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Elasticity and demand Paul C. Godfrey Mark H. Hansen Marriott School of Management

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What strategists need to know: What determines demand? How sensitive is demand? How can managers work with/influence demand to create competitive advantage?

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How sensitive is demand?

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The principle of elasticity Measures changes in quantity demanded (Q) in response to changes in –Price of the product, P x (own-price elasticity of demand) –Price of substitutes/ compliments, P y (cross-price elasticity) –Changes in income, M (income elasticity) If demand changes a lot (relative to the price change) a good is elastic If demand changes very little (relative to price change) a good is inelastic

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The price elasticity of demand Price Quantity Perfectly elastic Inelastic Elastic

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The Own Price Elasticity of Demand The percentage change in the quantity demanded of our good (X), given the percentage change in the price of our good (X) this tells us about the power of buyers this tells us how constrained we are in pricing

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The Own Price Elasticity of Demand P Q Unitary Elastic Inelastic when demand is elastic, you can increase total revenue by lowering price when demand is inelastic, you can increase total revenue by raising price when demand is unitary, total revenue is maximized Total Revenue

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QuantityPriceTotal Revenue 141141,974 137152,055 133162,128 129172,193 125182,250 121192,299 117202,340 113212,373 109222,398 105232,415 101242,424 97252,425 93262,418 89272,403 85282,380 81292,349 77302,310 73312,263 Unitary Elastic Inelastic The Own Price Elasticity of Demand Demand: Q = 197 – 4P Inverse Demand: P = 49.25 – 0.25Q

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Measuring Elasticity Elasticity measures the percentage change in quantity demanded relative to the percentage change in price, or % Q/% P –If % Q > % P (an elastic product), then | Q/ P| > 1 –If % Q < % P (an inelastic product), then | Q/ P| < 1 –If % Q = % P (unitary elasticity), then | Q/ P| = 1 More formally: = % Q / % P = ((Q 1 -Q 0 )/Q 0 ) / ((P 1 -P 0 )/P 0 ) = ( Q/Q 0 ) / ( P/P 0 ) or

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Measuring Elasticity QuantityPriceTotal Revenue 141141,974 137152,055 133162,128 129172,193 125182,250 121192,299 117202,340 113212,373 109222,398 105232,415 101242,424 97252,425 93262,418 89272,403 85282,380 81292,349 77302,310 73312,263 Ties What is the own price elasticity in moving from $18 to $15? What is the own price elasticity in moving from $28 to $25?

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Measuring Elasticity Unitary Elastic Inelastic What is the own price elasticity in moving from $18 to $15? What is the own price elasticity in moving from $28 to $25?

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The cross-price elasticity of demand The percentage change in the quantity demanded of our good (X), given the percentage change in the price of some good (Y) (could be a substitute or complement) this tells us about the closeness of a substitute this tells us about the strength of a complement this tells us about the threat of substitutes and/or the threat of rivalry

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Measuring Cross Price Elasticity QuantityPrice HamburgersHotdogs 61.13$0.75 61.50$1.00 61.88$1.25 62.25$1.50 62.63$1.75 63.00$2.00 63.38$2.25 63.75$2.50 64.13$2.75 64.50$3.00 64.88$3.25 65.25$3.50 Demand: Q h = 60 + 1.5P hd Inverse Demand: P hd = 0.6667Q h - 40

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Measuring Cross Price Elasticity QuantityPrice HamburgersHotdogs 61.13$0.75 61.50$1.00 61.88$1.25 62.25$1.50 62.63$1.75 63.00$2.00 63.38$2.25 63.75$2.50 64.13$2.75 64.50$3.00 64.88$3.25 65.25$3.50 What is the cross price elasticity when hot dogs go from $1.00 to $1.50? What is the cross price elasticity when hot dogs go from from $3.00 to $3.50? Hot dogs are substitutes for hamburgers as indicated by the positive elasticity

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