Managerial Economics & Overview

Business Strategy
I. The Elasticity Concept
Chapter 3 Own Price Elasticity
Elasticity and Total Revenue
Quantitative Demand Analysis Cross-Price Elasticity
Income Elasticity
II. Demand Functions
Linear
Log-Linear
III. Regression Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Own Price Elasticity of

The Elasticity Concept
Demand
d
How responsive is variable G to a change %QX
EQX , PX =
in variable S %PX
% G Negative according to the law of demand
EG ,S =
% S
Elastic: EQ X , PX > 1
+ S and G are directly related
Inelastic: EQ X , PX < 1
- S and G are inversely related
Unitary: EQX , PX = 1

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Perfectly Elastic & Elasticity Calculation

Inelastic Demand
Price Price
Suppose in the Lincoln Market, at a price of
D
$1.00 per gallon, 90 (thousand gallons) per
week are sold. Some world event happens
D
(a war) that causes price to rise to $1.25 per
gallon. Weekly sales fall to 88 (thousand
Quantity
gallons) per week. What is the price
Quantity
elasticity of demand?
Perfectly Elastic Perfectly Inelastic

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

1
 Own-Price Elasticity
Elasticity Calculation
and Total Revenue
From the definition of own price elasticity : Elastic
% change in P/ % change in Q, we can Increase (a decrease) in price leads to a decrease (an
operationalize this as by finding the average arc increase) in total revenue.
price elasticity:
E =( Q2-Q1/ P2-P1) x ( P2+P1/ Q2+Q1) so Inelastic
Increase (a decrease) in price leads to an increase (a
E = (88-90/1.25-1) x (1.25+1/88+90)
decrease) in total revenue.
E = -2/.25 x 2.25/178 = - 0.102
which is relatively inelastic.
Unitary
Total revenue is maximized at the point where demand
is unitary elastic.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Elasticity, TR, and Linear Factors Affecting

Demand Own Price Elasticity
Price Available Substitutes
The more substitutes available for the good, the more elastic
10 the demand.
Elastic
8 Time
Demand tends to be more inelastic in the short term than in
6 the long term.
4 Inelastic Time allows consumers to seek out available substitutes.
Expenditure Share
2 Goods that comprise a small share of consumers budgets
D tend to be more inelastic than goods for which consumers
1 2 3 4 5 spend a large portion of their incomes.
Quantity

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Cross Price Elasticity of

Income Elasticity
Demand
d
% QX
EQX , PY = % QX
d
% PY EQ X , M =
% M
+ Substitutes
+ Normal Good
- Complements - Inferior Good

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

2
 Example 1: Pricing and Cash
Flows Answer: Lower price!
According to an FTC Report by Michael
Since demand is elastic, a reduction in price
Ward, AT&Ts own price elasticity of
will increase quantity demanded by a
demand for long distance services is -8.64.
greater percentage than the price decline,
AT&T needs to boost revenues in order to resulting in more revenues for AT&T.
meet its marketing goals.
To accomplish this goal, should AT&T
raise or lower its price?

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Example 2: Quantifying the Answer

Change Calls would increase by 25.92 percent!
d
If AT&T lowered price by 3 percent, what % QX
EQX , PX = 8.64 =
would happen to the volume of long % PX
distance telephone calls routed through d
AT&T? % QX
8.64 =
3%
3% ( 8.64 ) = %QX
d

d
%QX = 25.92%
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Example 3: Impact of a change Answer

in a competitors price AT&Ts demand would fall by 36.24 percent!

According to an FTC Report by Michael % Q X

d

Ward, AT&Ts cross price elasticity of EQ X , PY = 9.06 =

%PY
demand for long distance services is 9.06.
d
If competitors reduced their prices by 4 % Q X
9.06 =
percent, what would happen to the demand 4%
for AT&T services? 4% 9.06 = %Q X
d

d
%Q X = 36.24%

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

3
 Demand Functions Specific Demand Functions
Mathematical representations of demand curves
Example: Linear Demand
d
Q X = 10 2 PX + 3PY 2 M d
Q X = 0 + X PX + Y PY + M M + H H
X and Y are substitutes (coefficient of PY is
PX PY M
positive) EQ X , PX = X EQX , PY = Y
QX
EQX ,M = M
QX QX
X is an inferior good (coefficient of M is Own Price Cross Price Income
negative) Elasticity Elasticity Elasticity

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Example of Linear Demand Log-Linear Demand

ln Q X d = 0 + X ln PX + Y ln PY + M ln M + H ln H
Qd = 10 - 2P
Own-Price Elasticity: (-2)P/Q
If P=1, Q=8 (since 10 - 2 = 8)
Own Price Elasticity : X
Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25 Cross Price Elasticity : Y
Income Elasticity : M

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Example of Log-Linear P
Demand P

ln Qd = 10 - 2 ln P
Own Price Elasticity: -2

D D

Q Q
Linear Log Linear

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

4
 Regression Analysis An Example
Used to estimate demand functions
Important terminology Use a spreadsheet to estimate log-linear
Least Squares Regression: Y = a + bX + e demand
Confidence Intervals
t-statistic
R-square or Coefficient of Determination
F-statistic ln Qx = 0 + x ln Px + e

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Summary Output Interpreting the Output

Regression Statistics
Multiple R 0.41
Estimated demand function:
R Square 0.17
Adjusted R Square 0.15
ln Qx = 7.58 - 0.84 lnPx
Standard Error 0.68
Observations 41.00
Own price elasticity: -0.84 (inelastic)
ANOVA How good is our estimate?
df SS MS F Significance F
Regression 1.00 3.65 3.65 7.85 0.01 t-statistics of 5.29 and -2.80 indicate that the estimated
Residual 39.00 18.13 0.46
Total 40.00 21.78 coefficients are statistically different from zero
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% R-square of .17 indicates we explained only 17 percent
Intercept 7.58 1.43 5.29 0.000005 4.68 10.48 of the variation
ln(P) -0.84 0.30 -2.80 0.007868 -1.44 -0.23
F-statistic significant at the 1 percent level.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Summary
Elasticities are tools you can use to quantify the impact
Sample Exam Problem
of changes in prices, income, and advertising on sales
and revenues. Variable Coefficient S. Error t-stat
Given market or survey data, regression analysis can be
Constant 100 5.00 ?
used to estimate:
Demand functions P -2.50 ? 4.0
Elasticities PY -1.20 0.5 ?
A host of other things, including cost functions M 0.10 ? 2.5
Managers can quantify the impact of changes in prices,
income, advertising, etc.
R2 = .75 # of Observations = 200

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

5
 Sample Exam Problem Sample Exam Problem
Fill in the table and assuming the null Variable Coefficient S. Error t-stat
hypothesis is that the coefficient is zero in Constant 100 5.00 20.0
each case. P -2.50 0.625 -4.0
PY -1.20 0.5 -2.4
Find the price elasticity of demand assuming M 0.10 0.04 2.5
average income is $2000, P=$100 and PY is
$5. Will revenue fall or rise is price is
R2 = .75 # of Observations = 200
lowered?

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Sample Exam Problem Sample Exam Problem

Q = 100 2.5P 1.2 PY +.1M demand fn. Given the demand curve we just calculated,
Q = 100 2.5P 1.2*5 + .1*2000 what price maximizes total revenue? What
Q = 294 2.5P demand curve is elasticity at that price?
We have Q = 294 2.5P and TR = Q*P so
E = -2.5*P/Q so P = 100 implies Q = 44 TR = (294 2.5P)P = 294P P2
E = -250/44 = -5.68 so highly elastic dTR/dP = 294-5P = 0 or P = $58.8 and Q =
147 so E = -2.5* (58.8/147) = -1
Lower price and revenue will rise.
Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

Sample Exam Problem Sample Exam Problem

Marginal revenue by definition is dTR/dQ. From previous slide: Q = 294 2.5P
MR >0 implies elastic demand Solve for P in terms of Q:
MR< 0 implies inelastic demand 2.5P = 294 Q or
MR=0 implies unitary elastic demand P = 117.6 0.4Q .
The demand cure is Q = f(P) but we need TR(Q) = P*Q = (117.6-0.4Q)Q
P = g(Q) or inverse demand curve to obtain MR = dTR/dQ = 117.6 0.8Q
the MR curve (to find dTR/dQ)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002 Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002

6
 Sample Exam Problem
By definition, MR = 0 implies we have
maximized total revenue. Solving:
117.6 0.8Q = 0 implies Q = 147
Substitute into inverse demand curve:
P = 117.6 0.4*147 so P = $58.8
Just like a couple of slides back. Note, we
checked that E=1 at that price.

Michael R. Baye, Managerial Economics and Business Strategy, 4e. The McGraw-Hill Companies, Inc. , 2002