Demand Theory Week 2 Demand Theory
EC260
Chapter 2 – Demand Theory
Week 2
Demand Theory -Good managers learn to understand the nature of demand for products and effectively manage it -Many other factors besides price affect consumer demand – some of these are controlled by managers, such as advertising, product quality, and distribution -Other factors, like the number of substitute goods, the prices of rival products, and the advertising of rivals are part of the competitive dynamics of the product space -Knowing the sensitivity of demand to changes in environmental factors lets a manager effectively respond to these changes -The sensitivity of one factor to another is called elasticity -Elasticity – elasticity measures the percentage change in one factor given a small (marginal) percentage change in another factor -Elasticity is used by managers to determine a product’s most efficient mix of inputs The Market Demand Curve -Ways to show how sales of a product are affected by its price: -Market demand schedule – table showing the total quantity of the good purchased at each price -Market demand curve – the plot of the market demand schedule on a graph -The vertical axis of the graph measures the price per unit of the good -The horizontal axis measures the quantity of the good demanded per unit of time -Factors that determine the position and shape of a market demand curve: time, tastes of consumers, level of consumer incomes, level of other prices, size of the population Industry and Firm Demand Functions -Market demand function – the relationship between the quantity demanded and the various factors that influence this quantity The Own-Price Elasticity of Demand -The elasticity of a function is defined as the percentage change in the dependent variable in response to a 1 percent change in the independent variable -A market demand curve is a function in which quantity demanded is dependent on a product’s price -Own-price elasticity of demand – more simply referred to as price elasticity of demand, this is the concept managers use to measure their own percentage change in quantity demanded resulting from a 1 percent change in their own price -The word own is used to convey the idea that managers generally measure the price elasticity of demand for a product or service produced by their firm -The price elasticity of demand is defined as the percentage change in quantity demanded resulting from a 1 percent change in price -The price elasticity of demand is expressed as a negative number -For most demand curves, the elasticity varies with price -The magnitude of the ales response to price changes does not remain constant Using the Demand Function to Calculate the Price Elasticity of Demand -Specify the point on the demand cure at which price elasticity is measured: Use Q=-700P + 200I – 500S +0.01A -Substitute the appropriate letters in
EC260
Chapter 2 – Demand Theory
Week 2
The Effect of Price Elasticity on the Firm’s Revenue -We can use price elasticity to determine how a price change will affect a firm’s total revenue -Suppose at the current price, demand for a product is price elastic; that is, the price elasticity of demand is less than -1. In this situation, if the price is reduced, the percentage increase in quantity demanded is greater than the percentage reduction in price. That is, although all units are now being sold at a lower price, the increase in units sold because of the lower price more than makes up for the slightly lower unit price. Hence, total revenue increases. Similarly, if demand is elastic at the current price and a manager increases the price, total revenue will decrease. Determinants of the Own-Price Elasticity of Demand -Depends heavily on the similarity of available substitute products. A product with many close substitutes generally has elastic demand. If managers increase the product’s price, consumers can easily switch to one of the several other substitutes. -A products price relative to a consumer’s total budget. Products that command a larger percentage of the consumer’s total budget tend to be more price elastic. -Length of the period to which the demand curve pertains. Demand is likely to be more elastic over a long period relative to a short period. This is because the longer the time period, the easier it is for consumers to substitute one good for another. The Strategic Use of the Price Elasticity of Demand -Good managers take strategic actions to use the price elasticity to their benefit. -Managers can also change the rice elasticity of demand for their product. The most common way managers impact the price elasticity of their product is with differentiation strategies. Managers who successfully increase the differentiation of their product decrease its price elasticity of demand -Differentiation strategies convince consumers the product is unique, hence it has fewer substitutes. -It is important for managers to understand that differentiation is not effective if consumers do not perceive it. Total Revenue, Marginal Revenue, and Price Elasticity -We want to look more closely at the effect of the price elasticity of demand on a firm’s total revenue -To a good’s producers, the total amount of money paid by consumers equals the firm’s revenue -Marginal revenue – the incremental revenue earned from selling the nth unit of output -Comparing the marginal revenue curve with the demand curve, we see that while both have the same intercept on the vertical axis, the slope of the marginal revenues curve is twice that the demand curve -As long as marginal revenue is positive, an increase in sales raises total revenue. However, at outputs where the incremental revenue is negative, total revenue will decrease -At quantities where demand is price elastic, marginal revenue is positive; as quantities where it is of unitary elasticity, marginal revenue is zero; and at quantities where it is price inelastic, marginal revenue is negative. The Income Elasticity of Demand -An important factor over which managers have little control is the level of consumer income -Income elasticity of demand – the percentage change in quantity demanded resulting from a 1 percent change in consumers income -Normal goods – when consumer incomes increase, they buy more of the product -Inferior goods – when incomes increase, quantity demanded decreases. Ex. Public transportation -In forecasting the long-term growth of the quantity demanded or many major products, the income
EC260
Chapter 2 – Demand Theory
Week 2
elasticity of demand is of key importance Cross-Price Elasticities of Demand -Price rivals influence the quantity demanded of a product -Holding constant to the product’s own price and allowing the price of another product to vary may result in important effects on the quantity demanded of the product in question -By observing these effects, we can classify pairs of products as substitutes or complements -The Cross-price elasticity of demand – the percentage change in the quantity demanded of one good resulting from a 1 percent change in the price of another good -If the cross-price elasticity of demand is positive, goods X and Y are classified as substitutes -If the cross-price elasticity of demand is negative, goods X and Y are classified as complements -If the cross-price elasticity of demand of two products is around zero, then the products have independent demand levels. Ex. If the price of butter increases, the demand for airline tickets remains constant. -The cross price elasticity of demand is of fundamental importance to managers because they continually must do their best to anticipate what will happen to their own sales if rivals change their prices – to do so they need information concerning the cross-price elasticities of demand -A high cross-price elasticity measure between products X and Y can cause concern that a merger between the producers of products X and Y might result in consumers experiencing higher prices and fewer brand choices The Advertising Elasticity of Demand -The Advertising elasticity of demand – the percentage change in the quantity demanded of the product resulting from a 1 percent change in the advertising expenditure The Constant-Elasticity and Unitary Elastic Demand Function -Constant-elasticity demand function – mathematical form that always yields the same elasticity, regardless of the product’s price and the consumers’ income -An important property o this type of demand is that the price elasticity of demand equals –b1 regardless of the value of P or I -This mathematical form explicitly recognizes that the effect on price on quantity demanded depends on income level and that the effect of income on quantity demanded depends on price -If the demand is of unitary elasticity, an increase or decrease in price has no effect on the amount spent on the commodity
Chapter 2 – Demand Theory
Week 2
Demand Theory -Good managers learn to understand the nature of demand for products and effectively manage it -Many other factors besides price affect consumer demand – some of these are controlled by managers, such as advertising, product quality, and distribution -Other factors, like the number of substitute goods, the prices of rival products, and the advertising of rivals are part of the competitive dynamics of the product space -Knowing the sensitivity of demand to changes in environmental factors lets a manager effectively respond to these changes -The sensitivity of one factor to another is called elasticity -Elasticity – elasticity measures the percentage change in one factor given a small (marginal) percentage change in another factor -Elasticity is used by managers to determine a product’s most efficient mix of inputs The Market Demand Curve -Ways to show how sales of a product are affected by its price: -Market demand schedule – table showing the total quantity of the good purchased at each price -Market demand curve – the plot of the market demand schedule on a graph -The vertical axis of the graph measures the price per unit of the good -The horizontal axis measures the quantity of the good demanded per unit of time -Factors that determine the position and shape of a market demand curve: time, tastes of consumers, level of consumer incomes, level of other prices, size of the population Industry and Firm Demand Functions -Market demand function – the relationship between the quantity demanded and the various factors that influence this quantity The Own-Price Elasticity of Demand -The elasticity of a function is defined as the percentage change in the dependent variable in response to a 1 percent change in the independent variable -A market demand curve is a function in which quantity demanded is dependent on a product’s price -Own-price elasticity of demand – more simply referred to as price elasticity of demand, this is the concept managers use to measure their own percentage change in quantity demanded resulting from a 1 percent change in their own price -The word own is used to convey the idea that managers generally measure the price elasticity of demand for a product or service produced by their firm -The price elasticity of demand is defined as the percentage change in quantity demanded resulting from a 1 percent change in price -The price elasticity of demand is expressed as a negative number -For most demand curves, the elasticity varies with price -The magnitude of the ales response to price changes does not remain constant Using the Demand Function to Calculate the Price Elasticity of Demand -Specify the point on the demand cure at which price elasticity is measured: Use Q=-700P + 200I – 500S +0.01A -Substitute the appropriate letters in
EC260
Chapter 2 – Demand Theory
Week 2
The Effect of Price Elasticity on the Firm’s Revenue -We can use price elasticity to determine how a price change will affect a firm’s total revenue -Suppose at the current price, demand for a product is price elastic; that is, the price elasticity of demand is less than -1. In this situation, if the price is reduced, the percentage increase in quantity demanded is greater than the percentage reduction in price. That is, although all units are now being sold at a lower price, the increase in units sold because of the lower price more than makes up for the slightly lower unit price. Hence, total revenue increases. Similarly, if demand is elastic at the current price and a manager increases the price, total revenue will decrease. Determinants of the Own-Price Elasticity of Demand -Depends heavily on the similarity of available substitute products. A product with many close substitutes generally has elastic demand. If managers increase the product’s price, consumers can easily switch to one of the several other substitutes. -A products price relative to a consumer’s total budget. Products that command a larger percentage of the consumer’s total budget tend to be more price elastic. -Length of the period to which the demand curve pertains. Demand is likely to be more elastic over a long period relative to a short period. This is because the longer the time period, the easier it is for consumers to substitute one good for another. The Strategic Use of the Price Elasticity of Demand -Good managers take strategic actions to use the price elasticity to their benefit. -Managers can also change the rice elasticity of demand for their product. The most common way managers impact the price elasticity of their product is with differentiation strategies. Managers who successfully increase the differentiation of their product decrease its price elasticity of demand -Differentiation strategies convince consumers the product is unique, hence it has fewer substitutes. -It is important for managers to understand that differentiation is not effective if consumers do not perceive it. Total Revenue, Marginal Revenue, and Price Elasticity -We want to look more closely at the effect of the price elasticity of demand on a firm’s total revenue -To a good’s producers, the total amount of money paid by consumers equals the firm’s revenue -Marginal revenue – the incremental revenue earned from selling the nth unit of output -Comparing the marginal revenue curve with the demand curve, we see that while both have the same intercept on the vertical axis, the slope of the marginal revenues curve is twice that the demand curve -As long as marginal revenue is positive, an increase in sales raises total revenue. However, at outputs where the incremental revenue is negative, total revenue will decrease -At quantities where demand is price elastic, marginal revenue is positive; as quantities where it is of unitary elasticity, marginal revenue is zero; and at quantities where it is price inelastic, marginal revenue is negative. The Income Elasticity of Demand -An important factor over which managers have little control is the level of consumer income -Income elasticity of demand – the percentage change in quantity demanded resulting from a 1 percent change in consumers income -Normal goods – when consumer incomes increase, they buy more of the product -Inferior goods – when incomes increase, quantity demanded decreases. Ex. Public transportation -In forecasting the long-term growth of the quantity demanded or many major products, the income
EC260
Chapter 2 – Demand Theory
Week 2
elasticity of demand is of key importance Cross-Price Elasticities of Demand -Price rivals influence the quantity demanded of a product -Holding constant to the product’s own price and allowing the price of another product to vary may result in important effects on the quantity demanded of the product in question -By observing these effects, we can classify pairs of products as substitutes or complements -The Cross-price elasticity of demand – the percentage change in the quantity demanded of one good resulting from a 1 percent change in the price of another good -If the cross-price elasticity of demand is positive, goods X and Y are classified as substitutes -If the cross-price elasticity of demand is negative, goods X and Y are classified as complements -If the cross-price elasticity of demand of two products is around zero, then the products have independent demand levels. Ex. If the price of butter increases, the demand for airline tickets remains constant. -The cross price elasticity of demand is of fundamental importance to managers because they continually must do their best to anticipate what will happen to their own sales if rivals change their prices – to do so they need information concerning the cross-price elasticities of demand -A high cross-price elasticity measure between products X and Y can cause concern that a merger between the producers of products X and Y might result in consumers experiencing higher prices and fewer brand choices The Advertising Elasticity of Demand -The Advertising elasticity of demand – the percentage change in the quantity demanded of the product resulting from a 1 percent change in the advertising expenditure The Constant-Elasticity and Unitary Elastic Demand Function -Constant-elasticity demand function – mathematical form that always yields the same elasticity, regardless of the product’s price and the consumers’ income -An important property o this type of demand is that the price elasticity of demand equals –b1 regardless of the value of P or I -This mathematical form explicitly recognizes that the effect on price on quantity demanded depends on income level and that the effect of income on quantity demanded depends on price -If the demand is of unitary elasticity, an increase or decrease in price has no effect on the amount spent on the commodity
