Chapter Four Demand. Copyright © Houghton Mifflin Company.All rights reserved. 4–24–2 What is...

Chapter Four

Demand

Copyright © Houghton Mifflin Company.All rights reserved. 4–2

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.

PR

ICE

QUANTITY

We typically draw demand curves as downward sloping lines -- but how steep?

P

Q

P2

Q2 Q3

What if the lower price means this higher quantity demanded?

The flatter curve is MORE ELASTIC

PR

ICE

QUANTITY

P

Q

P2

Q2 Q3

A price change leads to a greater change in quantity demanded


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?


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?


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?


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

• 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?


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.


Price per Ticket Tickets Sold per Day $1,000 200 900 400 800 600 700 800 600 1000 500 1200 400 1400 300 1600 200 1800 100 2000

Assignment: Plot the following data

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY200 600 1000 1400 1800

Price Quantity

$1,000 200

800 600

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY200 600 1000 1400 1800

Price Quantity

$1,000 200

800 600

600 1000

400 1400

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY200 600 1000 1400 1800

Price Quantity

$1,000 200

800 600

600 1000

400 1400

200 1800

D


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


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


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


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


Answers

• from $1,000 to $600 = -10

• from $600 to $400 = -1.2

• from $200 to $100 = -2/9 = -.22


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.


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.


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.

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY

D200 600 1000 1400 1800

Elastic Region e > 1

Inelastic Region e < 1

Unit Elastic Point


Elasticity and Total Revenue

• Total revenue = P x Q.

• The price of the item multiplied by the number of items sold is total revenue.

Price per Ticket Quantity Total Revenue $1000 200 900 400 800 600 700 800 600 1000 500 1200 400 1400 300 1600 200 1800 100 2000

Price per Ticket Quantity Total Revenue $1000 200 200,000 900 400 800 600 700 800 600 1000 500 1200 400 1400 300 1600 200 1800 100 2000

Price per Ticket Quantity Total Revenue $1000 200 200,000 900 400 360,000 800 600 700 800 600 1000 500 1200 400 1400 300 1600 200 1800 100 2000

Price per Ticket Quantity Total Revenue $1000 200 200,000 900 400 360,000 800 600 480,000 700 800 560,000 600 1000 600,000 500 1200 600,000 400 1400 560,000 300 1600 480,000 200 1800 360,000 100 2000 200,000


Elastic Region


Inelastic Region


Elastic Region

Inelastic Region

Unit Elastic e=1


Total Revenue and Elasticity

• As price decreases in the elastic region, total revenue . . .

• Increases.

• As price decreases in the inelastic region, total revenue . . .

• Decreases.


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.


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.

Demand would increase – so curve would shift out.

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY

DD

12

$200

$400

$600

$800

$1000

PR

ICE

QUANTITY

D D1 2

How far it shifts depends on the elasticity

0

1000

2000

3000

4000

5000

6000

1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995

RGDP United States

-20

-15

-10

-5

0

5

10

15

20

1910

1916

1922

1928

1934

1940

1946

1952

1958

1964

1970

1976

1982

1988

1994

Changes in RGDP United States


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.


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%.


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%.


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.


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?


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

Chapter Four Demand. Copyright © Houghton Mifflin Company.All rights reserved. 4–24–2 What is...

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