Page 75 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes Let us answer a basic question about this formula: Why use percentages rather than absolute
amounts in measuring consumer responsiveness? The answer is that if we use absolute changes,
our impression of buyer responsiveness will be arbitrarily affected by the choice of units.

To illustrate, if the price of product X falls from $3 to $2 and consumers, as a result, increase their
purchases from 60 to 100 pounds, we get the impression that the consumers are quite sensitive
to price changes and therefore demand is elastic. After all, a price change of "one" has caused a
change in the amount demanded of 'forty". But by changing the monetary units from dollars to
pennies (why not?), we find that a price change of "one hundred" causes a quantity change of
"forty", giving the impression of inelasticity. The use of percentage changes avoids this problem.
The given price decrease is 33 per cent whether measured in terms of dollars or in terms of
pennies. Thus, the use of percentages gives us the nice property that the units in which the
money or goods are measured — ¾ bushels or tons of wheat, dollars or cents or rupees — do not
affect elasticity.

Interpreting the Formula

!
Caution Demand is elastic if a given percentage change in price results in a larger
percentage change in quantity demanded. For example, if a two per cent decline in price
results in a 4 per cent increase in quantity demanded, demand is then said to be elastic. If
a given percentage change in price is accompanied by a relatively smaller change in the
quantity demanded, demand is inelastic. For example, if a 3 per cent change in price gives
rise to a 1 per cent increase in the amount demanded, demand is said to be inelastic. The
borderline case of unitary elasticity, which separates elastic and inelastic demands, occurs
where a percentage change in price and accompanying percentage change in quantity
demanded happen to be equal.

5.1.3 Computation of Elasticity Coefficients

We may use two measures of elasticity:
1. Arc elasticity, if the data is discrete and therefore incremental changes are measurable.
2. Point elasticity, if the demand function is continuous and therefore only marginal changes
are calculable.

Example: Given the following data, calculate the price elasticity of demand when
(a) price increases from 3.00 per unit to 4.00 per unit and (b) the price falls from 4.00 per unit
to 3.00 per unit.

P (per unit) 6 5 4 3 2 1
x
Q 750 1250 2000 3250 4650 8000
x

e =
p
(a) When price increases from 3 to Rs 4 per unit, P, the old price = 3 and Q, the old quantity
(from the table) = 3250 units.
New Price = 4
New Quantity = 2000 units.

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