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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

Negative according to the law of demand.


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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50

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

20

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

Answer: Lower 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.

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

Answer
Calls would increase by 25.92 percent!

EQX , PX

%QX = 8.64 = %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

Answer
AT&Ts demand would fall by 36.24 percent!

EQX , PY

%QX = 9.06 = %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

P EQX , PX = X X QX Own Price Elasticity

EQX , PY

PY = Y QX

Cross Price Elasticity

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