MGCR 293 DEMAND THEORY Professors: Dr. K. Salmasi Dr. T. Nizami Dr. T. Sidthidet T.A.: Brianna Mooney
1. CHAPTER REVIEW
THE MARKET DEMAND CURVE A curve that illustrates the quantity of goods that consumers are willing and able to purchase at each price
Changes with the Demand Curve 1. Movement along the curve Occurs when there is a change in price 2. Shift of the entire curve Occurs due to non-price determinants of demand: Changes in income Changes in tastes and preferences Prices of related goods (substitutes and complements) Advertising Change in population
PRICE ELASTICITY OF DEMAND Own Price Elasticity: percentage change in quantity demanded as a result of a 1% change in price η = P ΔQ Q ΔP Elastic (η<-1): greater than 1% change in Q Inelastic (η>-1):less than 1% change in Q Unitary elastic (η=-1): equal to 1% change in Q Perfect inelastic (η =0 0% change in Q Perfect elastic (η =- ) infinite change in Q
FACTORS AFFECTING PRICE ELASTICITY 1. Number of similarity of substitute products (many substitutes=elastic) 2. Products price relative to consumer s budget. (small items=inelastic) 3. Length of time good pertains (nondurable goods=elastic)
Price Elasticity & Marginal Revenue: MR= P 1+ 1 η Income Elasticity of Demand: η I = positive for normal goods, negative for inferior goods η I = I ΔQ Q ΔI Cross-Price Elasticity: η xy =substitute if positive, compliment if negative η xy = Advertising Elasticity: η A >1! elastic, <1! inelastic P y Q x ΔQ x ΔP y η A = A ΔQ Q ΔA
MARGINAL REVENUE AND ELASTICITY
https://www.youtube.com/watch?v=nquo7zjxai4
ELASTICITY AND TOTAL REVENUE When demand is inelastic, total revenue will increase if price increases Consumers are less sensitive to changes in price, therefore the potential gain of increasing price would offset the potential loss When demand is elastic, total revenue will increase by decreasing the price Consumers are more responsive to changes in price, therefore the potential gain would not outweigh the potential loss
2. CHAPTER QUESTIONS
QUESTION 1 The Dolan Corporation, a maker of small engines, determines that in 2008 the demand curve for its products is P=2000 50Q a) To sell 20 engines per month, what price would Dolan have to charge?
SOLUTION a) P=2000 50Q P=200-50(20) P=1000 b) If managers set a price of $500, how many engines will Dolan sell per month?
SOLUTION b) 500=2000 50Q Q=1500/50=30. 30 per month c)what is the price elasticity of demand if price equals $500.
SOLUTION
QUESTION 1
QUESTION 2 The Johnson Robot Company s marketing managers estimate that the demand curve for the company s robots in 2008 is P=3000 40Q a) Derive the marginal revenue curve for the firm
SOLUTION
QUESTION 2 b) At what price is the demand for the firm s product price elastic? c) If the firm wants to maximize its dollar sales volume, what price should it charge?
b) MR=0 3,000 80Q=0 Q=37.5 P=3,000-40(37.5) =$1,500 **Note: Demand is Unitary Elasticity when MR=0, price elastic when MR is positive, and price inelastic when MR is negative. We want to see where marginal revenue is positive, negative, and equal to zero MR: P=$1,400, Q=40 P= $1,500, Q=37.5 P=$1,800, Q=30
SOLUTION c) Maximize Total Revenue TR is maximized when MR=0 According to b), MR=0 when P=$1,500 (the price of unit elasticity) TR= $1,500 x 37.5 TR= $56,250
QUESTION 3 Q=500 3P +2P r +0.1I P r = price of rival products = 20 I = per capita disposable income = 6,000 P = price = 10 a) What is the price elasticity of demand for the firm s product?
SOLUTION
QUESTION 3 b) What is the income elasticity of demand for the firm s product? c)what is the cross-price elasticity of demand between its product and its rival s product? d) What is the implicit assumption regarding the population in the market?
SOLUTION Substitute the given values into the formulas for Income Elasticity and Cross Elasticity, respectively: b) Q I I = 0.1(6000) Q 1,110 = 600 1,110 c) Q P r P r Q = 2(20) 1,110 = 40 1,110 d) The assumption is that population is CONSTANT
QUESTION 4 The Haas Corporation s executive vice president argues for a reduction in the price of the firm s product. He says such a price cut will increase the firm s sales and profits. a) The firm s marketing manager responds that the price elasticity of demand for the firm s product is about -0.5. Why is this fact relevant? a) The firm s president concurs with the option of the executive vice president. Is she correct?
SOLUTION 4
QUESTION 5 Demand curve: P = 5 Q Current price is $1 a) Evaluate the wisdom of the firm s pricing policy. Profit-maximizing price occurs when MR = 0 b) A marketing specialists says that the price elasticity of demand for the firm s product is -1.0. Is this correct?
SOLUTION
SOLUTION
QUESTION 6 Richard Tennant has concluded, The consumption of cigarettes is relatively insensitive to change in price. But, the demand for individual brands is highly elastic in its response to price. In 1918, for example, Lucky Strike was sold for a short time at a higher retail price than Camel and Chesterfield and rapidly lost half its business. a) Explain why the demand for a particular brand is more elastic than the demand for all cigarettes. If Lucky Strike raised its prices by 1 percent in 1918, was the price elasticity of demand for its product greater than -2?
SOLUTION a) As there are many brands available for consumption, the price elasticity is elastic, as it is easy for consumer to switch to a close substitute. But since there is no substitute for cigarettes in general, the price elasticity is inelastic. The elasticity for Lucky Strike was less than -2.
QUESTION 6 b) Do you think that the demand curve for cigarettes is the same now as it was in 1918? If not, describe in detail the factors that have shifted the demand curve and whether each has shifted it to the left or right?
SOLUTION b) No, the demand curve for cigarettes has likely shifted to the left due to changes in consumer tastes and preferences (becoming more health conscious).
QUESTION 7 Price elasticity of demand for cigarettes is between -0.3 and -0.4, and the income elasticity of demand is about 0.5. a) Suppose the federal government, influenced by findings that link cigarettes and cancer, were to impose a tax on cigarettes that increased their price by 15%. What effect would this have on cigarette consumption?
SOLUTION Therefore, cigarette consumption would fall between 4.5-6% due to the increase in price of 15%
QUESTION 7 b) Suppose a brokerage house advised you to buy cigarette stocks because if income were to rise by 50 % in the next decade, cigarette sales would bound to spurt enormously. What would be your reaction to this advice?
SOLUTION b) Expected demand would increase by half of that, i.e 25%, since income elasticity equals 0.5. Other stocks are better
QUESTION 8 A survey of major U.S. firms estimates on average, the advertising elasticity of demand is only about 0.0003. Doesn t this indicate that managers spend too much on advertising?
SOLUTION An advertising elasticity of demand of 0.0003 means that a 1% increase in advertising expenditure results in a minimal increase for quantity demand. This could indicate that advertising is not the most effective factor in increasing quantity demanded. However, this is an average number across many industries, and advertising is more effective in some industries than others, thus this statement is not necessarily true for all firms.
QUESTION 9 Q=100P -3.1 (I 2.3 )(A 0.1 ) a) What is the price elasticity of demand? b) Will price increase result in increase or decrease in the amount spent on the product? c) What is the income elasticity of demand?
SOLUTION a) The price elasticity of demand is equal to the exponent of the P variable in the demand function, or -3.1. b) Since -3.1 is an elastic price elasticity, increasing price will reduce a firm s total revenue. c) The income elasticity of demand is equal to the exponent of the I variable in the demand function, or 2.3.
QUESTION 9 d) What is the advertising elasticity of demand? e) If the population in the market increased by 10%, what is the effect on the quantity demanded if P, I, and A are held constant?
SOLUTION d) The advertising elasticity of demand is equal to the exponent of the A variable in the demand function, or 0.1. e) The quantity demanded will increase by 10% (Q is defined as quantity demanded per capita. Quantity demanded per capita remains the same, however total quantity demanded increases by 10%).
QUESTION 10 Q=400 3P +4I +0.6A Q quantity demanded P products price (in $) I per capita disposable income (thousands of $) A advertising expenditure (thousands of $ per month) Population is assumed to be constant
QUESTION 10 a) During the next decade, per capita disposable income is expected to increase by $5000. What effect will this have on the firm s sales? b) If Schmidt wants to raise its price enough to offset the effect of the increase in per capita disposable income, by how much must it raise its price?
SOLUTION a) Q=400-3P +(4 x 5) + 0.6A Q= 400-3P + 20 + 0.6A Therefore, Quantity demanded would increase by 20, and thus sales would increase by 20.
SOLUTION
QUESTION 10 c) If Schmidt raises its price by this amount, will it increase or decrease elasticity of demand? Explain.
SOLUTION d) As price increases, demand becomes more elastic
Any questions?