Managerial
Managerial
Economics
Economics 2
2
The price mechanism:
The interdependence of
markets
Goods Market
Sg
Dg shortage Pg until Dg = Sg
(Dg > Sg) Dg
Factor Market
Sf
Sg Df shortage Pf until Df = Sf
(Df > Sf) Df
Elasticity
An elasticity is a measure of the sensitivity
of one variable to another. % change that
will occur in one variable in response to a 1
% change in another variable.
Point elasticity
Elasticity at a given point on a function
Arc elasticity
Average elasticity over a given range of a
function
Price Elasticity of Demand
Responsiveness of the quantity demanded to
changes in the price of the product, holding
constant the values of all other variables in the
demand function
Denoting quantity and price by Q and P, we write
the price elasticity of demand as
Ep = (%DQ)/(%DP)
(ΔQ / ΔP) (P / Q)
elastic demand
Situation in which a price change leads to
a more than proportionate change in
quantity demanded
Inelastic demand
Situation in which a price change leads to
a less than proportionate change in
quantity demanded
Unitary elasticity
Situation in which price and quantity
changes exactly offset each other
Long Run Elasticity for Gasoline
Long Run Elasticity for Automobile
Determinants of Price Elasticity
The extent to which a good is
considered to be a necessity
The availability of substitute goods to
satisfy a given need
The proportion of income spent on
the product.
The demand for good X is given by
Q=20 * P-1. Find the point Ped when
P=Rs100; P=Rs.300. Also find the
total revenue.
Find Ped when
a. Price changes from Rs.500 to Rs.700;
b. Price changes from Rs. 700 to Rs. 1000
c. Price changes from Rs. 1000 to Rs. 500
Price of Bicycle Quantity demanded per
month (‘000 of bicycles)
500 25
700 22
1000 15
A committee looking into railway
pricing finds the Ped at -1.5. So it
suggests the fares be increased by
40%. Work out the revenue effect if
the fare rises from Rs. 10 to Rs. 14
and daily 1000 passengers travel on
this route
Revenue
Defining total, average and marginal revenue
TR = P × Q
AR = TR / Q
MR = TR / Q
Revenue curves when firms are price takers
(horizontal demand curve)
average revenue (AR)
marginal revenue (MR)
total revenue (TR)
Deriving a firm’s AR and MR: price-taking firm
Price (Rs)
AR, MR (Rs)
S
D = AR
Pe
= MR
D
O O
Q (millions) Q
(hundreds)
(a) The market (b) The firm
fig
Total revenue for a price-taking firm
6000 Quantity Price = TR TR
(units) AR (Rs)
= MR (Rs)
5000 0 5 0
200 5 1000
400 5 2000
4000 600 5 3000
TR (Rs)
800 5 4000
1000 5 5000
3000 1200 5 6000
2000
1000
0
0 200 400 600 800 1000 1200
Quantity
TR curve for a firm facing a downward-sloping
D curve
20
16
12 Quantity P = AR TR TR
(units) (Rs) (Rs)
TR (Rs)
1 8 8
8 7
2 14
3 6 18
4 5 20
4 5 4 20
6 3 18
7 2 14
0
0 1 2 3 4 5 6 7
Quantity
AR and MR curves for a firm facing a downward-
sloping demand curve Q P TR MR
8
(unit =AR (Rs) (Rs)
s) (Rs)
1 8 8 6
6 2 7 14 4
3 6 18 2
4 5 20 0
AR, MR (Rs)
4 5 4 20 -2
6 3 18 -4
7 2 14
2 AR
0
1 2 3 4 5 6 7 Quantity
-2
-4
fig MR
AR and MR curves for a firm facing a downward-
sloping demand curve
8
Elastic
Elasticity = -1
6
AR, MR (Rs)
4 Inelastic
2 AR
0
1 2 3 4 5 6 7 Quantity
-2
-4
fig MR
TR curve for a firm facing a downward-sloping
D curve Elasticity = -1
20
In
tic
ela
as
st
16
El
ic
12 TR
TR (Rs)
0
0 1 2 3 4 5 6 7
Quantity
Income Elasticity
Responsiveness of demand to changes
in income, holding constant the effect
of all other variable
Normal goods
Products for which demand is positively
related to income
Inferior goods (Giffen Goods)
Products for which consumer demand declines
as income rises
(ΔQ / ΔI) (I / Q)
National Industries is a leading manufacturer of tufted
carpeting. Demand for Ironside’s products being closely tied to
the overall pace of building and remodeling activity is highly
sensitive to changes in national income. The carpet
manufacturing industry is highly competitive, making the
demand price sensitive. The past year saw National sell 15
million square yards (units) of carpeting at an average
wholesale price of $7.75 per unit. With the income per capita
expected to surge from $17,250 to $18,750 this year, current
sales are projected to reach 25 million units without any
increase in price.
A. Calculate the implied income arc elasticity of demand.
B. Given the projected rise in income, the marketing director
believes that the current volume of 15 million units could be
maintained despite an increase in price of $0.50 per unit. On
this basis, calculate the implied arc price elasticity of demand.
Cross Price Elasticity
Responsiveness of demand for one product
to changes in the price of another
Substitutes
Related products for which a price
increase for one leads to an
increase in demand for the other
Complements
Related products for which a
price increase for one leads to a
reduction in demand for the other
(ΔQy / ΔPx) (Px / Qy)
Lean is a catalog retailer of a wide variety of
sporting goods and recreational products. The
past year saw sales of Lean’s $140 deluxe
garment bag decline from 10,000 to 4,800 units.
During this period, a competitor offered whopping
$52 off their regular $137 price on deluxe garment
bags.
A. Calculate the arc cross-price elasticity of demand
for deluxe garment bag.
B. Lean’s deluxe garment bag sales recovered from
4,800 units to 6,000 units following a price
reduction to $130 per unit. Calculate Lean’s arc
price elasticity of demand for this product.
C. Assuming the same arc price elasticity of demand
calculated in part B, determine the further price
reduction necessary for Lean to fully recover lost
sales
