1. Demand Analysis (Cont.)
Managerial Economics
Riad Sultan
Lect. In managerial economics

2. Lect. In managerial economics
Your firm’s research department has estimated the income elasticity of demand for chicken to be
You have just read in an economic newspaper that due to an upturn in the economy, consumer incomes are expected to rise by 10% over the next three years.
As a manager of a chicken processing plant, how will this forecast affect your purchase of chicken?
Riad Sultan
Lect. In managerial economics

3. Lect. In managerial economics
Elasticities
When one of the determinants changes, demand will also change
The next issue is how much?
We analyse the magnitude of the change And hence we refer to ELASTICITIES
Riad Sultan
Lect. In managerial economics

4. Lect. In managerial economics
ELASTICITY OF DEMAND
Price in 2007= Rs20: Demand (Sales)= 43
Price in 2008= Rs10: Demand (Sales) =75
When price change by Rs10, demand changes by 32 units. Can we say that for each Rs1, demand rises by (32/10) 3.2 units? Yes
However, to compare different goods, we take the percentage change
Riad Sultan
Lect. In managerial economics

5. Lect. In managerial economics
Percentage change in demand
=[(New-old)/old] X 100
= [(75-43)/43]
= 75%
Hence, demand has increased by 75%
Percentage change in price
=(10-20)/20= -50%
Hence, price has decreased by 50%
Riad Sultan
Lect. In managerial economics

6. Lect. In managerial economics
Conclusion:
When price falls by 50%, demand rises by 75%
It follows that when price changes by 1%, demand will rise by (75%/50%) = 1.5%
1.5 is called elasticity
Riad Sultan
Lect. In managerial economics

7. Lect. In managerial economics
Formula for elasticity of demand:
% change of quantity demanded divided %change of price = 1.5
Riad Sultan
Lect. In managerial economics

8. Lect. In managerial economics
Elasticity of demand
Formula for elasticity of demand:
Riad Sultan
Lect. In managerial economics

9. Lect. In managerial economics
Calculation
Elastic demand = >0
Inelastic demand = <0
Elasticity = Unitary = 1
Riad Sultan
Lect. In managerial economics

10. Lect. In managerial economics
Elasticity
Calculate: prices move from P1 to P2:
P1=10 Q1=100
P2=20 Q2=50
Elasticity= 50%/100% = 0.5%
When price changes by 1%, demand falls by 0.5%
Riad Sultan
Lect. In managerial economics

11. Lect. In managerial economics
Arc elasticity
Riad Sultan
Lect. In managerial economics

12. Lect. In managerial economics
Point elasticity
Requirements: understand slope of a demand curve
Slope = change in vertical/change in horizontal = 40/80=1/2 40 A 35 B 6 5 72 80
Riad Sultan
Lect. In managerial economics

13. Lect. In managerial economics
Calculate elasticity at A =2 X (35/5)=14%
Calculate elasticity at B = 2 X (6/72) = 0.16%
At A, demand is elastic
At B, demand is inelastic
Riad Sultan
Lect. In managerial economics

14. Calculating elasticity from demand function
Suppose
Q = 100 – 5P
Change in Q/Change in P =-5
Elasticity = -5(P/Q)
Riad Sultan
Lect. In managerial economics

15. Elasticity and Total revenue
Suppose :
P1=10 Q1=100 TR= P1Q1=1000
P2=20 Q2=75 TR = P2Q2 = 1400
Elasticity= 25%/100% = 0.25%
When price rises by 1%, demand falls by 0.25%
Outcome: Total Revenue rises
Marginal revenue is positive
Riad Sultan
Lect. In managerial economics

16. Elasticity and Total revenue
Conclusion 1: when demand is elastic (>1), (when price rises, TR falls),
can not raise the price
Conclusion 2: when demand is inelastic (<1), when price rises, TR rises
always raise prices
Riad Sultan
Lect. In managerial economics

17. Elasticity and Total revenue
P1= 10 Q1= TR = 1000
P2=15 Q2=40 TR = 600
Elasticity = 60%/50%=1.2%
When price rises by 1%, quantity demanded falls by more than 1% (1.2%):
Total revenue: Falls
Marginal revenue: negative
Riad Sultan
Lect. In managerial economics

18. Relationship between marginal revenue, and price elasticity
Riad Sultan
Lect. In managerial economics

19. Determinants of Price elasticity
Availability of substitutes
Elasticity is high when there are substitutes
Nature of commodity
Luxury, durable = elastic; necessity, non-durable = inelastic;
Weightage in the total consumption
When proportion is large = elastic; when prop. is low = inelastic
Time factor in adjustment of consumption
The longer the time to adjust, the higher the price elasticity
Range of commodity use
Multi-purpose goods = high elasticity
Proportion of Market supplies
The proportion of consumers who are satisfied: if less than 50%, demand will be elastic
Riad Sultan
Lect. In managerial economics

20. Lect. In managerial economics
Cross price elasticity
Substitutes and complements
Income elasticity
Normal, necessities , inferior
Advertising elasticity
Elasticity of price expectations
Riad Sultan
Lect. In managerial economics

21. Advertising elasticity
=0: sales do not respond to advertisement
>0 but <1: less than proportionate increase in advertising
=1 proportionate increase in advertising
>0 more than proportionate increase in advertising
Riad Sultan
Lect. In managerial economics

22. Advertising elasticity
Determinants
The level of sales
Advertisement by other firms
Cumulative of past advertisement
Riad Sultan
Lect. In managerial economics

23. Elasticity of Price expectation
Riad Sultan
Lect. In managerial economics

24. Lect. In managerial economics
Application
Qc = 50 – 1.5Pc + 0.5Y Ps + 0.8A Qc = number of PCs demanded Pc = Price of PC Y = buyers income Ps = substitutes brand A = advertising Starting points: Pc = 40, Y= 60, Ps = 30, A = 25
Riad Sultan
Lect. In managerial economics

25. Lect. In managerial economics
Elasticities
Price Elasticity - Ep = -0.6
Income Elasticity - Ey = 0.3
Cross Elasticity - Es = 0.6
Advertising Elasticity - Ea = 0.2
Riad Sultan
Lect. In managerial economics

26. Lect. In managerial economics
Your firm’s research department has estimated the income elasticity of demand for non-fed ground beef to be You have just read in an economic newspaper that due to an upturn in the economy, consumer incomes are expected to rise by 10% over the next three years. As a manager of a meat-processing plant, how will this forecast affect your purchase of non-fed cattle?
Riad Sultan
Lect. In managerial economics

27. Elasticity and Demand functions (reconsider)
Elasticity of demand for linear demand function:
Own price elasticity =
Cross price elasticity =
Income elasticity = e
Riad Sultan
Lect. In managerial economics

28. Elasticity and Demand functions (reconsider)
Elasticity of demand for non-linear demand:
Own price elasticity = c
Cross-price elasticity = d
Income elasticity = e
Riad Sultan
Lect. In managerial economics