1. DEMAND ANALYSIS Demand Relationships The Price Elasticity of Demand
Arc and point price elasticity
Elasticity and revenue relationships
Why some products are inelastic and others are elastic
Income Elasticities
Cross Elasticities of Demand
Combined Effects of Elasticities 1

2. Health Care & Cigarettes
Raising cigarette taxes reduces smoking
In Canada, over $4 for a pack of cigarettes reduced smoking 38% in a decade
But cigarette taxes also helps fund health care initiatives
The issue then, should we find a tax rate that maximizes tax revenues?
Or a tax rate that reduces smoking?

3. Demand Analysis
An important contributor to firm risk arises from sudden shifts in demand for the product or service.
Demand analysis serves two managerial objectives:
(1) it provides the insights necessary for effective management of demand, and
(2) it aids in forecasting sales and revenues. 2

5. FIGURE 3.1 Demand for SUV (Ford Explorer) as Gasoline Price Doubled

6. Downward Slope to the Demand Curve
Economists presume consumers are maximizing their utility
This is used to derive a demand curve from utility maximization
income effect -- as the price of a good declines, the consumer can purchase more of all goods since his or her real income increased. So as the price falls, we typically buy more. 8

7. Downward Slope to the Demand Curve
substitution effect -- as the price declines, the good becomes relatively cheaper. A rational consumer maximizes satisfaction by reorganizing consumption until the marginal utility in each good per dollar is equal. We buy more. 8

8. FIGURE 3.2 Consumption Choice on a Business Trip

9. Downward Slope to the Demand Curve
targeting, switching, and positioning – marketing efforts such as loyalty programs affect demand. 8

10. Indifference Curves to
derive demand
Uo U1
Food
We can "derive" a demand curve graphically from maximization of utility subject to a budget constraint. Suppose the price of entertainment falls from line 1 to line 2
We tend to buy more from
the Income Effect and
the Substitution Effect.
From a to b, is the substitution effect. From b to c is the income effect. a c b 2 1
Entertainment PE
demand
Entertainment 26

11. The Price Elasticity of Demand
Elasticity is measure of responsiveness or sensitivity
Beware of using Slopes
Slopes
change
with a
change in
units of
measure
price price
per per
bu bu.
bushels hundred tons 10

12. Price Elasticity ED = % change in Q / % change in P
Shortcut notation: ED = %Q / %P
A percentage change from 100 to 150 is 50%
A percentage change from 150 to 100 is -33%
For arc price elasticities, we use the average as the base, as in 100 to 150 is +50/125 = 40%, and 150 to 100 is -40%
Arc Price Elasticity -- averages over the two points
Average quantity
arc price
elasticity
ED = DQ/ [(Q1 + Q2)/2]
DP/ [(P1 + P2)/2] D
Average price 11

13. Arc Price Elasticity Example
Q = 1000 when the price is $10
Q= 1200 when the price is reduced to $6
Find the arc price elasticity
Solution: ED = %Q/ %P = +200/1100
- 4 / 8 or
The answer is a number.
A 1% increase in price reduces quantity by .36 percent. 12

14. Point Price Elasticity Example
Need a demand curve or demand function to find the price elasticity at a point.
ED = %Q/ %P =(Q/P)(P/Q)
If Q = •P, find the point price elasticity at P = 30; P = 50; and P = 80
ED = (Q/P)(P/Q) = - 5(30/350) = - .43
ED = (Q/P)(P/Q) = - 5(50/250) = - 1.0
ED = (Q/P)(P/Q) = - 5(80/100) = - 4.0 13

15. Price Elasticity (both point price and arc elasticity )
If ED = -1, unit elastic
If ED > -1, inelastic, e.g.,
If ED < -1, elastic, e.g., -4.0
price
Straight line
demand curve
example
elastic region
unit elastic
inelastic region
quantity 14

16. FIGURE 3.4 Perfectly Elastic and Inelastic Demand Curves

17. TR and Price Elasticities
If you raise price, does TR rise?
Suppose demand is elastic, and raise price. TR = P•Q, so, %TR = %P+ %Q
If elastic, P , but Q a lot
Hence TR FALLS !!!
Suppose demand is inelastic, and we decide to raise price. What happens to TR and TC and profit? 15

18. Another Way to Remember
( Figure 3.2)
Another Way to Remember
Elastic
Unit Elastic
Inelastic A
Linear demand curve
TR on other curve
Look at arrows to see movement in TR
Increasing price in the inelastic region raises revenue
Increasing price in the elastic region lowers revenue B Q TR 16

19. FIGURE 3.5 Price Elasticity over Demand Function

20. FIGURE 3.5 Price Elasticity over Demand Function

21. MR and Elasticity Marginal revenue is DTR / DQ
To sell more, often price must decline, so MR is often less than the price.
MR = P ( 1 + 1/ED )
For a perfectly elastic demand, ED = -B. Hence, MR = P.
If ED = -2, then MR = .5•P, or is half of the price.

23. 1979 Deregulation of Airfares
Prices declined after deregulation
And passengers increased
Also total revenue increased
What does this imply about the price elasticity of air travel?
It must be that air travel was elastic, as a price decrease after deregulation led to greater total revenue for the airlines. 17

24. Determinants of the Price Elasticity
The availability and the closeness of substitutes
more substitutes, more elastic
The more durable is the product
Durable goods are more elastic than non-durables
The percentage of the budget
larger proportion of the budget, more elastic
The longer the time period permitted
more time, generally, more elastic
consider examples of business travel versus vacation travel for all three above. 18

25. Empirical Price Elasticities
Apparel (whole market) -1.1
Apparel (one firm) -4.1
Beer -.84
Wine -.55
Liquor -.50
Regular coffee -.16
Instant coffee -.36
Adult visits to dentist
men -.65
Women -.78
Children visit to dentist -1.4
Furniture -3.04
Glassware & China -1.2
School lunches -.47
Flights to Europe -1.25
Shoes -.73
Soybean meal -1.65
Telephones -.10
Tires -.60
Tobacco -.46
Tomatoes -2.22
Wool -1.32

26. Free Trade and Price Elasticities
NAFTA (North American Free Trade Agreement) and Europe having a common currency in the Euro are examples of greater freedom in trade
What does that do to price elasticities?
With more substitutes, we expect that products become More Elastic
Consumers gain as firms are less able to raise their prices, but firm face stiffer competition

27. Income Elasticity EY = %Q/ %Y = (Q/Y)( Y/Q) point income
arc income elasticity:
suppose dollar quantity of food expenditures of families of $20,000 is $5,200; and food expenditures rises to $6,760 for families earning $30,000.
Find the income elasticity of food
%Q/ %Y = (1560/5980)•(10,000/25,000) = .652
With a 1% increase in income, food purchases rise .652%
EY = DQ/ [(Q1 + Q2)/2] arc income
DY/ [(Y1 + Y2)/2] elasticity 19

28. Income Elasticity Definitions
If EY >0, then it is a normal or income superior good
some goods are Luxuries: EY > 1 with a high income elasticity
some goods are Necessities: EY < 1 with a low income elasticity
If EY is negative, then it’s an inferior good
Consider these examples:
Expenditures on new automobiles
Expenditures on new Chevrolets
Expenditures on 1996 Chevy Cavaliers with 150,000 miles
Which of the above is likely to have the largest income elasticity?
Which of the above might have a negative income elasticity? 20

29. Point Income Elasticity Problem
Suppose the demand function is:
Q = •P + 3•Y
find the income and price elasticities at a price of P = 2, and income Y = 10
So: Q = 10 -2(2) + 3(10) = 36
EY = (Q/Y)( Y/Q) = 3( 10/ 36) = .833
ED = (Q/P)(P/Q) = -2(2/ 36) = -.111
Characterize this demand curve, which means describe them using elasticity terms. 21

30. Advertising Elasticity
EA = %Q/ %ADV = (Q/ADV)( ADV/Q)
If the Advertising elasticity is .60, then a 1% increase in Advertising Expenditures increases the quantity of goods sold by .60%.

31. Cross Price Elasticities
EX = %QA / %PB = (QA/PB)(PB /QA)
Substitutes have positive cross price elasticities: Butter & Margarine
Complements have negative cross price elasticities: DVD machines and the rental price of DVDs at Blockbuster
When the cross price elasticity is zero or insignificant, the products are not related 22

33. Antitrust & Cross Price Elasticities
Whether a product is a monopoly or in a larger industry is dependent on the closeness of the substitutes
DuPont’s cellophane was at first viewed as a monopoly. Economists showed that the cross price elasticity with other products such as aluminum foil, waxed paper, and other flexible wrapping paper was Positive, the large, DuPont showed its cellophane was not a monopoly in this larger market.

35. PROBLEM: Find the point price elasticity, the point income elasticity, and the point cross-price elasticity at P=10, Y=20, and Ps=9, if the demand function were estimated to be: QD = ·P + 2·Y + 2·Ps Is the demand for this product elastic or inelastic? Is it a luxury or a necessity? Does this product have a close substitute or complement? Find the point elasticities of demand. 23

36. Answer
First find the quantity at these prices and income: QD = ·P + 2·Y + 2·Ps = 90 -8·10 + 2·20 + 2·9 = = 68
ED = (Q/P)(P/Q) = (-8)(10/68)= which is elastic
EY = (Q/Y)(Y/Q) = (2)(20/68) = +.59 which is a normal good, but a necessity
EX = (QA/PB)(PB /QA) = (2)(9/68) = +.26 which is a mild substitute

37. Combined Effect of Demand Elasticities
Most managers find that prices and income change every year. The combined effect of several changes are additive.
%DQ = ED(% DP) + EY(% DY) + EX(% DPR)
where P is price, Y is income, and PR is the price of a related good.
If you knew the price, income, and cross price elasticities, then you can forecast the percentage changes in quantity.

38. Example: Combined Effects of Elasticities
Toro has a price elasticity of -2 for snow blowers
Toro snow blowers have an income elasticity of 1.5
The cross price elasticity with professional snow removal for residential properties is +.50
What will happen to the quantity sold if you raise price 3%, income rises 2%, and professional snow removal companies raises its price 1%?
%DQ = EP • %DP +EY • %DY + Ecross • %DPR = -2 • 3% • 2% +.50 • 1% = -6% + 3% + .5%
%DQ = -2.5%. We expect sales to decline 2.5%.
Q: Will Total Revenue for your product rise or fall?

39. Example: Combined Effects of Elasticities
A: Total revenue will rise slightly (about + .5%), as the price rises 3% and the quantity of snow- blowers sold falls 2.5%.

40. Optimization Techniques

41. Economic Optimization Process
Optimal Decisions
Best decision helps achieve objectives most efficiently.
Maximizing the Value of the Firm
Value maximization requires serving customers efficiently.
What do customers want?
How can customers best be served?

42. Expressing Economic Relations
Tables and Equations
Simple graphs and tables are useful.
Complex relations require equations.
Total, Average, and Marginal Relations
Total increases when marginal is positive.

43. Revenue per time period ($)$
3 Total revenue = $1.50 ´ output 2 1
Output per time period (units)

44. Maximization Occurs when Marginal Switches from Positive to Negative.
If marginal is above average, average is rising.
If marginal is below average, average is falling.
Graphing Total, Marginal, and Average Relations
Deriving Totals from Marginal and Average Curves
Total is sum of marginal.

46. Marginal Analysis in Decision Making
Use of Marginals in Resource Allocation
Maximum and minimum points occur where marginal is zero.
Distinguishing Maximums from Minimums
Total and Marginal Relations
Maximizing the Difference Between Two Functions
Maximum profit requires MR = MC.
When profits are maximized, total profit decreases with a change in output.

48. Practical Applications of Marginal Analysis
Profit maximization requires Mπ = MR-MC = 0 and MR=MC and that π is falling as output expands.
Revenue maximization requires MR=0.
Firms sometimes grab market share when maximizing long-run profitability.
Average cost minimization requires MC=AC and that AC is rising as output expands.

49. Incremental Concept in Economic Analysis
Marginal v. Incremental Concept
Marginal relates to one unit of output.
Incremental relates to one managerial decision.
Multiple units of output is possible.
Incremental Profits
Profits tied to a managerial decision.
Incremental Concept Example