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# Managerial Economics & Business Strategy Chapter 3

## Quantitative Demand Analysis

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

## The Elasticity Concept

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

## The Elasticity Concept Using Calculus

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

## Own Price Elasticity of Demand

EQX , PX %QX = %PX
d

Elastic:

EQX , PX > 1

## Inelastic: EQX , PX < 1 Unitary:

EQX , PX = 1

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

## Perfectly Elastic & Inelastic Demand

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

## Own-Price Elasticity and Total Revenue

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

## Elasticity, Total Revenue and Linear Demand

P 100 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 80 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 80 60 1200 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 80 60 40 800 1200 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 80 60 40 20 800 1200 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 Elastic 80 60 40 20 800 1200 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 Elastic 80 60 Inelastic 40 20 800 1200 TR

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

## Elasticity, Total Revenue and Linear Demand

P 100 Elastic 80 60 Inelastic 40 20 800 Unit elastic 1200 TR Unit elastic

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

## Demand, Marginal Revenue (MR) and Elasticity

P 100 Elastic 80 60 Inelastic 40 20 Unit elastic

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.

10

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40 MR

50

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

## Factors Affecting Own Price Elasticity

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.

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

## Cross Price Elasticity of Demand

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.

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

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.

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

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!

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

## Example 1: Pricing and Cash Flows

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?

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

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.

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

## Example 2: Quantifying the Change

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

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

Calls would increase by 25.92 percent!

EQX , PX

d

## %QX 8.64 = 3% d 3% ( 8.64 ) = %QX %QX = 25.92%

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

## Example 3: Impact of a change in a competitors price

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?

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

AT&Ts demand would fall by 36.24 percent!

EQX , PY

d

## %QX 9.06 = 4% d 4% 9.06 = %QX %QX = 36.24%

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

## Interpreting Demand Functions

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).

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

## Linear Demand Functions and Elasticities

General Linear Demand Function and Elasticities:

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

EQX , PY

PY = Y QX

## M EQX , M = M QX Income Elasticity

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

## Example of Linear Demand

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.

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

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