BUS 525: Managerial

Economics
Lecture 3
Quantitative Demand Analysis

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

The Elasticity Concept

Elasticity is a measure of the responsiveness of a variable
to a change in another variable: the percentage change
in one variable that arises due to a given percentage
change in another variable
How responsive is variable G to a change in variable S?

EG , S

%G

%S

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.

The Elasticity Concept Using

Calculus
An alternative way to measure the
elasticity of a function G = f(S) is

EG , S

dG S

dS G

If EG,S > 0, then S and G are directly related.

If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.

Own Price Elasticity of

Demand
A measure of the responsiveness of the demand for a good to
changes in the price of that good: the percentage change in the
quantity demanded of the good divided by the percentage
change in the price of the good

EQX , PX

%QX

%PX

Negative according to the law of demand.

Elastic:

EQX , PX 1

Inelastic: EQ X , PX 1
Unitary:

EQX , PX 1

Perfectly Elastic &

Inelastic Demand
Price

Price
D
D

Quantity
Perfectly Elastic ( EQ X ,PX )

Quantity
Perfectly Inelastic ( EQX , PX 0)

Elasticity, Total Revenue and

Linear Demand
P
100

TR

10

20

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR

80

800

10

20

30

40

50

10

20

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR

80
1200

60

800

10

20

30

40

50

10

20

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR

80
1200

60
40

800

10

20

30

40

50

10

20

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR

80
1200

60
40

800

20

10

20

30

40

50

10

20

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR
Elastic

80
1200

60
40

800

20

10

20

30

40

50

10

20

Elastic

30

40

50

Elasticity, Total Revenue and

Linear Demand
P
100

TR
Elastic

80
1200

60
Inelastic

40

800

20

10

20

30

40

50

10
Elastic

20

30

40
Inelastic

50

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.

Elasticity, Total Revenue and

Linear Demand
P
100

TR
Elastic

80

Unit elastic
Unit elastic
1200

60
Inelastic

40

800

20

10

20

30

40

50

10
Elastic

20

30

40
Inelastic

50

Class Exercise I
Research department of an airline
estimates that the own price
elasticity of demand for a particular
route is -1.7. If the airline cuts price
by 5 percent, will the ticket sales
increase enough to increase overall
revenues?
If so, by how much?

Factors Affecting
Own Price Elasticity
Available substitutes
The more substitutes available for the good, the
more elastic the demand.
Broader categories of goods have more inelastic
demand than more specifically defined categories.

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 consumers
budgets tend to be more inelastic than goods for
which consumers spend a large portion of their
incomes.

Some Elasticity Estimates

Table 3-2 Selected Own Price Elasticities
Market

Own Price Elasticity

Transportation

-0.6

Motor vehicles

-1.4

Motorcycles and bicycles

-2.3

Food

-0.7

Cereal

-1.5

Clothing

-0.9

Womens clothing

-1.2

Table 3-3 Selected Short and Long-Term Own Price Elasticities

Market

Short-Term Own Price

Elasticity

Long-Term Own Price

Elasticity

Transportation

-0.6

-1.9

Food

-0.7

-2.3

Alcohol and tobacco

-0.3

-0.9

Recreation

-1.1

-3.5

Clothing

-0.9

-2.9

1-18

The Arc Price Elasticity of

Demand
How can the percentage changes in Q
and P be calculated in order to derive
the own price elasticity of demand?
Q

EQX,PX

--------------(Q1 + Q2)/2
=-----------------P
-------------(P1 + P2)/2

-------------(Q1 + Q2)
= -------------------P
------------(P1 + P2)

Class Exercise II

Consider a Demand Curve

Q=

40,000,000 - 2,500P

Calculate arc elasticity of demand from the given data

Price
16,000

P2=12,500
P1=12,000

B
A

Q
0

8,750,000
10,000,000

40,000,000

How sensitive are consumers to a

change in the avg. price of
automobiles?
We calculate the arc price elasticity of
demand between A and B as:

Ep =

10,000,000-8,750,000
-----------------------------(10,000,000+8,750,000)/2
-------------------------------- = - 3.267
12,000 - 12,500
----------------------(12,000 + 12,500)/2

Interpretation
Between points A and B (or between
the price range from $12,000 to
$12,500), a one-percent increase in
the average price of cars will bring
about, on average, a reduction of
sales by 3.267%, ceteris paribus.
Because the price elasticity of demand
is calculated between two points on a
given demand curve, it is called the
arc price elasticity of demand.

Caveat
Elasticity measure depends on
the price at which it is measured.
It is not generally a constant
(because the demand curve is not
likely to be a straight line).

The Point Price Elasticity of Demand

It measures the price

elasticity of demand at a
given price or a particular
point on the demand curve.
Q
P
ep = (-----)(----)
P
Q

Class Exercise III

Qxd = -2,500Px + 1,000M + 0.05PY - 1,000,000H+
0.05AX

Other things being equal,

if P1 = $12,000, Q1 = 10,000,000.
Calculate point elasticity of demand.
What's the point elasticity of demand at
P2 = $12,500?
Calculate arc elasticity of demand.

Calculation of the point elasticity using

the demand for automobile equation
Qxd = -2,500Px + 1,000M + 0.05PY - 1,000,000H+ 0.05AX

Other things being equal,

if P1 = $12,000, Q1 = 10,000,000.
The point price elasticity is:
Q
P
ep = (-----) (---)
P
Q
= (-2,500)(12,000/10,000,000)
=-3

Point price elasticity (cont.)

What's the point elasticity of demand at
P2 = $12,500?
At this price, Q = 8,750,000.
Hence,
ep =
=
=

Q
P
(-----) (---)
P
Q
(-2,500)(12,500/8,750,000)
- 3.571

Two versions of the elasticity of

demand Point vs. Arc
Price
16,000

ep= -3.571

Ep= -3.267

12,500
12,000

ep= -3.0

8,750,000

Q
10,000,00
0

From Concept to Applications

We began with a definition of the
elasticity of demand based on,

EQx, Px =

%in Qxd
--------------% in Px

If we know the price elasticity of

demand (Ep), the formula will let us
answer a number of "what if" questions.

Examples
(1) How great a price reduction is
necessary to increase sales by
10%?
(2) What will be the impact on sales
of a 5% price increase?
(3) Given marginal cost and price
elasticity information, what is the
profit-maximizing price?

Class Exercise IV
Supposing that the elasticity of
demand for diesel is -0.5, how much
prices must go up to reduce gasoline
use by 1%?

The price increase needed to reduce

diesel consumption by 1%
Supposing that the elasticity of
demand for diesel is -0.5, how much
prices must go up to reduce gasoline
use by 1%?
- 0.01
- 0.5 = ---------- ,

%Pd

%Pd = (-0.01/-0.5) = + 0.02 or 2%

Marginal Revenue and the Own

Price Elasticity Of Demand
Demand and marginal revenue
For a linear demand curve marginal revenue curve lies
exactly halfway between the demand curve and the
vertical axis
Marginal revenue is less than the price of each unit sold
When demand is elastic (-<E<-1), marginal revenue is
positive
When demand is unitary elastic (E=-1), marginal
revenue is zero
When demand is inelastic (-1<E<0), marginal revenue
is negative

Cross Price Elasticity of

Demand
A measure of the responsiveness of the demand for
a good to changes in the price of a related good:
the percentage change in the quantity demanded of
the good divided by the percentage change in the
price of a related good
d

EQX , PY

%QX

%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

Income Elasticity
A measure of the responsiveness of the demand for a
good to changes in consumer income: the percentage
change in the quantity demanded divided by the
percentage change in income

EQX , M

%QX

%M

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.

Some Elasticity Estimates

Table 3-4 Selected Cross-Price Elasticities
Cross-Price Elasticity
Transportation and recreation

-0.05

Food and recreation

-0.15

Clothing and food

-0.18

Table 3-5 Selected Income Elasticities

Income Elasticity
Transportation

1.80

Food

0.80

Ground beef, nonfed

-1.94

Table 3-6 Selected Long-Term Advertising Elasticities

Advertising Elasticity
Clothing

0.04

Recreation

0.25

1-36

Other Elasticities
Advertising elasticity
A measure of the responsiveness of the demand for a
good to changes in advertising expenditure: the
percentage change in the quantity demanded divided by
the percentage change in advertising expenditure

EQX , A

%QX

%Ax

Class Exercise V
Advertising elasticity of recreation :
0.25
How much should advertising
increase to increase the demand for
recreation by 15%?

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!

Example 1: Pricing and Cash

Flows
According to a BTRC Report by
Zahid Hussain, BTCLs own price
elasticity of demand for long
distance services is -8.64.
BTCL needs to boost revenues in
order to meet its marketing goals.
To accomplish this goal, should
BTCL raise or lower its price?

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 BTCL.

Example 2: Quantifying
the Change
If BTCL lowered price by 3 percent,
what would happen to the volume of
long distance telephone calls routed
through BTCL?

Answer
Calls would increase by 25.92 percent!

EQX , PX

%QX
8.64
%PX
d

%QX
8.64
3%
d
3% 8.64 %QX
d

%QX 25.92%

Example 3: Impact of a change

in a competitors price
According to an BTRC Report by
Zahid Hussain, BTCLs cross price
elasticity of demand for long distance
services is 9.06.
If competitors reduced their prices
by 4 percent, what would happen to
the demand for BTCLs services?

Answer
BTCLs demand would fall by 36.24 percent!

EQX , PY

%QX
9.06
%PY
d

%QX
9.06
4%
d
4% 9.06 %QX
d

%QX 36.24%

Interpreting Demand
Functions
Mathematical representations of demand
curves.
Example:
d

QX 10 2 PX 3PY 2 M

X and Y are substitutes (coefficient of P Y is

positive).
X is an inferior good (coefficient of M is
negative).

Linear Demand Functions

General Linear Demand Function:

QX 0 X PX Y PY M M H H
d

P
EQX , PX X X
QX
Own Price
Elasticity

EQX , PY

PY
Y
QX

Cross Price
Elasticity

M
EQX , M M
QX
Income
Elasticity

Class Exercise 6
Given the demand curve,
Qxd = 100- 3Px+4Py-.01M+2Ax
If Px=25, Py= 35, M= 20,000, Ax =50
Calculate (a) own price, (b) cross
price, and income elasticity of
demand

Example of Linear Demand

Qxd = 100- 3Px+4Py-.01M+2Ax.
Own-Price Elasticity: (-3)Px/Qx.
If Px=25, Py= 35, M= 20,000, Ax =50
Q=65 [since 100 3(25) +4(35) -.01(20,000)+2(50)] = 65
Own price elasticity of demand at Px=25, Q=65:
E
=(-3)(25)/65= - 1.15
Cross price elasticity of demand at Py=35, Q65
Q X , PX

EQX , Py

=(4)(35)/65= 2.15
Income elasticity of demand at M=20,000
E
=(-0.1)(20,000)/65= -3.08
QX , M

Elasticities for Nonlinear Demand

Functions
Qxd = c PxxPy yMMHH
General Log-Linear Demand Function:

ln Q X d 0 X ln PX Y ln PY M ln M H ln H

X
Cross Price Elasticity : Y
Income Elasticity :
M

Own Price Elasticity :

Example of Log-Linear
Demand
ln(Qd) = 10 - 2 ln(P).
Own Price Elasticity: -2.

Graphical Representation of
Linear and Log-Linear
Demand
P

D
Linear

D
Q

Log Linear

Regression Analysis
One use is for estimating demand
functions.
Important terminology and concepts:

Least Squares Regression: Y = a + bX + e.

Confidence Intervals.
t-statistic.
R-square or Coefficient of Determination.
F-statistic.

An Example
Use a spreadsheet to estimate the
following log-linear demand function.

ln Qx 0 x ln Px e

Summary Output

Interpreting the Regression

Output
The estimated log-linear demand function is:
ln(Qx) = 7.58 - 0.84 ln(Px).
Own price elasticity: -0.84 (inelastic).

How good is our estimate?

t-statistics of 5.29 and -2.80 indicate that the
estimated coefficients are statistically different
from zero.
R-square of .17 indicates we explained only 17
percent of the variation in ln(Qx).
F-statistic significant at the 1 percent level.

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.

Lessons:
(1) The first lessons in business: Never

lower your price in the inelastic range of

the demand curve. Such a price decrease
would reduce total revenue and might at
the same time increase average
production cost.
(2)When the demand is inelastic, raise the
price to increase revenue and, possibly,
profit.
(3)When demand is elastic, price increases
should be avoided.

Lessons (Cont.)
(4)But should we always cut price
when the demand is elastic?
Even over the range where demand is
elastic, a firm will not necessarily find it
profitable to cut prices; the profitability
of such an action depends on whether
the marginal revenues generated by
the price reduction exceed the marginal
cost of the added production.

Another Example: Optimal Pricing

Step 1 Using the relationship between MR and Ep
Given, TR = PQ,
TR
MR = ------Q

(PQ)
=--------Q

Q
P
= P(-----) + Q (-----)
Q
Q
Q
P
= P (1 + ----- -----) = P ( 1 +
P
Q

1
----)
ep

Optimal Pricing (Cont.)

Optimal Price is when MC = MR
i.e., MC = P (1 + 1/ep)
MC
P = ------------(1 + 1/ep)
That is, the profit-maximizing
price is determined by MC and ep

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:

R [ RX 1 EQX , PX RY EQY , PX ] %PX