Managerial Economics(chapter 3)

Chapter 3: Demand Theory Instructor: Maharouf Oyolola

Outline of the lecture • • • • •

- Determinants of Demand -graph of the demand function -Demand schedule -Law of Demand -Difference between change in Demand and Change in Quantity Demanded • -From individual to market demand • -

Outline of the lecture • -Price elasticity of Demand (Point and Arc) • -Income Elasticity of Demand (Point and Arc) • -Cross-Price elasticity of demand • - E-commerce

Demand Theory • In this chapter, we begin our analysis of consumer demand. Demand is one of the most important aspects of managerial economics, since a firm would not be established or survive if a sufficient demand for its product did not exist or could not be created.

• The fundamental objective of demand theory is to identify and analyze the basic determinants of consumer needs and wants. • Therefore, an understanding of the forces behind demand is a powerful tools for managers. Such knowledge provides the background needed to make pricing decisions, forecast sales, and formulate marketing strategies.

• Demand analysis was introduced as a tool for managerial economics. • For example, a knowledge of price and cross elasticities can assist managers in pricing and that income elasticities provide useful insights into how demand for a product will respond to different macroeconomic conditions.

Determinants of Demand We begin this section by examining the determinants of individual’s demand of a commodity. In managerial economics, we are primarily interested in the demand for a commodity faced by the firm.

Determinants of Demand • In determining what to purchase, individual consumers face a constrained optimization problem. That is, given their income (the constraint), they select that combination of goods and services that maximizes their personal satisfaction.

Determinants of Demand • The consumer demand theory postulates that the quantity demanded of a commodity is a function of, or depends on: • - the price of the commodity • -the consumer’s income • -the price of related commodities (complements and substitutes) • -tastes of the consumer

Graph of the demand function • However, when we graph the relationship between the price and the demand, we assume other variables( income, tastes and preferences) are constant, meaning their values do not change.

DEMAND SCHEDULE for milk

PRICE 0.90 1.00 1.10 1.20 1.30 1.40 1.50

QUANTITY 75 70 65 60 55 50 45

The Demand Schedule •Demand Schedule: a list showing quantities of a good that consumers would choose to purchase at different prices, with all other variables held constant.

DEMAND CURVE FOR milk p D r i $1.50 c 1.40 e

A B C

1.30

E

Price

1.20

F

1.10

G

1.00

H

.90

D 0

45

50

55

60

65

70

Quantity of milk Copyright  2000 by Harcourt, Inc. All rights reserved.

75

Law of Demand •The law of demand states that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall.

In functional form • • • • • • •

Qdx= F( Px, I, Py, T) Where Qdx= quantity demanded of commodity X Px= Price per unit of commodity X I= consumer’s income Py= Price of related commodities T= tastes of the consumer

Difference between change in quantity demanded and change in demand • Q=F (Px, I, Pr, T,…) • To study the relationship between the price and quantity demanded, we assume that income, price of related goods and tastes are constant.

MOVEMENT ALONG A DEMAND CURVE VERSUS SHIFT of the demand curve D1 D0

Price

$1.30

C

F

1.10

D1 D0 Quantity Demanded Copyright  2000 by Harcourt, Inc. All rights reserved.

Demand vs. Quantity Demanded

•Change in Quantity

Demanded = movement along the demand curve •Change in Demand = movement of the entire

From individual to market demand • The market demand curve is simply the horizontal summation of the demand curves of all the consumers in the market. • (include the 3 graphs on page 92)

The bandwagon effect • When people sometimes demand commodity because others are purchasing it and in order to be fashionable

The Snob effect • Occurs when many consumers who seek to be different and exclusive by demanding less of a commodity as more people consume it

Durable goods • Goods that provide services not only during the year when they are purchased but also in subsequent years. • Example: washing machines, automobiles

Price Elasticity of Demand • A price change can either increase or decrease total revenue, depending on the nature of the demand function. • The uncertainty involved could be reduced if managers had a method of measuring the probable effect of price changes on total revenue.

Price Elasticity of Demand • One such measure is the price elasticity of demand, which is defined as the percentage change in quantity demanded divided by the percentage change in price. • Measure the responsiveness of the consumer to a change in price.

Why is the concept of elasticity of demand to the firm? • From a decision-making perspective, the firm needs to know the effect of changes in any of the independent variables in the demand function on the quantity demanded. Some of these variables are under the control of management, such as price, advertising, product quality, and customer service. • By affecting sales, the pricing policies of the firm also affect its production costs, and thus its profitability.

How to find the percentage change? • Example 1: P1= $100 P2= $150 • Example 2: Q1=990 Q2=1500 • Example: P1=$5 P2=$3

Point Versus Arc Elasticity •

There are two approaches to computing price elasticities: (2) The point price elasticity (3) The arc price elasticity The choice between the two depends on the available data and the intended use.

Arc elasticity • They are appropriate for analyzing the effect of discrete changes in price. For example, a price increase from $1 to $2 could be evaluated by computing the arc elasticity. • In actual practice, most elasticity computations involve the arc method.

Point Elasticity • This approach can be used to evaluate the effect of a very small price changes or to compute the price elasticity at a particular price. • Point elasticities are important in theoretical economics.

Price Elasticity of Demand • Because of the inverse relationship between P and Q, Ep is negative. However, for simplicity, we use the absolute value of Ep or IEpI to interpret the result

∆Q Q ∆Q P Ep = = • ∆P ∆P Q P

• If IEpI>1

The demand is elastic

• Meaning: If the price of the product increases by 1%, the consumers respond by decreasing their demand of the product by more than 1%.

• If IEpI<1 the demand is inelastic • Meaning: if the price of the product increases by 1%, the consumers respond by decreasing their demand of the product by less than 1% • Example: a necessary good • gas, electricity, water

• If IEpI=1 the demand is unit elastic • Meaning: if the price of the product increases by 1%, the consumer responds by decreasing its demand of the product by exactly the same percent.

Price

demand curve 8 6 4 2 0

Q

0

200

400

600

Quantity demanded

800

• At B

∆Q = 100 − 0 = 100 ∆P = 5 − 6 = −1 P=5 Q = 100 IEpI = 5 > 1 ⇒ The demand is elastic

• Point elasticities can also be computed from a demand equation. • Suppose that the demand equation is as follows: Qd= 100 – 4P P=$10 Ep= -0.67 P=$20 Ep= -4.0

Arc Price Elasticity of Demand • Measures the price elasticity of demand between two prices

∆ Q ( P1 + P2 ) / 2 Ep = • ∆ P (Q1 + Q2 ) / 2

Example • Using the point elasticity of demand, let’s compute Ep: • C to D Ep=-2 • D to C Ep=-1 • To avoid this, we use the average of the two prices and the average of the two quantities

Between C and D • P1+P2=4+3= 7 • Q1+Q2=200+300=500 • Ep=-1.4

Example • Consider the NBA corporation, which had monthly basketball shoe sales of 10,000 pairs (at $100 per pair) before a price cut by its major competitor. After this competitor’s price reduction, NBA’s sales declined to 8,000 pairs a month. From the past experience NBA has estimated the price elasticity of demand to be about -2.0 in this price-quantity range. If the NBA wishes to restore its sales to 10,000 pairs a month, determine the price that must be charged.

Solution • Letting Q2=10,000 Q1=8,000 P1=$100 and ED=-2.0, the required price, P2, may be computed:

10,000 − 8,000 10,000 + 8,000 − 2.0 = P2 − $100 P2 + $100 P2 = $89.50

Price Elasticity, Total Revenue and Marginal Revenue • • • •

TR=P.Q MR=ΔTR/ΔQ If P increases IEpI<1 TR increases Example: Gas (necessary good) there is no close substitute for gas. • It can be an answer to many who wonder why oil companies are making huge profits when gas prices are increasing.

Price Elasticity, Total Revenue and Marginal Revenue • If P increases IEpI>1 TR falls • Availability of close substitutes led the consumer to substitute the product with the closest substitute • MR=P( 1 + 1/Ep) • Discuss this formula in detail

Factors affecting the price elasticity of demand • The price elasticity of demand depends primarily on: • - the existence of close substitutes for the commodity • -the length of time over which the quantity response to the price change is measured

• The price elasticity of demand is larger the closer and the greater is the number of available substitutes for the commodity • Intuitively, the price elasticity of sugar is higher than the price elasticity of salt • Example: Sugar has more substitutes than salt • Substitutes for sugar: honey, saccharine

• The price elasticity of demand is also larger the longer is the time period allowed for consumers to respond to the change in the commodity price. • As time goes by, consumers learn about the existence of substitutes and adjust their purchases to the price change

Example • During the period following the sharp increase in gasoline price in 1974, the price elasticity was very low. several years later, however, the reduction in the quantity demanded of gasoline was much greater than in the short-run as consumers changed their buying habits by purchasing fuel-efficient, compact cars; switched to public transportation and took other steps to reduce gasoline consumption.

Price elasticity and Decision Making • Information about price elasticities can be extremely useful to managers as they contemplate price decisions. • If demand is inelastic at the current price, a price decrease will result in a decrease in total revenue. • Alternatively, reducing the price of a product with elastic demand would cause revenue to increase.

Price elasticity and Decision Making • The relationship between elasticity and total revenue can be shown using simple calculus. • MR=P(1+1/Ep) • If Ep=-1 MR=0 → interpretation: if the demand is unitary elastic, prices will not change total revenues.

Price elasticity and Decision Making • If Ep<-1 → the demand is elastic →MR>0 → A price reduction would increase the quantity demanded. Therefore, total revenue would increase. • If Ep>-1 → the demand is inelastic →MR<0 → A price reduction would decrease total revenue.

Income Elasticity of Demand • Measures the responsiveness of the demand for a commodity to a change in consumer’s income

Why the income elasticity of demand is important to the firm? • -Income is one of the determinant of demand. • For instance, consumers tend to change their buying habit during a recession or expansion. Therefore, the firm needs to take that factor into consideration while choosing the amount of output to produce

Point Income elasticity of Demand

∆Q ∆Q I Q EI = = • ∆I ∆I Q I

Arc Income Elasticity of Demand

∆Q ( I1 + I 2 ) / 2 EI = • ∆I (Q1 + Q2 ) / 2 ∆Q I1 + I 2 EI = • ∆I Q1 + Q2

Definitions • A Normal good: a good whose quantity demanded rises as the income of the consumer increases. • Examples: automobiles, education, travel, movies, housing

• Inferior good: A good whose quantity demanded increases as the income of the consumer falls. • Example: Black and White TV, hot dogs hamburgers

• If EI>0

Normal goods

• If EI<0

Inferior goods

• Example of normal goods: luxury item such as vacations in the Caribbean, which will increase when the economy is booming

Normal goods • Food, clothing and housing EI>0 but low necessities • Healthcare and education EI>1

Inferior goods • EI<0 • Black and White TV • Flour

Cross-price elasticity of demand • The demand of a commodity also depends on the price of related (i.e. substitutes and complements) commodities. • Example: If the price of tea rises, the demand for coffee increases Consumers substitute coffee for tea in consumption • On the other hand, if the price of sugar (a complement of coffee) rises, the demand for coffee declines

The point cross-price elasticity of demand • Measures the responsiveness in the demand for commodity X to a change in the price of commodity Y.

∆ Qx Qx ∆ Qx Py E XY = = • ∆ Py ∆ Py Qx Py

• If Exy>0 commodities X and Y are substitutes • Examples: coffee and tea • butter and margarine

• If Exy<0 commodities X and Y are complements • Examples: sugar and coffee • cars and gasoline

• If EXY=0 X and Y are independent commodities • Examples: books and beer • cars and candy • pencils and potatoes

• The cross-price elasticity of demand is a very important concept in managerial decision-making. • Firms often use this concept to measure the effect of changing the price of a product they sell on the demand of other related products that the firms also sell.

Example • General motors corporation can use the cross-price elasticity of demand to measure the effects of changing the price of Chevrolets on the demand for Pontiacs. • Chevrolets and Pontiacs are substitutes. Therefore, lowering the price of Chevrolets will reduce the demand for Pontiacs

E-Commerce • It refers to the production, advertising, sale, and distribution of products and services from business to business and from business to consumers through the internet. • In e-commerce, there is no traveling to a traditional store, no salesperson, and no cashregister. • The e-commerce has tremendously change the way in which buyers and sellers interact in the marketplace.

Advantages of E-commerce • - reduction of time and distance barriers between buyers and sellers.

Substitution effect • When the price of a good – such as steak – declines, it becomes less expensive in relation to other goods – for example, chicken. As a result of the price decline, the rational consumer may be able to increase his or her satisfaction (or utility) by purchasing more of the good whose price has declined and less of the other goods. This is known as the substitution effect.

Example • Suppose that the prices of steak and chicken are $5 and $2 per pound, respectively. • Assume that an individual purchases two pounds of steak and two pounds of chicken per week for total expenditure of $14. • Suppose that the price of steak declines to $4 per pound. As a result of this price decrease, an individual who has a preference for steak may decide to increase his or her consumption of steak to three pounds per week- which requires the same total expenditure of $14 per week. • Thus we see that a decrease in the price of steak( relative to chicken) has led to an increase in the demand for steak.

Income effect • When the price of a good – for example, steak – declines, the effect of this decline is that the real income of the consumer has increased. This is known as the income effect. • If an individual normally purchases two pounds of steak per week at $5 per pound, a price decline to $4 per pound would enable the consumer to purchase the same amount of steak for $2 less per week • This savings of $2 represents an increase in real income of $2, which may be used to purchase greater quantities of steak (as well as other goods) each week

Problems • • • • •

In class problems Problem #1 page 128 Problem #2 page 128 Written assignment Problem #3 page 128