DEMAND ANALYSIS

Overview of Chapter 3

Demand Relationships
Demand Elasticities
Income Elasticities
Cross Elasticities of Demand
Combined Effects of Elasticities

2005 South-Western Publishing

Slide 1

Health Care & Cigarettes

Raising cigarette taxes reduces smoking
In Canada, $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

DemandAnalysis
Animportantcontributortofirmriskarises
fromsuddenshiftsindemandfortheproduct
orservice.
Demandanalysisservestwomanagerial
objectives:
(1)itprovidestheinsightsnecessaryfor
effectivemanagementofdemand,and
(2)itaidsinforecastingsalesandrevenues.
Slide 3

Demand Curves
Individual
Demand Curve

$/Q

the greatest quantity

of a good demanded
at each price the
consumers are willing
to buy, holding other
influences constant

$5

20 Q /time unit
Slide 4

 The Market
Demand Curve is
the horizontal sum of
the individual
demand curves.

The Demand
Function includes
all variables that
influence the
quantity demanded

Sam

Diane

Market

Q = f( P, Ps, Pc, Y, N W, PE)

+

? +

? +

P is price of the good

PS is the price of substitute goods
PC is the price of complementary goods
Y is income, N is population, W is wealth, and
PE is the expected future price
Slide 5

Downward Slope to the Demand Curve

Reasonsthatpriceandquantityarenegativelyrelatedinclude:

incomeeffectasthepriceofagooddeclines,the

consumercanpurchasemoreofallgoodssincehisorher
realincomeincreased.

substitutioneffectasthepricedeclines,thegood

becomesrelativelycheaper.Arationalconsumer
maximizessatisfactionbyreorganizingconsumptionuntil
themarginalutilityineachgoodperdollarisequal:

Slide 6

Elasticity as Sensitivity
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
Slide 7

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 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]

arc price
elasticity
D

Average price
Slide 8

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 9

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 10

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 11

Two Extreme Examples

( Figure 3.3)
D
D

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

Slide 12

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 13

( Figure 3.4 )

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

Elastic
Unit Elastic
Inelastic

Q
TR

Q
Slide 14

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, MR = P.
If ED = -2, then MR = .5P, or is half of the
price.
Slide 15

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 increase led to greater total revenue
for the airlines.
Slide 16

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 17

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

point income

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 18

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 19

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 20

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 21

PROBLEM:
Find the point price elasticity, the point income elasticity, and
the point cross-price elasticity at P=10, Y=20, and P s=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 22

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 23

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 24

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.
Q:
A:

Will Total Revenue for your product rise or fall?

Total revenue will rise slightly (about + .5%), as the price went up 3%
and the quantity of snow-throwers sold will fall 2.5%.
Slide 25