1 MANAGERIAL ECONOMICS An Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2 Chapter 7: Demand and Elasticity Objectives: After studying the chapter, you should understand: 1. The determinants of demand and its elasticity 2. The relationship between revenue and elasticity 3. The link between elasticity and the power of buyers

3 The Determinants of Demand n Demand is the quantity of a product that purchasers are willing and able to purchase in a specified period n It is determined by –Own Price - P o –Price of other products, especially close substitutes and complements, P c,s –Consumers’ disposable incomes, Y d –Consumers’ tastes, T –The amount spent on advertising the product, A o –The amount spent on advertising complements and substitutes, A c,s –Interest rates (i) and credit availability (C) –Expectations of future prices and supply conditions(E)

4 These Relationships May be Represented As: n A ‘demand function’ - the general mathematical form Q d = f(P o, P o,P s,Y d,A o,A c,A s,I,C,E) n A ‘demand curve’ Price Quantity Demanded The demand curve shows the quantity that would be bought at each price, for some fixed combination of all other factors

5 The Demand Curve n D-curve shifts when anything except own- price changes Own Price Quantity Demanded A demand-curve shows the quantities sold at each price, assuming other things do not change. “Assume” here does not mean “we believe this to be true” but simply “if”. We know the other things change but we can only show two dimensions on a diagram.

6 Concepts of Elasticity n Own price elasticity is: –percentage change in quantity demanded, divided by percentage change in price : n If demand is price-elastic, revenue increases with lower prices. n If demand is price-inelastic, revenue decreases with lower prices n Cross-price elasticity of demand between substitutes is positive n Income-elasticity determines how demand changes with customers’ incomes. For most goods income-elasticity is positive. n Advertising elasticity is important in deciding on advertising budgets. It is positive. As the level of advertising increases, we would expect advertising elasticity to fall.

7 The Demand-Curve:Examples n Zero-elasticity at all prices Price Quantity E d = 0

8 The Demand-Curve:Examples n Infinite elasticity at all prices Price Quantity E d = 

9 The Demand-Curve:Examples n Unitary elasticity at all prices Price Quantity E d = -1 This curve is a ‘rectangular hyperbola’ such that price x quantity is a constant

10 The Demand-Curve:Examples n A Linear Demand Curve Price Quantity E d = -1 E d = 0 E d = - 

11 Demand and Marginal Revenue n A Linear Demand Curve $ Quantity E d = -1 E d = 0 E d = -  Marginal Revenue

12 Determinants of Own-price Elasticity n Substitutes: how close and at what prices? –How narrowly defined is the product? The more narrowly defined the more close substitutes n Proportion of consumers’ income spent on the product (or % of industrial buyers’ costs accounted for) n Time. Demand is more elastic over longer periods of time

13 Determinants of Other Elasticities n Income Elasticity –Type of good necessities - salt, drinking water, zero elasticity luxuries, zero at low levels of income then high when income thresholds exceeded inferior goods - negative, purchase less as income rises - bus travel, low-grade margarine, paraffin n Cross-price elasticity –substitutes or complements,and how close? –An industry is a group of firms producing products with high positive cross-elasticities

14 The Demand Curve for an Individual Firm n Depends on the conditions of competition n For a monopoly, industry demand curve is the firm’s demand-curve n Under perfect competition, demand is infinitely elastic at the market price n Where competition is amongst a few firms it depends on each firm’s market share and rivals’ reactions

15 Elasticity and the Power of Buyers n Chapter 11 introduces the concept of ‘buyer power’ which is one of the ‘5-forces’ determining the structure of competition in an industry n Buyer power has two components –price sensitivity of buyers (looser version of the elasticity concept) –bargaining power of buyers

16 Price Sensitivity of Buyers Is Determined By: n Purchases of product as % of total purchases n Product differences and brand identity n Impact of product on the quality of the buyers’ product or service n Customers’ own profitability n Decision-makers’ incentives n THIS USEFULLY EXTENDS THE ANALYSIS OF DEMAND AWAY FROM CONSUMERS TO INDUSTRIAL BUYERS AND PROVIDES A LINK TO MARKETING