1. 2.1 Managerial Economics Prof. R. Michelfelder, Ph.D. Outline 2 Demand, Supply, Price, Revenues, Estimation of Demand Function and Prediction of Revenues

2. 2.2 Outline 2 2.1 Theory of Demand 2.2 Theory of Supply 2.3 Demand, Supply & Price 2.4 Demand, Price Elasticity & Revenue Prediction

3. 2.3 2.1 Theory of Demand The functional relationship between the price of a good or service and other variables and the quantity demanded or sales in units by consumers in a given time

4. 2.4 Non-Price Factors Influencing Demand 1. Tastes and preferences Affected by socioeconomic factors such as age, sex, race, marital status, and education level 2. Income The level of income (e.g. GDP) affects demand for normal goods and inferior goods

5. 2.5 Non-Price Factors Influencing Demand 3. Prices of related goods Substitute goods – when one good can be used in the place of another Complementary goods – two or more goods that consumers use together 4. Future expectations 5. Number of consumers 6. Others (weather for electricity sales)

6. 2.6 Demand Function Q XD = f (P X, T, Y, P Y, P Z, EXC, NC, … where Q XD = sales in unit s or “quantity demanded” for good X P X = price of good X T = variables representing tastes and preferences Y = income (continued on next slide)

7. 2.7 The Demand Function Q XD = f (P X, T, Y, P Y, P Z, EXC, NC, … where P Y and P Z = prices of goods Y and Z, which relate to consumption of good X EXC = consumer expectations about future prices NC = number of consumers

8. 2.8 Demand Curves A B Quantity Price P1P1 P2P2 0 Q1Q1 Q2Q2 Demand The demand curve shows the relationship between price of a good and quantity demanded, all else constant Figure 2.1

9. 2.9 More About Demand Curves  Demand shifters: variables held constant when defining a demand curve but would shift if their values changed  Negative (inverse) relationship: where an increase in one variable causes a decrease in another  Slope of demand curve determines degree of competition in an industry (negative slope reflects imperfect competition)

10. 2.10 Increase in Demand D2D2 D1D1 Quantity Price P1P1 0 Q1Q1 Q2Q2 A change in demand occurs when one or more of the factors are held constant in defining a given demand curve change Figure 2.2

11. 2.11 Individual Versus Market Demand Curve  Horizontal summation of individual demand curves: for every price, the quantity that each person demands at that price determines market quantity demanded at that price  The market demand curve, D M, considers quantities demand at other prices

12. 2.12 Individual Versus Market Demand Curve dBdB dAdA Quantity Figure 2.3 D M = d A + d B Price P1P1 0 Q1Q1 Q2Q2 Q3Q3 Q4Q4

13. 2.13 Demand Function as an Equation (for copper) Q D = 10 - 50P C + 0.31I + 1.5TC + 0.5E where Q D = sales of copper in pounds P C = price of copper per pound TC = index showing uses for copper I = consumer income index E = expectations index

14. 2.14 Managerial Rule of Thumb: Demand Considerations Managers must Understand what influences demand Determine which factors they can influence Determine how to handle factors they cannot influence

15. 2.15 2.2 Theory of Supply The functional relationship between the price of a good or service and other variables that affect cost and the quantity that producers are willing to supply in a given time

16. 2.16 Non-Price Factors Influencing Supply  State of technology  Input prices (labor, capital)  Prices of goods related in production  Future expectations  Number of producers

17. 2.17 The Supply Function Q XS = f (P X, TX, P I, P A, P B, EXP, NP, … where Q XS = quantity supplied of good X P X = price of good X TX = state of technology P I = prices of the inputs of production (continued on next slide)

18. 2.18 The Supply Function Q XS = f (P X, TX, P I, P A, P B, EXP, NP, … where P A, P B = price of goods A and B, related to good X EXP = producer expectations about future prices NP = number of producers

19. 2.19 Supply Curve for a Product Supply B A Relationship between price of a good and quantity supplied Figure 2.4 Quantity Price P2P2 P1P1 0 Q1Q1 Q2Q2

20. 2.20 Supply Relationships  Not all supply curves are linear  Supply curve does not show actual price of product but the relationship of alternative prices and quantities  A positive relationship is shown as upward line where increase in one variable causes increase in another variable

21. 2.21 Changes (Increase) in Supply Figure 2.5 S2S2 S1S1 Quantity Price P1P1 0 Q1Q1 Q2Q2 A change in supply occurs when one or more of the factors held constant in defining a given supply curve change

22. 2.22 Change in Quantity Supplied A price change causes movement from one point to another An increase in price of a substitute good causes the supply curve to shift to the left; a decreases shifts it to the right If the price of a complementary good increases, the supply increases An increase in the number of producers shifts it to the right

23. 2.23 Managers must Examine technology and costs of production Find ways to increase productivity while lowering production costs Supply curve is actually a portion the marginal cost curve Managerial Rule of Thumb: Supply Considerations

24. 2.24 2.3 Demand, Supply, and Price  A price for a good or service is determined when the market reaches equilibrium  The quantity demanded of good X equals the quantity producers are willing to supply  An upset in equilibrium pushes the price back toward equilibrium

25. 2.25 Market Equilibrium Figure 2.6 Quantity Q E = equilibrium quantity P E = equilibrium price Price 0 QEQE PEPE Market equilibrium occurs where demand equals supply Demand Supply

26. 2.26 Lower-Than- Equilibrium Prices  Consumers demand more of a good than producers are willing to supply at that price  Supply and demand become unstable  An adjustment process begins which seeks to again bring equilibrium

27. 2.27 Changes in Equilibrium Prices and Quantities  Change in demand  Change in supply  Changes on both sides of the market

28. 2.28 4. Demand, Price Elasticity, Revenues & Prediction  Mature & Start-up Firms Predict Income Statements and Cash Flows in a Business Plan {see Michelfelder and Morrin (2013) diffusion curves}  Revenues are Driven by Sales: (predicted from demand 20122013201420152016 Revenues Expenses Oper. Cash Flow

29. 2.29 Price Elasticity The percentage change in the quantity demanded of a given good relative to a percentage change in its price e P = % ΔQ x % ΔP x where Δ = the absolute change e P = price elasticity of demand Q x = quantity demanded of good X P x = the price of good X

30. 2.30 Price Elasticity A B Quantity Price P1P1 P2P2 0 Q1Q1 Q2Q2 Demand Measured as a movement along a demand curve Figure 3.1 Q P

31. 2.31 Price Elasticity and Decision Making  Tells managers what will happen if product prices change  Helps firms to develop pricing strategies  Helps to develop pricing strategies in the public sector

32. 2.32 Elasticity  Elastic demand: change in quantity demanded is greater than the change in price  Inelastic demand: change in quantity demanded is less than the change in price  Unitary elasticity: change in quantity demand is equal to change in price

33. 2.33 Elasticity and Total Revenue  If demand is elastic, higher prices result in lower total revenue. Lower prices result in higher total revenue  Changes in price and the resulting total revenue are inversely proportionate  (see Figure 3.2 on next slide)

34. 2.34 Demand Elasticity  Demand elasticity shows the percentage change in quantity demanded of a product relative to the percentage change in both variables  The coefficient represents the ratio of the two percentage changes

35. 2.35 Elastic Demand and Total Revenue A B X Y C Quantity Price (P 1 ) 10 (P 2 ) 9 0 2 (Q 1 ) Demand 3 (Q 2 ) 12 If prices decrease, revenue increases. If prices increase, revenue decreases. Figure 3.2 Area X = Q 1 CBQ 2 Area Y = P 1 ACP 2

36. 2.36 Inelastic Demand  When units are sold at a lower price, the quantity demanded has not increased proportionately  Total revenue decreases  Changes in price and the resulting total revenue move in the same direction  (See Figure 3.3 on next slide)

37. 2.37 Inelastic Demand and Total Revenue Figure 3.3 A B X Y C Quantity Price (P 1 ) 4 (P 2 ) 3 0 8 (Q 1 ) Demand 9 (Q 2 ) 12 If prices decrease, revenue decrease. If prices increase, revenue increases. Area X = Q 1 CBQ 2 Area Y = P 1 ACP 2

38. 2.38 Managers can estimate price elasticity by asking customers: 1. What do you currently pay for my product? 2. At what price would you stop buying my product altogether? Managers should ask themselves: 1. How much will revenue increase as a result of higher sales? 2. How much will revenue decrease as a result of lower prices for each unit? Managerial Rule of Thumb: Estimating Price Elasticity

39. 2.39 Determinants of Price Elasticity of Demand 1. Number of substitute goods 2. Percent of a consumer’s income that is spent on the product 3. Time period under consideration 4. Nature of the good (durable or non-durable)

40. 2.40 Calculating Price Elasticities  Arc price elasticity: base quantity (or price) is the average value of the starting and ending points  Point price elasticity: measurement of the price elasticity of demand calculated at a point on the curve using infinitesimal changes in prices and quantities

41. 2.41 Numerical Examples  Demand function Shows relationship between quantity demanded and price Q = 12 – P or P = 12 – Q  Total revenue function Shows total revenue received by producer as a function of the level of output TR = (P) (Q) = (12 – Q) (Q) = 12Q – Q 2

42. 2.42 Numerical Examples  Average revenue function: shows how average revenue is related to level of output AR = TR / Q = [(P) (Q)] / Q = P  Marginal revenue function: shows the additional revenue a producer receives by selling an additional unit of output at different levels MR = (  TR) / (  Q) = (TR2 – TR1) / (Q2 – Q1) MR = dTR / dQ = 12 – 2Q

43. 2.43 Demand and Marginal Revenue  Firms are always constrained by demand curve  Top half of the demand curve in Figure 3.4 indicates when managers lower price, total revenue increases  Bottom half indicates a price decrease causes total revenue to fall

44. 2.44 Demand and Marginal Revenue |e P | > 1 Demand, marginal revenue, and total revenue functions are related Figure 3.4 |e P | = 1 |e P | < 1 Marginal Revenue Quantity 6 0 6 12 Demand

45. 2.45 The Total Revenue Function 0 18 36 126 Total Revenue Figure 3.5

46. 2.46 Extreme Demand Curves  Vertical demand curve Represents perfectly inelastic demand Example might be insulin for diabetics  Horizontal demand curve Represents perfectly elastic demand Example would be a bushel of wheat from an agricultural producer

47. 2.47 Extreme Demand Curves 0 P1 Quantity Price Horizontal demand curve Demand 0 Q1 Quantity Price Vertical demand curve Demand

48. 2.48 Elasticities of Demand  Income elasticity of demand: percentage change in quantity demanded of a given good relative to percentage change in consumer income Necessities – elasticity between 0 and 1 Luxuries – elasticity greater than 1

49. 2.49  Calculating income elasticity of demand is based on two questions for a consumer: 1. What fraction of your total budget do you spend on Product X? 2. If you earned a bonus of $1000, what part of that bonus would you spend on Product X? Managerial Rule of Thumb: Calculating Income Elasticity

50. 2.50 Elasticities of Demand  Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of Good Y Substitute goods have positive cross elasticity Complementary goods have negative cross elasticity  Defines relevant market in which different products compete

51. 2.51 Which demand elasticity should be used in making appropriate decisions: the one for the entire product or the one for the individual producer? (The answer depends upon how other firms react to price changes) Managerial Rule of Thumb: Price Elasticity Decision Making

52. 2.52 Marketing Literature Regarding Elasticity Issues  Advertising elasticity of demand: the percentage change in quantity demanded of a good relative to the percentage change in advertising dollars spent on that good  Marketing studies Tellis, 1988 Sethuraman and Tellis, 1991 Hoch, et al, 1995