m.e Price Elasticity 1

8/13/2019 m.e Price Elasticity 1

1/72

Chapter 3: Demand Theory

Instructor: Maharouf Oyolola


2/72

Outline of the lecture

- Determinants of Demand

-graph of the demand function

-Demand schedule

-Law of Demand

-Difference etween change in Demandand Change in !uantity Demanded

-"rom indi#idual to mar$et demand

-


3/72

Outline of the lecture

-%rice elasticity of Demand &%oint and 'rc(

-Income )lasticity of Demand &%oint and

'rc( -Cross-%rice elasticity of demand

- )-commerce


4/72

Demand Theory

In this chapter* we egin our analysis ofconsumer demand+ Demand is one of themost important aspects of managerialeconomics* since a firm would not eestalished or sur#i#e if a sufficientdemand for its product did not e,ist or

could not e created+


5/72

The fundamental oecti#e of demand theory isto identify and analy.e the asic determinants ofconsumer needs and wants+

Therefore* an understanding of the forcesehind demand is a powerful tools for managers+/uch $nowledge pro#ides the ac$groundneeded to ma$e pricing decisions* forecast

sales* and formulate mar$eting strategies+


6/72

Demand analysis was introduced as a toolfor managerial economics+

"or e,ample* a $nowledge of price andcross elasticities can assist managers inpricing and that income elasticities pro#ideuseful insights into how demand for a

product will respond to differentmacroeconomic conditions+


7/72

Determinants of Demand

0e egin this section y e,amining thedeterminants of indi#idual1s demand of a

commodity+In managerial economics* we are primarilyinterested in the demand for a commodity

faced y the firm+


8/72


In determining what to purchase*indi#idual consumers face a constrainedoptimi.ation prolem+ That is* gi#en their

income &the constraint(* they select thatcomination of goods and ser#ices thatma,imi.es their personal satisfaction+


9/72


The consumer demand theory postulatesthat the 2uantity demanded of acommodity is a function of* or depends on:

- the price of the commodity

-the consumer1s income

-the price of related commodities&complements and sustitutes(

-tastes of the consumer


10/72

raph of the demand function

4owe#er* when we graph the relationshipetween the price and the demand* weassume other #ariales& income* tastes

and preferences( are constant* meaningtheir #alues do not change+


11/72


12/72

The Demand ScheduleThe Demand Schedule

Demand Schedule:Demand Schedule: a list showinga list showingquantities of a good thatquantities of a good that

consumers would choose toconsumers would choose to

purchase at different prices, withpurchase at different prices, with

all other variables held constant.all other variables held constant.


13/72

DEMAND CURVE FOR milkDEMAND CURVE FOR milk

Copyright 888 y 4arcourt* Inc+ 'll rights reser#ed+

$1.50

1.40

1.30

1.20

1.10

1.00

.90

0 45 50 55 60 65 70 75

Quani! "# milk

$%i&'

AB

D

C

E

F

G

H

D

p

rice


14/72

Law of DemandLaw of Demand

TheThe law of demandlaw of demandstatesstates

that when the price of athat when the price of a

good rises and everythinggood rises and everything

else remains the same, theelse remains the same, thequantity of the goodquantity of the good

demanded will fall.demanded will fall.


15/72

In functional form

!d,A "& %,* I* %y* T(

0here

!d,A 2uantity demanded of commodity B %,A %rice per unit of commodity B

IA consumer1s income

%yA %rice of related commodities TA tastes of the consumer


16/72

Difference etween change in 2uantitydemanded and change in demand

!A" &%,* I* %r* T*(

To study the relationship etween theprice and 2uantity demanded* we assumethat income* price of related goods andtastes are constant+


17/72

MOVEMEN( A)ON* A DEMAND CURVEMOVEMEN( A)ON* A DEMAND CURVE

VER+U+ +,-F( "# ' /'man/ &u%'VER+U+ +,-F( "# ' /'man/ &u%'

D0

D0

D1

D1

$1.30

1.10

C

F

Quani! D'man/'/

$%i&'

Copyright 888 y 4arcourt* Inc+ 'll rights reser#ed+


18/72

Demand vs. QuantityDemand vs. Quantity

DemandedDemandedChange in QuantityChange in Quantity

Demanded =Demanded = movementmovement

alongalongthe demand curvethe demand curve

Change in Demand =Change in Demand =

movementmovement of the entireof the entire


19/72

"rom indi#idual to mar$et demand

The mar$et demand cur#e is simply thehori.ontal summation of the demandcur#es of all the consumers in the mar$et+

&include the 3 graphs on page


20/72

The andwagon effect

0hen people sometimes demandcommodity ecause others are purchasingit and in order to e fashionale


21/72

The /no effect

Occurs when many consumers who see$to e different and e,clusi#e ydemanding less of a commodity as more

people consume it


22/72

Durale goods

oods that pro#ide ser#ices not onlyduring the year when they are purchasedut also in suse2uent years+

),ample:washing machines* automoiles


23/72

%rice )lasticity of Demand

' price change can either increase ordecrease total re#enue* depending on thenature of the demand function+

The uncertainty in#ol#ed could e reducedif managers had a method of measuringthe proale effect of price changes on

total re#enue+


24/72


One such measure is the price elasticity ofdemand* which is defined as thepercentage change in 2uantity demanded

di#ided y the percentage change in price+

Measure the responsi#eness of theconsumer to a change in price+


25/72

0hy is the concept of elasticity ofdemand to the firm

"rom a decision-ma$ing perspecti#e* the firmneeds to $now the effect of changes in any of

the independent #ariales in the demandfunction on the 2uantity demanded+ /ome ofthese #ariales are under the control ofmanagement* such as price* ad#ertising*product 2uality* and customer ser#ice+

Ey affecting sales* the pricing policies of thefirm also affect its production costs* and thus itsprofitaility+


26/72

4ow to find the percentagechange

),ample 7: %7A F788 %A F768

),ample : !7A


27/72

%oint Gersus 'rc )lasticity

There are two approaches to computingprice elasticities:

&( The point price elasticity

&3( The arc price elasticity

The choice etween the two depends on thea#ailale data and the intended use+


28/72

'rc elasticity

They are appropriate for analy.ing theeffect of discrete changes in price+

"or e,ample* a price increase from F7 toF could e e#aluated y computing thearc elasticity+

In actual practice* most elasticitycomputations in#ol#e the arc method+


29/72

%oint )lasticity

This approach can e used to e#aluate theeffect of a #ery small price changes or tocompute the price elasticity at a particular

price+ %oint elasticities are important in

theoretical economics+


30/72


Eecause of the in#erse relationshipetween % and !* )p is negati#e+4owe#er* for simplicity* we use the

asolute #alue of )p or I)pI to interpretthe result

Q

P

P

Q

P

PQ

Q

Ep

=

=


31/72

If I)pIH7 The demand is elastic

Meaning: If the price of the productincreases y 7* the consumers respondy decreasing their demand of the producty more than 7+


32/72

If I)pIJ7 the demand is inelastic

Meaning: if the price of the productincreases y 7* the consumers respondy decreasing their demand of the producty less than 7

),ample: a necessary good

gas* electricity* water


33/72

If I)pIA7 the demand is unit elastic

Meaning: if the price of the productincreases y 7* the consumer respondsy decreasing its demand of the producty e,actly the same percent+


34/72

/'man/ &u%0'

8

:5

9

K

8 :88 588 988 K88

Quani! /'man/'/

$%

i&'

!


35/72

't E

>=

=

=

==

==

15

100

5

165

1000100

IEpI

Q

P

P

Q

The demand is elastic


36/72


37/72

'rc %rice )lasticity of Demand

Measures the price elasticity of demandetween two prices

2/)(

2/)(

21

21

QQ

PP

P

Q

Ep+

+

=


38/72

),ample

=sing the point elasticity of demand* let1scompute )p:

C to D )pA-

D to C )pA-7

To a#oid this* we use the a#erage of thetwo prices and the a#erage of the two2uantities


39/72

Eetween C and D

%7%A53A ;

!7!A88388A688

)pA-7+5


40/72

),ample

Consider the >E' corporation* which hadmonthly as$etall shoe sales of 78*888 pairs&at F788 per pair( efore a price cut y its maorcompetitor+ 'fter this competitor1s price

reduction* >E'1s sales declined to K*888 pairs amonth+ "rom the past e,perience >E' hasestimated the price elasticity of demand to eaout -+8 in this price-2uantity range+ If the >E'

wishes to restore its sales to 78*888 pairs amonth* determine the price that must echarged+


41/72

/olution

Letting !A78*888 !7AK*888 %7AF788 and

)DA-+8* the re2uired price* %* may e

computed:

50.89$

100$100$

000,8000,10

000,8000,10

0.2

2

2

2

=

+

+

=

P

PP


42/72

%rice )lasticity* Total @e#enue andMarginal @e#enue

T@A%+!

M@ANT@N!

If % increases I)pIJ7 T@ increases

),ample: as &necessary good( there is noclose sustitute for gas+

It can e an answer to many who wonder why

oil companies are ma$ing huge profits whengas prices are increasing+


43/72

%rice )lasticity* Total @e#enue andMarginal @e#enue

If % increases I)pIH7 T@ falls

'#ailaility of close sustitutes led theconsumer to sustitute the product withthe closest sustitute

M@A%& 7 7)p(

Discuss this formula in detail


44/72

"actors affecting the price elasticityof demand

The price elasticity of demand dependsprimarily on:

- the e,istence of close sustitutes for thecommodity

-the length of time o#er which the 2uantityresponse to the price change is measured


45/72

The price elasticity of demand is larger thecloser and the greater is the numer ofa#ailale sustitutes for the commodity

Intuiti#ely* the price elasticity of sugar ishigher than the price elasticity of salt

),ample: /ugar has more sustitutes than

salt

/ustitutes for sugar: honey* saccharine


46/72

The price elasticity of demand is alsolarger the longer is the time period allowedfor consumers to respond to the change in

the commodity price+ 's time goes y* consumers learn aout

the e,istence of sustitutes and adust

their purchases to the price change


47/72

),ample

During the period following the sharp increase ingasoline price in 7


48/72

%rice elasticity and DecisionMa$ing

Information aout price elasticities can ee,tremely useful to managers as theycontemplate price decisions+

If demand is inelastic at the current price*a price decrease will result in a decreasein total re#enue+

'lternati#ely* reducing the price of aproduct with elastic demand would causere#enue to increase+

% i l ti it d D i i


49/72


The relationship etween elasticity andtotal re#enue can e shown using simplecalculus+

M@A%&77)p(

If )pA-7 M@A8 Q interpretation: if thedemand is unitary elastic* prices will notchange total re#enues+

% i l ti it d D i i


50/72


If )pJ-7 Q the demand is elastic QM@H8Q ' price reduction would increase the2uantity demanded+ Therefore* total

re#enue would increase+

If )pH-7 Q the demand is inelastic

QM@J8 Q ' price reduction woulddecrease total re#enue+


51/72

Income )lasticity of Demand

Measures the responsi#eness of thedemand for a commodity to a change inconsumer1s income

0h th i l ti it f


52/72

0hy the income elasticity ofdemand is important to the firm

-Income is one of the determinant ofdemand+

"or instance* consumers tend to changetheir uying hait during a recession ore,pansion+ Therefore* the firm needs tota$e that factor into consideration while

choosing the amount of output to produce


53/72

%oint Income elasticity of Demand

Q

I

I

Q

I

I

Q

Q

EI

=

=


54/72

'rc Income )lasticity of Demand

21

21

21

21

2/)(

2/)(

QQ

II

I

QE

QQ

II

I

QE

I

I

+

+

=

+

+

=


55/72

Definitions

' >ormal good:a good whose 2uantitydemanded rises as the income of theconsumer increases+

),amples: automoiles* education* tra#el*mo#ies* housing


56/72

Inferior good: ' good whose 2uantitydemanded increases as the income of theconsumer falls+

),ample:Elac$ and 0hite TG* hot dogshamurgers


57/72

If )IH8 >ormal goods

If )IJ8 Inferior goods

),ample of normal goods: lu,ury itemsuch as #acations in the Cariean* which

will increase when the economy isooming


58/72

>ormal goods

"ood* clothing and housing )IH8 ut low

necessities

4ealthcare and education )I

H7


59/72

Inferior goods

)IJ8

Elac$ and 0hite TG

"lour


60/72

Cross-price elasticity of demand

The demand of a commodity alsodepends on the price of related &i+e+sustitutes and complements(

commodities+ ),ample: If the price of tea rises* thedemand for coffee increases Consumerssustitute coffee for tea in consumption

On the other hand* if the price of sugar &acomplement of coffee( rises* the demandfor coffee declines

The point cross price elasticity of


61/72

The point cross-price elasticity ofdemand

Measures the responsi#eness in thedemand for commodity B to a change inthe price of commodity ?+

x

y

y

x

y

y

x

x

XY Q

P

P

Q

P

P

Q

Q

E

=

=


62/72

If ),yH8 commodities B and ? are

sustitutes

),amples:coffee and tea

utter and margarine


63/72

If ),yJ8 commodities B and ? are

complements

),amples:sugar and coffee

cars and gasoline


64/72

If )B?A8 B and ? are independentcommodities

),amples: oo$s and eer

cars and candy

pencils and potatoes


65/72

The cross-price elasticity of demand is a#ery important concept in managerialdecision-ma$ing+

"irms often use this concept to measurethe effect of changing the price of aproduct they sell on the demand of other

related products that the firms also sell+


66/72

),ample

eneral motors corporation can use thecross-price elasticity of demand tomeasure the effects of changing the price

of Che#rolets on the demand for %ontiacs+ Che#rolets and %ontiacs are sustitutes+

Therefore* lowering the price of Che#rolets

will reduce the demand for %ontiacs


67/72

)-Commerce

It refers to the production* ad#ertising* sale* anddistriution of products and ser#ices fromusiness to usiness and from usiness toconsumers through the internet+

In e-commerce* there is no tra#eling to atraditional store* no salesperson* and no cash-register+

The e-commerce has tremendously change theway in which uyers and sellers interact in themar$etplace+


68/72

'd#antages of )-commerce

- reduction of time and distance arriersetween uyers and sellers+


69/72

/ustitution effect

0hen the price of a good such as stea$ declines* it ecomes less e,pensi#e inrelation to other goods for e,ample*

chic$en+ 's a result of the price decline*the rational consumer may e ale toincrease his or her satisfaction &or utility(y purchasing more of the good whose

price has declined and less of the othergoods+ This is $nown as the sustitutioneffect+


70/72

),ample

/uppose that the prices of stea$ and chic$en are F6 andF per pound* respecti#ely+

'ssume that an indi#idual purchases two pounds ofstea$ and two pounds of chic$en per wee$ for totale,penditure of F75+

/uppose that the price of stea$ declines to F5 perpound+ 's a result of this price decrease* an indi#idualwho has a preference for stea$ may decide to increasehis or her consumption of stea$ to three pounds perwee$- which re2uires the same total e,penditure of F75

per wee$+ Thus we see that a decrease in the price of stea$&relati#e to chic$en( has led to an increase in the demandfor stea$+


71/72

Income effect

0hen the price of a good for e,ample* stea$ declines* the effect of this decline is that the real incomeof the consumer has increased+ This is $nown as theincome effect+

If an indi#idual normally purchases two pounds of stea$per wee$ at F6 per pound* a price decline to F5 perpound would enale the consumer to purchase the sameamount of stea$ for F less per wee$

This sa#ings of F represents an increase in real income

of F* which may e used to purchase greater 2uantitiesof stea$ &as well as other goods( each wee$


72/72

%rolems

In class prolems

%rolem R7 page 7K

%rolem R page 7K

0ritten assignment

%rolem R3 page 7K

m.e Price Elasticity 1

Documents