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Chapter3:DemandElasticitiesChapter3:DemandElasticityDemandelasticityshowsthepercentagechangeinquantitydemandedofaproductrelativetothepercentagechangeinbothvariablesThecoefficientrepresentstheratioofthetwopercentagechangesDemandElasticityDemandelastiPriceElasticity
ofDemandEquationThepercentagechangeinthequantitydemandedofagivengoodrelativetoapercentagechangeinitspriceeP=%ΔQx%ΔPxwhereΔ
=theabsolutechangeeP=priceelasticityofdemandQx=quantitydemandedofgoodXPx=thepriceofgoodXPriceElasticity
ofDemandEquPriceElasticityABQuantityPriceP1P20Q1Q2DemandMeasuredasamovementalongademandcurveFigure3.1QPPriceElasticityABQuantityPriPriceElasticityandDecisionMakingTellsmanagerswhatwillhappenifproductpriceschangeHelpsfirmstodeveloppricingstrategiesHelpstodeveloppricingstrategiesinthepublicsectorPriceElasticityandDecisionElasticityElasticdemand:changeinquantitydemandedisgreaterthanthechangeinpriceInelasticdemand:changeinquantitydemandedislessthanthechangeinpriceUnitary
elasticity:changeinquantitydemandisequaltochangeinpriceElasticityElasticdemand:chanElasticityand
TotalRevenueIfdemandiselastic,higherpricesresultinlowertotalrevenue.LowerpricesresultinhighertotalrevenueChangesinpriceandtheresultingtotalrevenueareinverselyproportionate(seeFigure3.2onnextslide)Elasticityand
TotalRevenueIfElasticDemandandTotalRevenueABXYCQuantityPrice(P1)
10(P2)902(Q1)Demand3(Q2)1212Ifpricesdecrease,revenueincreases.Ifpricesincrease,revenuedecreases.Figure3.2AreaX=Q1CBQ2AreaY=
P1ACP2ElasticDemandandTotalRevenInelasticDemandWhenunitsaresoldatalowerprice,thequantitydemandedhasnotincreasedproportionatelyTotalrevenuedecreasesChangesinpriceandtheresultingtotalrevenuemoveinthesamedirection(SeeFigure3.3onnextslide)InelasticDemandWhenunitsareInelasticDemandandTotalRevenueFigure3.3ABXYCQuantityPrice(P1)
4(P2)308(Q1)Demand9(Q2)1212Ifpricesdecrease,revenuedecrease.Ifpricesincrease,revenueincreases.AreaX=Q1CBQ2AreaY=
P1ACP2InelasticDemandandTotalRevManagerscanestimatepriceelasticitybyaskingcustomers:Whatdoyoucurrentlypayformyproduct?Atwhatpricewouldyoustopbuyingmyproductaltogether?Managersshouldaskthemselves:Howmuchwillrevenueincreaseasaresultofhighersales?Howmuchwillrevenuedecreaseasaresultoflowerpricesforeachunit?ManagerialRuleofThumb:EstimatingPriceElasticityManagerscanestimatepriceelDeterminantsofPriceElasticityofDemandNumberofsubstitutegoodsPercentofaconsumer’sincomethatisspentontheproductTimeperiodunderconsiderationNatureofthegood(durableornon-durable)DeterminantsofPriceElasticiCalculatingPriceElasticitiesArcpriceelasticity:basequantity(orprice)istheaveragevalueofthestartingandendingpointsPointpriceelasticity:measurementofthepriceelasticityofdemandcalculatedatapointonthecurveusinginfinitesimalchangesinpricesandquantitiesCalculatingPriceElasticitiesEquationforPointPriceElasticityofDemandP=thepricechargeda
=theverticalinterceptoftheplotteddemandcurve(theP=axis)(P-a)ep
=PwhereEquationforPointPriceElastNumericalExamplesDemandfunctionShowsrelationshipbetweenquantitydemandedandpriceQ=12–PorP=12–QTotalrevenuefunctionShowstotalrevenuereceivedbyproducerasafunctionofthelevelofoutputTR=(P)(Q)=(12–Q)(Q)=12Q–Q2NumericalExamplesDemandfunctNumericalExamplesAveragerevenuefunction:showshowaveragerevenueisrelatedtolevelofoutputAR=TR/Q=[(P)(Q)]/Q=PMarginalrevenuefunction:showstheadditionalrevenueaproducerreceivesbysellinganadditionalunitofoutputatdifferentlevelsMR=(TR)/(Q)=(TR2
–
TR1)/(Q2
–
Q1)MR=dTR/dQ=12
–
2QNumericalExamplesAveragereveDemandand
MarginalRevenueFirmsarealwaysconstrainedbydemandcurveTophalfofthedemandcurveinFigure3.4indicateswhenmanagerslowerprice,totalrevenueincreasesBottomhalfindicatesapricedecreasecausestotalrevenue
tofallDemandand
MarginalRevenueFiDemandand
MarginalRevenue|eP|>1Demand,marginalrevenue,andtotalrevenuefunctionsarerelatedFigure3.4|eP|=1|eP|<1MarginalRevenueQuantity6061212DemandDemandand
MarginalRevenue|eTheTotalRevenueFunction01836126TotalRevenueTotalRevenueFigure3.5TheTotalRevenueFunction0183ExtremeDemandCurvesVerticaldemandcurveRepresentsperfectlyinelasticdemandExamplemightbeinsulinfordiabeticsHorizontaldemandcurveRepresentsperfectlyelasticdemandExamplewouldbeabushelofwheatfromanagriculturalproducerExtremeDemandCurvesVerticalExtremeDemandCurves0P1QuantityPriceHorizontaldemandcurveDemand0Q1QuantityPriceVerticaldemandcurveDemandExtremeDemandCurves0P1QuantiElasticitiesofDemandIncomeelasticityofdemand:percentagechangeinquantitydemandedofagivengoodrelativetopercentagechangeinconsumerincomeNecessities–elasticitybetween0and1Luxuries–elasticitygreaterthan1ElasticitiesofDemandIncomeeCalculatingincomeelasticityofdemandisbasedontwoquestionsforaconsumer:WhatfractionofyourtotalbudgetdoyouspendonProductX?Ifyouearnedabonusof$1000,whatpartofthatbonuswouldyouspendonProductX?ManagerialRuleofThumb:CalculatingIncomeElasticityCalculatingincomeelasticityElasticitiesofDemandCross-priceelasticityofdemand:measureshowdemandforGoodXvarieswithchangesinthepriceofGoodYSubstitutegoodshavepositivecrosselasticityComplementarygoodshavenegativecrosselasticityDefinesrelevantmarketinwhichdifferentproductscompeteElasticitiesofDemandCross-prWhichdemandelasticityshouldbeusedinmakingappropriatedecisions:theonefortheentireproductortheonefortheindividualproducer?(Theanswerdependsuponhowotherfirmsreacttopricechanges)ManagerialRuleofThumb:PriceElasticityDecisionMakingWhichdemandelasticityshouldMarketingLiteratureRegardingElasticityIssuesAdvertisingelasticityofdemand:thepercentagechangeinquantitydemandedofagoodrelativetothepercentagechangeinadvertisingdollarsspentonthatgoodMarketingstudiesTellis,1988SethuramanandTellis,1991Hoch,etal,1995MarketingLiteratureRegardingSummaryofKeyTermsAveragerevenueandaveragerevenuefunctionCross-priceelasticityofdemandDemandelasticityLuxuryandnecessityMarginalrevenueandmarginalrevenuefunctionSummaryofKeyTermsAveragereSummaryofKeyTermsPerfectlyelasticdemandPerfectlyinelasticdemandPointpriceelasticityofdemandPriceelasticityofdemandTotalrevenueandtotalrevenuefunctionUnitaryelasticitySummaryofKeyTermsPerfectlyDoyouhaveanyquestions?Doyouhaveanyquestions?Chapter3:DemandElasticitiesChapter3:DemandElasticityDemandelasticityshowsthepercentagechangeinquantitydemandedofaproductrelativetothepercentagechangeinbothvariablesThecoefficientrepresentstheratioofthetwopercentagechangesDemandElasticityDemandelastiPriceElasticity
ofDemandEquationThepercentagechangeinthequantitydemandedofagivengoodrelativetoapercentagechangeinitspriceeP=%ΔQx%ΔPxwhereΔ
=theabsolutechangeeP=priceelasticityofdemandQx=quantitydemandedofgoodXPx=thepriceofgoodXPriceElasticity
ofDemandEquPriceElasticityABQuantityPriceP1P20Q1Q2DemandMeasuredasamovementalongademandcurveFigure3.1QPPriceElasticityABQuantityPriPriceElasticityandDecisionMakingTellsmanagerswhatwillhappenifproductpriceschangeHelpsfirmstodeveloppricingstrategiesHelpstodeveloppricingstrategiesinthepublicsectorPriceElasticityandDecisionElasticityElasticdemand:changeinquantitydemandedisgreaterthanthechangeinpriceInelasticdemand:changeinquantitydemandedislessthanthechangeinpriceUnitary
elasticity:changeinquantitydemandisequaltochangeinpriceElasticityElasticdemand:chanElasticityand
TotalRevenueIfdemandiselastic,higherpricesresultinlowertotalrevenue.LowerpricesresultinhighertotalrevenueChangesinpriceandtheresultingtotalrevenueareinverselyproportionate(seeFigure3.2onnextslide)Elasticityand
TotalRevenueIfElasticDemandandTotalRevenueABXYCQuantityPrice(P1)
10(P2)902(Q1)Demand3(Q2)1212Ifpricesdecrease,revenueincreases.Ifpricesincrease,revenuedecreases.Figure3.2AreaX=Q1CBQ2AreaY=
P1ACP2ElasticDemandandTotalRevenInelasticDemandWhenunitsaresoldatalowerprice,thequantitydemandedhasnotincreasedproportionatelyTotalrevenuedecreasesChangesinpriceandtheresultingtotalrevenuemoveinthesamedirection(SeeFigure3.3onnextslide)InelasticDemandWhenunitsareInelasticDemandandTotalRevenueFigure3.3ABXYCQuantityPrice(P1)
4(P2)308(Q1)Demand9(Q2)1212Ifpricesdecrease,revenuedecrease.Ifpricesincrease,revenueincreases.AreaX=Q1CBQ2AreaY=
P1ACP2InelasticDemandandTotalRevManagerscanestimatepriceelasticitybyaskingcustomers:Whatdoyoucurrentlypayformyproduct?Atwhatpricewouldyoustopbuyingmyproductaltogether?Managersshouldaskthemselves:Howmuchwillrevenueincreaseasaresultofhighersales?Howmuchwillrevenuedecreaseasaresultoflowerpricesforeachunit?ManagerialRuleofThumb:EstimatingPriceElasticityManagerscanestimatepriceelDeterminantsofPriceElasticityofDemandNumberofsubstitutegoodsPercentofaconsumer’sincomethatisspentontheproductTimeperiodunderconsiderationNatureofthegood(durableornon-durable)DeterminantsofPriceElasticiCalculatingPriceElasticitiesArcpriceelasticity:basequantity(orprice)istheaveragevalueofthestartingandendingpointsPointpriceelasticity:measurementofthepriceelasticityofdemandcalculatedatapointonthecurveusinginfinitesimalchangesinpricesandquantitiesCalculatingPriceElasticitiesEquationforPointPriceElasticityofDemandP=thepricechargeda
=theverticalinterceptoftheplotteddemandcurve(theP=axis)(P-a)ep
=PwhereEquationforPointPriceElastNumericalExamplesDemandfunctionShowsrelationshipbetweenquantitydemandedandpriceQ=12–PorP=12–QTotalrevenuefunctionShowstotalrevenuereceivedbyproducerasafunctionofthelevelofoutputTR=(P)(Q)=(12–Q)(Q)=12Q–Q2NumericalExamplesDemandfunctNumericalExamplesAveragerevenuefunction:showshowaveragerevenueisrelatedtolevelofoutputAR=TR/Q=[(P)(Q)]/Q=PMarginalrevenuefunction:showstheadditionalrevenueaproducerreceivesbysellinganadditionalunitofoutputatdifferentlevelsMR=(TR)/(Q)=(TR2
–
TR1)/(Q2
–
Q1)MR=dTR/dQ=12
–
2QNumericalExamplesAveragereveDemandand
MarginalRevenueFirmsarealwaysconstrainedbydemandcurveTophalfofthedemandcurveinFigure3.4indicateswhenmanagerslowerprice,totalrevenueincreasesBottomhalfindicatesapricedecreasecausestotalrevenue
tofallDemandand
MarginalRevenueFiDemandand
MarginalRevenue|eP|>1Demand,marginalrevenue,andtotalrevenuefunctionsarerelatedFigure3.4|eP|=1|eP|<1MarginalRevenueQuantity6061212DemandDemandand
MarginalRevenue|eTheTotalRevenueFunction01836126TotalRevenueTotalRevenueFigure3.5TheTotalRevenueFunction0183ExtremeDemandCurvesVerticaldemandcurveRepresentsperfectlyinelasticdemandExamplemightbeinsulinfordiabeticsHorizontaldemandcurveRepresentsperfectlyelasticdemandExamplewouldbeabushelofwheatfromanagriculturalproducerExtremeDemandCurvesVerticalExtremeDemandCurves0P1QuantityPriceHorizontaldemandcurveDemand0Q1QuantityPriceVerticaldemandcurveDemandExtremeDemandCurves0P1QuantiElasticitiesofDemandIncomeelasticityofdemand:percentagechangeinquantitydemandedofagivengoodrelativetopercentagechangeinconsumerincomeNecessities–elasticitybetween0and1Luxuries–elasticitygreaterthan1ElasticitiesofDemandIncomeeCalculatingincomeelasticityofdemandisbasedontwoquestionsforaconsumer:WhatfractionofyourtotalbudgetdoyouspendonProductX?Ifyouearnedabonusof$1000,whatpartofthatbonuswouldyouspendonProductX?ManagerialRuleofThumb:CalculatingIncomeElasticityCalculatingin
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