Managerial Economics

SEEG5013
Chapter 3
Datuk Prof. Mohd Yusof Kasim

Demand Analysis
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
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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?

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.

FIGURE 3.1 Demand for SUV (Ford

Explorer) as Gasoline Price Doubled

Downward Slope to the Demand Curve

Economists presume consumers are maximizing their utility
This is used to derive a demand curve from utility maximization

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.

Downward Slope to the Demand Curve

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.

FIGURE 3.2 Consumption Choice on a

Business Trip

Downward Slope to the Demand Curve

targeting, switching, and positioning

marketing efforts such as loyalty programs affect
demand.

The Price Elasticity of Demand

Elasticity is measure of responsiveness or
sensitivity
Beware of using slopes
price
per
bu.

price
per
bu.

bushels

Slopes
change
with a
change in
units of
measure

hundred tons

Price Elasticity
ED = % change in Q / % change in P

Shortcut notation: ED = %Q / %P = Q / P Base P / Base

Q.
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

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.

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

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

FIGURE 3.4 Perfectly Elastic and

Inelastic Demand Curves

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?

( Figure 3.5)

Another Way to
Remember

Elastic

Unit Elastic
A

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

Inelastic
B
Q

TR

FIGURE 3.5 Price Elasticity over

Demand Function

FIGURE 3.5 Price Elasticity over

Demand Function

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
For a perfectly elastic demand, ED = -B.
Hence, MR = P.
If ED = -2, then MR = .5P, or is half of the
price.

Empirical Price Elasticities

Selections from Table 3.4

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 -1.4

Furniture -3.04
Glassware & China -1.2
Household appliances -.64
Flights to Europe -1.25
Shoes -.73
Soybean meal -1.65
Telephones -.10
Tires -.60
Tobacco products -.46
Tomatoes -2.22
Wool -1.32

Factors Affecting the Elasticity of Demand

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

The percentage of the consumer's budget

larger proportion of the budget, more elastic

Positioning as income superior

Products that are viewed as superior goods with large income
elasticities, tend to be more elastic. (Clash for Clunkers lowered prices and helped
sales of larger cars more than tiny ones)

The longer the time period of adjustment

more time, generally, more elastic
Predictable end-of-season discounts more elastic than unexpected
midnight madness sales.

Income Elasticity
EY = %Q/ %Y = (Q/ Y)( Y/Q)

point income

EY = Q/ [(Q1 + Q2)/2] arc income

Y/ [(Y1 + Y2)/2] elasticity

arc income elasticity: 7

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%

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 Ford Focus
3. Expenditures on 2005 Ford Focus 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?

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.

Advertising Elasticity
EA = %Q/ %ADV = (Q/ ADV)( ADV/Q)
If the Advertising elasticity is .60, then a 1%
increase in Advertising Expenditures increases
the quantity of goods sold by .60%.

Cross Price Elasticities

Ecross = %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

Antitrust & Cross Price Elasticities

Whether a product is a monopoly or in a
larger industry is dependent on the
closeness of the substitutes
DuPonts cellophane was at first viewed as
a monopoly. Economists showed that the
cross price elasticity with other products
such as aluminum foil, waxed paper, and
other flexible wrapping paper was Positive,
the large, DuPont showed its cellophane
was not a monopoly in this larger market.

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) + Ecross(% 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. The forecast
for period 2 is:
Q2 = Q1[ 1 + ED(% P) + EY(% Y) + Ecross(% PR)

Example: Combined Effects of Elasticities

Toro has a price elasticity of -2 for snow blowers
Toro snow blowers 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 + Ecross %PR = -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?

Example: Combined Effects of Elasticities

A: Total revenue will rise slightly (about + .5%), as the
price rises 3% and the quantity of snow- blowers sold
falls 2.5%.