Elasticity

of
Demand and
Supply
DEMAND ELASTICITIES
Law of Demand – Direction of change in the
quantity
Elasticity of Demand – Degree of responsiveness
of consumers to a price change

Cont….
Classification of Demand Curves According to Their Elasticities
Depending on how the total revenue changes, when price changes we can
classify all demand curves in the following five categories:
i. Perfectly inelastic demand curve
ii. Inelastic demand curve
iii. Unitary elastic demand curve
iv. Elastic demand curve
v. Perfectly elastic demand curve

Cont….
 A Variety of Demand Curves
• Inelastic Demand
– Quantity demanded does not
respond strongly to price
changes.
– Price elasticity of demand is less
than one.
• Elastic Demand
– Quantity demanded responds
strongly to changes in price.
– Price elasticity of demand is
greater than one.
 A Variety of Demand Curves

• Pe rfe ctly In e la stic

– Q u a n tity d e m a n d e d d o e s n o t
re sp o n d to p rice ch a n g e s.
• Pe rfe ctly E la stic
– Q u a n tity d e m a n d e d ch a n g e s
in fin ite ly w ith a n y ch a n g e in
p rice .
• U n it E la stic
– Q u a n tity d e m a n d e d ch a n g e s b y
th e sa m e p e rce n ta g e a s th e
p rice .
 Perfectly Inelastic Demand
Price
Demand E =
0

$5.00

$4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity demanded

unchanged.
 Inelastic Demand
Price
Demand
E < 1

$5.00

$4.00
1. A 25%
increase in
price…

0 90 100 Quantity

2. … Leads to a 10% decrease in quantity

demanded.
 Unit Elastic Demand
Price E =
1
Demand

$5.00

$4.00
1. A 25%
increase in
price…

0 80 100 Quantity

2. … Leads to a 20% decrease in quantity

demanded.
 Elastic Demand
Price E > 1
Demand

$5.00

$4.00
1. A 25%
increase in
price…

0 50 100 Quantity

2. … Leads to a 50% decrease in quantity

demanded.
 Perfectly Elastic Demand
Price E =
∞

1. At any price above $4, quantity

demanded is zero.

$4.00 Demand
2. At exactly $4, consumers will buy any
quantity.

3. At any price below $4, quantity demanded is

infinite.

0
Quantity
Elasticity of Demand

Consumers’ responsiveness or
sensitivity to changes
in price.
 Elasticity of Demand
uConsumers buy more or less
Elastic
Elastic of a product when the
Demand
Demand price changes

Inelastic uAn increase or decrease in

Inelastic price will not significantly
Demand
Demand affect demand

uAn increase in sales exactly

Unitary
Unitary offsets a decrease in prices,
Elasticity
Elasticity and revenue is unchanged
3 Elasticity of Demand
Price
PriceGoes...
Goes... Revenue
RevenueGoes...
Goes... Demand is...

Down Up Elastic

Down Down Inelastic

Up Up Inelastic

Up Down Elastic

Up or Down Stays the Same Unitary Elasticity

 Price Elasticity of Demand (Ed) How total revenues or expenditures
are affected by price changes

Ed Value
Term for Price increases Price decreases
Elasticity of
demand

Zero Perfectly Increase Decrease

inelastic Proportionally proportionally
with price with price
0 << E1d Relatively increase less Decease less
Inelastic than than
proportionally proportionally
with price with price
= 1 Ed Unitary elastic Unaffected
by price
changes
1 a > Ed Relatively Decrease but Increase, but
elastic less than less than
proportionally proportionally
Perfectly elastic Total revenue Increase more
8

falls to zero than

proportionally
Numerical Measurement of Elasticity
What does it mean when we say that the elasticity of demand is 0.5? 0.4? 2.3? To answer this
question we have to examine the following definition for elasticity coefficient, Ed.

Percentage change in quantity demanded

E =
One
d calculates
Percentagethese percentage
change in price changes, of course, by dividing the change in price by the
original price and the consequent change in quantity demanded by the original quantity
demanded. Thus we can restate our formula as:
Change inquantity demanded
Original uantity
q demanded
E =
d Change inprice
This formula can also beOriginal
written as
ni price

Ed= Q 1- Q 0
Q0
P1 - P0
Where P0
P0 = Original Price
P1 = New price
Q0 = Original quantity demanded
Q1 = New quantity demanded
Sometimes we may also find this written as
Ed =
∆ Q
Q
∆P
P
Factors Determining Elasticity of Demand
Some important factors that determine the elasticity of demand are:
i. Luxury or Necessity Good s
ii. Percentage of Income
iii. Substitutes
iv . Time
Price Elasticity of Demand
The concept of price elasticity of demand is a numerical measure of the
extent to which quantity demanded responds to a change in price, other
determinants of demand being kept constant.

ep − % change in quantity demanded

% change in price

The factors that govern the price elasticity of demand are :

i. The number and closeness of substitutes
ii. Number of uses the commodity satisfied
iii. Time period
iv. Proportion of income spent on the commodity
v. How narrowly the commodity is defined
Cont….
A review of the basic formula of elasticity will show that it follows from
the definition of price elasticity.
ep =
% change in quantity demanded
−
% change in price
where,

% change in Quantity demanded =

New Quantity −Old Quantity
× 100
Old Quantity
and % change in price =
New Price −Old Price
Let P = Old price × 100
Old Price
Q = Old quantity
DQ = New quantity – Old quantity
DP = New price – Old price

∆Q
× 100
ep Q ∆Q P
= (-) = ( −) .
∆P ∆P Q
× 100
P
Income Elasticity
The income elasticity of demand is a numerical measure of the degree to
which quantity demanded responds to a change in income, other determinants
of demand being kept constant.
For example, let there be two goods, clothing and salt. Let the consumers
income increase by 5%. Then the percentage change (increase) in quantity
demanded would be different for clothing and different for salt (the
percentage increase in quantity demanded for clothing is likely to be much
higher than that for salt). Thus, clothing and salt are said to have a
different income elasticity of demand. Thus, for the same percentage
increase in income (i.e., 5%) the percentage increase in the quantity
demanded for different goods is different. Income elasticity of demand
provides us with a numerical measure of this difference.
Thus, income elasticity of demand allows us to compare the sensitivity of
the demand for various goods for the same change in income. From the
definition,
e1 =
%change in quantity demanded
%change in income
 CASE

A small state university is faced with a critical financial problem. At present

tuition rates, the university is loosing Rs 5 crore per year. The head of the
university urges that there should be a 25% increase in tuition fee. Based on the
total students enrolled, he projects that this increase would cover the Rs 5 crore
deficit in revenues.
Student leaders protest but it falls on deaf ears. Students realise that their only
hope is to demonstrate that the tuition hike is not in the best interest of the
university. What can they do?
Students find a journal article that discuss the price elasticity of demand for
college education. The author estimates that the elasticity of enrollment at state
universities is –1.3 with respect to tuition charges. That is, a 1% increase in
tuition would decrease enrollments by 1.3%. The data are current.
Based on the elasticity estimate, the students calculate that the proposed tuition
hike of 25% would decrease enrollment by 32.5%. This would result in a decrease in
total revenue even after tuition increase.
The university is given this information and it is forced to withdraw its proposed
hike and find alternative ways to meet the deficit.
Cross Elasticity of Demand
The concept of cross elasticity provides a numerical measure of the
percentage change in quantity demanded due to a change in price of other
commodities. It measure the degree to which quantity demanded is a
function of the price of all other commodities. From the definition,
ec =
%change in
quantity demanded of good X
%change magnitude
The higher the numerical in priceofofcross
good Y
elasticity , the greater is the
degree of complementary / substitution between the two goods. Thus,
theoretically the value of cross elasticity ranges from minus infinity (–
∞) for perfect complements to plus infinity (+ ∞) for perfect substitutes.
ec =

dQ x dPx
÷
Q
=x Px
dQ x Px
⋅ Cont….
dPx Q x
Promotional / Advertising Elasticity of Demand
The relationship that exists between sales and advertising of any product
can be enumerated as:
i. Some sales are possible even if there is no advertising. Thus for the
minimum level of sales, no advertising is needed.
ii. Sales increase and decrease with advertisement respectively. That is,
there is a direct relationship between sales and advertising if other
things are assumed to be constant.
iii. In the initial stages of advertisement expenditure, the resulting
increase in sales will be more than proportionate to the increase in
advertisement expenditure.
Some goods are more responsive to advertising, e.g., cosmetics. Others are
less, e.g., heavy machinery. The factors that influence the advertising
elasticity of demand are:
a. Stage of the product in market, e.g., old or new product, growing or
established market etc.
b. Effect of advertising in terms of time
c. Influence of advertising by rivals.
The Optimal Level of Advertising Expenditure
The total revenue curve shows that increased advertising expenditure can
always increase physical volume, though after a point, diminishing returns
may set in. This implies that total revenue must vary with advertising
expenditure directly.
Total sales (revenue) total profit

C
Total cost

Total revenue

M
C
P1
0 P AP AC
P1 Cont….
Advertising expenditure (Rs)
MARGINAL UTILITY ANALYSIS
Assumptions
The basic propositions of this traditional approach are:
v Cardinal measure of utility : Utility is a measurable and
quantifiable concept. A person can specify that he gets five units of
utility by consuming one unit of good A etc. Utility is an imaginary
unit of measuring utility.
v Independent utilities : Utility is additive; the utilities derived
from different independent goods can be added to get the measure of total
utility.
v Constant marginal utility of money : The marginal utility of
money remains constant for a particular consumer when he spends money on
various goods. All other commodities except money are subject to the law
of diminishing marginal utility.
Cont….
The Law of Diminishing Marginal Utility
Marginal utility refers to the change in satisfaction which results when a
little more or little less of that good is consumed. For example, when a
thirsty person takes five bottles of cold drink continuously, the
consumption of first bottle gives him utility, second bottle gives him
lesser utility than first but his total utility increases. Third bottle
gives him still less utility but increases total utility. The utility from
fourth bottle may be zero as he is no more thirsty. But the fifth bottle
may cause uneasiness and thus give negative utility, i.e., the total utility
may now actually go down.
Bottle consumed Total Utility ( Units )
Marginal Utility ( Units )
0 0 –
1 14 14
2 23 9
3 27 4
4 27 0
5 24 –3
6 18 –6

Cont….
 T.U.

M.U.

Cont….
INDIFFERENCE CURVE ANALYSIS
Assumptions
The following assumptions about the consumer psychology are implicit in
this analysis:
v Transitivity : If a consumer is indifferent to two combinations of
two goods, then he is unaware of the third combination also.
v Diminishing marginal rate of substitution : The scarcer a good
the greater is its substitution value.
v Rationality : The consumer aims to maximise his total satisfaction
and has got complete market information.
v Ordinal Utility : Utility in this approach is not measurable. A
consumer can only specify his preference for a particular combination of
two goods, he cannot specify how much.

Cont….
The Indifference Curve
If a consumer is asked whether he prefers combination 1 of two goods X and
Y (assuming that the market price of X and Y are fixed) or combination 2,
he may give one of the following answers:
v he prefers combination 1 to 2
v he prefers combination 2 to 1
v he is indifferent about combinations 1 and 2.

Indifference Combination of X and Y goods

Combination Units of X Units of Y
1 3 21
2 4 15
3 5 11
4 6 8
5 7 6

Cont….
The I ndifferenc e Curve

Cont….
The Budget Line
The budget line is also known as
the price line, the consumption
possibility line or the price
opportunity line. It represents
different combinations of two goods
X and Y which the consumer can buy
by spending all his income.
Example
A consumer having Rs 1200 as income can
buy 600 units of Y at Rs 2 per unit or
300 units of X at Rs 4 per unit as
shown in Figure 12. The straight line
joining the two points A and B is
called the budget line.
At any point on AB, the consumer spends
all his income but point C is
unattainable. At point D or any other
point in DOAB he does not spend all his
income. Cont….
 Demand
Forecasting
Introduction
Forecasts can be classified into two broad categories
i. Passive forecasts
ii. Active forecasts
Passive forecast is one where prediction about the future is based on
the assumption that the firm does not change the course of its action,
and active forecast is where forecasting is done under the condition
of likely future changes in the actions by the firm.
Choice of the Right Forecasting Technique
To handle the increasing variety and complexity of managerial
forecasting problems, many forecasting techniques have been developed
in recent years. Each has its special use, and care must be taken to
select the correct technique for a particular application. The manager
as well as the forecaster has a role to play in technique selection;
and the better he understands the range of forecasting possibilities,
the more likely it is that a company's forecasting efforts will bear
fruit.
Manager , Forecaster and Choice of Methods
Successful forecasting begins with collaboration between the manager and
the forecaster in which they work out answers to the following questions.
v What is the purpose of the forecast - how is it to be used?
v What are the dynamics and components of the system for
which the forecast will be made?
v How important is the past in estimating the future?
Determinants of Demand Forecast
Goods can be broadly classified into three categories :
i. Capital goods
ii. Durable consumer goods
iii. Non durable consumer goods
Methods of Demand Forecasting
Forecasting of demand is done for knowing the future demand of a
product. The choice of method of demand forecasting will depend
on various factors like convenience to handle, relevance of
purpose (knowing future demand) applicable to available data and
also inexpensive.
 Methods of Demand Forecasting

Survey Methods
Statistical
Methods

Opinion Consumer BarometricEconometric

Trend Projection
Poll Methods Survey Methods Methods
Methods

Expert Delphi RegressionSimultaneous

Opinion Method Least Graphical Method Equations
Method Squvants Method Method
Method

Complete Sample
Enumeration Survey
Method Method
Survey Methods of Demand Forecasting

Survey Methods

Opinion Poll Method Consumer Survey Method

Expert Opinion Delphi Sample Survey

Complete
Method Method Method
Enumeration
Method

Types of Demand Forecasting by Survey Methods

Opinion Poll Method
The opinion poll methods of demand forecasting adopts the method of
collecting opinions of those experts who are aware of the market of the
product e.g. sales executives and representatives, consultants, marketing
experts, owners of companies, and researchers.
v Experts Opinion Method
v Delphi Methods
v Consumer Survey Method
v Complete Enumeration Method
v Sample Survey Method

Cont….
Statistical Methods of Demand Forecasting

Statistical Methods

Trend Projection Methods Barometric Methods Econometric Methods

Graphical Least Squares Simultaneous

Regression
Methods Methods Equation Method
Method

Types of Statistical Methods

Trend Method
Graphical Method : The time-series data on the variable (e.g. sales) under
forecast are used to fit a trend line graphically. For example, the graph
below shows the sale of passenger cars in a country from 1985-2001.

Trend Line

Actual Sales
Sales
( $)

85 86 87 01
8

Time
Sale of Passenger Cars Cont….
Lease Square Method : The trend line can be projected for knowing the
future demand by two methods – linear trend and exponential trend.
When the time series data shows a rising trend in the sales, then a
straight line trend equation of the following kind is used
S=a+bt
where S=annual sales, t-time (in years) a and b are constants. The
parameter b gives the measures of annual increase in sales. The
coefficients of a and b are estimated by the following two equations:
Σ S= na+bΣ t
Σ St=aΣ t + bΣ L2

where n is the number of time period (years). Solving such equations can be
learnt from the following example.
Barometric Method of Forecasting
Barometric method uses economic indicators as barometer to forecast trends
in business activities. This method is based on the work done by NBEF
(national Bureau of Economic Research) of U.S. Barometric method are
classified into three categories – leading indicators, coincident
indicators and lagging indicators.

Leading Indicators

Indicator
Level Coincident Indicators
(Value)

Lagging Indicators

Time
Peak Trough
Business Cycle
Barometric Indicators
Econometric Method
The econometric methods incorporate statistical tools with economic
theories to estimate the economic variables and to forecast economic
events. The forecasts made through econometric methods are more reliable.
An econometric method consists of a single-equation regression model or a
system of simultaneous equations. Single equation regression serves the
purpose of demand forecasting in case of many commodities. But, in case of
economic variables due to complex relationships, a single equation
regression model is not appropriate. In this case, a system of simultaneous
equations is used to estimate and forecast. The econometric methods are
described here under two methods:
v Regression method;
v Simultaneous equations method.
Regression Methods of Demand Forecasting
In regression techniques of demand forecasting, the analysts estimate the
demand function for a product. In the demand function, quantity to be
forecast is a “department variable” and the variables that affect or
determine the demand (the department variable) one called as “independent
or explanatory variables”.
The hypothetical data of consumption of sugar given in table.

Year Population Sugar Consumed

( millions ) ( 000 ) tones )
1995-96 10 40
1996-97 12 50
1997-98 15 60
1998-99 20 70
2000-2001 25 80
2001-2002 30 90
2002-2003 40 100

Cont….

Consumption of Sugar
 Calculation of Terms

Year population Sugar X2 Xy

(X) Consumed
(Y)
1995-96 10 40 100 400
1996-97 12 50 144 400
1997-98 15 60 225 900
1998-99 20 70 400 1400
2000-01 25 80 625 2000
2001-02 30 90 900 2700
2002-03 40 100 1600 4000

∑n= 7 ∑X t
= 152 ∑Y t
= 490 ∑X 2
t
= 3994 ∑X t
Y t = 12 , 000
Simultaneous Equation Method
Simultaneous equation method considers the interdependence of both
dependent and independent variables.
The steps of simultaneous method can be presented in simple
form as :
v To develop a complete model and specify the assumptions regarding the
variables included in the model.
v Endogenous variables are variables that are determined within the
model.
v Exogenous variables are those that are determined outside the model.
Examples of exogenous variables are money supply, tax rates, time,
climate etc.
v To collect data on both exogenous and endogenous variables.
v To estimate the model through some appropriate method (e.g. least
square method) and predict the values of exogenous variables.
v The model is solved for each endogenous variable in terms of exogenous
variable.
v Prediction is mode by putting the values of exogenous variables into
the equations.
Forecasting the demand of colour television in
India
Various Factor Affecting the Demand of Colour TV
v CPI : Consumer Price Index
v WPI : Wholesale Price Index
v Consumer Electronic Industry Growth
v GDP ( Gross domestic Product45)
40
v Per Capita Income 35
30
v Price of TV 25
20
15
10
5
0

1992-93 1993-94 1994-95 1995-96

1996-97
Cont….
Forecast Result
Regression equation formed is as follows:
Y=-01.258 - 0.2683*(WPI) + 0.03429*(CPI) - 0.002375*(industry growth) +
0.184*(GDP) + 0.0416* (income) -0.018*(price)
Equating the independent variables values, the forecast of demand is as
follows:
97-98 – 2.54 millions
98-99 – 3.03 millions
The factors that we have correlated to the demand of colour picture tubes
are forecasted by analysing the economic environment of the country,
trends in the industry and tools used for regression analysis.
v CPI / WPI
v Consumer Electronic Industry Growth
v GDP
v Per Capita Income
v Price of TV
Cont….
 Market W P I% C P I% C onsu m er GDP Per Price
D e m and Electronic (ten C apita of T V
(in millions ) dustry thousand Inco m e (in thousands )
Gro w th crore) (in thousands )
(int housand c rore)

1 9 9 2 -9 3 0 .7 9 .4 8 2 0 .1 2 2 .4 6 6 .5 1 5 .2 5

1 9 9 3 -9 4 1 .1 8 .6 8 .6 8 .8 2 3 .6 1 7 .3 1 1 4 .5

1 9 9 4 -9 5 1 .4 8 .9 1 0 .3 1 1 .9 2 5 .1 8 .4 14

1 9 9 5 -9 6 1 .8 5 8 .3 1 0 .4 40 2 6 .7 1 9 .3 1 13

1 9 9 6 -9 7 2 .2 8. 25 9 .8 3 4 .4 2 8 .3 1 1 0 .2 6 1 2 .5

Protection-1 1 9 9 7 -9 8 2 .5 6 .07 8 8 0 .9 8 4 3 0 .1 5 1 1 .2 1 1 1 .7 5

Protection-2 1 9 9 8 -9 9 3 .0 3 7 .89 8 6.9 6 4 3 2 .2 1 2 .1 6 1 1 .0 5

Correlation -0 .8 6 4 1 9 8 8 0 .7 5 2 0 8 2 0 .7 0 7 7 6 8 5 2 4 0 .9 9 7 1 9 5 0 .9 9 6 7 5 1 1 6 -0 .9 9 8 3 4 4
Price of Tv Inco m e GDP Industry CPl W PI C onst b

M n ,..,m 1 ,b -0 .0 1 8 0 2 5 2 0 .0 4 1 6 8 4 0 .1 8 4 1 9 7 6 2 5 -0 .0 0 2 3 7 5 6 0 .0 3 4 2 9 7 7 1 -0 .2 6 8 3 3 8 -1 .2 5 8 0 8

Y= m 1 * x 1 + m 2 0 S en,..,s e1 ,s eb 0 0 0 0

x 2 + .....+ b r2 ,s ey 1 1 8 E-1 8
.5 # N /A # N /A # N /A # N /A # N /A

Cont….
 Market Demand
( millions )
3.5

2.5

1.5

0.5

0
1992- 1993-
93 1994- 1995- Market Demand (millions)
94 95 1996-
96 1997-
97 1998-
98
99
Review Questions
1. What is the significance of sales forecast for making (a) pricing decision (b)
advertising decision (c) distribution decision and (d) new produce decision.
2. What is the role of time element in the context of demand forecasting? What
factors would you normally consider in choosing a forecasting technique?
3. What is the importance of forecasting for managers? What are the factors
determining the process of demand forecasting?
4. Discuss critically any four important methods of demand forecasting.
5. The annual turnover of a company is an follows:

Year Sales ( in thousand of

rupees )
1985 45
1986 58
1987 72
1988 52
1989 73
1990 74 Cont….

Estimate the annual sales for 1991.

6 . The following table shows the business expenditure on new plant and equipment
i.e., demands for capital goods.

Year Expenses (in thousand of rupees)

1990 75
1991 76
1992 81
1993 84
1994 86

Project the business expenditure on new plant and equipment for the year 1995.
7. Explain how a manager can choose the right forecasting technique.
8 . Outline the various steps which would be necessary for forecasting demand for
a typical mass consumption item.