Topic 7: Demand and Elasticity
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1 Topic 7: Demand and Elasticity 1 Market vs. firm s demand 2 Elasticity and revenue 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 Demand and Elasticity Slide 1
2 Perfect vs. imperfect competition firms are price-takers vs. firms have market power Firms are price-takers (Perfect competition) Firms have market power (Imperfect competition) (Sessions 5 7) (Sessions 8 15) Session 7 Demand and Elasticity Slide 2
3 From the individual firm s viewpoint Imperfect competition = firm has market power = firm sees a trade-off between price and volume P i Demand curve for i s output Q i Perfect competition = firm is a price-taker = firm believes it can sell any amount at the market price (e.g., market price is 3) P i s volume price trade-off Q i Session 7 Demand and Elasticity Slide 3
4 Market power: where it comes from P i d i (P i ) Two cases: Q i 1. Differentiated products: the firm s branded product is differentiated from other products. 2. Homogeneous goods: Though products are not differentiated, the firm is a big player: increased output pushes down the market price. Next let s compare market demand vs. a firm s demand Session 7 Demand and Elasticity Slide 4
5 Case 2: Homogeneous goods Market vs. firm s demand starting with no market power MARKET DEMAND FIRM S DEMAND El Guadal finca cafetera P P i US Cents per Pound US Cents per Pound when total output of other farms is 7.5M metric tons Millions of metric tons Q Metric tons Q i Session 7 Demand and Elasticity Slide 5
6 Market power: Our simulation Market demand vs. firm s demand MARKET DEMAND FIRM S DEMAND Q = P When Q i = 3173 P P i Thousands Q Q i Session 7 Demand and Elasticity Slide 6
7 Corning and glass substrate Corning has over 50% market share of glass substrate. There are different grades ( 5G, 6G, ), but for a particular grade the products of different suppliers are viewed as close substitutes. News item from December 2005 (for example): The aggressive capacity added by both Corning of the U.S., the world s No. 1 substrate supplier, and AGC, the No. 2, will lead to price drops for glass substrates and will especially benefit TV panel makers Session 7 Demand and Elasticity Slide 7
8 Market demand curve vs. Corning s demand curve MARKET DEMAND FIRM S DEMAND Q = P When Q i = 1500 P 60 P Thousands Q Thousands Q i Session 7 Demand and Elasticity Slide 8
9 Case 1: Differentiated products Market demand vs. a firm s demand Example: Airbus and Boeing Individual demand functions: Q A = 60 3P A + 2P B Q B = 60 3P B + 2P A Market demand: Choose measure of aggregate output, say Q = Q A + Q B. Choose price index, say P = (P A + P B )/2. Q = 120 2P (See workbook-style Exercise on Demand and Elasticity for details and review.) Session 7 Demand and Elasticity Slide 9
10 Topic 7: Demand and Elasticity 1 Market vs. firm s demand 2 Elasticity and revenue 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 Demand and Elasticity Slide 10
11 Labor markets: minimum wage /hour d(p) Q (millions) Session 7 Demand and Elasticity Slide 11
12 Key point: % changes matter An increase in minimum wage has two effects on total wage bill: P : Each worker is more expensive : wage bill by %ΔP Q : Firms employ fewer workers : wage bill by %ΔQ Session 7 Demand and Elasticity Slide 12
13 Key point: % changes matter An increase in minimum wage has two effects on total wage bill: P : Each worker is more expensive : wage bill by %ΔP Q : Firms employ fewer workers : wage bill by %ΔQ Net effect depends on which is greater: %ΔP or %ΔQ Session 7 Demand and Elasticity Slide 12
14 Example: linear demand /hour Q (millions) Session 7 Demand and Elasticity Slide 13
15 Key point: own-price elasticity of demand Useful measure of price-sensitivity of demand: Elasticity E = % change in Q % change in P. If E < 1 E = 1 E > 1 then a price increase causes revenue (expenditure) to and we say demand is Session 7 Demand and Elasticity Slide 14
16 Other elasticities We can measure elasticities between any two related variables (e.g., demand and income, supply and price, etc.) Elasticity = sensitivity in terms of % changes (rather than slope). Some elasticities of demand: Own-price elasticity: %ΔQ %ΔP Cross-price elasticity: %ΔQ %ΔP s Income elasticity: %ΔQ %ΔI Remember: This course: 97% on own-price elasticity; 3% on other elasticities. Elasticity of demand (no qualifier) means own-price elasticity. Own-price elasticity is only one we use the minus sign for. Session 7 Demand and Elasticity Slide 15
17 Topic 7: Demand and Elasticity 1 Market vs. firm s demand 2 3 Elasticity and revenue Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 Demand and Elasticity Slide 16
18 Point elasticity Loosely: E = % change in Q % change in P. Point elasticity: If d(p) is smooth then elasticity at point (P, Q) is E = dq dp P Q. Session 7 Demand and Elasticity Slide 17
19 Elasticity of linear demand: Q = A BP Choke price: price at which demand is zero = P = Point elasticity: P P P. Price ($1000s) Demand for minivans (100,000s) Session 7 Demand and Elasticity Slide 18
20 Elasticity of log-linear demand: Q = AP B Taking logs yields: log Q = log A B log P Price d 1 (P) = 6P 3 d 2 (P) = 1.7P 1.5 d 1 (P) d 2 (P) Quantity Session 7 Demand and Elasticity Slide 19
21 Topic 7: Demand and Elasticity 1 Market vs. firm s demand Elasticity and revenue Numerical examples: Elasticity for linear and log-linear demand Determinants of elasticity 5 Demand estimation exercise. Session 7 Demand and Elasticity Slide 20
22 Determinants of elasticity 1. The more close substitutes a good has, the elastic is demand. 2. Demand for a particular brand (Samsung) or type ( 17 flat panel) is elastic than demand for the entire category (computer displays). 3. The more differentiated the brand, the elastic is demand. 4. Advertising usually both increases demand and makes it elastic. 5. When a product s close substitutes become more expensive, demand for the product becomes elastic. 6. Demand is typically elastic for people with lower income. Session 7 Demand and Elasticity Slide 21
23 Elasticity of demand for some cars in USA (1980s data) Model Elasticity Mazda Honda Accord 4.8 Nissan Maxima 4.8 Nissan Sentra 6.5 Ford Taurus 4.2 Ford Escort 6.0 Lexus LS Chevrolet Cavalier 6.4 Cadillac Seville 3.9 BMW 735i 3.5 But for entire category: 0.8 Session 7 Demand and Elasticity Slide 22
24 Topic 7: Demand and Elasticity 1 Market vs. firm s demand Elasticity and revenue Numerical examples: Elasticity for linear and log-linear demand Determinants of elasticity Demand estimation exercise. Session 7 Demand and Elasticity Slide 23
25 Estimating demand: Get some data 1. Consumer surveys. 2. Consumer focus groups. 3. Market experiments. 4. Historical (real) data: cross-section, time-series, or both (panel). Session 7 Demand and Elasticity Slide 24
26 Estimating demand: Fit a curve 1. Write down model (equation) for demand, with unspecified coefficients. 2. Fit line or curve to data points using statistical techniques (regression). It s all approximate: Include most relevant variables. Pick a simple functional form without too many coefficients. Session 7 Demand and Elasticity Slide 25
27 Two common parametric forms Linear e.g. Q = A B 1 P + B 2 P s + B 3 I + FPR = P F + 0.4P M 0.07MPR GDP Log-linear (constant elasticity) taking logs yields Q = A P B 1 P B 2 s I B3 log Q = log A B 1 log P + B 2 log P s + B 3 log I + Session 7 Demand and Elasticity Slide 26
28 Demand for US Gasoline Consumption Variables: GPC = Per-capita U.S. gasoline consumption PG = Price index for gasoline Y = Per capita disposable income PNC = Price index for new cars PUC = Price index for used cars Model: GPC = APG B 1 Y B 2 PNC B 3 PUC B 4 Or: log GPC = log A + B 1 log PG + B 2 log Y + B 3 log PNC + B 4 log PUC Session 7 Demand and Elasticity Slide 27
29 Regression results log G = log PG log Y log PNC log PUC Or: G = PG Y PNC PUC Session 7 Demand and Elasticity Slide 28
30 Coming up Firms are price-takers (Perfect competition) Firms have market power (Imperfect competition) Individual decisions Equilibrium (Sessions 8 11) (Sessions 12 15) Session 7 Demand and Elasticity Slide 29
31 Session 8: Pricing with Market Power For a single firm with demand d(p) and cost curve c(q): Output decision: MR = MC. Entry/exit decision: VΠ > FC? FPM reading. Chapter 7. Deliverables. Exercises 7.4 and 7.5. Session 7 Demand and Elasticity Slide 30
Say: We did uniform pricing and price discrimination at individual level, but we only bring uniform pricing to equilibrium.
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If you have never done this before - go to CASA for fingerprint/picture process before your test date.
MATH 33 Review for Test - When: Where: CASA Testing Center Time: minutes Number of questions: 3 Multiple Choice Questions (total: 84 points) Free Response Questions (total: 6 points) For the free response