ECONOMICS FOR MANAGERS

BA533
MODULE 2: Consumer Demand

“Estimating the Demand for Tagamet”

“Selected Estimates of Own-Price Elasticities”
“Deriving and Estimating Demand Equations”

Fall 2017 Economics for Managers: Module 2A 1

 Topics….
How consumers make decisions “at the
margin”
Consumer Surplus
Elasticity of Demand
Own price, cross price, arc elasticities
Links to Total Revenues
Demand Estimation

Fall 2017 Economics for Managers: Module 2A 2

 Module 2 Assignments
Background material from P&R, and the
3 cases, listed on the syllabus
Practice problems 6 - 12
Study Guide:
Chapter 2 Problems:
7 - 8, 20 - 23

Chapter 4 Problems;
5-9, 13, 20, 21, 25-29

Fall 2017 Economics for Managers: Module 2A 3

 Consumer Demand

How much will they pay, and how

many will they buy?

Fall 2017 Economics for Managers: Module 2A 4

 A Typical Consumer of Tuna
Price
“choke price”
.89
.79
.69
Inverse Demand Function
Demand

(P = .89 - .1Q)

0 1 2 Quantity

Fall 2017 Economics for Managers: Module 2A 5

Two Interpretations of Demand
For each price, the demand function
indicates the amount of the good the
consumer is willing to purchase.
explains how consumers behave.
For each quantity, the inverse demand
function represents the consumer’s
willingness to pay.
demonstrates why consumers are better
off.
Fall 2017 Economics for Managers: Module 2A 6
 Consumer Behavior
Suppose that the consumer faces a
market price of .59
We can write the Demand Function as:

Q = 8.9 - 10P

So the quantity demanded is:

8.9 - 10(.59) = 3.

Fall 2017 Economics for Managers: Module 2A 7

 Let’s draw the graph...
Willingness to pay for
Price the first unit: .79
.89
Willingness to pay for
the second unit: .69

.59
Demand

1 2 3 Quantity

Fall 2017 Economics for Managers: Module 2A 8

 Consumer Surplus
Is the benefit that a consumer obtains
from purchasing a product.
Is the difference between what
consumers are willing to pay, and what
they actually have to pay.
The rule: Keep buying as long as the
willingness to pay exceeds the market
price.
Fall 2017 Economics for Managers: Module 2A 9
 Consumer Surplus
Price
Consumer Surplus
.89

.59

Demand

3 Quantity

Fall 2017 Economics for Managers: Module 2A 10

 AN EXAMPLE
The Pricing of Electric
Power
Electricity consumers in Philadelphia and Indiana
face different pricing
How should you judge whether a consumer is “Better
or Worse Off?”
What determines the optimal purchase decision?
How do fixed fees affect consumer surplus?

Fall 2017 Economics for Managers: Module 2A 11

Philadelphia customers face a “flat price” of 8¢ per kwh
Inverse Demand Function
Price per Kilowatt Hour
(cents)
Linear Demand: Q = 1600 - 100P
OR P = 16 - .01Q
16
14
12 Decision Rule:
Continue usage until Price of next
unit is greater than the Marginal
8
Benefit. (Stop when P=MB)

2
Quantity of
800

1600
Kilowatt Hours
per month
Philadelphia: If P = 8¢, then Q = 800.
Fall 2017 Economics for Managers: Module 2A 12
 Measuring Consumer Surplus
Price Consumer Surplus (CS) =
16 …amount willing to pay – amount paid
14 …total value – total expenditure
12
…area under demand curve above price
8 Philadelphia CS = $32
(= 3200¢)

2
Q
800

1600

Philadelphia: Price = 8¢
Fall 2017 Economics for Managers: Module 2A 13
 First 100 KWH 14 ¢ per KWH
Indiana: Next 200 KWH 10 ¢ per KWH
Next 200 KWH 8 ¢ per KWH
Remaining KWH 6 ¢ per KWH

Price
16 Q1: Are Consumers Better Off in Indiana?
14

10
No!
8
Indiana CS = $30.00
6 Philadelphia CS =
$32.00

Q
1000
100

300
500

1600

Fall 2017 Economics for Managers: Module 2A 14

Average Price vs Consumer
Surplus
State Average Consumer
Price Surplus
Indiana 8¢ $30.00

Philadelphia 8¢ $32.00

Fall 2017 Economics for Managers: Module 2A 15

Q2: A customer in Ann Arbor might face
the following rate schedule:
First 500 KWH 7 ¢ per KWH
Next 300 KWH 10 ¢ per KWH
Remaining KWH 14 ¢ per KWH

What would be the consumption level,

electric bill, and average rate paid?
How would these compare to other
cities? Is she better off or worse off
than in other cities?
Fall 2017 Economics for Managers: Module 2A 16
 Demand: Q = 1600 - 100p
P
16
14

10

500 600 800 1600

Total Expenditure = 500(.07) + 100(.10) = $45
Average rate = ($45)/600 = 7.5 ¢
Consumer Surplus = .06(600)/2 + .03(500) = $33
Fall 2017 Economics for Managers: Module 2A 17
Q3: Utility companies could increase
revenues by increasing the fixed
monthly charge and decreasing the
charge per KWH. What is the maximum
fixed charge a customer with demand
represented by Figure 1 would be
willing to pay? What would be her
consumption level, electric bill, and
average rate be? Would she be better
off or worse off than in Philadelphia?

Fall 2017 Economics for Managers: Module 2A 18

 P
16 With only a fixed fee,
the price for each “marginal”
kwh is effectively zero

Total
Willingness to Pay The Maximum Fee

1600
At P = 0, the consumer purchases 1600 kwh
The total willingness to pay at P = 0 is .16(1600)/2 = $128
Average rate at the max fee= ($128)/1600 = 8 ¢
Consumer Surplus at the max fee = 0
Fall 2017 Economics for Managers: Module 2A 19
 Consumer Demand
The Demand Curve depicts the
quantity a consumer purchases as the
price changes.

This exercise assumes that everything

else affecting the consumer’s demand is
held constant.

Fall 2017 Economics for Managers: Module 2A 20

 Movement along the D Curve
An increase in the price of tuna causes
a reduction in the amount purchased.

.79

.69
Demand

1 2 Quantity

Fall 2017 Economics for Managers: Module 2A 21

 Shifts of the Demand Curve:
Substitutes
An increase in the price of a substitute
causes an increase in the quantity
demanded of a product

Example: an increase in the price of tea

causes an increase in the quantity
demanded of coffee

Fall 2017 Economics for Managers: Module 2A 22

 An increase in the price of tea

Price of high tea price

Coffee

D’cof

low tea price

Dcof

Quantity of Coffee

Fall 2017 Economics for Managers: Module 2A 23

 Shifts in the Demand Curve:
Complements
An increase in the price of a
complement reduces the quantity
demanded of a product

Example: An increase in the price of

cream reduces the quantity demanded
of coffee

Fall 2017 Economics for Managers: Module 2A 24

 An increase in the price of
cream
Price of
Coffee
low cream price

Dcof

high cream
price D’cof
Quantity of Coffee
Fall 2017 Economics for Managers: Module 2A 25
 Shifts in the Demand Curve:
Consumer Income
“Normal” Good: an increase in
consumer income causes an increase in
the demand for the good.
Example: Steak
“Inferior” Good: an increase in
consumer income causes a decrease in
the demand for the good.
Example: potatoes

Fall 2017 Economics for Managers: Module 2A 26

 Market Demand

We need to move from the

demand of an individual consumer
to the level of demand for an
entire market

Fall 2017 Economics for Managers: Module 2A 27

 Deriving the Market Demand
Market Demand is the horizontal summation of
the individual consumers’ demands
Consumer A Consumer B Market

P
D

QA QB QA+QB
DA DB
Fall 2017 Economics for Managers: Module 2A 28
 A Few Points...
Firms sell in a market, and so face the
“Market Demand”.
In what follows, when we refer to
“demand”, we will mean “market demand”.
Firms want to Maximize Profit:
= TR - TC

Total Revenues Total Costs

Fall 2017 Economics for Managers: Module 2A 29

Consider the following question:

If a firm raises its price, will total

revenues increase or decrease?

The answer, as it turns out, isn’t

entirely obvious….

Fall 2017 Economics for Managers: Module 2A 30

 Total Revenues
Total Revenues = Price Quantity
The Problem: Raising price drives
down quantity!
Recall that Demand is downward-sloping

Price

Quantity
D
Fall 2017 Economics for Managers: Module 2A 31
 Price Back to the Tuna Example...
.89
P = .89 - .1Q
.79

.09
0 Quantity
D
Total
Revenues

.79
.72
Quantity
0 1 8 8.9
Fall 2017 Economics for Managers: Module 2A 32
 Demand Elasticity
Total Revenues = Price Quantity

Price and Quantity are inversely related.

An increase in price is associated with a
decrease in quantity.
The effect on Total Revenues depends
on the relative magnitudes of the two
effects.

Fall 2017 Economics for Managers: Module 2A 33

 Demand Elasticity

When Does an increase in price result

in an increase in Total Revenues?

Total Revenues = Price Quantity

If the % in P exceeds the % in Q

Fall 2017 Economics for Managers: Module 2A 34

 Demand Elasticity
The intuition: Total revenues increase if
you can increase price faster than you
drive customers away.
The Price Elasticity of Demand:

% Q
EP =
% P
This is always a negative number!

Fall 2017 Economics for Managers: Module 2A 35

 Demand Elasticity
If EP < -1, then increasing P
decreasing TR
“Elastic Demand”

If EP > -1, then increasing P

increasing TR
“Inelastic Demand”

Fall 2017 Economics for Managers: Module 2A 36

 Demand Elasticity
We can write the price elasticity as:

Q
Q Q P
EP = = P Q
P
P

This is the slope of Demand (or,

1/slope of the inverse demand function)

Fall 2017 Economics for Managers: Module 2A 37

 Let’s return to the Tuna
fisherman….
Recall that the consumer’s inverse
demand curve was
P = .89 - .1Q
The slope of the inverse demand is: -.1
P 1
-.1

D
Q
Fall 2017 Economics for Managers: Module 2A 38
 Tuna Demand Elasticity

1 P 10P
EP = = -
-.1 Q Q

Demand Elasticity changes as we move

along a linear Demand Curve!

Fall 2017 Economics for Managers: Module 2A 39

 Tuna Demand Elasticity
P EP = - EP = -10P/Q
.89

EP = -1

.445
EP = 0

0 4.45 8.90 D
Q

Fall 2017 Economics for Managers: Module 2A 40

 Elasticity: Linear Demand
P EP < -1
“elastic”

EP = -1

EP > -1
“inelastic”

D Q
Fall 2017 Economics for Managers: Module 2A 41
 Elasticity and Total Revenues
Demand Elasticity = -1

Demand

Total Revenues

TR Maximized
Fall 2017 Economics for Managers: Module 2A 42
 Elasticity: Two Extremes

P P
D

Q Q
Perfectly Inelastic Infinitely Elastic

Fall 2017 Economics for Managers: Module 2A 43

 Other Elasticity Concepts
We have been examining the own-price
elasticity of demand. There are others...

Income Elasticity of Demand

EI = % change in Q
% change in Income

Fall 2017 Economics for Managers: Module 2A 44

 Other Elasticity Concepts
Cross-Price Elasticity of Demand
Percentage change in the quantity
demanded in one product resulting from
a 1% change in the price of another
product
EQ tuna ,Psalmon=

% change in Q of tuna demanded

% change in the price of salmon
Fall 2017 Economics for Managers: Module 2A 45
 Arc Elasticity
The elasticity concepts that we have
discussed so far are point elasticities
They involve the elasticity of the demand
curve at each point
Point elasticity is the effect on TR of an
infinitesimal increase in price
Sometimes, the elasticity of demand
over a discrete range of possibilities is
of interest to the decision-maker
The concept of arc elasticity is relevant
Fall 2017 Economics for Managers: Module 2A 46
 p2

p1
D

q2 q1

The Question: Suppose a firm is considering

increasing its price from p1 to p2. What is the
net effect on Total Revenue?

Fall 2017 Economics for Managers: Module 2A 47

 Own-Price Arc Elasticity
Q
Q
Own-Price Arc Elasticity =
P
P
q 2 q1
q1 q 2
= 2
p 2 p1
p1 p 2
2

Fall 2017 Economics for Managers: Module 2A 48

 CASE: Estimating the
Demand for Tagamet

•Tagamet is an ulcer treatment.

•Before 1977, ulcers were treated using various moderately
effective drugs. The best known: Carafate (6% share).
•In 1977, Tagamet introduced by SmithKline-Beecham. It
was the first of several revolutionary new treatments. In
1983, Glaxo, Inc. introduced Zantac, which (at least in the
public’s perception) had somewhat fewer side effects. By the
mid-1980s, Zantac had surpassed Tagamet as the leading
brand in the anti-ulcer market, which in turn was the largest
prescription drug market in the U.S.
Fall 2017 Economics for Managers: Module 2A 49
 The Estimated Demand
Relationship

QTagamet = 354.08 - 321.83PTagamet +

18.75PZantac+ 128.16PCarafate -.09Income

Substitute Products

Fall 2017 Economics for Managers: Module 2A 50

Estimated Demand for Tagamet
slope of inverse D = -1/321= -.0031
Ptag

Pzan Pcar Income

Qtag
D

354.08 + 18.76Pzan+ 128.16Pcar - .09Income

Fall 2017 Economics for Managers: Module 2A 51

 The mean values of each of these
variables over the 1983 - 1989 time
period are:
Variable Sample Mean
QTagamet 68.52
PTagamet 0.29 (price per daily
dose)
PZantac 0.65
PCarafate 0.26
Income 2641.56

Fall 2017 Economics for Managers: Module 2A 52

 Calculate the own-price elasticity of demand for
Tagamet at the mean price. Is demand estimated as
elastic or inelastic?
Calculate the cross-price elasticities of demand (again,
at the mean). Are these drugs good substitutes or poor
substitutes for Tagamet, according to your answer?
Explain.
The estimated effect of an increase in disposable
personal income on the quantity of Tagamet sold is
negative. Does this make sense? Explain.
Does this economic model account for all the important
factors affecting the demand for Tagamet? What other
variables might you want to include and why?

Fall 2017 Economics for Managers: Module 2A 53