10 : Theory of Demand · Promotional/ Advertising Elasticity of Demand Prof. Trupti Mishra, School...

1

10 : Theory of Demand

2 Prof. Trupti Mishra, School of Management, IIT Bombay

Change in Demand Supply, Law of Supply Market Equilibrium Change in Equilibrium

Recap from last session

3

D1

S1

0 Quantity of Ice-Cream

Cone

Price of Ice-Cream

Cone

Q1

D2

Large increase

in demand

P2

S2

Q2

New

equilibrium

Small

decrease in

supply

Initial equilibrium P1

A Shift in Both Supply and Demand

Prof. Trupti Mishra, School of Management, IIT Bombay

4

D1

S1

0 Quantity of Ice-Cream

Cone

Price of Ice-Cream

Cone

Q1

D2

Large

decrease in

supply

P2

S2

Q2

New

equilibrium

Small increase

in demand

Initial equilibrium

P1

A Shift in Both Supply and Demand


5

When demand & supply shift simultaneously

Can predict either the direction in which price changes or the direction in which quantity changes, but not both

The change in equilibrium price or quantity is said to be indeterminate when the direction of change depends on the relative magnitudes by which demand & supply shift

Simultaneous Shifts


6

What Happens to Price and Quantity when Supply or Demand Shifts?


7

Session Summary

• The demand curve shows how the quantity of a good depends upon the price.

– According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.


8

Session Summary

– In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers.

– If one of these factors changes, the demand curve shifts.


9

Session Summary

• The supply curve shows how the quantity of a good supplied depends upon the price.

• According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.


10

Session Summary

• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers.

• If one of these factors changes, the supply curve shifts.


11

Session Summary

• Market equilibrium is determined by the intersection of the supply and demand curves.

• At the equilibrium price, the quantity demanded equals the quantity supplied.

• The behavior of buyers and sellers naturally drives markets toward their equilibrium.



• 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.

Elasticity of Demand


• It allows us to analyze demand with greater precision.

• It is a measure of how much buyers and sellers respond to changes in market conditions

Elasticity of Demand

Elasticity of Demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the determinants of demand.


Types of Elasticity of Demand

Price elasticity of Demand Income Elasticity of Demand

Cross Elasticity of Demand


Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Percentage change in quantity demanded given a percent change in the price.


Price Elasticity of Demand

% QE

% P

P & Q are inversely related by the law of demand so E is always negative. The larger the absolute value of E, the more sensitive buyers are to a change in price


Degree of Price Elasticity of Demand

Inelastic Demand

Quantity demanded does not respond strongly to price changes.

Elastic Demand

Quantity demanded responds strongly to changes in price.



Perfectly Inelastic

Quantity demanded does not respond to price changes.

Perfectly Elastic

Quantity demanded changes infinitely with any change in price.

Unit Elastic

Quantity demanded changes by the same percentage as the price.



Perfectly Elastic

D

Price

Quantity

Perfectly Inelastic

D

Price

Quantity

E =∞ Ep = 0


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E < 1

0 Quantity

Price

100

1. A 25%

increase in

price…

5.00

2. … Leads to a 10% decrease in quantity demanded.

Demand

4.00

90

Inelastic Demand


22

E = 1

0 Quantity

Price

100

1. A 25%

increase in

price…

5.00


Demand

4.00

75

Unit Elastic Demand


23

E > 1

0 Quantity

Price

100

1. A 25%

increase in

price…

5.00


Demand

4.00

50

Elastic Demand


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The own-price elasticity can be measured between two points on a demand curve (for arc elasticity) or on a point ( for point elasticity)


Measurement of Price Elasticity of Demand

% QE

% P

Q

Q

P

P

100

100

Q P

P Q

Point Elasticity of Demand


ARC Elasticity of Demand

Q PE

P Q

Average

Average

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Price

Quantity 0 100

Demand

P x Q = 400

(revenue)

4.00

Total Revenue and Price Elasticity of Demand


28

Price

Quantity 0 80

Demand

3.00

P x Q = 240

(revenue)

P x Q = 100

(revenue)

1.00

100

How Total Revenue Changes When Prices Changes: Inelastic Demand


29

Price

Quantity

Change in Total Revenue when Price Changes

0 50

Demand

4.00

5.00

20

Revenue = 100

Revenue = 200

How Total Revenue Changes When Prices Changes: Elastic Demand


30

Price

Quantity 2 4 6 8 10 12 0

6

5

4

3

2

1

7

14

Elasticity

is larger

than 1.

Elasticity

is smaller

than 1.

A Linear Demand Curve


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Elastic

Q-effect dominates

Unitary elastic

No dominant effect

Inelastic

P-effect dominates

Price

rises

Price

falls

TR falls

TR rises

No change in TR

No change in TR

TR rises

TR falls

% Q % P % Q % P % Q % P

Price Elasticity & Total Revenue


Determinants of Price Elasticity of Demand

Nature of Commodity : The demand for luxury goods is more price-elastic than the demand for necessities and comforts. The demand for necessity goods is price-inelastic. Comforts have more elastic demand than necessities, and less elastic demand than luxuries.



Availability and proximity of Substitutes : The higher the degree of closeness between the commodity and its substitutes, the greater the price-elasticity of demand for the commodity.



Proportion of Income Spent on the Commodity: The larger the proportion of income spent on a commodity, the greater will be the elasticity of demand for such commodity, and vice versa.



Time: The longer the adjustment time, the greater the price-elasticity of demand



Durability of the Commodity Items of addiction


Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant.

Income Elasticity of Demand

d d

M

d

% Q Q ME

% M M Q


Positive for a normal good

Negative for an inferior good

Zero for a neutral goods



If Em > 1, Luxury good If Em < 1, Necessity Goods If Em = 1, Semi Luxury goods



40

Cross-price elasticity of demand (EXY) measures the responsiveness of quantity demanded of good X to changes in the price of related good Y, holding the price of good X & all other demand determinants for good X constant

Cross-Price Elasticity of demand


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Positive when the two goods are substitutes

Negative when the two goods are complements

X X Y

XY

Y Y X

% Q Q PE

% P P Q

Cross-Price Elasticity of demand


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It measures the response of quantity demanded to change in the expenditure on advertising and other sales promotion activities.

Promotional/ Advertising Elasticity of Demand


43

Ea = ∂Q/∂A.A/Q

Q= quantity of goods sold

A= unit of advertising expenditure on goods

Promotional/ Advertising Elasticity of Demand



Managerial Economics; D N Dwivedi, 7th Edition Managerial economics – Christopher R Thomas, S Charles Maurice and Sumit Sarkar Managerial economics – Geetika, Piyali Ghosh and Purba Roy Choudhury Managerial economics- Paul G Keat, Philip K Y Young and Sreejata Banerjee Micro Economics : ICFAI University Press

Session References

Numericals

Demand Schedule

Price Quantity Demanded

3 20

4 15

5 11

6 9

7 7

Compute point price elasticity of demand for decrease in price from Rs 6 to 5.

Compute point price elasticity of Demand for a increase in price from Rs 5 to 6.

45

The current price is Rs 12 per kg. Compute E using arc method for an increase in price by one rupee per kg.

Price Quantity Demanded

10 30

11 25

12 21

13 18


10 : Theory of Demand · Promotional/ Advertising Elasticity of Demand Prof. Trupti Mishra, School...

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