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Topic 7: Demand and Elasticity 1 Market vs. firm’s demand 2 Elasticity and revenue 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets Session 7 • Demand and Elasticity Slide 1
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Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

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Page 1: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Topic 7: Demand and Elasticity

1➥ Market vs. firm’s demand

2 Elasticity and revenue

3 Numerical examples: Elasticity for linear and log-linear demand

4 Determinants of elasticity

5 Demand estimation exercise.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 1

Page 2: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Perfect vs. imperfect competition “firms are price-takers” vs.“firms have market power”

(Sessions 5–7)

Firms are price-takers(Perfect competition)

(Sessions 8–15)

Firms have market power(Imperfect competition)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 2

Page 3: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

From the individual firm’s viewpoint

Imperfect competition = firm has market power

= firm sees a trade-offbetween price and volume

1

2

3

4

5

1 2 3 4 5 6 7Qi

Pi Demand curve for i ’s output

Perfect competition = firm is a price-taker

= firm believes it can sell anyamount at the market price(e.g., market price is 3)

1

2

3

4

5

1 2 3 4 5 6 7Qi

P i ’s volume–price trade-off

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 3

Page 4: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Market power: where it comes from

Qi

Pi

di (Pi )

Two cases:

1. Differentiated products: the firm’s branded product is differentiatedfrom other products.

2. Homogeneous goods: Though products are not differentiated, the firmis a big player: increased output pushes down the market price.

Next let’s compare market demand vs. a firm’s demand …

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 4

Page 5: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Case 2: Homogeneous goods Market vs. firm’s demand…starting with no market power

MARKET DEMAND

30

60

90

120

150

180

210

240

270

2 4 6 8 10 12

P

Q

US

Cen

tspe

rPo

und

Millions of metric tons

FIRM’S DEMAND

“El Guadal”finca cafetera

30

60

90

120

150

180

210

240

270

1 2 3 4 5 6 7 8

Pi

Qi

US

Cen

tspe

rPo

und

Metric tons

…when total output of other farmsis 7.5M metric tons

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 5

Page 6: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Market power: Our simulation Market demand vs.firm’s demand

MARKET DEMAND

Q = 6000 − 100P

10

20

30

40

50

60

1 2 3 4 5 6

P

QThousands

FIRM’S DEMAND

When Q−i = 3173

10

20

30

40

50

60

20 40 60 80 100 120

Pi

Qi

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 6

Page 7: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Corning and glass substrate

Corning has over 50% market share of glass substrate.

There are different grades (“5G, 6G, …”), but for a particular grade theproducts of different suppliers are viewed as close substitutes.

News item from December 2005 (for example):

The aggressive capacity added by both Corning of the U.S., theworld’s No. 1 substrate supplier, and AGC, the No. 2, will lead toprice drops for glass substrates and will especially benefit TV panelmakers …

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 7

Page 8: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Market demand curve vs. Corning’s demand curve

MARKET DEMAND

Q = 6000 − 100P

10

20

30

40

50

60

1 2 3 4 5 6

P

QThousands

FIRM’S DEMAND

When Q−i = 1500

10

20

30

40

50

60

1 2 3 4 5 6

P

QiThousands

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 8

Page 9: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Case 1: Differentiated products Market demand vs.a firm’s demand

Example: Airbus and Boeing

Individual demand functions:

QA = 60 − 3PA + 2PB

QB = 60 − 3PB + 2PA

Market demand:

Choose measure of aggregate output, say Q = QA + QB .

Choose price index, say P = (PA + PB )/2 .

Q = 120 − 2P

(See workbook-style “Exercise on Demand and Elasticity” for details and review.)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 9

Page 10: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Topic 7: Demand and Elasticity

1✓ Market vs. firm’s demand

2➥ Elasticity and revenue

3 Numerical examples: Elasticity for linear and log-linear demand

4 Determinants of elasticity

5 Demand estimation exercise.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 10

Page 11: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Labor markets: minimum wage

d (P )

123456789

10111213

1 2 3 4 5 6 7 8 9

Q (millions)

€/hour

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 11

Page 12: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Key point: % changes matter

An increase in minimum wage has two effects on total wage bill:

P ↑ : Each worker is more expensive : wage bill ↑ by %ΔP

Q ↓ : Firms employ fewer workers : wage bill ↓ by %ΔQ

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 12

Page 13: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Key point: % changes matter

An increase in minimum wage has two effects on total wage bill:

P ↑ : Each worker is more expensive : wage bill ↑ by %ΔP

Q ↓ : Firms employ fewer workers : wage bill ↓ by %ΔQ

Net effect depends on which is greater:

%ΔP or %ΔQ

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 12

Page 14: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Example: linear demand

123456789

1011121314151617

1 2 3 4 5 6 7 8

Q (millions)

€/hour

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 13

Page 15: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Key point: own-price elasticity of demand

Useful measure of price-sensitivity of demand: Elasticity

E = −% change in Q

% change in P.

If …then a price increase causesrevenue (expenditure) to …

and we saydemand is …

E < 1

E = 1

E > 1

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 14

Page 16: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Other elasticities

We can measure elasticities between any two related variables(e.g., demand and income, supply and price, etc.)

Elasticity = sensitivity in terms of % changes (rather than slope).

Some elasticities of demand:

• Own-price elasticity: −%ΔQ%ΔP

• Cross-price elasticity: %ΔQ%ΔPs

• Income elasticity: %ΔQ%ΔI

Remember:

• This course: 97% on own-price elasticity; 3% on other elasticities.

• “Elasticity of demand” (no qualifier) means “own-price elasticity.

• Own-price elasticity is only one we use the minus sign for.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 15

Page 17: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Topic 7: Demand and Elasticity

1✓ Market vs. firm’s demand

2✓ Elasticity and revenue

3➥ Numerical examples: Elasticity for linear and log-linear demand

4 Determinants of elasticity

5 Demand estimation exercise.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 16

Page 18: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Point elasticity

Loosely:

E = −% change in Q

% change in P.

Point elasticity: If d (P ) is smooth then elasticity at point (P, Q) is

E = −dQdP

PQ

.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 17

Page 19: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Elasticity of linear demand: Q = A − BP

Choke price: price at which demand is zero = P̄ =

Point elasticity:P

P̄ − P.

5

10

15

20

25

30

2 4 6 8 10 12 14 16

Price($1000s)

Demand for minivans (100,000s)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 18

Page 20: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Elasticity of log-linear demand: Q = AP−B

“Taking logs” yields:

log Q = log A − B log P

Price

Quantity

d1 (P )

d2 (P )

d1(P ) = 6P−3

d2(P ) = 1.7P−1.5

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 19

Page 21: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Topic 7: Demand and Elasticity

1✓ Market vs. firm’s demand

2✓ Elasticity and revenue

3✓ Numerical examples: Elasticity for linear and log-linear demand

4➥ Determinants of elasticity

5 Demand estimation exercise.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 20

Page 22: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Determinants of elasticity

1. The more close substitutes a good has, the elastic is demand.

2. ⇒ Demand for a particular brand (Samsung) or type ( 17′′ flat panel) iselastic than demand for the entire category (computer

displays).

3. ⇒ The more differentiated the brand, the elastic is demand.

4. ⇒ Advertising usually both increases demand and makes itelastic.

5. When a product’s close substitutes become more expensive, demand forthe product becomes elastic.

6. Demand is typically elastic for people with lower income.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 21

Page 23: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Elasticity of demand for some cars in USA (1980s data)

Model Elasticity

Mazda 323 6.3

Honda Accord 4.8

Nissan Maxima 4.8

Nissan Sentra 6.5

Ford Taurus 4.2

Ford Escort 6.0

Lexus LS400 3.0

Chevrolet Cavalier 6.4

Cadillac Seville 3.9

BMW 735i 3.5

But for entire category: 0.8

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 22

Page 24: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Topic 7: Demand and Elasticity

1✓ Market vs. firm’s demand

2✓ Elasticity and revenue

3✓ Numerical examples: Elasticity for linear and log-linear demand

4✓ Determinants of elasticity

5➥ Demand estimation exercise.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 23

Page 25: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Estimating demand: Get some data

1. Consumer surveys.

2. Consumer focus groups.

3. Market experiments.

4. Historical (real) data: cross-section, time-series, or both (panel).

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 24

Page 26: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Estimating demand: Fit a curve

1. Write down model (equation) for demand, with unspecifiedcoefficients.

2. Fit line or curve to data points using statistical techniques (regression).

It’s all approximate:

• Include most relevant variables.

• Pick a simple functional form without too many coefficients.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 25

Page 27: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Two common parametric forms

Linear

Q = A − B1P + B2Ps + B3 I + · · ·e.g.

FPR = −0.02 − 0.8PF + 0.4PM − 0.07MPR + 0.35GDP

Log-linear (constant elasticity)

Q = A P−B1 PB2s IB3 · · ·

taking logs yields

log Q = log A − B1 log P + B2 log Ps + B3 log I + · · ·

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 26

Page 28: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Demand for US Gasoline Consumption

Variables:

GPC = Per-capita U.S. gasoline consumption

PG = Price index for gasoline

Y = Per capita disposable income

PNC = Price index for new cars

PUC = Price index for used cars

Model:

GPC = A PGB1 YB2 PNCB3 PUCB4

Or:

log GPC = log A + B1 log PG + B2 log Y + B3 log PNC + B4 log PUC

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 27

Page 29: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Regression results

log G = −5.36 − 0.059 log PG + 1.373 log Y − 0.127 log PNC − 0.119 log PUC

Or:

G = 0.00000436 PG−0.059 Y1.373 PNC−0.127 PUC−0.119

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 28

Page 30: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Coming up …

Firms are price-takers(Perfect competition)

Firms have market power(Imperfect competition)

(Sessions 8–11)

Individualdecisions

(Sessions 12–15)

Equilibrium

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 29

Page 31: Topic 7: Demand and Elasticity - faculty.insead.edu · 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise.

Session 8: Pricing with Market Power

For a single firm with demand d (P ) and cost curve c (Q) :

• Output decision: MR = MC .

• Entry/exit decision: VΠ > FC ?

FPM reading. Chapter 7.

Deliverables. Exercises 7.4 and 7.5.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 7 • Demand and Elasticity Slide 30