Page 85 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes
Example: If X and Y (say butter and bread) are complements, e will be negative. If the
c
price of bread rose ceteris paribus, there would be a decrease in the quantity demanded of bread
and a decrease in the quantity demanded of butter. Thus, for complements, a change in price of
one good ceteris parbius causes the quantity demanded of the complements to move in the
opposite direction. If there is a percentage increase in the price of bread, the denominator in the
formula would be positive. Similarly, if there is a percentage decrease in the quantity of butter,
the numerator in the formula would be negative. Hence, e is negative for complements.
c
If X and Y (say tea and coffee) are substitutes, e will be positive. If the price of coffee rose ceteris
c
paribus, there would be a decrease in the quantity demanded of coffee and an increase in the
quantity demanded of tea as consumers would readily "substitute" tea for coffee. Thus, for
substitutes the price change of one good ceteris paribus causes the quantity demanded of the
substitute to move in the same direction. If there is a percentage increase in the price of coffee,
the denominator in the formula would be positive. Similarly, if there is a percentage increase in
the quantity demanded of tea, the numerator in the formula would be positive. Hence, e is
c
positive for substitutes.
The higher the numerical magnitude of cross elasticity, the greater is the degree of
complementarity/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.
dQ dP
e = x x
c Q P
x x
dQ x P x
= .
dP Q
x x

Notes Applications of Elasticity
The concept of elasticity has a wide range of applications in economics. In particular, an
understanding of elasticity is fundamental in understanding the response of supply and
demand in a market.
Some common applications of elasticity include:
1. Effect of changing price on firm's revenues: If the demand for the product is price
inelastic, the firm would not want to lower its price since that would reduce its total
revenue, increase its total costs and this will give it lower profits.
2. Analysis of incidence of the tax burden and other government policies: In economics,
tax incidence is the analysis of the effect of a particular tax on the distribution of
economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the
day, bears the burden of the tax. The key concept is that the tax incidence or tax
burden does not depend on where the revenue is collected, but on the price elasticity
of demand (and price elasticity of supply). For example, a tax on orange farmers
might actually be paid by owners of agricultural land or consumers of oranges.
3. Effect of international trade and terms of trade effects: Marshall-Lerner Condition
gives a technical reason why a reduction in value of a nation's currency need not
immediately improve its balance of payments. The condition states that, for a currency
devaluation to have a positive impact on trade balance, the sum of price elasticity of
exports and imports (in absolute value) must be greater than 1.
Contd...

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