasticity of
demand is said to be positive. It generally happens in case of inferior goods. For example,
consumers may prefer small cars with a limited income. However, with a rise in income, they
may prefer using luxury cars
 Types of Income Elasticity of Demand

• Zero income elasticity of demand: When a proportionate change in the income of a

consumer does not bring any change in the demand for a product, income elasticity of demand
is said to be zero. It generally occurs for utility goods such as salt, kerosene, electricity.
 Factors Influencing Income Elasticity of Demand

Income of Consumers in a Country

The purchasing capacity of consumers increases with a rise in their income

Nature of Products
Even with a rise in the income of a consumer, the demand for basic products does not change and remains inelastic.

Consumption Pattern
With a rise in income, people quickly change their consumption patterns.
 Cross Elasticity of Demand

•  
 Types of Cross Elasticity of Demand

• Positive cross elasticity of demand: When an increase in the price of a related product
results in an increase in the demand for the main product and vice versa, the cross elasticity of
demand is said to be positive. Cross-elasticity of demand is positive in case of substitute
goods.
• For example, the quantity demanded for tea has increased from 200 units to 300 units with an
increase in the price of coffee from Rs 25 to Rs 30
• Negative cross elasticity of demand: When an increase in the price of a related product
results in the decrease of the demand of the main product and vice versa, the negative
elasticity of demand is said to be negative. In complementary goods, cross elasticity of
goods is negative.
• For example, if the price of butter is increased from Rs 20 to Rs 25, the demand for bread is
decreased from 200 units to 125 units.
 Cross Elasticity of Demand

• Zero cross elasticity of demand: When a proportionate change in the price of a related
product does not bring any change in the demand for the main product, the negative elasticity
of demand is said to be negative. In simple words, cross elasticity is zero in case of
independent goods. In this case, ec becomes zero.
 Cross Elasticity of Demand

• Assume that the quantity demanded for detergent cakes has increased from 600 units to 700
units with an increase in the price of detergent powder from Rs.35 to Rs.42. Calculate the
cross elasticity of demand between two products.
 Cross Elasticity of Demand

• Assume that the quantity demanded for detergent cakes has increased from 600 units to 700
units with an increase in the price of detergent powder from Rs.35 to Rs.42. Calculate the
cross elasticity of demand between two products.

• Ec=[(700-600/600]/[(42-35)/35] = 0.833
 Advertisement Elasticity Of Demand

• The effectiveness of elasticity of demand decides the sales of an organisation. Thus, is it

important for the organisation to determine how advertisements affect its sales.
• The advertisement elasticity of demand is a degree of responsiveness of a change in the sales
of a product with respect to a proportionate change in advertisement expenditure.
• By measuring the advertisement elasticity of demand, an organisation can determine optimum
level of advertisement expenditure under various situations, such as government’s restrictions
on the cost of advertisement and high competition
 Advertisement Elasticity Of Demand

Advertisement elasticity of demand (AED) is a useful measure of advertising

effectiveness. It measures the percentage change in demand for the product or service
compared to the percentage change in the level of advertising expenditure.

PercentageChange in theQuantity Demanded

Advertisement elasticity of demand 
PercentageChange in advertisement cos t

Ea=0, When a proportionate change in advertisement expenditure does not result in any
proportionate change in the demand of an organisation.
0<Ea<1, When a proportionate change in advertisement expenditure results in a
comparatively less proportionate change in the total demand for
products.
Ea=1, When a proportionate change in advertisement expenditure results in an equal
proportionate change in total demand for products.
 Advertisement Elasticity Of Demand

Suppose the advertisement expenditure of an organisation increases from Rs25,000 to Rs

60,000. Consequently, the demand of the organisation’s products increases from 40,000
units to 70,000 units. Calculate the advertisement elasticity of demand
 Advertisement Elasticity Of Demand

Suppose the advertisement expenditure of an organisation increases from Rs25,000 to Rs

60,000. Consequently, the demand of the organisation’s products increases from 40,000
units to 70,000 units. Calculate the advertisement elasticity of demand

PercentageChange in theQuantity Demanded

Advertisement elasticity of demand 
PercentageChange in advertisement cos t

Ea=[(70000-40000)/40000]/[(60000-25000)/25000] = 0.535
 Significance of Advertisement Elasticity Of Demand

• If the value for AED that is calculated is below one, then the product is said to be inelastic in
response to advertising expenditure. This means that an increase in advertising expenditure
of, say 20%, has led to a growth in demand for the product of less than 20%. The lower the
value of the AED, the less effective advertising expenditure has been at boosting demand.
• A value of greater than 1 indicates that the demand for the product is highly responsive to
changes in advertising expenditure. This means that an increase in advertising expenditure
will generate a greater increase in demand for the product.
 Estimating Demand Elasticities

 Managers use price, income, and cross-price elasticities to set prices.

 To calculate an arc elasticity, managers use data from before and after the price change.
 By comparing quantities just before and just after a price change, managers can be
reasonably sure that other variables, such as income, have not changed appreciably.
 A manager might want an estimate of the demand elasticity before actually making a
price change to avoid a potentially expensive mistake.
 A manager may fear a reaction by a rival firm in response to a pricing experiment, so
they would like to have demand elasticity in advance.
 A manager would like to know the effect on demand of many possible price changes
rather than focusing on just one price change.
 However, managers might need an estimate of the entire demand curve to have demand
elasticities before making any real price change. The tool needed is regression analysis.
 Regression Analysis
 A regression analysis is a statistical technique used to estimate the relationship between a
dependent variable and independent variables

 Suppose that a firm’s demand function is Y =A +B1X+ B2P+ B3I+ B4Pr where

• Y is the quantity demanded of the firm’s product,

• X is the selling expense (such as advertising) of the firm

• P is the price of its product

• I is the disposable income of consumers

• Pr is the price of the competing product sold by its rival.

What we want are estimates of the values of A, B1, B2, B3, and B4. Regression analysis
enables us to obtain them from historical data concerning Y, X, P, I, and Pr.
 Regression Analysis

The regression line predicts that sales will equal 4.04 millions of units when
selling expense is $1 million
 Managerial Problem
 How can managers use the data to estimate the demand curve facing iTunes? How can
managers determine if a price increase is likely to raise revenue, even though the quantity
demanded will fall?

Solution: Managers can use empirical methods to analyze economic relationships that affect a
firm’s demand.

 Elasticity measures the responsiveness of one variable, such as quantity demanded, to a

change in another variable, such a price.
 Regression analysis is a method used to estimate a mathematical relationship between a
dependent variable, such as quantity demanded, and explanatory variables, such as price
and income. This method requires identifying the properties and statistical significance of
estimated coefficients, as well as model identification.
 Forecasting is the use of regression analysis to predict future values of important
variables as sales or revenue.
 LET US SUM UP

• The elasticity of demand is a measure a change in the quantity demanded of a product in

response to its determinants, such as price of products.
• Different types of elasticity of demand, namely price elasticity of demand, income elasticity of
demand, advertisement elasticity of demand and cross elasticity of demand.
• The cross elasticity of demand can be defined as measure of change in the demand for a good
as a result of change in the price of related goods.
• The advertisement elasticity of demand is a measure of change in the sales of a product with
respect to a proportionate change in advertisement expenditure.