Applications- Demand-Supply

Framework

Kalika Bansal, PhD, NMIMS University, Mumbai

https://www.economist.com/business/2020/08/01/air-travels-sudden-
collapse-will-reshape-a-trillion-dollar-industry
Kalika Bansal, PhD, NMIMS University, Mumbai
➢ Airlines sell fewer tickets, owing to pandemic travel restrictions or travellers’ fear
of infection.
➢ Aircraft-makers will make fewer passenger jets and so need fewer parts from their
suppliers.
➢ Ticket-sellers will see less custom and airport operators, lower footfall. Many firms
have cut output and laid off thousands of workers.

The Airline-industrial Complex Is Vast.

➢ Last year 4.5bn passengers buckled up for take-off. Over 100,000 commercial
flights a day filled the skies.
➢ These journeys supported 10m jobs directly, according to the Air Transport Action
Group, a trade body: 6m at airports, including staff of shops and cafés, luggage
handlers, cooks of in-flight meals and the like; 2.7m airline workers; and 1.2m
people in plane making.
➢ In 2019 they helped generate revenues of $170bn for the world’s airports and
$838bn for airlines. Airbus and Boeing, the duopoly atop the aircraft supply chain,
had sales of $100bn between them. For the aerospace industry as a whole they were
perhaps $600bn.
➢ Add travel firms like Booking Holdings, Expedia and Trip.com, and you get annual
revenues of some $1.3trn in normal times for listed firms alone, supporting roughly
as much in market capitalisation before covid-19—and rising.
Kalika Bansal, PhD, NMIMS University, Mumbai
 Crude Oil Prices turning negative- Another
example of Demand-Supply Framework at work.
• On April 20th oil was less than worthless. The price of the benchmark West
Texas Intermediate (WTI) futures contract crashed into negative territory for
the first time in its history.
• The slide is the result of both global phenomena and local conditions.
Around the world the supply of oil far exceeds demand for it, as
governments try to limit the spread of covid-19. Citizens are no longer
driving to work; planes remain on the ground. Steps to restrain production
and support prices have been grand in scope but so far limited in effect.
• On April 12th the Organisation of the Petroleum Exporting Countries (OPEC)
and its allies agreed to cut 9.7m barrels a day from the market in May and
June, a record and equivalent to about 10% of global supply. However, even
assuming that members of the alliance stick to the deal, which history
suggests they may not, demand is already plunging further.
• Citigroup, a bank, says that global supply needs to fall by 10m barrels a day,
12% of the total, for tanks not to spill over. Prices in parts of the world may
fall below $10, says Goldman Sachs, another bank—or turn negative, as
producers pay to have their oil taken away rather than shut in wells.

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Elasticity

Kalika Bansal, PhD, NMIMS University, Mumbai

Price Elasticity of Demand

• Measures buyers’ responsiveness to price changes

• Elastic demand
•Sensitive to price changes
•Large change in quantity
• Inelastic demand
•Insensitive to price changes
•Small change in quantity

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Price Elasticity of Demand Formula
• Formula for price elasticity of demand

percentage change in quantity

demanded of product X
Ed =
percentage change in price
of product X

Kalika Bansal, PhD, NMIMS University, Mumbai

6-7
 Price Elasticity of Demand Formula
• Use the midpoint formula
• Ensures consistent results

Change in quantity Change in price

Ed = ÷
Sum of quantities/2 Sum of prices/2

Kalika Bansal, PhD, NMIMS University, Mumbai

6-8
Price Elasticity of Demand Formula

• Use percentages
•Unit free measure
•Compare elasticities across products
• Eliminate the minus sign
•Easier to compare elasticities

Kalika Bansal, PhD, NMIMS University, Mumbai

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Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic
• Ed < 1 demand is inelastic
• Extreme cases
•Ed = 0 demand is perfectly inelastic
•Ed = ∞ demand is perfectly elastic

Kalika Bansal, PhD, NMIMS University, Mumbai

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Extreme Cases

P D1
Perfectly
inelastic
demand
(Ed = 0)

Perfectly inelastic demand

Kalika Bansal, PhD, NMIMS University, Mumbai
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Extreme Cases

D2
Perfectly elastic
demand
(Ed = ∞)

0
Perfectly elastic demand
Kalika Bansal, PhD, NMIMS University, Mumbai
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Total Revenue Test

• Total Revenue = Price X Quantity

• Total Revenue Test
• Inelastic demand
•P and TR move in the same direction
• Elastic demand
•P and TR move in opposite directions

Kalika Bansal, PhD, NMIMS University, Mumbai

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Kalika Bansal, PhD, NMIMS University, Mumbai
 Total Revenue Test
• Lower price and elastic demand
• Blue gain exceeds orange loss

P
$3

a
2

b
1
D1

0 10 20 30 40 Q
Kalika Bansal, PhD, NMIMS University, Mumbai
LO2 6-15
 Total Revenue Test
• Lower price and inelastic demand
• Orange loss exceeds blue gain

P
$4 c

d
1

D2
LO2 0 Kalika Bansal, PhD, NMIMS University, Mumbai
10 20 Q 6-16
 Total Revenue Test
• Lower price and unit elastic demand
• Blue gain equals orange loss

P
$3 e

f
1
D3

0 10 20 30 Q
Kalika Bansal, PhD, NMIMS University, Mumbai
LO2 6-17
 Total Revenue Test

Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total Revenue Test
(1)
Total Quantity of (3) (4) (5)
Tickets Demanded (2) Elasticity Total Revenue Total-Revenue
per Week, Thousands Price per Ticket Coefficient (Ed) (1) X (2) Test

1 $8 ] 5.00 $ 8,000 ] Elastic

2 7 ] 2.60 14,000 Elastic
]
3 6 ] 18,000
1.57 ] Elastic
4 5 ] 20,000
1.00 ] Unit-elastic
5 4 ] 20,000
0.64 ] Inelastic
6 3 18,000
] 0.38 ] Inelastic
7 2 14,000
] 0.20 ] Inelastic
8 1 8,000

Kalika Bansal, PhD, NMIMS University, Mumbai

LO2 6-18
 Elasticity and Total Revenue
$8 Elastic
7 a Ed > 1
6 b
5 c Unit elastic
Price
4 d Ed = 1
3 e Inelastic
2 f Ed < 1
1 g
h D
0 1 2 3 4 5 6 7 8
Quantity demanded

$20
(Thousands of dollars)

18
16
Total revenue

14
12
10
8
6 TR
4
2
LO2
0 Kalika
1 2Bansal,
3 PhD,
4 NMIMS
5 6University,
7 8 Mumbai 6-19
Quantity demanded
Summary of Price Elasticity of Demand
Price Elasticity of Demand: A Summary

Absolute Value Impact on Total Revenue of a:

of Elasticity
Coefficient Demand Is: Description Price Increase Price Decrease
Greater than 1 Elastic or Qd changes by a Total Revenue Total Revenue
(Ed > 1) relatively larger percentage decreases increases
elastic than does price

Equal to 1 Unit or unitary Qd changes by the Total revenue is Total revenue

(Ed = 1) elastic same percentage unchanged is unchanged
as does price

Less than 1 Inelastic or Qd changes by a Total revenue Total revenue

(Ed < 1) relatively smaller increases decreases
inelastic percentage than
does price
Kalika Bansal, PhD, NMIMS University, Mumbai
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Determinants of Price Elasticity of Demand

• Substitutability
•More substitutes, demand is more elastic
• Proportion of income
•Higher proportion of income, demand is
more elastic

Kalika Bansal, PhD, NMIMS University, Mumbai

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Determinants of Price Elasticity of Demand

• Luxuries versus necessities

•Luxury goods, demand is more elastic
• Time
•More time available, demand is more
elastic

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Price Elasticity of Demand
Selected Price Elasticities of Demand
Price Elasticity of Price Elasticity of
Product or Service Demand (Ed) Product or Service Demand (Ed)
Newspapers .10 Milk .63
Electricity (household) .13 Household appliances .63
Bread .15 Liquor .70
MLB Tickets .23 Movies .87
Telephone Service .26 Beer .90
Cigarettes .25 Shoes .91
Sugar .30 Motor vehicles 1.14
Medical Care .31 Beef 1.27
Eggs .32 China, glassware 1.54
Legal Services .37 Residential land 1.60
Automobile repair .40 Restaurant meals 2.27
Clothing .49 Lamb and mutton 2.65
Gasoline .60 Fresh peas 2.83
Kalika Bansal, PhD, NMIMS University, Mumbai
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Applications of Price Elasticity of Demand

• Large crop yields

•Inelastic demand, lower total revenue
• Excise taxes
•Inelastic demand, more total revenue
• Decriminalization of illegal drugs
•Inelastic demand, more total revenue

Kalika Bansal, PhD, NMIMS University, Mumbai

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Price Elasticity of Supply

• Measures sellers’ responsiveness to price changes

• Elastic supply, producers are responsive to price changes
• Inelastic supply, producers are not as responsive to price changes

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Price Elasticity of Supply
• Formula for price elasticity of supply

percentage change in quantity

supplied of Product X
Es =
percentage change in price
of product X

Kalika Bansal, PhD, NMIMS University, Mumbai

6-26
Price Elasticity of Supply

• Es > 1 supply is elastic

• Es = 1 supply is unit elastic
• Es < 1 supply is inelastic
• Additionally,
•Es = 0 supply is perfectly inelastic

Kalika Bansal, PhD, NMIMS University, Mumbai

6-27
Price Elasticity of Supply

• Time is primary determinant of elasticity of supply

• Time periods considered
•Immediate market period
•Short run
•Long run

Kalika Bansal, PhD, NMIMS University, Mumbai

6-28
 Es: The Immediate Market Period
• Perfectly inelastic supply

P
Sm

Pm

P0
D2
D1
Q0 Q
Kalika Bansal, PhD, NMIMS University, Mumbai
6-29
 The Short Run
• Short run supply is more elastic than in the immediate market period

P
Ss

Ps

P0
D2
D1
Q0 Qs
Kalika Bansal, PhD, NMIMS University, Mumbai Q 6-30
 The Long Run
• Long run supply is even more elastic than in the short run

SL

Pl

P0
D2
D1
Q Q
Kalika Bansal, PhD,0NMIMS University,
l Mumbai
Q
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Applications of Elasticity of Supply

• Antiques
•Inelastic supply
• Reproductions
•More elastic supply
• Volatile gold prices
•Inelastic supply

Kalika Bansal, PhD, NMIMS University, Mumbai

6-32
 Cross Elasticity of Demand

• Formula for cross elasticity of demand

percentage change in quantity

Ex,y = demanded of product X
percentage change in price
of product Y

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Cross Elasticity of Demand
• Measures responsiveness of purchases of one good to change in the
price of another good
• Substitute goods if elasticity is positive
• Complement goods if elasticity is negative
• Independent goods if elasticity is 0

Kalika Bansal, PhD, NMIMS University, Mumbai

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Cross Elasticity of Demand

• Applications of cross elasticity of demand

• Should a company change a price?
• Should the government allow a merger?

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Income Elasticity of Demand
• Formula for income elasticity of demand

percentage change in quantity demanded

Ei =
percentage change in income

Kalika Bansal, PhD, NMIMS University, Mumbai

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Income Elasticity of Demand

• Measures responsiveness of buyers to changes in their income

• Normal goods if elasticity is positive
• Inferior goods if elasticity is negative

Kalika Bansal, PhD, NMIMS University, Mumbai

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Income Elasticity Insights

• High income elasticities

•Most affected by a recession
• Low or negative income elasticity
•Not affected that much by a recession

Kalika Bansal, PhD, NMIMS University, Mumbai

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 Cross and Income Elasticities
Cross and Income Elasticities of Demand

Value of Coefficient Description Type of Good(s)

Cross elasticity: Quantity demanded of W changes in same Substitutes
Positive (Ewz > 0) direction as change in price of Z

Negative (Exy < 0) Quantity demanded of X changes in opposite Complements

direction from change in price of Y

Income elasticity: Quantity demanded of the product changes in Normal or superior

Positive (Ei >0) same direction as change in income

Negative (Ei<0) Quantity demanded of the product changes in Inferior

opposite direction from change in income

Kalika Bansal, PhD, NMIMS University, Mumbai

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Elasticity and Pricing Power

• Charge different prices to different buyers based on price elasticities

• Business air travelers
• Children discounts
• College tuition

Kalika Bansal, PhD, NMIMS University, Mumbai

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➢ Wal-Mart’s revenues fall during good times whereas Target’s rise during
good times. Consumers view purchases at Wal-Mart as inferior goods
whereas purchases at Target are normal goods. A well-established cross-
sectional fact is that Wal-Mart’s shoppers have relatively low incomes
compared to, say, Target’s shoppers.
➢ Demand on Valentine's Day is what economists call highly price inelastic,
meaning that large increases in the price have only a small dampening
effect on demand. Very few men will dare show up without the requisite
red roses merely because a dozen of them now cost three or four times
what they do on an ordinary day. Likewise, the drive-thru is not a very
good substitute for candles, wine, so restaurants charge accordingly. Even
so, they don't charge a market clearing price; in New York, it is thought
well to book at least a few months in advance if you want a decent
restaurant, longer for a really good one.

Kalika Bansal, PhD, NMIMS University, Mumbai

Kalika Bansal, PhD, NMIMS University, Mumbai
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