1. Chapter Four Demand

2. Copyright © Houghton Mifflin Company.All rights reserved. 4–24–2 What is demand? It is the response of customers to your firm’s prices and all other attributes of the good or service your firm offers. To “know the customer” means to understand what influences the customer’s demand and to what degree changes will affect the customer’s behavior.

3. PRICE QUANTITY We typically draw demand curves as downward sloping lines -- but how steep? P Q P2P2 Q2Q2 Q3Q3 What if the lower price means this higher quantity demanded?

4. The flatter curve is MORE ELASTIC PRICE QUANTITY P Q P2P2 Q2Q2 Q3Q3 A price change leads to a greater change in quantity demanded

5. Copyright © Houghton Mifflin Company.All rights reserved. 4–54–5 Who Cares? The airline who wants to increase passengers on a flight from Phoenix to Los Angeles might care. What will a price increase do if demand is VERY ELASTIC?

6. Copyright © Houghton Mifflin Company.All rights reserved. 4–64–6 Answer the following: What will a price decrease do if demand is not elastic? How are the airline executives to decide whether to raise or lower price and by how much?

7. Copyright © Houghton Mifflin Company.All rights reserved. 4–74–7 Answer the following: Consider the Glaxo-Wellcome company who produces the only known retardant of the onset of AIDS once HIV is contracted. How high of a price should it set? What will a price decrease do? How is the company to decide whether to raise or lower price and by how much?

8. Copyright © Houghton Mifflin Company.All rights reserved. 4–84–8 Definition of Price Elasticity of Demand Percentage change in quantity demanded divided by percentage change in price. % change in Qd/ % change in P (Q2-Q1)/Q1 divided by (P2-P1)/P1 or dlogQd/dlogP

9. If price changes by 10% and quantity demanded changes by 15%, what is the price elasticity of demand? If price changes by 10% and quantity demanded changes by 5%, what is the price elasticity of demand?

10. Copyright © Houghton Mifflin Company.All rights reserved. 4–10 Definition of Price Elasticity of Demand If price elasticity is less than 1, we say that demand is inelastic. If price elasticity is greater than 1, we say that demand is elastic. If price elasticity is 1, we say that demand is unit elastic.

11. Copyright © Houghton Mifflin Company.All rights reserved. 4–11 Assignment: Plot the following data

12. $200 $400 $600 $800 $1000 PRICE QUANTITY 200600100014001800 Price Quantity $1,000 200 800 600

13. $200 $400 $600 $800 $1000 PRICE QUANTITY 200600100014001800 Price Quantity $1,000 200 800 600 600 1000 400 1400

14. $200 $400 $600 $800 $1000 PRICE QUANTITY 200600100014001800 Price Quantity $1,000 200 800 600 600 1000 400 1400 200 1800 D

15. Copyright © Houghton Mifflin Company.All rights reserved. 4–15 Price Elasticity Calculation Calculate the price elasticity of demand between the following prices: from $1,000 to $600 from $600 to $400 from $200 to $100

16. Copyright © Houghton Mifflin Company.All rights reserved. 4–16 Assignment from $1,000 to $600 P1 = $1,000; P2 = $600 Q1 = 200; Q2 = 1000 (Q2-Q1)/Q1 = 800/200 = 4 (P2-P1)/P1 = $600-$1000/$1,000 = - $400/$1,000 = -.4 %ChQd/%ChP = 4/-.4 = -10

17. Copyright © Houghton Mifflin Company.All rights reserved. 4–17 Assignment from $600 to $400 P1 = $600; P2 = $400 Q1 = 1000; Q2 = 1400 (Q2-Q1)/Q1 = 400/1000 =.4 (P2-P1)/P1 = $400-$600/$600 = -$200/$600 = -.33 %ChQd/%ChP =.4/-.33 = -1.2

18. Copyright © Houghton Mifflin Company.All rights reserved. 4–18 Price Elasticity from $200 to $100 P1 = $200; P2 = $100 Q1 = 1800; Q2 = 2000 (Q2-Q1)/Q1 = 200/1800 = 1/9 (P2-P1)/P1 = $100/$200 = -1/2 %ChQd/%ChP = 1/9/-1/2 = -2/9

19. Copyright © Houghton Mifflin Company.All rights reserved. 4–19 Answers from $1,000 to $600 = -10 from $600 to $400 = -1.2 from $200 to $100 = -2/9 = -.22

20. Copyright © Houghton Mifflin Company.All rights reserved. 4–20 Negative Value What do you notice with the first three elasticities calculated? from $1,000 to $600 = -10 from $600 to $400 = -4/6= -.67 from $200 to $100 = -2/9 = -.22 (1) All are negative.

21. Copyright © Houghton Mifflin Company.All rights reserved. 4–21 Price Elasticity Is Always Negative We have “e” stand for price elasticity of demand. We know that: (1) e is always negative --- Why? So we drop the negative (use the absolute value |e|). (2) e declines as we move down the demand curve.

22. Copyright © Houghton Mifflin Company.All rights reserved. 4–22 Price Elasticity Is Always Negative What do you notice regarding price elasticity of demand from the three calculations we’ve made? First: all are negative. Second: e declines as we move down the demand curve; it becomes smaller in absolute value as price declines.

23. $200 $400 $600 $800 $1000 PRICE QUANTITY D 200600100014001800 Elastic Region e > 1 Inelastic Region e < 1 Unit Elastic Point

24. Copyright © Houghton Mifflin Company.All rights reserved. 4–24 Elasticity and Total Revenue Total revenue = P x Q. The price of the item multiplied by the number of items sold is total revenue.

29. Elastic Region

30. Inelastic Region

31. Elastic Region Inelastic Region Unit Elastic e=1

32. Copyright © Houghton Mifflin Company.All rights reserved. 4–32 Total Revenue and Elasticity As price decreases in the elastic region, total revenue... Increases. As price decreases in the inelastic region, total revenue... Decreases.

33. Copyright © Houghton Mifflin Company.All rights reserved. 4–33 Determinants of Elasticity Number of substitutes. Importance of the good in a consumer’s budget. The higher the % of the budget, the more sensitive consumers are to a 1% price increase -- the more elastic is the demand. The time period. The longer the time period, the more elastic is the demand.

34. Copyright © Houghton Mifflin Company.All rights reserved. 4–34 Income and Other Elasticities When the price changes, we move along the demand curve -- how much we move is the price elasticity of demand. When something other than the price changes that affects demand, the demand curve shifts.

35. Demand would increase – so curve would shift out. $200 $400 $600 $800 $1000 PRICE QUANTITY D D 1 2

36. $200 $400 $600 $800 $1000 PRICE QUANTITY D D 1 2 How far it shifts depends on the elasticity

37. RGDP United States

38. Changes in RGDP United States

39. Copyright © Houghton Mifflin Company.All rights reserved. 4–39 Income and Other Elasticities When something other than the price changes that affects demand, the demand curve shifts. Suppose that income changes by 10% and sales rise by 20%. Then we say that the income elasticity of demand is 2. Income elasticity is the % change in demand divided by % change in income.

40. Copyright © Houghton Mifflin Company.All rights reserved. 4–40 Who Cares? The economy is growing --- income is rising by 5%. What does this mean? You work for a construction company. You’ve calculated that the income elasticity of demand is 4. Your quantity sold will rise by 20%.

41. Copyright © Houghton Mifflin Company.All rights reserved. 4–41 If income elasticity is lower? What if income elasticity of demand is.5? Then the 5% income increase would mean a sales (quantity) increase of only 2.5%.

42. Copyright © Houghton Mifflin Company.All rights reserved. 4–42 Cross Price Elasticity Percentage Change of Qd Percentage Change of P This indicates relationships between two products. If the price of medical services rises and the quantity demanded of health food rises, we say the two goods are substitutes.

43. Copyright © Houghton Mifflin Company.All rights reserved. 4–43 Cross Price Elasticity If the price of cigarettes rises and the quantity demanded of alcohol decreases, we say the two goods are complements. Of what use is cross price elasticity?

44. Copyright © Houghton Mifflin Company.All rights reserved. 4–44 OTHER ELASTICITY MEASURES ADVERTISING PROMOTION SALES FORCE How are these measured? What do they tell us? PIMS Data: 1500 business units: Average Price elasticity =.985 Advertising =.003 Promotion =.008 Sales force =.304