10 : Theory of Demand
1 Recap from last session
.Change in Demand .Supply, Law of Supply .Market Equilibrium .Change in Equilibrium
2 Prof. Trupti Mishra, School of Management, IIT Bombay A Shift in Both Supply and Demand
Price of Large increase Ice-Cream in demand Cone S New 2 equilibrium S1
P2 Small decrease in supply
P 1 Initial equilibrium D2
D1
Quantity of 0 Q1 Q2 Ice-Cream Cone 3 Prof. Trupti Mishra, School of Management, IIT Bombay A Shift in Both Supply and Demand
Price of Small increase Ice-Cream in demand Cone New S2 equilibrium S1
P2
Large decrease in supply
P1 Initial equilibrium
D2
D1
Quantity of 0 Q2 Q1 Ice-Cream Cone 4 Prof. Trupti Mishra, School of Management, IIT Bombay Simultaneous Shifts
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
5 Prof. Trupti Mishra, School of Management, IIT Bombay What Happens to Price and Quantity when Supply or Demand Shifts?
6 Prof. Trupti Mishra, School of Management, IIT Bombay 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.
7 Prof. Trupti Mishra, School of Management, IIT Bombay 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. 8 Prof. Trupti Mishra, School of Management, IIT Bombay 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.
9 Prof. Trupti Mishra, School of Management, IIT Bombay 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.
10 Prof. Trupti Mishra, School of Management, IIT Bombay 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.
11 Prof. Trupti Mishra, School of Management, IIT Bombay Elasticity of Demand
• 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.
12 Prof. Trupti Mishra, School of Management, IIT Bombay 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
13 Prof. Trupti Mishra, School of Management, IIT Bombay .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.
Prof. Trupti Mishra, School of Management, IIT Bombay
Types of Elasticity of Demand
.Price elasticity of Demand
.Income Elasticity of Demand
.Cross Elasticity of Demand
Prof. Trupti Mishra, School of Management, IIT Bombay .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.
Prof. Trupti Mishra, School of Management, IIT Bombay Price Elasticity of Demand
%Q E %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
Prof. Trupti Mishra, School of Management, IIT Bombay 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.
Prof. Trupti Mishra, School of Management, IIT Bombay Degree of Price Elasticity of Demand
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.
Prof. Trupti Mishra, School of Management, IIT Bombay Degree of Price Elasticity of Demand
Price Price D
D
Quantity Quantity Perfectly Elastic Perfectly Inelastic
E =∞ Ep = 0
Prof. Trupti Mishra, School of Management, IIT Bombay 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. 21 Prof. Trupti Mishra, School of Management, IIT Bombay Unit Elastic Demand
Price E = 1 Demand
5.00
4.00
1. A 25% increase in price…
0 75 100 Quantity
2. … Leads to a 25% decrease in quantity demanded. 22 Prof. Trupti Mishra, School of Management, IIT Bombay 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. 23 Prof. Trupti Mishra, School of Management, IIT Bombay The own-price elasticity can be measured between two points on a demand curve (for arc elasticity) or on a point ( for point elasticity)
24 Prof. Trupti Mishra, School of Management, IIT Bombay Measurement of Price Elasticity of Demand Point Elasticity of Demand
Q 100 %Q Q QP E %P P PQ 100 P
Prof. Trupti Mishra, School of Management, IIT Bombay ARC Elasticity of Demand
QPAverage E PQAverage Total Revenue and Price Elasticity of Demand
Price
4.00
P x Q = 400 (revenue) Demand
0 100 Quantity
27 Prof. Trupti Mishra, School of Management, IIT Bombay How Total Revenue Changes When Prices Changes: Inelastic Demand Price
3.00 P x Q = 240 (revenue) 1.00 P x Q = 100 (revenue) Demand
0 80 100 Quantity
28 Prof. Trupti Mishra, School of Management, IIT Bombay How Total Revenue Changes When Prices Changes: Elastic Demand Price Change in Total Revenue when Price Changes
5.00
4.00
Demand Revenue = 200
Revenue = 100
0 20 50 Quantity
29 Prof. Trupti Mishra, School of Management, IIT Bombay A Linear Demand Curve
Price 7 Elasticity is larger than 1. 6
5
4 Elasticity is smaller 3 than 1.
2
1
0 2 4 6 8 10 12 14 Quantity
30 Prof. Trupti Mishra, School of Management, IIT Bombay Price Elasticity & Total Revenue
Elastic Unitary elastic Inelastic
Q-effect dominates No dominant effect P-effect dominates %Q%P %Q%P %Q%P Price TR falls No change in TR TR rises rises Price falls TR rises No change in TR TR falls
31 Prof. Trupti Mishra, School of Management, IIT Bombay 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.
Prof. Trupti Mishra, School of Management, IIT Bombay
Determinants of Price Elasticity of Demand
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.
Prof. Trupti Mishra, School of Management, IIT Bombay Determinants of Price Elasticity of Demand
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.
Prof. Trupti Mishra, School of Management, IIT Bombay Determinants of Price Elasticity of Demand
Time: The longer the adjustment time, the greater the price- elasticity of demand
Prof. Trupti Mishra, School of Management, IIT Bombay Determinants of Price Elasticity of Demand
Durability of the Commodity Items of addiction
Prof. Trupti Mishra, School of Management, IIT Bombay Income Elasticity of Demand
Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income, holding the price of the good & all other demand determinants constant.
%QQ M E dd M %MMQ d
Prof. Trupti Mishra, School of Management, IIT Bombay Income Elasticity of Demand
.Positive for a normal good .Negative for an inferior good .Zero for a neutral goods
Prof. Trupti Mishra, School of Management, IIT Bombay Income Elasticity of Demand
If Em > 1, Luxury good If Em < 1, Necessity Goods If Em = 1, Semi Luxury goods
Prof. Trupti Mishra, School of Management, IIT Bombay Cross-Price Elasticity of demand
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
40 Prof. Trupti Mishra, School of Management, IIT Bombay Cross-Price Elasticity of demand
%QQPXXY EXY %PPQYYX
. Positive when the two goods are substitutes . Negative when the two goods are complements
41 Prof. Trupti Mishra, School of Management, IIT Bombay Promotional/ Advertising Elasticity of Demand
It measures the response of quantity demanded to change in the expenditure on advertising and other sales promotion activities.
42 Prof. Trupti Mishra, School of Management, IIT Bombay Promotional/ Advertising Elasticity of Demand
Ea = ∂Q/∂A.A/Q
Q= quantity of goods sold A= unit of advertising expenditure on goods
43 Prof. Trupti Mishra, School of Management, IIT Bombay Session References
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
44 Prof. Trupti Mishra, School of Management, IIT Bombay 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 Price Quantity Demanded 10 30 11 25 12 21 13 18
The current price is Rs 12 per kg. Compute E using arc method for an increase in price by one rupee per kg.
46 Prof. Trupti Mishra, School of Management, IIT Bombay