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Overview of Chapter 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.
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Uo
Foo d
PE
Indifference Curves to U1 derive demand We can "derive" a demand curve graphically from maximization of utility a c b subject to a budget 2 constraint. Suppose the price of entertainment 1 Entertainment falls from line 1 to line 2 We tend to buy more from (i) the Income Effect and (ii) the Substitution Effect. demand From a to b, is the Entertainment substitution effect. From b to c is the income effect.
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bushels
hundred tons
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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%
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ED = %Q/ %P =( Q/P)(P/Q)
If Q = 500 - 5P, find the point price elasticity at P = 30; P = 50; and P = 80
1. ED = ( Q/P)(P/Q) = - 5(30/350) = - .43 2. ED = ( Q/P)(P/Q) = - 5(50/250) = - 1.0 3. ED = ( Q/P)(P/Q) = - 5(80/100) = - 4.0
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Price Elasticity
(both point price and arc elasticity )
If ED = -1, unit elastic If ED > -1, inelastic, e.g., - 0.43 If ED < -1, elastic, e.g., -4.0
price
elastic region
unit elastic
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( Figure 3.2)
Elastic
Unit Elastic
Inelastic B Q
TR
Q
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MR and Elasticity
Marginal revenue is TR / Q To sell more, often price must decline, so MR is often less than the price. MR = P ( 1 + 1/ED ) equation 3.7 on page 90 For a perfectly elastic demand, ED = -B. Hence, MR = P. If ED = -2, then MR = .5P, or is half of the price.
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Income Elasticity
EY = %Q/ %Y = (Q/ Y)( Y/Q)
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%
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point income
Q = 10 - 2P + 3Y
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
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 = 90 - 8P + 2Y + 2Ps
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.
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Answer
First find the quantity at these prices and income: QD = 90 - 8P + 2Y + 2Ps = 90 -810 + 220 + 29 =90 -80 +40 +18 = 68 ED = (Q/P)(P/Q) = (-8)(10/68)= -1.17 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
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If you knew the price, income, and cross price elasticities, then you can forecast the percentage changes in quantity.
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What will happen to the quantity sold if you raise price 3%, income rises 2%, and professional snow removal companies raises its price 1%?
%Q = EP %P +EY %Y + EX %Px = -2 3% + 1.5 2% +.50 1% = -6% + 3% + .5% %Q = -2.5%. We expect sales to decline 2.5%. Q: Will Total Revenue for your product rise or fall? A: Total revenue will rise slightly (about + .5%), as the price rises 3% and the quantity of snow-throwers sold falls 2.5%.Slide 26