DEMAND ANALYSIS

Overview of Chapter 3

Demand Relationships The Price Elasticity of Demand

Arc and point price elasticity Elasticity and revenue relationships Why some products are inelastic and others are elastic

Income Elasticities Cross Elasticities of Demand Combined Effects of Elasticities

2008 Thomson * South-Western
Slide 1

Health Care & Cigarettes

Raising cigarette taxes reduces smoking
In Canada, over $4 for a pack of cigarettes reduced smoking 38% in a decade

But cigarette taxes also helps fund health care initiatives

The issue then, should we find a tax rate that maximizes tax revenues? Or a tax rate that reduces smoking?
Slide 2

Demand Analysis
An important contributor to firm risk arises from sudden shifts in demand for the product or service. Demand analysis serves two managerial objectives:
(1) it provides the insights necessary for effective management of demand, and (2) it aids in forecasting sales and revenues.
Slide 3

Downward Slope to the Demand Curve

Economists presume consumers are maximizing their utility This is used to derive a demand curve from utility maximization Reasons that price and quantity are negatively related include:

income effect -- as the price of a good declines, the

consumer can purchase more of all goods since his or her real income increased. So as the price falls, we typically buy more.

substitution effect -- as the price declines, the good

becomes relatively cheaper. A rational consumer maximizes satisfaction by reorganizing consumption until the marginal utility in each good per dollar is equal. We buy more.
Slide 4

Uo

Foo d

PE

Indifference Curves to U1 derive demand We can "derive" a demand curve graphically from maximization of utility a c b subject to a budget 2 constraint. Suppose the price of entertainment 1 Entertainment falls from line 1 to line 2 We tend to buy more from (i) the Income Effect and (ii) the Substitution Effect. demand From a to b, is the Entertainment substitution effect. From b to c is the income effect.
Slide 5

The Price Elasticity of Demand

Elasticity is measure of responsiveness or sensitivity Beware of using Slopes
price per bu. price per bu. Slopes change with a change in units of measure

bushels

hundred tons
Slide 6

Price Elasticity
ED = % change in Q / % change in P Shortcut notation: ED = %Q / %P
A percentage change from 100 to 150 is 50% A percentage change from 150 to 100 is -33% For arc price elasticities, we use the average as the base,
as in 100 to 150 is +50/125 = 40%, and 150 to 100 is -40%

Arc Price Elasticity -- averages over the two points

Average quantity

ED = Q/ [(Q1 + Q2)/2] P/ [(P1 + P2)/2]

Average price

arc price elasticity D

Slide 7

Arc Price Elasticity Example

Q = 1000 when the price is $10 Q= 1200 when the price is reduced to $6 Find the arc price elasticity Solution: ED = %Q/ %P = +200/1100 -4/8 or -.3636. The answer is a number. A 1% increase in price reduces quantity by .36 percent.
Slide 8

Point Price Elasticity Example

Need a demand curve or demand function to find the price elasticity at a point.

ED = %Q/ %P =( Q/P)(P/Q)
If Q = 500 - 5P, find the point price elasticity at P = 30; P = 50; and P = 80
1. ED = ( Q/P)(P/Q) = - 5(30/350) = - .43 2. ED = ( Q/P)(P/Q) = - 5(50/250) = - 1.0 3. ED = ( Q/P)(P/Q) = - 5(80/100) = - 4.0
Slide 9

Price Elasticity
(both point price and arc elasticity )
If ED = -1, unit elastic If ED > -1, inelastic, e.g., - 0.43 If ED < -1, elastic, e.g., -4.0
price

elastic region
unit elastic

Straight line demand curve example

inelastic region quantity

Slide 10

Two Extreme Examples

( Figure 3. 1)
D D D

Perfectly Elastic | ED| = B and Perfectly Inelastic |ED | = 0

Slide 11

TR and Price Elasticities

If you raise price, does TR rise? Suppose demand is elastic, and raise price. TR = PQ, so, %TR = %P+ %Q If elastic, P , but Q a lot Hence TR FALLS !!! Suppose demand is inelastic, and we decide to raise price. What happens to TR and TC and profit?
Slide 12

( Figure 3.2)

Another Way to Remember

A

Elastic

Unit Elastic
Inelastic B Q

Linear demand curve TR on other curve Look at arrows to see movement in TR

A. Increasing price in the inelastic region raises revenue B. Increasing price in the elastic region lowers revenue

TR

Q
Slide 13

MR and Elasticity
Marginal revenue is TR / Q To sell more, often price must decline, so MR is often less than the price. MR = P ( 1 + 1/ED ) equation 3.7 on page 90 For a perfectly elastic demand, ED = -B. Hence, MR = P. If ED = -2, then MR = .5P, or is half of the price.
Slide 14

1979 Deregulation of Airfares

Prices declined after deregulation And passengers increased Also total revenue increased What does this imply about the price elasticity of air travel?
It must be that air travel was elastic, as a price decrease after deregulation led to greater total revenue for the airlines.
Slide 15

Determinants of the Price Elasticity

The availability and the closeness of substitutes
more substitutes, more elastic

The more durable is the product

Durable goods are more elastic than non-durables

The percentage of the budget

larger proportion of the budget, more elastic

The longer the time period permitted

more time, generally, more elastic consider examples of business travel versus vacation travel for all three above.
Slide 16

Empirical Price Elasticities

Table 3.5
Apparel (whole market) -1.1 Apparel (one firm) -4.1 Beer -.84 Wine -.55 Liquor -.50 Regular coffee -.16 Instant coffee -.36 Adult visits to dentist men -.65 Women -.78 Children visit to dentist -1.4 Furniture -3.04 Glassware & China -1.2 School lunches -.47 Flights to Europe -1.25 Shoes -.73 Soybean meal -1.65 Telephones -.10 Tires -.60 Tobacco -.46 Tomatoes -2.22 Wool -1.32
Slide 17

Free Trade and Price Elasticities

NAFTA (North American Free Trade Agreement) and Europe having a common currency in the Euro are examples of greater freedom in trade What does that do to price elasticities? With more substitutes, we expect that products become More Elastic Consumers gain as firms are less able to raise their prices, but firm face stiffer competition
Slide 18

Income Elasticity
EY = %Q/ %Y = (Q/ Y)( Y/Q)
arc income elasticity:
suppose dollar quantity of food expenditures of families of $20,000 is $5,200; and food expenditures rises to $6,760 for families earning $30,000. Find the income elasticity of food %Q/ %Y = (1560/5980)(10,000/25,000) = .652 With a 1% increase in income, food purchases rise .652%
Slide 19

point income

EY = Q/ [(Q1 + Q2)/2] arc income Y/ [(Y1 + Y2)/2] elasticity

Income Elasticity Definitions

If EY >0, then it is a normal or income superior good
some goods are Luxuries: EY > 1 with a high income elasticity some goods are Necessities: EY < 1 with a low income elasticity

If EY is negative, then its an inferior good Consider these examples:

1. Expenditures on new automobiles 2. Expenditures on new Chevrolets 3. Expenditures on 1996 Chevy Cavaliers with 150,000 miles Which of the above is likely to have the largest income elasticity? Which of the above might have a negative income elasticity?
Slide 20

Point Income Elasticity Problem

Suppose the demand function is:

Q = 10 - 2P + 3Y
find the income and price elasticities at a price of P = 2, and income Y = 10 So: Q = 10 -2(2) + 3(10) = 36
EY = ( Q/ Y)( Y/Q) = 3( 10/ 36) = .833 ED = ( Q/ P)(P/Q) = -2(2/ 36) = -.111

Characterize this demand curve, which

means describe them using elasticity terms.
Slide 21

Cross Price Elasticities

EX = %QA / %PB = (QA/ PB)(PB /QA)
Substitutes have positive cross price elasticities: Butter & Margarine Complements have negative cross price elasticities: DVD machines and the rental price of DVDs at Blockbuster
When the cross price elasticity is zero or insignificant, the products are not related
Slide 22

PROBLEM: Find the point price elasticity, the point income elasticity, and the point cross-price elasticity at P=10, Y=20, and Ps=9, if the demand function were estimated to be:

QD = 90 - 8P + 2Y + 2Ps
Is the demand for this product elastic or inelastic? Is it a luxury or a necessity? Does this product have a close substitute or complement? Find the point elasticities of demand.

Slide 23

Answer
First find the quantity at these prices and income: QD = 90 - 8P + 2Y + 2Ps = 90 -810 + 220 + 29 =90 -80 +40 +18 = 68 ED = (Q/P)(P/Q) = (-8)(10/68)= -1.17 which is elastic EY = (Q/ Y)(Y/Q) = (2)(20/68) = +.59 which is a normal good, but a necessity EX = (QA/ PB)(PB /QA) = (2)(9/68) = +.26 which is a mild substitute
Slide 24

Combined Effect of Demand Elasticities

Most managers find that prices and income change every year. The combined effect of several changes are additive. %Q = ED(% P) + EY(% Y) + EX(% PR)
where P is price, Y is income, and PR is the price of a related good.

If you knew the price, income, and cross price elasticities, then you can forecast the percentage changes in quantity.
Slide 25

Example: Combined Effects of Elasticities

Toro has a price elasticity of -2 for snow-throwers Toro snow throwers have an income elasticity of 1.5 The cross price elasticity with professional snow removal for residential properties is +.50

What will happen to the quantity sold if you raise price 3%, income rises 2%, and professional snow removal companies raises its price 1%?
%Q = EP %P +EY %Y + EX %Px = -2 3% + 1.5 2% +.50 1% = -6% + 3% + .5% %Q = -2.5%. We expect sales to decline 2.5%. Q: Will Total Revenue for your product rise or fall? A: Total revenue will rise slightly (about + .5%), as the price rises 3% and the quantity of snow-throwers sold falls 2.5%.Slide 26