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Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

How responsive is variable G to a change in variable S

EG , S

% G = % S

If EG,S > 0, then S and G are directly related. If EG,S < 0, then S and G are inversely related. If EG,S = 0, then S and G are unrelated.

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

An alternative way to measure the elasticity of a function G = f(S) is

EG , S

dG S = dS G

If EG,S > 0, then S and G are directly related. If EG,S < 0, then S and G are inversely related. If EG,S = 0, then S and G are unrelated.

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

EQX , PX %QX = %PX

d

Elastic:

EQX , PX > 1

EQX , PX = 1

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

Price Price D D

Quantity

Perfectly Elastic ( EQ X ,PX = )

Quantity

Perfectly Inelastic ( EQX , PX = 0)

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

Elastic

Increase (a decrease) in price leads to a decrease (an increase) in total revenue.

Inelastic

Increase (a decrease) in price leads to an increase (a decrease) in total revenue.

Unitary

Total revenue is maximized at the point where demand is unitary elastic.

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

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Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

P 100 Elastic 80 60 Inelastic 40 20 800 1200 TR

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For a linear inverse demand function, MR(Q) = a + 2bQ, where b < 0. When

MR > 0, demand is elastic; MR = 0, demand is unit elastic; MR < 0, demand is inelastic.

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Available Substitutes

The more substitutes available for the good, the more elastic the demand.

Time

Demand tends to be more inelastic in the short term than in the long term. Time allows consumers to seek out available substitutes.

Expenditure Share

Goods that comprise a small share of consumers budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

EQX , PY %QX = %PY

d

If EQX,PY > 0, then X and Y are substitutes. If EQX,PY < 0, then X and Y are complements.

Income Elasticity

EQX , M %QX = %M

d

If EQX,M > 0, then X is a normal good. If EQX,M < 0, then X is a inferior good.

Uses of Elasticities

Pricing. Managing cash flows. Impact of changes in competitors prices. Impact of economic booms and recessions. Impact of advertising campaigns. And lots more!

According to an FTC Report by Michael Ward, AT&Ts own price elasticity of demand for long distance services is -8.64. AT&T needs to boost revenues in order to meet its marketing goals. To accomplish this goal, should AT&T raise or lower its price?

Since demand is elastic, a reduction in price will increase quantity demanded by a greater percentage than the price decline, resulting in more revenues for AT&T.

If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T?

Answer

Calls would increase by 25.92 percent!

EQX , PX

d

d

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

According to an FTC Report by Michael Ward, AT&Ts cross price elasticity of demand for long distance services is 9.06. If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?

Answer

AT&Ts demand would fall by 36.24 percent!

EQX , PY

d

d

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

Mathematical representations of demand curves. Example:

QX = 10 2 PX + 3PY 2 M

d

Law of demand holds (coefficient of PX is negative). X and Y are substitutes (coefficient of PY is positive). X is an inferior good (coefficient of M is negative).

General Linear Demand Function and Elasticities:

QX = 0 + X PX + Y PY + M M + H H

d

EQX , PY

PY = Y QX

Qd = 10 - 2P. Own-Price Elasticity: (-2)P/Q. If P=1, Q=8 (since 10 - 2 = 8). Own price elasticity at P=1, Q=8: (-2)(1)/8= - 0.25.

Conclusion

Elasticities are tools you can use to quantify the impact of changes in prices, income, and advertising on sales and revenues. Given market or survey data, regression analysis can be used to estimate:

Demand functions. Elasticities. A host of other things, including cost functions.

Managers can quantify the impact of changes in prices, income, advertising, etc.

Michael R. Baye, Managerial Economics and Business Strategy, 6e. The McGraw-Hill Companies, Inc., 2008

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