Session _5 Demand in Detail

# Session _5 Demand in Detail - Demand in Detail Demand in...

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Unformatted text preview: Demand in Detail Demand in Detail Adapted from BSZ chp. 4 OBJECTIVES OBJECTIVES You should be able to: 1. EXPLAIN the difference between change in: 1. 2. 2. 3. EXPLAIN & Calculate Price Elasticity ESTIMATE Demand: 1. “Demand” and “Quantity demanded” Firm Demand & Demand Function Demand Function A mathematical representation of the relationship between the quantity demanded and all factors influencing demand: Q = f(X1, X2,… Xn) where Q is quantity demanded and the Xis are the factors influencing demand Demand Function Example Demand Function Example Q = 117 ­ 6.6P + 1.66Ps ­ 3.3Pr + 0.00661I where P is PTC ticket price, Ps is price of symphony tickets, Pr is price of nearby restaurant meals, and I is average per capita income. BSZ chp. 4 Demand Function Example Demand Function Example Suppose the variables have the following values: P = \$30 Ps = \$50 Pr = \$40 I = \$50,000 How many tickets will PTC sell? Demand Curve Demand Curve Substitute variable values (except for P) into the equation and simplify: P = 60 ­ 0.15Q This is the equation for the demand curve. What generalized assumption is illustrated? Demand Curve Demand Curve Demand Curves illustrate the FIRST LAW of DEMAND The lower the price the more one will purchase, have, use or consume. Therefore, Demand Curves are negatively sloped with respect to price. Graph the Demand Curve Graph the Demand Curve Change in Amount Demand vs. Shift in Demand What is the Difference? Make a Friend exercise – BSZ chp.4­2 Make a Friend exercise – How will each of the following affect the position of the demand curve for DVD players? a. An increase in the price of DVDs. b. A decrease in the price of DVD players. c. An increase in per capita income. d. A decrease in the price of movie tickets. Demand Elasticity Demand Elasticity How responsive is the amount demanded of a good to a change (either rise or fall) in its price? Demand Elasticity Demand Elasticity The Price Elasticity of Demand is given by %∆Q η = − %∆P [Note: the convention used here is to express the elasticity as a negative quantity so that, when calculated, the result is a positive number] Information requirements: Quantity demanded before and after the price change • • Calculating elasticity Calculating elasticity arc price elasticity Price before and after the price change • • Q1 Q2 P1 P2 Calculating elasticity Calculating elasticity arc price elasticity ∆Q (Q1 + Q2 ) ∆Q (Q + Q ) 2 2 = − 1 η=− ∆P ∆P ( P + P2 ) ( P + P2 ) 1 1 2 Arc price elasticity Arc price elasticity example What does it mean? BSZ chp. 4 Question Question 4–17. Prior to a price increase, the price and quantity demanded for a product were \$10 and 100, respectively. After the price increase, they were \$12 and 90. a. Calculate the arc elasticity of demand. b. Is the demand elastic or inelastic over this region? c. What happened to total revenue? Determinants of price elasticity Determinants of price elasticity Availability of substitutes Price of Complements Size of good in consumer budget few substitutes for milk many substitutes for milk from a particular grocer Time period for consumer adjustment consider salt versus a Lexus given enough time, how do we adjust to higher fuel prices? SECOND LAW OF DEMAND Range of Price Elasticities Range of Price Elasticities The longer the time allowed to adjust amount demanded in response to a price change, the greater is the change in amount demanded, that is, the greater the elasticity. Range of Price Elasticities Range of Price Elasticities Make a friend exercise – BSZ chp.4­21 Make a friend exercise – Southwest Airlines estimates the short­run price elasticity of business fares to be 2 and the long­run elasticity to be 5. Is ticket demand more elastic in the short­ run or long­run? Does this seem reasonable? Explain. Why does elasticity matter? Why does elasticity matter? Because it determines the impact on revenue when price is changed Recall that Revenue = Price x Quantity Thus, revenue changes based on where the firm operates on the demand curve Revenue can be increased or decreased with an increase in price depending on elasticity Elasticity also indicates pricing flexibility and even market power (elastic pricing = less flexibility, more competition) Total Revenue & Marginal Revenue Total Revenue & Marginal Revenue Marginal Revenue is the change in Total Revenue give a one­unit change in quantity PTC’s total revenue is TR=P× Q The inverse demand curve is P = 60­.15Q Substituting, TR=(60­.15Q)× Q = 60Q­.15Q 2 From this we can derive marginal revenue (MR=∆ TR/∆ Q=60­.30Q) (ok, some calculus was involved) Note: without calculus you can simply memorize Marginal Revenue (MR) is a line that has the same intercept as the demand curve, but with twice the negative slope: Price Changes, Total Revenue & Price Changes, Total Revenue & Marginal Revenue If P = 60 ­ .15Q Then MR = 60 ­ .30Q Interpret Price Elasticity Interpret Price Elasticity |η | > 1 implies elastic demand |η | = 1 implies unitary elasticity |η | < 1 implies inelastic demand Interpreting elasticity – a 1% increase in price results in an η % decrease in quantity demanded Consider some examples Textbooks Lexus – Water – Milk – Diamonds – Walmart shirt Other Elasticities Other Elasticities Elasticity = % change in Q with respect to % change in some other factor Examples: Cross Price Elasticity Income Elasticity Make a friend exercise – BSZ 4­26, pg 127 Make a friend exercise – In an article appearing in the Dow Jones News Service on February 5th, 2004, the agency cites Saudi Arabia’s concern about the production of oil by the OPEC cartel. Assume the current daily demand for OPEC’s oil is given by the following equation: P = 50 – 0.001Q where P is the price per barrel (ppb) and Q is the quantity of barrels sold daily (in thousands). Moreover, suppose the marginal cost of producing a barrel is constant at zero. A. Would it surprise you to learn that OPEC’s declared objective is to sell 25 million barrels a day for an average price of \$25 per barrel? Why or why not? Explain. You may use a graph to support your argument. Make a friend exercise – BSZ 4­26, pg 127 Make a friend exercise – B. Assume that after OPEC’s meeting this week, the new demand for OPEC oil will be given by: P = 40 ­ .001Q. Would OPEC’s stated objective (25 million barrels at an overall price of \$25) be attainable after this change? Explain. Assume OPEC ignores the demand shift. What’s the maximum price per barrel they can charge if theydecide to keep producing 25 million barrels per day? What is the profit in this case? C. Now suppose that OPEC recognizes that demand has changed (as in (b)) and wants to maximize profits. What is the daily quantity they should supply? At what price? What is the profit in this case? What is the price elasticity of demand at this price/quantity combination? Explain. Estimate Demand Estimate Demand CarMax example \$25,000 \$24,500 \$24,000 \$23,500 Price \$23,000 \$22,500 \$22,000 \$21,500 \$21,000 0 5 10 15 20 25 Thousands of Miles 2007 Price Linear (2007 Price) 2006 Price Linear (2006 Price) y = -143.42x + 24368 R2 = 0.7681 y = -221.07x + 26883 R2 = 0.4985 How would you calculate the Price Elasticity? Estimate Firm vs. Industry Demand Estimate Firm vs. Industry Demand IM Flash Example ...
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