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Quantitative Demand Analysis Pertemuan Matakuliah: J0434/EKONOMI MANAJERIAL Tahun: 2008

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Bina Nusantara Managerial Economics & Business Strategy Chapter 3 Quantitative Demand Analysis McGraw-Hill/Irwin Michael R. Baye, Managerial Economics and Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

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Bina Nusantara Overview I. The Elasticity Concept –Own Price Elasticity –Elasticity and Total Revenue –Cross-Price Elasticity –Income Elasticity II. Demand Functions –Linear –Log-Linear III. Regression Analysis 3-4

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Bina Nusantara The Elasticity Concept How responsive is variable “G” to a change in variable “S” If E G,S > 0, then S and G are directly related. If E G,S < 0, then S and G are inversely related. If E G,S = 0, then S and G are unrelated. 3-5

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Bina Nusantara The Elasticity Concept Using Calculus An alternative way to measure the elasticity of a function G = f(S) is If E G,S > 0, then S and G are directly related. If E G,S < 0, then S and G are inversely related. If E G,S = 0, then S and G are unrelated. 3-6

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Bina Nusantara Own Price Elasticity of Demand Negative according to the “law of demand.” Elastic: Inelastic: Unitary: 3-7

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Bina Nusantara Perfectly Elastic & Inelastic Demand D Price Quantity D Price Quantity 3-8

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Bina Nusantara Own-Price Elasticity and Total Revenue Elastic –Increase (a decrease) in price leads to a decrease (an increase) in total revenue. Inelastic –Increase (a decrease) in price leads to an increase (a decrease) in total revenue. Unitary –Total revenue is maximized at the point where demand is unitary elastic. 3-9

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR Elastic

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR Inelastic Elastic Inelastic

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Bina Nusantara Elasticity, Total Revenue and Linear Demand QQ P TR Inelastic Elastic Inelastic Unit elastic 3-17

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Bina Nusantara Demand, Marginal Revenue (MR) and Elasticity For a linear inverse demand function, MR(Q) = a + 2bQ, where b < 0. When –MR > 0, demand is elastic; –MR = 0, demand is unit elastic; –MR < 0, demand is inelastic. Q P Inelastic Elastic Unit elastic MR 3-18

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Bina Nusantara Factors Affecting 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. 3-19

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Bina Nusantara Cross Price Elasticity of Demand If E Q X,P Y > 0, then X and Y are substitutes. If E Q X,P Y < 0, then X and Y are complements. 3-20

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Bina Nusantara Predicting Revenue Changes from Two Products Suppose that a firm sells to related goods. If the price of X changes, then total revenue will change by: 3-21

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Bina Nusantara Income Elasticity If E Q X,M > 0, then X is a normal good. If E Q X,M < 0, then X is a inferior good. 3-22

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Bina Nusantara Uses of Elasticities Pricing. Managing cash flows. Impact of changes in competitors’ prices. Impact of economic booms and recessions. Impact of advertising campaigns. And lots more! 3-23

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Bina Nusantara 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 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? 3-24

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Bina Nusantara 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. 3-25

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Bina Nusantara 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? 3-26

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Bina Nusantara Answer Calls would increase by percent! 3-27

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Bina Nusantara 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 If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services? 3-28

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Bina Nusantara Answer AT&T’s demand would fall by percent! 3-29

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Bina Nusantara Interpreting Demand Functions Mathematical representations of demand curves. Example: –Law of demand holds (coefficient of P X is negative). –X and Y are substitutes (coefficient of P Y is positive). –X is an inferior good (coefficient of M is negative). 3-30

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Bina Nusantara Linear Demand Functions and Elasticities General Linear Demand Function and Elasticities: Own Price Elasticity Cross Price Elasticity Income Elasticity 3-31

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Bina Nusantara Example of Linear Demand Q d = P. Own-Price Elasticity: (-2)P/Q. If P=1, Q=8 (since = 8). Own price elasticity at P=1, Q=8: (-2)(1)/8=

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Bina Nusantara Log-Linear Demand General Log-Linear Demand Function: 3-33

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Bina Nusantara Example of Log-Linear Demand ln(Q d ) = ln(P). Own Price Elasticity:

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Bina Nusantara P Q Q D D LinearLog Linear Graphical Representation of Linear and Log-Linear Demand P 3-35

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Bina Nusantara Regression Analysis One use is for estimating demand functions. Important terminology and concepts: –Least Squares Regression model: Y = a + bX + e. –Least Squares Regression line: –Confidence Intervals. –t-statistic. –R-square or Coefficient of Determination. –F-statistic. 3-36

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Bina Nusantara An Example Use a spreadsheet to estimate the following log- linear demand function. 3-37

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Bina Nusantara Summary Output 3-38

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Bina Nusantara Interpreting the Regression Output The estimated log-linear demand function is: –ln(Q x ) = ln(P x ). –Own price elasticity: (inelastic). How good is our estimate? –t-statistics of 5.29 and indicate that the estimated coefficients are statistically different from zero. –R-square of 0.17 indicates the ln(P X ) variable explains only 17 percent of the variation in ln(Q x ). –F-statistic significant at the 1 percent level. 3-39

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Bina Nusantara 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. –A host of other things, including cost functions. Managers can quantify the impact of changes in prices, income, advertising, etc. 3-40

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