EC2204- Business Economics 2: Demand, Supply and Elasticity
Learning OutcomesUpon completing this section, you should be able to: Differentiate between demand and supply. Calculate equilibrium price and output. Define price and income elasticity. Apply formulas for price and income elasticity. Interpret price and income elasticity values. Describe factors influencing price elasticity. Show that total revenue is maximized at unit elasticity
Figure 3.1: Individual and Market Demand •The market demand curve is obtained through the horizontal summation of the quantities demanded at each price.
Demand FunctionAlgebraically, the demand function can be represented as:Qd = f (P, Ps, Pc, Y, A, A’, N, CP, PE, TA, T/S ) where Qd = quantity demanded of the good or service P = price of the good or service Ps = price of substitute goods or services Pc = price of complementary goods or services. Y = income of consumers. A = advertising expenditures (and other marketing expenditures) A’ = competitors advertising expenditures on the good or service. N = population (and other demographic factors). CP = consumer tastes and preferences for the good or service. PE= expected (future) changes in price. TA= adjustment time period. T/S = taxes or subsidies.
Supply FunctionThe main determinants of the supply of a commodity can be represented as: Qs = f (P, Ps, Pc, C, Tn, Tx, Ms, O) where P = the market price of the good or service Ps = price of substitute goods or services Pc = price of complementary goods or services. C = Costs of producing the good/service Tn = state of technology. Tx = indirect taxation (VAT). Ms = market size O = objectives of the business.
Market Equilibrium When Qd = Qs at a given price, the market for the product is said to be in equilibrium. Aldi wants to know at what price will clear all its stock of Chateauneuf Du Pape. The Firms manager has established both its demand and supply functions. Aldi’s Demand function is for Chateauneuf Du Pape: Qd = 90 – 2p. Aldi’s Supply function is for Chateauneuf Du Pape: Qs = 10 + 3p At what Price and Quantity is Qd = Qs? Let Qd = Qs 90 – 2p = 10 +3p 80 = 5p, so p = 16 Equilibrium price (Supply = Demand) Chateauneuf Du Pape = €16/bottle. Substitute p into either demand [90 – 2(16) = 58] or supply [10 + 3(16) = 58] Equilibrium level of output = 58 units. Aldi can clear their stock of Chateauneuf Du Pape if they charge €16 per bottle. Drama Queen
Price Elasticity of Demand Effective demand management requires that the firm should be able to measure the impact of changes in price on the quantity demanded. To predict consumer behaviour, economists use well-defined techniques evaluating the sensitivity of consumers to changes in price. The most commonly used measure of consumers sensitivity to price is known as "price elasticity of demand." We define the price elasticity of demand (Ed) as the ratio of the percentage change in quantity demanded to percentage change in price: %∆ D Q ED = , where ΔQD is change in quantity demanded and ΔP is the change in price %∆P ∆QD PThis formula can also be expressed as ED = ∆P QD (2.1)
Price Elasticity of Demand Giffen, snob value goods, Unit Elastic if Ed = -1 exclusive goods have +ive E d’s, do not obey the law of demand Furniture Ed = -3 Caviar, Designer clothes-∞ -4 -3 -2 -1 0 1 2 3 4 5 Shoes Ed = -0.73 Luxuries Necessities 0 to -1Goods with E d between 0 and -1 tend to be necessities, food – no closesubstitutes available - inelasticGoods with E d from -1 to - ∞ tend to be luxury goods with many substitutesavailable – elastic
Price Elasticity of DemandP P P P D Perfectly Inelastic Inelastic Elastic Perfectly Elastic D D Fixed in price D Q Q Q Qchicken Plasma Units of Insulin screens electricitytelephones Furniture ChemotherapyShoes`, food Ipod’s
Total Revenue and Price Elasticity of Demand•The aim of the business manager is to maximize profit.•Profit is total revenue less total cost (TR-TC).•Your aim should be to maximise your revenue while minimizing your costs.•As TR = price per unit of output (P*Q), you can increase your revenue byeither increasing price and/or increasing your output or market share.•Increasing market share is undertaken by strategies such as advertisingcampaigns, which we deal with later.•Here we concentrate on pricing strategies.•Understanding the relationship between price elasticity and changes in totalrevenue is an important component of pricing strategy for the businessmanager.•It is vital that the manager knows whether the good s/he sells or produces isprice elastic or inelastic.
Total Revenue and Price Elasticity of DemandIf you raise price, does TR automatically rise? Suppose you are selling I-products, Ipods,Iphones etc and you raise price what happens to your TR?if P ↑ , then Q ↓ a lot – customers will shop around, you’ll lose market shareHence your TR FALLS !!!Suppose food outlets (TESCO, DUNNES) raise price. What happens to their TR andprofit? Inelastic: P ↑ → Q↓ → TR ↑ (Necessities, Food etc.) Inelastic: P ↓ → Q↑ → TR ↓ Elastic: P ↑ → Q↓ → TR ↓ (Luxury Goods) Elastic: P ↓ → Q↑ → TR ↑ Unit Elastic: P ↑ → Q↓ → TR unchanged → π ↑ (E d = -1)
1979 Deregulation of Airfares Prices declined Passengers increased Total Revenue Increased• P ↓ → Q↑ → TR ↑ What does this imply about the price elasticity of air travel ? Is air travel elastic or inelastic Is air travel a necessity or a luxury
Determinants of Price Elasticity of Demand: Substitutes: The more substitutes, the higher the elasticity, as people can easily switch from one good to another if a minor price change is made. Percentage of income: The higher the percentage that the products price is of the consumers’ income, the higher the elasticity, as people will be careful with purchasing the good because of its cost. Necessity: The more necessary a good is, the lower the elasticity, as people will buy it no matter the price, such as insulin Time: The longer a price change holds, the higher the elasticity, as more and more people will stop demanding the good (i.e. if you go to the supermarket and find that blueberries have doubled in price, youll buy it because you need it this time, but next time you wont, unless the price drops back down again) Breadth of definition: The broader the definition, the lower the elasticity. For example, McDonalds burger will have a relatively high elasticity, where as food in general will have an extremely low elasticity Blonde
Cross Price Elasticity Two goods are substitutes if an increase (decrease) in the price of Good 1 results in an increase (decrease) in the quantity demanded of Good 2, holding other factors constant, such as the price of Good 2, other prices, income, and so on, or vice versa-(pepsi/coke) Similarly, two goods are complements if an increase in the price of Good I results in a decrease in the quantity demanded of Good 2. An increase in the price of DVD players would have the effect of decreasing the demand for DVDs, ceteris paribus. (petrol/cars, shoes/socks) ∆Q D A PB ED = Where ΔQDA = change in quantity demanded of Good A ∆PB Q DA ΔPB = change in price of Good BSubstitutes have a positive cross price elasticity: Butter & Margarine (+0.81)Complements have a negative cross price elasticity: VCR machines and the rentalprice of tapes, computer hardware and software (-0.5)When the cross price elasticity is zero or insignificant, the products are not related.
Income Elasticity of Demand Income elasticity of demand measures the responsiveness of a change in quantity demanded of some good or service to a change in income. It can be expressed as: ∆QD I ID = where ΔQD= change in quantity ∆I QD demanded, ΔI= change in IncomeA normal good or service is a good/service you demand more of as your incomeincreases.An inferior good or service is a good/service you demand less of as your incomeincreases.
Sample Questions Suppose the demand function is Q = 10 - 2P + 3I. Find the income and price elasticities at a price, P = 2, and income, I = 10. Characterise the good. Step 1: Calculate quantity demanded? Q = 10 -2(2) + 3(10) = 36 Step 2: Determine Price Elasticity of Demand ∆QD P 2 ED = E D = −2 = -0.111 - inelastic ∆P QD 36Step 3: Determine income Elasticity of Demand ∆Q D I 10 = 0.833 – normal goodID = ID =3 ∆I QD 36
Sample QuestionsQuestion 1: In September 2008, when Meteor charged €10 for mobile phone credit, theyfound the average number of units used per week was 1,000. When Meteor cut their chargesto €6 the average number of units increased to 1,200 units. Calculate the point priceelasticity of demand for mobile phone credit, and interpret your result. = - 0.5Interpretation: A 1% increase in price of mobile phone credit reduces quantity demanded by0.5 percent. Car Accident
Sample QuestionsQuestion 3: In January 2009, when the average price of a litre of petrol was €1.00,Ford sold 1000 units of their car range. By September the price of petrol had increasedto €1.40, the demand had Ford cars had dropped to 800 units. Calculate the cross-price elasticity of demand for Ford cars, and interpret your result. ∆QD PB − 200 A 100 ED = A ED = =-0.5 ∆PB Q D A 40 1000 AInterpretation: A 10% increase in the price of petrol reduces quantity demandedof cars by 5%. Note: Cars and Petrol are compliments. Why?Question 4: In January 2009, when the average price of a bottle of both Pepsi Cocaand Cola was €1.00, Coca Cola sold 1000 per day in Tesco. By September when theprice of Pepsi Cola increased to €1.40, the demand had Coca Cola increased to 1500units. Calculate the cross-price elasticity of demand , and interpret your result. ∆Q DA PB 500 A 100 ED = ED = =0.25 ∆PB QDA 40 1000 AInterpretation: A 10% increase in the price of Pepsi Cola increases the quantitydemanded of Coca Cola by 2.5%. Note: Pepsi and Coca Cola are substitutes. Why?
Sample QuestionsQuestion 5 (See QB1- S 2009):Find the point price elasticity, the point income elasticity, and the point cross-priceelasticity at P=10, I=20, and Ps=9, if the demand function were estimated to be: Qd = 90 - 8P + 2I + 2Ps/cIs the demand for this product elastic or inelastic? Is it a luxury or a necessity?Does this product have a close substitute or complement?Recall the Differentiation Rule:Multiply the coefficient by the Power and reduce the power by 1.Example: if y = 6x3 – 4x2 + 5x + 3 , Δy/Δx = 18x2 - 8x + 5Qd = 90 - 8P + 2I +2Ps/cΔQ/ΔP = -8ΔQ/ΔI = 2ΔQ/ΔPs/c = 2Step 1: Calculate quantity demanded?Qd = 90 – 8(10) + 2(20) + 2(9) = 68
Sample Questions Step 2: Determine Price elasticity of demand ∆QD P 10 ED = E D = −8 =-1.176 ∆P Q D 68 Step 3: Determine Income elasticity of demand ∆Q D I I D =2 20 ID = 68 = 0.588 ∆I QD Step 4: Determine cross elasticity of demand ∆Q DA PB 9 ED = CrossE D = 2 = 0.263 ∆PB QDA 68Conclusion: The good/service is price elastic, not essential, it’s a normal good, it has asubstitute but not a close substitute.
Sample QuestionsQuestion 7: Find the level of output that maximizes Total Revenue for the demand function P = 18 – Q ?Demand Function for Soft Drinks Q = 18 – PTR = P * Q so P = 18 – QTR = (18 - Q) * (Q )so TR = 18Q – Q²MR = ∆TR/∆Q = 18 – 2QTR is maximised at MR = 0Set MR = 18 – 2Q = 018 = 2QQ = 9 ( TR is Max where at Q = 9 where MR = 0)TR is maximised where Q =9
Sample QuestionsQuestion 8 (See Q B3-Summer 2009):Show that Total Revenue is maximized where MR = 0 at unit elasticity for the demand function for Printed t-shirts is Q = 150 – 10P where P = price in € per unit and Q = quantity demanded in units?Write the demand function in terms of Price: P = 15 – Q/10[TR = P * Q] [TR = (15-10/ Q) * Q] = 15 Q – Q2 / 10MR = change in revenue associated with a unit change in quantity or the first derivative of TR with respect to Q. ∆TR MR = = 15 – 1/10(2Q) = 15 - Q/5 ∆QD
Sample QuestionsRecall TR is Max when MR = 0 therefore set 15 – Q/5 = 0 Q/5 = 15 so, Q = 75 units(Solve for Price)Substitute Q = 75 units into original demand function 15 – Q /10 P = 15 – (75/10) = €7.50 per unit TR is maximised at Q = 75 and P = €7.50 ∆Q D P ED = of Q = 150 –10P ∆P Q D 7 .5 E D = −10 = −1 So when MR = 0, ED = -1 75
Recall Our Learning OutcomesYou should now be able to: Differentiate between demand and supply. Calculate equilibrium price and output. Define price and income elasticity. Apply formulas for price and income elasticity. Interpret price and income elasticity values. Describe factors influencing price elasticity. Show that total revenue is maximized at unit elasticity