1. DETERMINANTS OF DEMAND Chapter 3 slide 1 A firm ’ s quantity of sales depends on multiple economic factors. For instance, an airline ’ s seat demand might be described by the equation: Q = 25 + 3Y + P  – 2P. Here, demand depends on: customer income (Y), the rival ’ s price (P  ), and the airline ’ s price (P).

2. 3.2 SHIFTS IN DEMAND Any change in the firm ’ s own price shows up as a movement along the firm ’ s demand curve. A change in any other variable constitutes a shift in the position of the demand curve For instance, an increase in a competitor ’ s price would cause a favorable demand shift as shown.

3. ELASTICITY OF DEMAND 3.3 How Responsive are Sales to Changes in Price? The Concept of Elasticity Supplies the Answer. E P = [% Change Q]/[% Change P] = [  Q/Q]/[  P/P]. Example: P 0 = 100 & Q 0 = 1200 P 1 = 110 & Q 1 = 1160 E P = [(1160 – 1200)/1200]/[(110 – 100)/100] = -3.33%/10% = -.333.

4. PROPERTIES OF ELASTICITY 3.4 Unitary Elastic: E P = -1 Inelastic: -1 < E P < 0 Elastic: -  < E P < -1 Elasticity Varies along a Linear Demand Curve. 100 200 300 400 Demand is Inelastic Demand is Elastic E P = -1 E P = (  Q/  P)(P/Q) Q = 1600 - 4P B A 400 800 1200 1600 MR MR = 0 = (-4)(100/1200) = -.333 B = (-4)(300/400) = -3 A

5. USING ELASTICITY 3.5 Predicting Sales:  Q/Q = (E P )(  P/P) + (E Y )(  Y/Y) + (E P  )(  P  /P  ). Other Elasticities: Income Elasticity: E Y = (% change Q)/(% change Y) Necessities: 0 < E Y < 1 Discretionary: E Y > 1 Cross Price Elasticity: E P  = (% change Q)/(% change P  )

6. USING ELASTICITY 3.6 Maximizing Profit and Revenue in Pure Selling Problems (MC = 0). Examples: Selling Software Selling a CD Utilizing a Sports Stadium Optimal Solution: MR = 0 or equivalently: E P = -1. Capacity Revenue With high demand, price to fill stadium. With low demand, do not cut price to fill stadium.

7. OPTIMAL PRICING 3.7 1. The Markup Rule [P - MC]/P = -1/E P or P = [E P /(1+ E P )] MC MC = 100 E P P -2 -3 -4 -6 2. Price Discrimination Apply Markup rule to separate segments. More inelastic segments get the higher markups (over common MC). Equivalently, Set MR 1 = MR 2 = MC. 200 150 133 120

8. 3.8 MAXIMIZING REVENUE W/ LIMITED CAPACITY Airline Yield Management: Maximizing Revenue utilizing Business Class and Economy Class seats. The key is to set: MR B = MR E. Example: Airline has 180 seats and faces demand: P B = 330 – Q B and P E = 250 – Q E. Therefore, MR B = 330 - 2Q B = MR E = 250 – 2Q E. We also know that: Q B + Q E = 180. The solution to these simultaneous equations is: Q B = 110 seats and Q E = 70 seats. In turn, P B = $220 and P E = $180.