Elasticity and Its

Application

Chapter 3
 Elasticity . . .

 … is a measure of how much buyers and sellers

respond to changes in market conditions
 … allows us to analyze supply and demand with
greater precision.
Journal Question-Name 3 necessities and 3
luxuries that you would buy.
TYPES OF ELASTICITY OF DEMAND

• 1) PRICE ELASTICITY OF DEMAND

• 2) CROSS ELASTICITY OF DEMAND

• 3) INCOME ELASTICITY OF DEMAND

• 4) ADVERTISING OR PROMOTIONAL
ELASTICITY OF DEMAND

Prof.Swati Padoshi
 Price Elasticity of Demand
 Price elasticity of demand is the percentage change in quantity
demanded given a percent change in the price.

 It is a measure of how much the quantity demanded of a good

responds to a change in the price of that good.
 Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the percentage change in
the quantity demanded divided by the percentage change in price.

Price Elasticity = Percentage Change in Qd

Of Demand Percentage Change in Price
 Ranges of Elasticity

Inelastic Demand
 Percentage change in price is greater than
percentage change in quantity demand.
 Price elasticity of demand is less than one.
Elastic Demand
 Percentage change in quantity demand is greater
than percentage change in price.
 Price elasticity of demand is greater than one.
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An Rs5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Inelastic Demand
- Elasticity is less than 1
Price

Rs5
1. A 25%
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% Rs5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% R
increase s5
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above Rs4, quantity
demanded is zero.

Rs4 Demand

2. At exactly Rs4,
consumers will
buy any quantity.

3. At a price below Rs4, Quantity

quantity demanded is infinite.
 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 Definition of the Market
 Time Horizon
Determinants of Price Elasticity of Demand
• Demand tends to be more inelastic
• If the good is a necessity.
• If the time period is shorter.
• The smaller the number of close substitutes.
• The more broadly defined the market.
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
 if the good is a luxury.
 the longer the time period.
 the larger the number of close substitutes.
 the more narrowly defined the market.
 Income Elasticity of Demand
 Income elasticity of demand measures how much the quantity
demanded of a good responds to a change in consumers’ income.
 It is computed as the percentage change in the quantity demanded
divided by the percentage change in income.
 Computing Income Elasticity

Percentage Change
Income Elasticity = in Quantity Demanded
of Demand Percentage Change
in Income
 Income Elasticity
- Types of Goods -
 Normal Goods
 Income Elasticity is positive.
 Inferior Goods
 Income Elasticity is negative.
 Higher income raises the quantity demanded for normal goods but
lowers the quantity demanded for inferior goods.
 DETERMINANTS OF INCOME
ELASTICITY OF DEMAND
• Nature of commodity: Commodities are grouped in to necessities,
comforts & luxuries.
• Income level: Depends upon the income of the country.
• Time period: Over a long run a luxury may become a necessity.
• Demonstration effect: Changing tastes, preferences & choices of
people.
• Frequency: Higher frequency ,income elasticity will be high.

Prof.Swati Padoshi
USE OF INCOME ELASTICITY
IN BUSINESS DECISIONS
• Planning of the firm’s growth: The knowledge of income
elasticity of demand is important for both the firms &
govt.
• Formulation of farm policy: The govt. of India has
considered it necessary to continue & increase various
agricultural subsidies.
• Forecasting demands: Used in forecasting future demand
provided the firm knows the growth rate of income &
income elasticity of demand for the good
• Formulating marketing strategies: The income elasticity
of demand of potential buyer class for products affects
the no. ,nature & location of sales centres ,& the policies
related to other sales promotion activities.
Prof.Swati Padoshi
 Cross Price Elasticity of Demand
• Elasticity measure that looks at the impact a change in the price of
one good has on the demand of another good.
• % change in demand Q1/% change in price of Q2.
• Positive-Substitutes
• Negative-Complements.
APPLICATIONS OF CROSS ELASTICITY
IN MANAGEMENT
• PRODUCTION

• DEMAND FORECASTING AND PRICING

• INTERNATIONL TRADE AND BALANCE OF PAYMENTS

Prof.Swati Padoshi
 ADVERTISING / PROMOTIONALELASTICITY OF
DEMAND

• Advertising elasticity of demand is the measure of the rate of change

in demand due to changes in advertising expenditure.
• The amount of change in demand of goods due to advertisement is
known as advertising elasticity of demand

Prof.Swati Padoshi
 FACTORS INFLUENCING
ADVERTISING ELASTICITY OF
DEMAND
• Stage of product’s development

• Degree of competition

• Effects of advertising in terms of time

• Effect of advertising by rival firms

Prof.Swati Padoshi
DEMAND Forecasting
Decisions that Need Forecasts
• Which markets to pursue?
• What products to produce?
• How many people to hire?
• How many units to purchase?
• How many units to produce?
• And so on……
Common Characteristics of Forecasting
• Forecasts are rarely perfect

• Forecasts are more accurate for aggregated data than for individual
items

• Forecast are more accurate for shorter than longer time periods
Forecasting Steps
• What needs to be forecast?
• Level of detail, units of analysis & time horizon required
• What data is available to evaluate?
• Identify needed data & whether it’s available
• Select and test the forecasting model
• Cost, ease of use & accuracy
• Generate the forecast
• Monitor forecast accuracy over time
Types of Forecasting Models
• Qualitative (technological) methods:
• Forecasts generated subjectively by the forecaster

• Quantitative (statistical) methods:

• Forecasts generated through mathematical modeling
 Qualitative Methods
Type Characteristics Strengths Weaknesses
Executive A group of managers Good for strategic or One person's opinion
opinion meet & come up with new-product can dominate the
a forecast forecasting forecast

Market Uses surveys & Good determinant of It can be difficult to

research interviews to identify customer preferences develop a good
customer preferences questionnaire

Delphi Seeks to develop a Excellent for Time consuming to

method consensus among a forecasting long-term develop
group of experts product demand,
technological
Statistical Forecasting
• Time Series Models:
• Assumes the future will follow same patterns as the past

• Causal Models:
• Explores cause-and-effect relationships
• Uses leading indicators to predict the future
• E.g. housing starts and appliance sales
Composition
of Time Series Data
• Data = historic pattern + random variation
• Historic pattern may include:
• Level (long-term average)
• Trend
• Seasonality
• Cycle
Factors for Selecting a
Forecasting Model
• The amount & type of available data
• Degree of accuracy required
• Length of forecast horizon
• Presence of data patterns
Forecasting Software
• Spreadsheets
• Microsoft Excel, Quattro Pro, Lotus 1-2-3
• Limited statistical analysis of forecast data
• Statistical packages
• SPSS, SAS, NCSS, Minitab
• Forecasting plus statistical and graphics
• Specialty forecasting packages
• Forecast Master, Forecast Pro, Autobox, SCA