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Department of Business Administration FALL 2016-17 Demand and Supply Theories by Prof. Dr. Sami Fethi Ch 3: Demand Theory Demand and Supply Economics begins and ends with the “Law” of supply and demand. The laws of supply and demand are an important beginning in the attempt to answer vital questions about the working of a market system. (i.e. Perfect competition) Managerial Economics in a Global Economy 2 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Demand Demand for a good or service is defined as quantities of a good or service that people are ready (willing and able) to buy at various prices within some given time period, other factors besides price held constant. Managerial Economics in a Global Economy 3 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Supply The supply of a good or service is defined as quantities of a good or service that people are ready to sell at various prices within some given time period, other factors besides price held constant. Managerial Economics in a Global Economy 4 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Demand Side Every market has a demand side and a supply side. The demand side can be represented by a market demand curve which shows the amount of commodity buyers would like to purchase at different prices. Demand curves are drawn on the assumption that buyers’ tastes, income, the number of consumers in the market and the price of related commodities are unchanged. Managerial Economics in a Global Economy 5 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Law of Demand The inverse relationship between the price of the commodity and the quantity demanded per period is referred to as the law of demand. A decrease in the price of a good, all other things held constant (ceteris paribus), will cause an increase in the quantity demanded of the good. An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good. Managerial Economics in a Global Economy 6 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Any exceptional case against Law of Demand Giffen goods i.e. An increase in the price of bread, all other things held constant, will cause a increase in the quantity demanded of bread. luxury Brand goods i.e. superior goods and Veblen goods Armani, Chanel, Pierre Cardin, Christian Dior Managerial Economics in a Global Economy 7 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Quantity Demanded Price An increase in price causes a decrease in quantity demanded. P1 P0 Q1 Managerial Economics in a Global Economy Q0 Quantity 8 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Quantity Demanded Price A decrease in price causes an increase in quantity demanded. P0 P1 Q0 Managerial Economics in a Global Economy Q1 Quantity 9 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Changes in Demand Changes in price result in changes in the quantity demanded. This is shown as movement along the demand curve. Changes in nonprice determinants result in changes in demand. This is shown as a shift in the demand curve. Managerial Economics in a Global Economy 10 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Changes in Demand Change in Buyers’ Tastes -Today’ consumer purchases leaner meats compared to old generations -due to the level of blood cholesterol and body weight Change in Buyers’ Incomes Normal Goods i.e., shoes, steaks, travel, automobiles, education Inferior Goods i.e., potatoes, hotdogs, hamburger Change in the Number of Buyers Change in the Price of Related Goods Substitute Goods i.e., Carrots can be replaced by cabbage Complementary Goods i.e., cars and gasoline or electric stove and electricity. Managerial Economics in a Global Economy 11 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Changes in Demand Non-price determinants of demand Tastes and preferences Income Prices of related products Future expectations Number of buyers Reel interest rate Managerial Economics in a Global Economy 12 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Demand An increase in demand refers to a rightward shift in the market demand curve. Price P0 Q0 Managerial Economics in a Global Economy Q1 Quantity 13 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Demand A decrease in demand refers to a leftward shift in the market demand curve. Price P0 Q1 Managerial Economics in a Global Economy Q0 Quantity 14 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Demand, Supply and Equilibrium Every market has a demand side and a supply side. The Supply side can be represented by a market supply curve which shows the amount of commodity sellers would offer a sale at various prices. Supply curves are drawn on the assumption of technology and input or resources (as such labor, capital and land) and prices. Managerial Economics in a Global Economy 15 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Law of Supply The direct relationship between the price of the commodity and the quantity supplied per period is referred to as the law of supply. A decrease in the price of a good, all other things held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good. An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good. Managerial Economics in a Global Economy 16 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Quantity Supplied A decrease in price causes a decrease in quantity supplied. Price P0 P1 Q1 Managerial Economics in a Global Economy Q0 Quantity 17 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Quantity Supplied An increase in price causes an increase in quantity supplied. Price P1 P0 Q0 Managerial Economics in a Global Economy Q1 Quantity 18 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Changes in Supply Nonprice determinants of supply Costs and technology Prices of other goods or services offered by the seller Future expectations Number of sellers Weather conditions Managerial Economics in a Global Economy 19 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Changes in Supply Change in Production Technology - An improvement in the technology and a reduction in input prices would make it possible to produce a commodity at a lower cost. This indicates that sellers would be willing to sell more the goods at each price Change in Input Prices - ↑ in agriculture product, ↑ quantity supplied so rightward shift in the market supply curve Change in the Number of Sellers - ↑ in number of sellers, the market supply curve shifts to right or ↓ in number of sellers, the market supply curve shifts to left Prices of other goods or services offered by the seller - i.e., BMW, Mercedes, Woswagen (Subs. Goods) - i.e., lamp meat and lamp leather (comp. Goods) Managerial Economics in a Global Economy 20 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Supply An increase in supply refers to a rightward shift in the market supply curve. Price P0 Q0 Managerial Economics in a Global Economy Q1 Quantity 21 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Change in Supply A decrease in supply refers to a leftward shift in the market supply curve. Price P0 Q1 Managerial Economics in a Global Economy Q0 Quantity 22 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Market equilibrium is determined at the intersection of the market demand curve and the market supply curve. Equilibrium price: The price that equates the quantity demanded with the quantity supplied. Equilibrium quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level. The equilibrium price causes quantity demanded to be equal to quantity supplied. An increase or decrease in the demand or supply curve, it defines a new equilibrium point. Managerial Economics in a Global Economy 23 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Price D S P Q Quantity Managerial Economics in a Global Economy If the quantity supplied of a commodity exceeds the quantity demanded, this is called excess supply or surplus between D and S over point p. If the quantity demanded of a commodity exceeds the quantity supplied, this is called excess demand or shortage between D and S below point p. 24 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Shortage: A market situation in which the quantity demanded exceeds the quantity supplied. A shortage occurs at a price below the equilibrium level. Surplus: A market situation in which the quantity supplied exceeds the quantity demanded. A surplus occurs at a price above the equilibrium level. Managerial Economics in a Global Economy 25 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Managerial Economics in a Global Economy 26 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Price D0 D1 An increase in demand will cause the market equilibrium price and quantity to increase. P1 P0 Q0 Q1 Managerial Economics in a Global Economy S0 Quantity 27 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Price D1 D0 A decrease in demand will cause the market equilibrium price and quantity to decrease. P0 P1 Q1 Q0 Managerial Economics in a Global Economy S0 Quantity 28 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Price D0 S0 P0 P1 Q0 Q1 Managerial Economics in a Global Economy S1 An increase in supply will cause the market equilibrium price to decrease and quantity to increase. Quantity 29 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Market Equilibrium Price D0 S1 P1 P0 Q1 Q0 Managerial Economics in a Global Economy S0 A decrease in supply will cause the market equilibrium price to increase and quantity to decrease. Quantity 30 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory The Demand Schedule and the demand curve-Example How can the relationship between quantity demanded and price be portrayed? Demand schedule Demand curve Managerial Economics in a Global Economy 31 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Table 1: A demand schedule for carrots P (price per ton) D (quantity demanded) Thousands ton per months U $ 20 110 V 40 90 W 60 77.5 X 80 67.5 Y 100 62.5 Z 120 60 Av income:$ Managerial Economics in a Global Economy Table: 1 is a hypothetical demand schedule for carrots. It shows the quantity of carrots that would be demanded at various prices on the assumption that average household income is fixed at $ 20000 and all other price do not change. (i.e. if the price of carrots were $60 per ton, consumers would desire to purchase $77,500 tons of carrots per month. 20000 32 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory A demand curve for carrots A second method of showing the relation between quantity demanded and price is to draw a graph. It is a downward slope which indicates quantity demanded increases as price falls. 140 120 Price 100 80 60 40 20 0 60 62.5 67.5 77.5 90 110 Quantity Managerial Economics in a Global Economy 33 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Shifts in the demand curve-Example A demand curve or line is drawn on the assumption that everything except the commodity’s own price is held constant. A change in any of variables previously held constant will shift the demand curve or line to a new position. (i.e. A rise in household income has shifted the demand curve or line to the right. A demand curve can shift in mainly two ways: If more bought at each price, the demand curve shift right so that each price corresponds to a higher quantity than before. If less is bought at each price, the demand curve shifts left so that each price represents to a lower quantity than before. Managerial Economics in a Global Economy 34 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Table 2: Two Alternative Demand Schedule for carrots P Q (D) Q1 (D1) $ 20 110 140 40 90 116 60 77.5 100.8 80 67.5 87.5 100 62.5 81.3 120 60 78 Av in: $ 20000 Managerial Economics in a Global Economy $ 24000 An increase in average income will rise the quantity demanded at each price. When AV income rises from $20000 to $ 24000 per year, quantity demanded at price of $60 per ton increases from 77500 tons per month to 100800 tons per month. Similar rise occurs at every other price. 35 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Table 2: Two Alternative Demand Schedule for carrots Put differently, A rise in av household income shifts the demand curve for most commodities to right so this indicates that more will be demanded at each possible price. Ultimately, the demand schedule relating columns P and D is replaced by one relating columns P and D1 in the previous table. The graphical presentation of the two functions are seen in the following graph. Managerial Economics in a Global Economy 36 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Shifts in the demand curve-Example Q (D) Q1(D1) $ 20 110 140 40 90 116 60 77.5 100.8 80 67.5 87.5 100 62.5 81.3 120 60 78 Managerial Economics in a Global Economy 160 140 120 100 80 60 40 20 0 price P Q1D1 QD 60 80 90 100 120 140 Quantity 37 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Other Prices Earlier, we saw that the downward slope of a commodity’s demand curve occurs because the lower its price, the cheaper the commodity is relative to other commodities that can satisfy the same needs or desires. Those other commodities are called substitutes (i.e. Carrots can be made cheap relative to cabbage either by lowering the price of carrots or raising the price of cabbage). A rise in the price of a substitute for a commodity shifts the demand curve for the commodity to the right. Managerial Economics in a Global Economy 38 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Other Prices Another class of commodities is called complements. These are the commodities that tend to be used jointly each other. Such as cars and gasoline or electric stove and electricity. A fall in the price of a complementary commodity will shift a commodity’s demand curve to the right. For example, a fall in the price of airplane trips to Paris will lead to a rise in the demand for Disney Land tickets at Paris even though their price is unchanged. Managerial Economics in a Global Economy 39 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Tastes Tastes have a large effect on people’s desired purchased. A change in tastes may be long-lasting such as the shift from fontain pens to ball-point pens. In this case, a change in tastes in favor of a commodity shifts the demand curve to the right. Managerial Economics in a Global Economy 40 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Distribution of Income A change in the distribution of income will shift to the right the demand curves for commodities bought most by those gaining income. On the other hand, it will shift to the left the demand curves for commodities bought most by those losing income. If, for example, the government increases the deductions for children on the income tax and compensates by raising basic taxes, income will be transferred from childness persons to the large familes. So commodity more heavily bought by families with no child decline in demand. Managerial Economics in a Global Economy 41 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Population Population growth does not by itself create new demand. The additional people must have purchasing power before demand is changed. Extra people of working age, however, usually means extra output and if they produce, they will earn income. When this happens, the demand for all the commodities purchased by the new income earners will rise. Thus a rise in population will shift the demand curves to the right. Managerial Economics in a Global Economy 42 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Individual Demand function The demand for a commodity arises from the consumers’ willingness and ability to purchase the commodity. Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, and the tastes of the consumer. Managerial Economics in a Global Economy 43 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Functional form Qdx= (Px, I, Py, T) An inverse relationship is expected between the quantity demanded of a commodity and its price (law of demand). That is, when the price rises, the quantity purchased declines, and when the price falls, the quantity sold increases. Managerial Economics in a Global Economy 44 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Functional form Qdx= (Px, I, Py, N,T) QdX/PX < 0 QdX/I > 0 if a good is normal QdX/I < 0 if a good is inferior QdX/PY > 0 if X and Y are substitutes QdX/PY < 0 if X and Y are complements Managerial Economics in a Global Economy 45 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Individual and Market Demand Curve Example Horizontal Summation: From Individual to Market Demand Managerial Economics in a Global Economy 46 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Individual and Market Demand Curve Example Given the following data: Pdx=$4 and Qdx=4 and Qddx=400, while at Px=$3, Qdx=6 and Qdd=600, construct the relevant individuals and market curves Market 8 6 4 2 0 Px Px Individuals 0 2 4 6 Qdx Managerial Economics in a Global Economy 8 10 12 8 6 4 2 0 0 200 400 600 800 1000 1200 Qdx 47 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand Responsiveness or sensitivity in the quantity demanded of a commadity to a change in its price. Price Elasticity of Demand The measurement of this sensitivity in percentage terms is called Price Elasticity of Demand Elasticity is a percentage relationship between two variables. Type of elasticities: Point, Arc, income and cross price. Managerial Economics in a Global Economy 48 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand: Factor Affecting the price elasticity of demand The price elasticity of demand (Ep) is mainly depends on the following factors: Availability of substitutes effect e.g. Oil product cannot easily be substituted-demand of oil product is inelastic. e.g. The demand for taxi services is expected to be elastic. Instead, You may use bus, train etc.. Managerial Economics in a Global Economy 49 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand: Factor Affecting the price elasticity of demand The price elasticity of demand (Ep) is mainly depends on the following factors: The portion of money allocated in the budget (percentage of Consumer’s budget) A change in the price of a product do not influence consumers’ budget in a negative way. (the importance of being unimportant) e.g. An increase in black pepper will not decrease the demand of consumers on black pepper due to their small portion of money allocated in their budget. o Managerial Economics in a Global Economy 50 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand The price elasticity of demand (Ep) is mainly depends on the following factors: The time period after changes in price (Time Period of Adjustment) As long as time period gets longer, the demand becomes more elastic. e.g. When oil prices increase, consumers cannot find a solution to change the current system to another alternative system in a short run period. This shows us demand for oil will remain same to a certain extent and an increase or a decrease in demand will be depend on time. o Managerial Economics in a Global Economy 51 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand The price elasticity of demand (Ep) is measured by the percentage change in the quantity demanded of the commodity divided by the percentage change in commodity’s price, holding constant all other variables in the demand function. Q / Q Q P EP P / P P Q Managerial Economics in a Global Economy 52 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand Point Definition Or Elasticity at given point Q / Q Q P EP P / P P Q Linear Function P EP a1 Q Managerial Economics in a Global Economy 53 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand Arc Definition It measures elasticity between two points on the demand curve Managerial Economics in a Global Economy Q2 Q1 P2 P1 EP P2 P1 Q2 Q1 54 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Marginal Revenue and Price Elasticity of Demand 1 MR P 1 EP MR can be defined in terms of price and price elasticity of demand. Managerial Economics in a Global Economy 55 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand- Example Market Px 8 A 6 4 2 0 0 B 200 C 400 D 600 Qdx Managerial Economics in a Global Economy E 800 F G 1000 1200 Find Ep at point A, B, C and G Ep=(ΔQ/ ΔP) (P/Q) At point A, Ep=(0200/ 6-5) (6/0) Ep=-200 (6/0)= indefinite At point B, Ep= (200-400/5-4) (5/200)=-5 At point C, Ep=(400-600/4-3) (4/400)=-2 At point G, Ep=(-200)(0/1200)=0 56 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Price Elasticity of Demand- Example Find Ep at point A, B, C and G Ep=(ΔQ/ ΔP) (P/Q) At point A, Ep=(-200/ 6-5) (6/0) Ep=-200 (6/0)= - indefinite At point B, Ep= (200-400/5-4) (5/200)=-5 At point C, Ep=(400-600/4-3) (4/400)=-2 At point G, Ep=(-200) (0/1200)=0 Managerial Economics in a Global Economy 57 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Arc Elasticity of Demand- Example Find arc Ep between points B and C Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) Ep= (400-200)/(4-5) (4+5)/(400+200) Ep=-3 Market Absolute value of Ep 8 A Greater than 1- elastic 6 B C 4 D Equals 1- unit elastic 2 0 Less than 1- inelastic Px 0 200 400 600 E 800 F 1000 G 1200 Qdx Managerial Economics in a Global Economy 58 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory MR and TR based on Elasticity- Example P Q Ep TR=P.Q MR=DTR/DQ (1) (2) (3) (4) (5) $6 0 -indefinite $0 - 5 200 -5 1,000 5 4 400 -2 1,600 3 3 600 -1 1,800 1 2 800 -1/2 1,600 -1 1 1,000 -1/5 1,000 -3 0 1,200 0 0 -5 Managerial Economics in a Global Economy 59 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory MR and TR based on Elasticity- Example Find MR by using P and Ep at Px =$4 and $3 MR= P{1+(1/Ep)} At Px =$4 MR=4{1+(1/-2)=$2 At Px =$3 MR=3{1+(1/-1)=0 Based on the previous table: P decreases TR increases when Ep is elastic TR max or unchanged when Ep is unitary elastic TR decreases when Ep is inelastic Managerial Economics in a Global Economy 60 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Graphically Showing Elasticities and MR-TR MR>0 MR<0 EP 1 E 1 TR P 0 600 EP 1 MR=0 Managerial Economics in a Global Economy 1200 QX 61 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Graphically Showing Elasticities and MR-TR PX 6 EP 1 EP 1 EP 1 0 600 1200 QX MR X Managerial Economics in a Global Economy 62 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Income Elasticity of Demand Point Definition Linear Function EI Q / Q Q I I / I I Q EI a3 Managerial Economics in a Global Economy I Q 63 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Income Elasticity of Demand Arc Definition Normal Good E I 0 Luxuries Good E I 1 Managerial Economics in a Global Economy Q2 Q1 I 2 I1 EI I 2 I1 Q2 Q1 Inferior Good EI 0 Necessities Good 0 <I E < 1 64 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Cross-Price Elasticity of Demand Point Definition Linear Function Managerial Economics in a Global Economy QX / QX QX PY E XY PY / PY PY QX E XY PY a4 QX 65 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Cross-Price Elasticity of Demand Arc Definition QX 2 QX 1 PY 2 PY 1 EXY PY 2 PY 1 QX 2 QX 1 Substitutes Complements EXY 0 EXY 0 No relationship EXY 0 Managerial Economics in a Global Economy 66 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Income, Cross and Arc Elasticises- Example Find arc EI between two levels of income i.e I=$10000 and I=$ 11000 when the demand for commodity X is 400. Market Ep=(Q2-Q1)/(I2-I1) (I2+I1)(Q2+Q1) 8 A 6 B C D Ep= (600-400)/(11-10) (11+10)/(600+400) 42 E F 0 EI= 4.2 0 200 400 600 800 1000 Qdx Thus commodity x is normal and luxury. Find arc Exy between two levels of price y i.e Py=$ 1 and Py =$ 2 when the demand for commodity X is 400. Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) XY Ep= (600-400)/(2-1) (2+1)/(600+400) Substitutes EI= 0.6 Thus commodity y is substitute compared to commodity X Managerial Economics in a Global Economy Px E G 1200 0 67 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Using Elasticises In Managerial Decision Making-Example A firm selling coffee brand X and estimated relevant demand regression as follows: Qx=1.5-3.0 Px+0.8 I+2.0 Py-0.6 Ps+1.2 A Qx is sales of coffee brand X, I is disposable income, Py is price of competitive coffee brand, Ps is price of sugar and A is advertising expenditures for coffee brand X. Suppose: Px=$2, I=$2.5, Py=$1.80, Ps=$0.50 and A=$1 Managerial Economics in a Global Economy 68 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Using Elasticities In Managerial Decision Making Example Calculate Qx and the elasticities of sales with respect to each variable in the relevant demand function Qx=1.5-3.0 Px+0.8 I+2.0 Py-0.6 Ps+1.2 A Qx=1.5-3.0(2)+0.8(2.5)+2(1.8)-0.6(0.5)…1.2(1) =2mn pounds coffee Calculate the elasticities of the demand for coffee brand X Ep=-3(2/2)=-3,Ei=0.8(2.5/2)=1, Exy=2(1.8/2) Exs=-0.6(0.5/2)=-0.15, Ea=1.2(1/2)=0.6 RECALL the Formulae EP P a1 Q Managerial Economics in a Global Economy E XY P a4 Y QX EI I a3 Q 69 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Using Elasticises In Managerial Decision Making-Example Next year, the firm would like to increase Px by 5%, A by 12%, I by 4%, and Py 7% whereas Ps fall by 8%. Determine sales of coffee brand X in the next year. Qxx=Qx+Qx(DPx/Px)Ep……+Qx(DA/A)Ea Qxx=2+2(5%)(-3)+2(4%)(1)+2(7%)(1.8) +2(-8%)(-0.15)+2(12%)(0.6) Qxx=2.2 or 2,200,000 pounds Managerial Economics in a Global Economy 70 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Managerial Economics in a Global Economy 71 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? 1 percent increase in price leads to a reduction in the quantity demanded of clothing of 0.90 percent in the short-run and 2.90 percent in the long-run. Price elasticity of demand for gasoline is three times higher in the long-run. Both elasticities are very small. It seems that people cannot find suitable substitutes for gasoline. Managerial Economics in a Global Economy 72 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Managerial Economics in a Global Economy 73 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Income elesticity of demand is 2.59 for wine and -0.36 for flour. This means that a 1 percent increase in consumers’ income leads to a 2.59 percent increase in expenditure on wine but to a 0.36 percent reduction in expenditures on flour. Thus wine is a luxury while flour is a inferior good. Electricity is also a luxury and so European cars, Asian cars, and domestic cars in the U.S. While cigarettes, beer, chicken and pork are necessities. Beef is a borderline commodity Managerial Economics in a Global Economy 74 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Managerial Economics in a Global Economy 75 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? The cross price elesticity of demand of margarine with respect to the price of butter is 1.53 percent. This means that a 1 percent increase in the price of butter leads to a 1.53 percent increase in the demand for margarine. Thus margarine and butter are substitutes in the U.S. The cross price elesticity of demand of cereals (e.g. Bread) with respect to the price of fresh fish is -0.87 percent. This means that a 1 percent increase in the price of cereals leads to a 0.87 percent reduction in the demand for fresh fish. Thus cereal and fresh fish are complements. Managerial Economics in a Global Economy 76 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Managerial Economics in a Global Economy 77 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? The price elesticity of demand of beer is -0.23 percent. This means that a 10 percent increase in the price of beer leads to a 2.3 percent reduction in the quantity of beer demanded and thus an increase in consumer expenditures on beer. The price elesticity of wine is -0.40 and spirits is -0.25 so that an increase in their price also leads consumers to demand a smaller quantity of wine and spirits, but also to spend more on the alcoholic beverages. The cross price elesticity of demand for beer with respect to the price of wine is 0.31 and with respect to spirits is 0.15. This means that wine and spirits are substitutes for beer, with wine being better substitute. Managerial Economics in a Global Economy 78 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory How do you interpret? Thus a 10 percent increase in the price of wine will lead to a 3.1 percent increase in demand for beer, while a 10 percent increase in the price of spirits leads to a 1.5 percent increase in demand for beer. a 10 percent increase in consumer income will lead to a 0.9 percent reduction in the demand for beer, but 50.3 percent increase in demand for wine, while a 12.1 percent increase in demand for spirits. Thus beer can be considered an inferior good, while wine and spirits can be regarded as a luxury goods. Wine seems much stronger luxury than spirits. Managerial Economics in a Global Economy 79 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory The important steps by using Elasticities The analysis of the forces or variables that affect on demand and reliable estimates of their quantitative effect on sales (elasticities) are essential in order for firm to make best operating decisions in shor-run and to plan for its growth in the long-run. The firms can use the elasticities of demand of the variables under their controls to find out best policies as well as to maximize their profits. If the demand for the firm’s product is price inelastic, the firm will want to increase the product price since that would increase its total revenue and reduce its total cost. If the elasticity of the firm’s sales wrt the variable beyod its control or If the cross-price elasticity of demand for the firm’s product is very high, the firm will need to respond quickly to a competitor’s price reduction otherwise losing a great deal of its sales. Managerial Economics in a Global Economy 80 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory The important steps by using Elasticities The size of the price elasticity of demand is larger, the closer and the greater is the number of available substitutes for the commodity. For example, sugar is more price elastic than table salt (e.g. honey) In general, the greater is its price elasticity of demand, the greater will be the number of substitutes For a given price change, the quantity response is likely to be much larger in the long run than short run so the price elasticity of demand is likely to be much greater in the long run than short run . Managerial Economics in a Global Economy 81 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Recall: Consumer Demand Theory Consumer demand theory postulates that the quantity demanded of a commodity per time period increases with a reduction in its price, with an increase in the consumer’s income, with an increase in the price of substitute commodities and a reduction in the price of complementary commodities, and with an increased taste for the commodity. On the other hand, the quantity demanded of a commodity declines with the opposite changes. Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, the number of consumers in the market, and the tastes of the consumer. Managerial Economics in a Global Economy 82 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory Relating Concepts The increase in Qx when Px falls occurs because in consumption, the individual consumer substitutes commodity x for other commodities which are now relatively expensive. This is called the substitution effect. In addition, when Px falls, a consumer can purchase more of x with a given amount of money (i.e., the consumer’s real income increases). This is called the income effect. The movement along a given demand curve resulting from a change in the commodity price is referred to as a change in the quantity demanded, while a shift in the demand curve resulting from a change in any of the factors that affect demand, other than the commodity price, is referred to as a change in demand. Managerial Economics in a Global Economy 83 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved. Ch 3: Demand Theory The End Thanks Managerial Economics in a Global Economy 84 © Dominick Salvatore; ed. 2007;2011, 2012/13, Sami Fethi, EMU, All Right Reserved.