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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
Copyright © Houghton Mifflin Company.All rights reserved. 4–5
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?
Copyright © Houghton Mifflin Company.All rights reserved. 4–6
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?
Copyright © Houghton Mifflin Company.All rights reserved. 4–7
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?
Copyright © Houghton Mifflin Company.All rights reserved. 4–8
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?
Copyright © Houghton Mifflin Company.All rights reserved. 4–10
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.
Copyright © Houghton Mifflin Company.All rights reserved. 4–11
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
Copyright © Houghton Mifflin Company.All rights reserved. 4–15
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
Copyright © Houghton Mifflin Company.All rights reserved. 4–16
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
Copyright © Houghton Mifflin Company.All rights reserved. 4–17
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
Copyright © Houghton Mifflin Company.All rights reserved. 4–18
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
Copyright © Houghton Mifflin Company.All rights reserved. 4–19
Answers
• from $1,000 to $600 = -10
• from $600 to $400 = -1.2
• from $200 to $100 = -2/9 = -.22
Copyright © Houghton Mifflin Company.All rights reserved. 4–20
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.
Copyright © Houghton Mifflin Company.All rights reserved. 4–21
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.
Copyright © Houghton Mifflin Company.All rights reserved. 4–22
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
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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
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
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
Inelastic Region
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
Unit Elastic e=1
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Total Revenue and Elasticity
• As price decreases in the elastic region, total revenue . . .
• Increases.
• As price decreases in the inelastic region, total revenue . . .
• Decreases.
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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.
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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
Copyright © Houghton Mifflin Company.All rights reserved. 4–39
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.
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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%.
Copyright © Houghton Mifflin Company.All rights reserved. 4–41
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%.
Copyright © Houghton Mifflin Company.All rights reserved. 4–42
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.
Copyright © Houghton Mifflin Company.All rights reserved. 4–43
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?
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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