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Managerial Economics
Prof. R. Michelfelder, Ph.D.
Outline 2
Demand, Supply, Price, Revenues,
Estimation of Demand Function and
Prediction of Revenues
2.1
Outline 2
2.1 Theory of Demand
2.2 Theory of Supply
2.3 Demand, Supply & Price
2.4 Demand, Price Elasticity &
Revenue Prediction
2.2
2.1 Theory of Demand
The functional relationship
between the price of a good
or service and other
variables and the quantity
demanded or sales in units
by consumers in a given
time
2.3
Non-Price Factors
Influencing Demand
1. Tastes and preferences
Affected by socioeconomic factors
such as age, sex, race, marital
status, and education level
2. Income
The level of income (e.g. GDP)
affects demand for normal goods
and inferior goods
2.4
Non-Price Factors
Influencing Demand
3.
Prices of related goods
Substitute goods – when one good
can be used in the place of another
Complementary goods – two or more
goods that consumers use together
4.
Future expectations
5.
Number of consumers
6.
Others (weather for electricity sales)
2.5
Demand Function
QXD = f (PX, T, Y, PY, PZ, EXC, NC, …
where
QXD = sales in unit s or “quantity
demanded” for good X
PX = price of good X
T = variables representing tastes and
preferences
Y = income
(continued on next slide)
2.6
The Demand Function
QXD = f (PX, T, Y, PY, PZ, EXC, NC, …
where
PY and PZ = prices of goods Y and Z,
which relate to consumption of good X
EXC = consumer expectations about
future prices
NC = number of consumers
2.7
Demand Curves
Figure 2.1
P1
P2
A
B
The demand curve
shows the
relationship between
price of a good and
quantity demanded,
all else constant
Demand
0
Q1 Q2
Quantity
2.8
More About
Demand Curves
 Demand shifters: variables held
constant when defining a demand
curve but would shift if their values
changed
 Negative (inverse) relationship: where
an increase in one variable causes a
decrease in another
 Slope of demand curve determines
degree of competition in an industry
(negative slope reflects imperfect
competition)
2.9
Increase in Demand
Figure 2.2
A change in demand
occurs when one or
more of the factors
are held constant in
defining a given
demand curve change
D2
D1
P1
0
Q1
Q2
Quantity
2.10
Individual Versus
Market Demand Curve
 Horizontal summation of individual
demand curves: for every price, the
quantity that each person demands
at that price determines market
quantity demanded at that price
 The market demand curve, DM,
considers quantities demand at
other prices
2.11
Individual Versus Market
Demand Curve Figure 2.3
P1
dB
DM =dA + dB
dA
0
Q1
Q2
Q3
Q4
Quantity
2.12
Demand Function as an
Equation (for copper)
QD = 10 - 50PC + 0.31I + 1.5TC + 0.5E where
QD = sales of copper in pounds
PC = price of copper per pound
I = consumer income index
TC = index showing uses for copper
E = expectations index
2.13
Managerial Rule of Thumb:
Demand Considerations
Managers must
• Understand what influences
demand
• Determine which factors they can
influence
• Determine how to handle factors
they cannot influence
2.14
2.2 Theory of Supply
The functional relationship between
the price of a good or service and
other variables that affect cost
and the quantity that producers
are willing to supply in a given
time
2.15
Non-Price Factors
Influencing Supply
 State of technology
 Input prices (labor, capital)
 Prices of goods related in
production
 Future expectations
 Number of producers
2.16
The Supply Function
QXS = f (PX, TX, PI, PA, PB, EXP, NP, … where
QXS = quantity supplied of good X
PX = price of good X
TX = state of technology
PI = prices of the inputs of production
(continued on next slide)
2.17
The Supply Function
QXS = f (PX, TX, PI, PA, PB, EXP, NP, … where
PA, PB = price of goods A and B, related
to good X
EXP = producer expectations about
future prices
NP = number of producers
2.18
Price
Supply Curve
for a Product
B
P2
P1
0
Supply
Relationship
between price
of a good and
quantity
supplied
A
Q1
Figure 2.4
Q2
Quantity
2.19
Supply Relationships
 Not all supply curves are linear
 Supply curve does not show actual
price of product but the relationship
of alternative prices and quantities
 A positive relationship is shown as
upward line where increase in one
variable causes increase in another
variable
2.20
Changes (Increase)
in Supply
Figure 2.5
S1
S2
P1
0
Q1
Q2
A change in
supply occurs
when one or more
of the factors held
constant in
defining a given
supply curve
change
Quantity
2.21
Change in
Quantity Supplied
A price change causes movement from
one point to another
• An increase in price of a substitute
good causes the supply curve to shift
to the left; a decreases shifts it to the
right
• If the price of a complementary good
increases, the supply increases
• An increase in the number of
producers shifts it to the right
2.22
Managerial Rule of Thumb:
Supply Considerations
Managers must
• Examine technology and costs of
production
• Find ways to increase productivity
while lowering production costs
Supply curve is actually a portion
the marginal cost curve
2.23
2.3 Demand, Supply,
and Price
 A price for a good or service is
determined when the market
reaches equilibrium
 The quantity demanded of good X
equals the quantity producers are
willing to supply
 An upset in equilibrium pushes
the price back toward equilibrium
2.24
Market Equilibrium
Figure 2.6
Supply
PE
Market
equilibrium
occurs where
demand
equals supply
Demand
0
QE
Quantity
QE = equilibrium quantity
2.25
PE = equilibrium price
Lower-ThanEquilibrium Prices
 Consumers demand more of a
good than producers are willing to
supply at that price
 Supply and demand become
unstable
 An adjustment process begins
which seeks to again bring
equilibrium
2.26
Changes in Equilibrium
Prices and Quantities
 Change in demand
 Change in supply
 Changes on both sides of the
market
2.27
4. Demand, Price Elasticity,
Revenues & Prediction
Mature & Start-up Firms Predict Income
Statements and Cash Flows in a
Business Plan {see Michelfelder
and Morrin (2013) diffusion curves}
Revenues are Driven by Sales:
2012 2013
2014
2015 2016
(predicted
from
demand
Revenues
Expenses
Oper. Cash
Flow
2.28
Price Elasticity
The percentage change in the quantity
demanded of a given good relative to a
percentage change in its price
eP =
% ΔQx
% ΔPx
where
eP = price elasticity of demand
Δ = the absolute change
Qx= quantity demanded of good X
Px= the price of good X
2.29
Price Elasticity
Figure 3.1
P1
A
P
B
P2
0
Measured as a
movement along a
demand curve
Q
Q1
Demand
Q2
Quantity
2.30
Price Elasticity and
Decision Making
 Tells managers what will happen
if product prices change
 Helps firms to develop pricing
strategies
 Helps to develop pricing
strategies in the public sector
2.31
Elasticity
 Elastic demand: change in
quantity demanded is greater than
the change in price
 Inelastic demand: change in
quantity demanded is less than
the change in price
 Unitary elasticity: change in
quantity demand is equal to
change in price
2.32
Elasticity and
Total Revenue
 If demand is elastic, higher prices
result in lower total revenue.
Lower prices result in higher total
revenue
 Changes in price and the resulting
total revenue are inversely
proportionate
 (see Figure 3.2 on next slide)
2.33
Demand Elasticity
 Demand elasticity shows the
percentage change in quantity
demanded of a product relative to
the percentage change in both
variables
 The coefficient represents the
ratio of the two percentage
changes
2.34
Elastic Demand and
Total Revenue Figure 3.2
If prices decrease,
revenue increases.
If prices increase,
revenue decreases.
12
(P1) 10
(P2) 9
A
Y
B
C
X
0
2
3
(Q1) (Q2)
Area X = Q1CBQ2
Area Y = P1ACP2
12
Demand
Quantity
2.35
Inelastic Demand
 When units are sold at a lower
price, the quantity demanded has
not increased proportionately
 Total revenue decreases
 Changes in price and the resulting
total revenue move in the same
direction
 (See Figure 3.3 on next slide)
2.36
Inelastic Demand and
Total Revenue Figure 3.3
If prices decrease,
revenue decrease. If
prices increase,
revenue increases.
12
(P1) 4
(P2) 3
0
Area X = Q1CBQ2
Area Y = P1ACP2
A
Y
B
C X
8
9 12
(Q1) (Q2)
Demand
Quantity
2.37
Managerial Rule of Thumb:
Estimating Price Elasticity
Managers can estimate price elasticity by
asking customers:
1. What do you currently pay for my product?
2. At what price would you stop buying my
product altogether?
Managers should ask themselves:
1. How much will revenue increase as a
result of higher sales?
2. How much will revenue decrease as a
result of lower prices for each unit?
2.38
Determinants of Price
Elasticity of Demand
1. Number of substitute goods
2. Percent of a consumer’s income
that is spent on the product
3. Time period under consideration
4. Nature of the good (durable or
non-durable)
2.39
Calculating Price
Elasticities
 Arc price elasticity: base quantity
(or price) is the average value of
the starting and ending points
 Point price elasticity:
measurement of the price
elasticity of demand calculated at
a point on the curve using
infinitesimal changes in prices
and quantities
2.40
Numerical Examples
 Demand function
• Shows relationship between quantity
demanded and price
• Q = 12 – P or P = 12 – Q
 Total revenue function
• Shows total revenue received by
producer as a function of the level of
output
• TR = (P) (Q) = (12 – Q) (Q) = 12Q – Q2
2.41
Numerical Examples
 Average revenue function: shows how
average revenue is related to level of output
• AR = TR / Q = [(P) (Q)] / Q = P
 Marginal revenue function: shows the
additional revenue a producer receives by
selling an additional unit of output at
different levels
• MR = (TR) / (Q) = (TR2 – TR1) / (Q2 – Q1)
MR = dTR / dQ = 12 – 2Q
2.42
Demand and
Marginal Revenue
 Firms are always constrained by
demand curve
 Top half of the demand curve in
Figure 3.4 indicates when
managers lower price, total
revenue increases
 Bottom half indicates a price
decrease causes total revenue
to fall
2.43
Demand and
Marginal Revenue
12
|eP| > 1
|eP| = 1
6
0
6
Figure 3.4
Demand,
marginal
revenue, and
total revenue
functions are
related
|eP| < 1
Demand
Marginal 12 Quantity
Revenue
2.44
The Total Revenue
Function
Figure 3.5
Total
Revenue
36
18
Total
Revenue
0
6
12
2.45
Extreme Demand Curves
 Vertical demand curve
• Represents perfectly inelastic demand
• Example might be insulin for diabetics
 Horizontal demand curve
• Represents perfectly elastic demand
• Example would be a bushel of wheat
from an agricultural producer
2.46
Extreme Demand Curves
Vertical demand curve
Price
Demand
0
Q1
Quantity
Horizontal demand curve
Price
P1
Demand
0
Quantity
2.47
Elasticities of Demand
 Income elasticity of demand:
percentage change in quantity
demanded of a given good
relative to percentage change in
consumer income
• Necessities – elasticity between 0
and 1
• Luxuries – elasticity greater than 1
2.48
Managerial Rule of Thumb:
Calculating Income Elasticity
 Calculating income elasticity of
demand is based on two
questions for a consumer:
1. What fraction of your total budget
do you spend on Product X?
2. If you earned a bonus of $1000,
what part of that bonus would
you spend on Product X?
2.49
Elasticities of Demand
 Cross-price elasticity of demand:
measures how demand for Good X
varies with changes in the price of
Good Y
• Substitute goods have positive cross
elasticity
• Complementary goods have negative
cross elasticity
 Defines relevant market in which
different products compete
2.50
Managerial Rule of Thumb:
Price Elasticity Decision Making
Which demand elasticity should be
used in making appropriate decisions:
the one for the entire product or the
one for the individual producer?
(The answer depends upon how other
firms react to price changes)
2.51
Marketing Literature
Regarding Elasticity Issues
 Advertising elasticity of demand: the
percentage change in quantity
demanded of a good relative to the
percentage change in advertising
dollars spent on that good
 Marketing studies
• Tellis, 1988
• Sethuraman and Tellis, 1991
• Hoch, et al, 1995
2.52