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7/24/2019 ME- Unit-2 Elasticity & Its Applications
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Elasticity and ItsApplication
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Learning Objectives
By the end of these sessions, students shouldunderstand:
The types of the elasticity of demand and its
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
app ca on n us ness ec s on The types of the elasticity of supply and its
application in business decision
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Question: If business want to generate more
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
of product or decrease the price of
product?
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Elasticity . . .
is a measure of how much buyers
and sellers respond to changes in market
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
con ons
allows us to analyze supply and
demand with greater precision.
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Recall the law of demand, which shows the inverse relationbetween price of a commodity and its quantity demanded.
You know that when price of a commodity increases(decreases),
its quantity demanded fall (or rise).
But this knowledge can not answer a simple question that if price
increases by one unit, by what proportion will quantity demanded
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
decrease.
In order to ascertain this proportion, you need to know another
concept, that is elasticity of demand.
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Elasticity of Demand
In fact, why only price? A firm needs to know about the
responsiveness or sensitivity of demand for the commodity itproduces to changes in all the independent variables
(determinants of demand) that influence its demand.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Elasticity of demand measures the degree of responsivenessof the quantity demanded of a commodity to a given change in
any of the determinants of demand.
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Let us now explain the different types of elasticity of
demand:Note here that there can be as many types of elasticities of
demand, as the number of determinants of demand.
However, we would restrict ourselves to only four types of
elasticity, namely price elasticity, income elasticity, cross elasticity
and advertising (or promotional) elasticity.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
As you know that demand is a function of multiple variables and
each of these variables independently affects demand in a
different manner; therefore in order to assess the impact of one
variable, we assume other variables as constant (ceteris paribus).
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Price Elasticity of Demand
Price elasticity of demand is thepercentage change in quantity
demanded iven a ercent chan e in
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
the price.
It is a measure of how much thequantity demanded of a good responds
to a change in the price of that good.
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Computing the Price Elasticity
of DemandThe price elasticity of demand is computed as
the percentage change in the quantitydemanded divided by the percentage change in
price.
P e r c e n ta g e C h a n g e
P e r c e n ta g e C h a n g e
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
P r ic e E la s t ic ity o f D e m a n d =
P e r c e n ta g e C h a n g ein P r ic e
P r ic e E la s t ic ity o f D e m a n d =
P e r c e n ta g e C h a n g ein P r ic e
ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )
Where Q1 = original quantity demanded , Q2 = new quantity demanded
. P1 = initial price level, P2 = new price level.
ep = (Q/Q) / (P/P ) (Q/ P) (P/Q)
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Computing the Price Elasticityof Demand
priceinchangePercentagedemandedquatityinchangePercentagedemandofelasticityPrice =
Example: If the price of an ice cream cone increases
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
from $2.00 to $2.20 and the amount you buy falls from10 to 8 cones then your elasticity of demand would be
calculated as:
210
20
100
00.2
)00.220.2(
10010
)108(=
=
percent
percent
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Determinants of Price Elasticity of Demand
Nature of commodity (i.e. Luxurious and necessity)
Availability of Close Substitutes
Alternative use of the Commodity(i.e. electricity, Bottle of water
Proportion of income spent on the commodity (i.e. Match
box & Salt).
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Definition of the Market (More elastic in more narrow market because it is easy tofind substitute i.e. Ice cream is a narrower category where as food is broad category)
Time Horizon (More elastic in long run i.e. a shift from petrol driven
vehicle to CNG driven one)
Items of Addiction
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Computing the Price Elasticity of
Demand Using the Midpoint Formula
The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless of
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
e rec on o e c ange.
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=SupplyofElasticityPrice
1212
1212
+
+
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Ranges (or degree) of Elasticity
Relatively Inelastic DemandQuantity demanded does not respondstrongly to
price in changes.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Price elasticity of demand is less than one (Ed< 1 ).
More Elastic Demand
Quantity demanded responds strongly to changes in
price.
Price elasticity of demand isgreater than one(Ed> 1 ).
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Ranges (or degree )ofElasticity
Perfectly InelasticQuantity demanded does not respond to pricechanges(Ed= 0).
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
er ec y as c
Quantity demanded changes infinitely with any
change in price (Ed= ).
Unit ElasticQuantity demanded changes by the same
percentage as the price (Ed= 1).
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A Variety of Demand Curves
Because the price elasticity of demandmeasures how much quantity demanded
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
,
to the slope of the demand curve.
Economists classify demand curves
according to their elasticity.
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Perfectly Inelastic Demand- Elasticity equals 0
Price
$5
Demand
1. An
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4
1002. ...leaves the quantity demanded unchanged.
in price...
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Relatively Inelastic Demand(Elasticity is less than
1)
Price
4
$51. A 22%increase
in price...
Demand
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity100902. ...leads to a 11% decrease in quantity.
Calculate the elasticity of demand, using the midpoint
formula.
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=Ep
1212
1212
+
+
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Unit Elastic Demand- Elasticity equals 1
Price
$51. A 22%
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4in price...
Demand
100802. ...leads to a 22% decrease in quantity.
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Elastic Demand
- Elasticity is greater than 1
Price
$51. A 22%
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4in price...
Demand
100502. ...leads to a 67% decrease in quantity.
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Perfectly Elastic Demand- Elasticity equals infinity
Price
1. At any priceabove $4, quantitydemanded is zero.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
Demand$4
2. At exactly $4,consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.Elasticity & its applications
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Elasticity and Total Revenue
Total revenue is the amount paid bybuyers and received by sellers of a good.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
multiple by quantity sold of the same
good.
TR = P x Q
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$4
Price
Elasticity and Total Revenue
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Demand
Quantity
P
0
P xQ = $400(total revenue)
100Q
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Elasticity and Total Revenue
With an relatively inelastic demand curve,an increase in price leads to a decrease in
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
.
Thus, total revenue increases.
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Elasticity and Total Revenue:Relatively Inelastic Demand
PricePrice
An increase in price
from $1 to $3...
leads to an increasein total revenue
from$100 to $240
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
$3
Quantity0 80
Revenue = $240 Demand$1 Demand
Quantity0
Revenue = $100
100
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Elasticity and Total Revenue
With an elastic demand curve, anincrease in the price leads to a
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
is proportionately larger. Thus, total
revenue decreases.
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Elasticity and Total Revenue:Elastic Demand
Price PriceAn increase in price
from $4 to $5...
leads to a decreasein total revenue
from$200 to $100
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Demand
Quantity0
$4
50
Demand
Quantity0
Revenue = $100
$5
20
Revenue = $200
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Income Elasticity ofDemand
Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
consumers income.It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
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Computing Income Elasticity
Income Elasticity
of Demand
Percentage Changein Quantity Demanded
Percentage Changein Income
=
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
ey= (Q2- Q1/Q1) / (Y2- Y1/ Y1)
Where Q1 = original quantity demanded, Q2 = new quantity demanded
Where Y1= initial level of income, Y2 = new level of income
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Income elasticity of demand also has similar degree
of elasticity like price elasticity of demand:
Perfectly Elastic Ey= Relatively Elastic Ey> 1
Unit Elastic Ey= 1
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Relatively Inelastic Ey< 1
Perfectly Inelastic Ey= 0
The value of income elasticity can be either negative or positive,
depending upon nature of product.
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Income Elasticity and types of Goods
-Normal Goods: Higher income raises the
quantity demanded for normal goods such
as, sports cars, mobile, and expensive
foods, etc.
Inferior Goods:Higher income lowers the
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
quantity demanded for inferior goodssuch as, bread , and jawar etc.
Neutral Goods:Higher income does not
affect the quantity demanded for neutral
goods such as, match box, salt, postcard and
needles, etc.Elasticity & its applications
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If a consumers income rises from Rs. 300 to Rs. 350, his
purchase of a good X increases from 25 units per day to 35 units,find income elasticity of demand for X.
Solution:
ey= (Q2- Q1/Q1) / (Y2- Y1/ Y1)
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
= (10/25) / (50/300)
= 0.4 / 0.1666
= 2.4
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Cross Elasticity of DemandThe cross elasticity of demand, which explains theresponsiveness of demand for one good to the change in
price of anothergood (ceteris paribus).
Expressed in ratio form, cross elasticity (eC) is defined as:
Proportionate change in quantity demanded of commodity X
eC =
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
eC= (QX2- QX1/QX1) / (PY2- PY1/ PY1)
Where QX1 = original quantity for commodity X, QX2 = new quantity for commodity X
Where PY1= initial price level of commodity Y, PY
2 = new price level of commodity Y
In case of substitutes good, the value of eC would be positive, and in case of complements,
it would be negative.Elasticit & its a lications
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Class exercise: 1. Consider two goods X and Y. There was no change in price of
X. but its demand was seen to fall from 6000 units to 5500 units. On analysis itwas found that price of another commodity Y has decreased 250 to 225. Find out
the cross elasticity between X and Y and the relationship between the two goods.
2. Consider two goods X and Y. There was no change in price of X, but its
demand increased from 5500 units to 6000 units. On analysis it was found thatprice of another commodity Y had decreased from 250 to 225. Find out the cross
elasticity between X and Y and the relationship between the two goods.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
o ut on- :
eC = (5500-6000/6000) / (225-250/250)
Since elasticity is positive, it concluded that X and Y are substitute.
Solution-2:eC = ( 6000-5500/5500) / (225-250/250)
Since elasticity is negative, it can be concluded hat X and Y are complements.
=(-500/6000) / (-25/250)= -0.08333 / -0.1 = 0.8333
=(500/5500) / (-25/250)= 0.0909 / -0.1 = -0.9090
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Promotional or advertising elasticityPromotional elasticity of demand measures the degree of
responsiveness of demand to a given change in advertising
expenditure (ceteris paribus).
In ratio from ea can be expressed as:
Proportionate change in quantity demanded of commodity XProportionate change in advertising expenditure of X
ea =
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
a=
2-
1 1
2-
1
1
Where Q1 = original quantity demanded, Q2 = new quantity demanded
A1 = initial level of advertising expenditure, A2 = new level of advertising expenditure
Here also degree of elasticity are similar to those discussed in context of price.
When ea > 1, a firm should go for heavy expenditure on advertisement.
When , ea < 1 a firm should not spend too much on advertisement.
As for example, you find advertisements for generators, inverters, etc., but would
not find advertisements for electricity, petrol or diesel.Elasticit & its a lications
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Methods of Measuring Elasticity
1. Ratio (or Percentage) Method:
In ratio method price elasticity of demand is expressed as the
ratio of proportionate change in quantity demanded and
proportionate change in the price of the commodity.
Proportionate change in quantity demanded of commodity X
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Proportionate change in price of X
p
ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )
Where Q1 = original quantity demanded , Q2 = new quantity demanded .P1 = initial price level, P2 = new price level.
ep = (Q/Q) / (P/P ) = (Q/ P) (P/Q)
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2. Arc Elasticity Method
Arc elasticity measures elasticity at the midpointof an arcbetween any two points on a demand curve.
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=Ep
1212
1212
+
+
Where Q1 = original quantity demanded , Q2 = new quantity demanded
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
This method finds particular application when we want to
calculate price elasticity of demand between any two points on the
demand curve.
This method finds wider applications, as it reflects a movementalong a portion (arc) of demand curve.
The basic assumption of this method is that elasticity is the same
over the range of the value of the variables under consideration.
.
P1 = initial price level, P2 = new price level.
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Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones. Q. calculate the elasticity of demand, using the
midpoint formula?.
)/2]P)/[(PP(P)/2]Q)/[(QQ(Q=Ep
1212
1212
+
+
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
32.2
5.9
22
2/)00.220.2()00.220.2(
2/)108(
)108(
=
=
+
+
percent
percent
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Q. Calculate the elasticity of demand, using the
midpoint formula?.
$5
Price
5.00)/2(4.005.00)-(4.00
50)/2(100
50)-(100
ED
+
+=
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Demand is price elastic
4 Demand
Quantity1000 50
-3percent22-
percent67 ==
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Importance of elasticity of demand
1. Determination of price
2. Basis of price discrimination. (eg. Basis on place, time, use etc.)
3. Government policies of taxation (eg. Excise duties).
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
4. To the trade unions.
5. To international trading transactions.
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Price Elasticity of Supply
Price elasticity of supply is thepercentage change in quantity supplied
resultin from a ercent chan e in
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
price.It is a measure of how much the
quantity supplied of a good responds to
a change in the price of that good.
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Computing the Price Elasticity of Supply
Elasticity of Supply =
Percentage Change inQuantity Supplied
Percentage Changein Price
Elasticity of Supply =
Percentage Change inQuantity Supplied
Percentage Changein Price
ES
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Where P = initial price level, P = Change in price level.
Q = initial quantity supplied, Q = Change in quantity supplied.
Elasticity & its applications
ep = (Q2 - Q1 / Q1) / (P2 - P1 / P1 )Where Q1 = original quantity supplied, Q2 = new quantity supplied .
P1 = initial price level, P2 = new price level.
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Firm XYZ supplied 2000 pens at price of Rs. 8 per pen.
When price increases to Rs.10 per pen. The supply of XYZincreases to 3000 pens. Find the elasticity of supply of
pens?
P = Rs. 8, P = Rs. 10 Rs. 8 = Rs. 2
Solution:
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Q = 2000 pens, Q = 3000-2000 = 1000 pens
ES
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Ranges of Elasticity
Perfectly Elastic
ES=
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
ES> 1
Unit Elastic
ES= 1
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Ranges of Elasticity
Relatively Inelastic
ES< 1
P rf l In l i
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
ES= 0
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Perfectly Inelastic Supply
- Elasticity equals 0
Price
$5
Supply
1. An
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4
1002. ...leaves the quantity supplied unchanged.
in price...
Elasticity & its applications
Relatively inelastic Supply (Elasticity is less than 1
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y pp y ( y
Price
4
$51. A 22%increase
in price...
Supply
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity1101002. ...leads to a 10% increase in quantity.
Calculate the elasticity of supply, using the midpoint formula.
)/2]P)/[(PP(P
)/2]Q)/[(QQ(Q=Es
1212
1212
+
+
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Unit Elastic Supply
- Elasticity equals 1
Price
$51. A 22%
Supply
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4in price...
1251002. ...leads to a 22% increase in quantity.
Elasticity & its applications
S
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Elastic Supply
- Elasticity is greater than 1
Price
$51. A 22%
Supply
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
4in price...
2001002. ...leads to a 67% increase in quantity.
Elasticity & its applications
P f tl El ti S l
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Perfectly Elastic Supply
- Elasticity equals infinity
Price
1. At any priceabove $4, quantitysupplied is infinite.
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Quantity
Supply$4
2. At exactly $4,producers will
supply any quantity.
3. At a price below $4,quantity supplied is zero.
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Determinants of Elasticity of Supply
1. Ability of sellers to change the amount of the good they
produce. Beach-front land is inelastic.
Books, cars, or manufactured goods are elastic.
2. Time period: (Market period, Short period-inelastic and Long period-elastic)
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
3. Nature of Production (eg. Art works like painting is inelastic)4. Mobility of factors (immobility has inelastic supply)
5. Availability of input ( greater availability-more elastic)
6. Size of firm and the number of products produced(more-elastic and less- inelastic)
Elasticity & its applications
U li i d S I d i h i 2006 h
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Unlimited Storage Income, determines that in year 2006 the
demand curve for its removable storage media (pen drive) is: P=2000-50Q, where P is the price of a pen drive, and Q is the number
of pen drives sold per month.
1. What price would the company have to charge to sell 20 pen
drives per month?2. If it sets a price of Rs. 500 for a pen drive, how many pen drives
will it sell per month?
arcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Solution:
1). P = 2000 (50 X 20 ) = Rs. 1000
2). 500=2000- 50Q
50Q = 2000-500Q = 1500/50
Q= 30
Elasticity & its applications