Demand Analysis (Cont.) Managerial Economics Riad Sultan Lect. In managerial economics

Lect. In managerial economics Your firm’s research department has estimated the income elasticity of demand for chicken to be -1.94. You have just read in an economic newspaper that due to an upturn in the economy, consumer incomes are expected to rise by 10% over the next three years. As a manager of a chicken processing plant, how will this forecast affect your purchase of chicken? Riad Sultan Lect. In managerial economics

Lect. In managerial economics Elasticities When one of the determinants changes, demand will also change The next issue is how much? We analyse the magnitude of the change And hence we refer to ELASTICITIES Riad Sultan Lect. In managerial economics

Lect. In managerial economics ELASTICITY OF DEMAND Price in 2007= Rs20: Demand (Sales)= 43 Price in 2008= Rs10: Demand (Sales) =75 When price change by Rs10, demand changes by 32 units. Can we say that for each Rs1, demand rises by (32/10) 3.2 units? Yes However, to compare different goods, we take the percentage change Riad Sultan Lect. In managerial economics

Lect. In managerial economics Percentage change in demand =[(New-old)/old] X 100 = [(75-43)/43] = 75% Hence, demand has increased by 75% Percentage change in price =(10-20)/20= -50% Hence, price has decreased by 50% Riad Sultan Lect. In managerial economics

Lect. In managerial economics Conclusion: When price falls by 50%, demand rises by 75% It follows that when price changes by 1%, demand will rise by (75%/50%) = 1.5% 1.5 is called elasticity Riad Sultan Lect. In managerial economics

Lect. In managerial economics Formula for elasticity of demand: % change of quantity demanded divided %change of price = 1.5 Riad Sultan Lect. In managerial economics

Lect. In managerial economics Elasticity of demand Formula for elasticity of demand: Riad Sultan Lect. In managerial economics

Lect. In managerial economics Calculation Elastic demand = >0 Inelastic demand = <0 Elasticity = Unitary = 1 Riad Sultan Lect. In managerial economics

Lect. In managerial economics Elasticity Calculate: prices move from P1 to P2: P1=10 Q1=100 P2=20 Q2=50 Elasticity= 50%/100% = 0.5% When price changes by 1%, demand falls by 0.5% Riad Sultan Lect. In managerial economics

Lect. In managerial economics Arc elasticity Riad Sultan Lect. In managerial economics

Lect. In managerial economics Point elasticity Requirements: understand slope of a demand curve Slope = change in vertical/change in horizontal = 40/80=1/2 40 A 35 B 6 5 72 80 Riad Sultan Lect. In managerial economics

Lect. In managerial economics Calculate elasticity at A =2 X (35/5)=14% Calculate elasticity at B = 2 X (6/72) = 0.16% At A, demand is elastic At B, demand is inelastic Riad Sultan Lect. In managerial economics

Calculating elasticity from demand function Suppose Q = 100 – 5P Change in Q/Change in P =-5 Elasticity = -5(P/Q) Riad Sultan Lect. In managerial economics

Elasticity and Total revenue Suppose : P1=10 Q1=100 TR= P1Q1=1000 P2=20 Q2=75 TR = P2Q2 = 1400 Elasticity= 25%/100% = 0.25% When price rises by 1%, demand falls by 0.25% Outcome: Total Revenue rises Marginal revenue is positive Riad Sultan Lect. In managerial economics

Elasticity and Total revenue Conclusion 1: when demand is elastic (>1), (when price rises, TR falls), can not raise the price Conclusion 2: when demand is inelastic (<1), when price rises, TR rises always raise prices Riad Sultan Lect. In managerial economics

Elasticity and Total revenue P1= 10 Q1= 100 TR = 1000 P2=15 Q2=40 TR = 600 Elasticity = 60%/50%=1.2% When price rises by 1%, quantity demanded falls by more than 1% (1.2%): Total revenue: Falls Marginal revenue: negative Riad Sultan Lect. In managerial economics

Relationship between marginal revenue, and price elasticity Riad Sultan Lect. In managerial economics

Determinants of Price elasticity Availability of substitutes Elasticity is high when there are substitutes Nature of commodity Luxury, durable = elastic; necessity, non-durable = inelastic; Weightage in the total consumption When proportion is large = elastic; when prop. is low = inelastic Time factor in adjustment of consumption The longer the time to adjust, the higher the price elasticity Range of commodity use Multi-purpose goods = high elasticity Proportion of Market supplies The proportion of consumers who are satisfied: if less than 50%, demand will be elastic Riad Sultan Lect. In managerial economics

Lect. In managerial economics Cross price elasticity Substitutes and complements Income elasticity Normal, necessities , inferior Advertising elasticity Elasticity of price expectations Riad Sultan Lect. In managerial economics

Advertising elasticity =0: sales do not respond to advertisement >0 but <1: less than proportionate increase in advertising =1 proportionate increase in advertising >0 more than proportionate increase in advertising Riad Sultan Lect. In managerial economics

Advertising elasticity Determinants The level of sales Advertisement by other firms Cumulative of past advertisement Riad Sultan Lect. In managerial economics

Elasticity of Price expectation Riad Sultan Lect. In managerial economics

Lect. In managerial economics Application Qc = 50 – 1.5Pc + 0.5Y + 2.0 Ps + 0.8A Qc = number of PCs demanded Pc = Price of PC Y = buyers income Ps = substitutes brand A = advertising Starting points: Pc = 40, Y= 60, Ps = 30, A = 25 Riad Sultan Lect. In managerial economics

Lect. In managerial economics Elasticities Price Elasticity - Ep = -0.6 Income Elasticity - Ey = 0.3 Cross Elasticity - Es = 0.6 Advertising Elasticity - Ea = 0.2 Riad Sultan Lect. In managerial economics

Lect. In managerial economics Your firm’s research department has estimated the income elasticity of demand for non-fed ground beef to be -1.94. You have just read in an economic newspaper that due to an upturn in the economy, consumer incomes are expected to rise by 10% over the next three years. As a manager of a meat-processing plant, how will this forecast affect your purchase of non-fed cattle? Riad Sultan Lect. In managerial economics

Elasticity and Demand functions (reconsider) Elasticity of demand for linear demand function: Own price elasticity = Cross price elasticity = Income elasticity = e Riad Sultan Lect. In managerial economics

Elasticity and Demand functions (reconsider) Elasticity of demand for non-linear demand: Own price elasticity = c Cross-price elasticity = d Income elasticity = e Riad Sultan Lect. In managerial economics