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ECO 550 ASSIGNMENT- OPTION 1
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Running head: DEMAND ESTIMATION

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Introduction

Supply and demand is a model for understanding how prices and quantities are determined in a

market system. To better understand this, two groups of people will be considered, consumers

and sellers/producers.

The supply and demand model is dependent on a high degree of competition between

consumers and producers. Competition among consumers raises the price, while sellers compete

with each other and thereby lowering the price. The equilibrium is a point where the demand and

supply curves intersect each other. At this point, equilibrium price is often called the "marketclearing" price because both buyers and sellers are satisfied at this price. The supply and

demand model applies most accurately when there is perfect competition. In reality, few markets

are perfectly competitive. However, the supply and demand framework still provides a good

approximation for what is happening much of the time.

Elasticity is a measure of the responsiveness of one variable to changes in another variable; the

percentage change in one variable that arises due to a given percentage change in another

variable.

1. Computation

If P= 500, PX=600, I=5,500, A=10,000, and M=5000,

Then using the regression equation and pugging in the variables,

QD= - 5200 42(500) + 20(600) + 5.2(5500) + 0.20(10000) + 0.25(5000) =17,650

The Elasticitys

Price Elasticity = (P/Q) (Q/P)

but Q/P = -42.

Running head: DEMAND ESTIMATION

Hence

a) Price Elasticity (Ep) = (-42) (500/17650) = -1.1898016997= -1.1

b) Cross Price Elasticity (Epx) = 20(600/17560) = 0.6798866856 =0.68

c) Advertisement Elasticity (EA)= (0.20) (10000/17650) = 0.11

d) Income Elasticity(EI) = (5.2) (5500/17650) = 1.62

e) EM = (0.25) (5000/17650) = 0.07

2. Implications

a) Price Elasticity is 1.19. This means that if there is a 10% increase in the product price leads

to a 11.9 % decline in the quantity demanded of the good, since -11.9%/10% = -1.19. The

demand is said to be elastic because the absolute value of the Price Elasticity is greater than 1.

When the absolute value of the own price elasticity is greater than 1, an increase in price leads to

a reduction in total revenue and this may cause consumers to look for other alternatives. On the

other hand, if there is a 10% decrease in the product price by setting -1.19 = E

and -5=

Q ,P

x x

x

-1.19=%Qd/-10.

Solving this equation for %Qd yields %Qd= 11.9. Meaning, the quantity of good demanded

will rise by 11.9 % if prices are reduced by 10%. Since the percentage increase in quantity

demanded is greater than the percentage decline in prices (|E

Q ,P

x x

actually raise the firms sales revenues . Expressed differently, since demand is elastic, price cut

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Running head: DEMAND ESTIMATION

results in a greater than proportional increase in sales and thus increases the firms total revenues.

(Baye, 2010)

b) Cross-price elasticity is a measure of the responsiveness of the demand for a good to changes

in the price of a related good; the percentage change in the quantity demanded of one good

divided by the percentage change in the price of a related good. Cross Price Elasticity is 0.68

means that if the price of the product is raised by 10%, then quantity demanded of this product

will increase by 6.8%, since 6.8%/10%=0.68. This product is fairly inelastic to a competitors

price and there exists no need to be concerned about the competitor, since their pricing wont

affect sales. (Webster, 2003)

income. Since the income-elasticity is 1.62, this implies that a 10% rise in income will boost the

quantity demanded by 16.2%. This product is elastic and the company can make the decision to

increase the price if the average income increases. Since a low-calorie food product has an

income elasticity of 1.62 and consumer income is expected to rise by 10%, you can expect to sell

16.2% more good demanded. As an example, when good X is a normal good, an increase in

income leads to an increase in the consumption of X. Thus, E

Q ,M

x

good. When X is an inferior good, an increase in income leads to a decrease in the consumption

of X. Thus, E

Q ,M

x

d) Advertisement elasticity is 0.11, which means that a 10% increase in advertising expense will

raise the quantity demanded by 1.1%. Therefore, demand is rather inelastic to advertising. For

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Running head: DEMAND ESTIMATION

this reason, more advertisement doesnt automatically means a company can raise their prices,

for this could drive consumers away.

With respect to microwave ovens in the area, elasticity is 0.07, which shows an elevation of 1%

in the number of ovens in the area, increasing the quantity demanded by a mere 0.07%.

Therefore, in this aspect, demand is inelastic and the pricing strategy can simply skip this

element. (Baye, 2010)

3. Recommendation

It is in my opinion that this firm cut its price. Cutting the price will lead to an increase in the

companys market share, as the price elasticity demand is -1.19.

Since the price elasticity demand is greater than one in absolute value, a decline in price will lead

to an even greater increase in quantity demanded, leading to an increase in market shares.

4. Factors

a)

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Running

head:

DEMAND

ESTIMATION

c) With all others factors remaining constants, the demand equation is as follows:

Q = -5200 - 42(P) + 20(600) +5.2(5500) +0.2(10,000) +0.25(5000)

Q = 38,650 42P,

P = - 5200/45 + Q/45

Equating the demand and supply curves equations and solving for the equilibrium price means

38,650 - 42P = 5200 + 45P

87P = 33,450 ==>P = 384.48 and Q = 5200 + 45(384.48), ==> Q = 22,501.6

Therefore, the equilibrium price is $384.00 and the equilibrium quantity is 22,501 units.

This reflects a situation in which the market price has reached the level at which quantity

supplied equals quantity demanded. From the graph, the point of intersection of the supply and

demand curves indicates the markets equilibrium. Careful analysis of the graph shows the

equilibrium price is at $384.48 and the equilibrium quantity is 22501.

Equilibrium quantity is the quantity supplied and the quantity demanded at the equilibrium

price. The demand curves display the typical inverse relation between price and quantity. This

provides insight about each individuals willingness to pay and reveals information about the

marginal benefits of additional quantity to each consumer.

Noteworthy, the consumers doesnt get an equal number of low calorie foods. This is typical of

markets because tastes and incomes vary across individuals. If the actual market price is higher

than the equilibrium price, there will be a surplus of the good. To eliminate this surplus,

Running head: DEMAND ESTIMATION

producers will lower the price until the market reaches equilibrium. If the actual price is lower

than the equilibrium price, there will be a shortage of the good. Sellers will respond to the

shortage by raising the price of the good until the market reaches equilibrium. The equilibrium

price is often called the "market-clearing" price because both buyers and sellers are satisfied at

this price. (Mankiw, 2007)

d) As identified in the demand equation, demand of the low-calorie food can change if there is a

change in consumer income, a change in the pricing of a competitor product, or change of price

of correlating goods (microwave ovens). This change can also happen as the result of change in

consumer preference (e.g. awareness towards low-calorie food). Supply of the product can

change if there is a change in the number of product suppliers or production technological

advances. Additional elements such as changes in the availability of labor and raw materials, can

directly affect production costs.

5. Crucial factors

Rightward Shifts:

A rightward shift in the demand curve is called an increase in demand, since more of the good is

demanded at each price. (Baye,2010)

a) increase in consumer income

b) price cut in the price of complementary product (e.g. microwave ovens)

c) population increase or increased preference for the produce

d) technology advances in food processing

e) increased availability of cheap labor and raw materials

d) increased tax-cuts and government subsidies

Leftward Shifts:

a) decrease in consumer income or a recession

b) increase in a price of a complementary product (e.g. microwave ovens)

c) decrease in availability or an increase in price of labor and raw materials; increased taxes

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Running head: DEMAND ESTIMATION

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References:

Webster, T. J. (2003) Managerial Economics, Theory and Practice: The essentials of demand and

supply and additional topics in demand theory. Elsevier (USA) (pg.100-188). Retrieved from

http://www.itu.dk/~mounma/bouba/081009/0127408525.pdf

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Baye, M. R. (2010) Managerial Economics and Business Strategy: Market forces, Demand and

Supply, Edition 7 (pp.35-72)

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Mankiw, N.G. (2007) Instructors Manual: Principle of Microeconomics, Edition 4 (pp.53-90).

Retrieved from http://jigjids.files.wordpress.com/2011/05/instructors-manual-micro.pdf

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