Managerial Economics & Business

Strategy
Chapter 3
Quantitative Demand Analysis
 3-2

The Elasticity Concept

• How responsive is variable “G” to a change in
variable “S”

%G
EG , S 
%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.

If EG,S = 0, then S and G are unrelated.

 3-3

Price Elasticity of Demand

d
%QX
EQX , PX 
%PX
• Negative according to the “law of demand.”

Elastic: EQX , PX  1
Inelastic: EQX , PX  1
Unitary: EQX , PX  1
 3-4
Perfectly Elastic &
Inelastic Demand

Price Price
D

D Perfectly Inelastic ( EQX , PX  0)

Quantity Quantity

Perfectly Elastic ( EQX , PX  )

 3-5

Own-Price Elasticity
and Total Revenue
• Elastic
– Increase (a decrease) in price leads to a decrease (an
increase) in total revenue. (Negative relation with price)
• Inelastic
– Increase (a decrease) in price leads to an increase (a
decrease) in total revenue. (positive relation with price)
• Unitary
– Total revenue is maximized at the point where demand
is unitary elastic.
 3-6

Elasticity, Total Revenue and Linear Demand

P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-7

Elasticity, Total Revenue and Linear Demand

P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-8

Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-9

Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-10

Elasticity, Total Revenue and Linear Demand

P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-11

Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 3-12

Elasticity, Total Revenue and Linear Demand

P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-13

Elasticity, Total Revenue and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 Factors Affecting 3-14

Own Price Elasticity

– Available Substitutes
• The more substitutes available for the good, the more
elastic the demand.
– Time
• Demand tends to be more inelastic in the short term
than in the long term.
• Time allows consumers to seek out available substitutes.
– Expenditure Share
• Goods that comprise a small share of consumer’s
budgets tend to be more inelastic than goods for which
consumers spend a large portion of their incomes.
 3-15

Cross Price Elasticity of Demand

d
%QX
EQX , PY 
%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQ < 0, then X and Y are complements.

X,PY
 3-16

Income Elasticity

d
%QX
EQX , M 
%M

If EQ > 0, then X is a normal good.

X,M

If EQX,M < 0, then X is a inferior good.

 Elasticity of Supply
• Price Elasticity of Supply

– The percentage change in the quantity supplied

that occurs in response to a percentage change in
price.
s
%QX
EQX , PX 
%PX
 3-18
Perfectly Elastic &
Inelastic Supply

Price Price
S

S
Perfectly Inelastic ( EQX , PX  0)

Quantity Quantity

Perfectly Elastic ( EQX , PX  )

Factors Affecting Price Elasticity of Supply

– Resource Substitution possibilities.

– Time frame for the supply decision.

Momentary supply (Perfectly inelastic)

Long run supply (elastic)
Short run supply (inelastic)
 3-20

Uses of Elasticities

• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and recessions.
• Impact of advertising campaigns.
 3-21

Example 1: Pricing and Cash Flows

• According to an FTC Report by Michael
Ward, AT&T’s own price elasticity of
demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to
meet it’s marketing goals.
• To accomplish this goal, should AT&T raise
or lower it’s price?
 3-22

Answer: Lower price!

• Since demand is elastic, a reduction in price
will increase quantity demanded by a
greater percentage than the price decline,
resulting in more revenues for AT&T.
 3-23

Example 2: Quantifying the Change

• If AT&T lowered price by 3 percent, what

would happen to the volume of long
distance telephone calls routed through
AT&T?
 3-24

Answer
• Calls would increase by 25.92 percent!
d
% Q X
EQX , PX  8.64 
%PX
d
%QX
 8.64 
 3%
 3%    8.64  %QX
d

d
%QX  25.92%
 3-25

Example 3: Impact of a change in

a competitor’s price
• According to an FTC Report by Michael Ward,
AT&T’s cross price elasticity of demand for
long distance services is 9.06.
• If competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?
 3-26

Answer
• AT&T’s demand would fall by 36.24 percent!

d
%QX
EQX , PY  9.06 
%PY
d
%QX
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%
 3-27

Interpreting Demand Functions

• Mathematical representations of demand curves.
• Example:
d
QX  10  2 PX  3PY  2 M
– Law of demand holds (coefficient of PX is negative).
– X and Y are substitutes (coefficient of PY is positive).
– X is an inferior good (coefficient of M is negative).
 3-28

Linear Demand Functions and Elasticities

• General Linear Demand Function and Elasticities:

QX   0   X PX   Y PY   M M   H H
d

PX PY M
EQ X , PX X EQX , PY  Y EQX , M  M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
 3-29

Log-Linear Demand

• General Log-Linear Demand Function:

ln Q X d   0   X ln PX  Y ln PY   M ln M   H ln H

Own Price Elasticity : X

Cross Price Elasticity : Y
Income Elasticity : M
 3-30

Regression Analysis
• One use is for estimating demand functions.
• Important terminology and concepts:
– Least Squares Regression model: Y = a + bX + e.
– t-statistic.
– R-square or Coefficient of Determination.
– F-statistic.
• Slope:

  x  x  y  y 
ˆ1  i i

 x  x
2
i

• Intercept:

ˆ0  y  ˆ1x
 3-32

Conclusion
• Elasticities are tools you can use to quantify
the impact of changes in prices, income,
and advertising on sales and revenues.
• Given market or survey data, regression
analysis can be used to estimate:
– Demand functions.
– Elasticities.
• Managers can quantify the impact of
changes in prices, income, advertising, etc.