Scribd Logo
Upload

Welcome to Scribd!

  • Unit 3b

    Uploaded by

    rupasree dey
    10 views20 pages

    Original Title

    2. Unit 3b (1)

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    10 views20 pages

    Unit 3b

    Uploaded by

    rupasree dey

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 20
    84 PARTTWO Demand Analysis KEY TERMS {inthe order of their appearance) Price elasticity of demand (E,) Marginal revenue (MR) ross-price elasticity of demand (E,.) Point price elasticity of demand Income elasticity of demand (E) Point cross-price elasticity of demand ‘Arc price elasticity of demand, Point income elasticity of demand ‘Arc cross-price elasticity of demand, ‘Total revenue (TA) ‘Arcincome elasticity of demand Ecommerce ‘nthe previous chapter, we discussed the determinants of consumer behavior and how that translates to effective demand. It is important to know what drives the behavior of con- mers and how they would react to different managerial decisions, However, a firm may jot survive by merely knowing what the consumer wants. The firm must also manage to know the quantification aspects of the consumer demand. A firm could have the most efficient pro- duction techniques and the most effective management, but without a demand for its product that ig sufficient to cover at least all production and selling costs over the long run, it simply ‘vould not survive. Indeed, many firms go out of business soon after being set up because their expectation of a sufficient demand for their products fails to materialize, even with a great deel of advertising. Each year also sees many previously established and profitable firms close ‘ts a result of consumers shifting their purchases to different firms and products. Therefore, knowing appropriate tools of demand measurement and changes in demand as a result of any | action by the firm or by the exogenous market variables is essential forthe creation, survival, and profitability of a firm. Tn this chapter we examine the measurement aspect of the demand theory, or the identi- at fication, measurement, and management of the forces that determine the demand for a firm's i product or service. For this purpose, we introduce the important concept of elasticity. This vevasures the responsiveness in the quantity demanded of a commodity to changes in each of the forces that determine demand, The forces that determine consumers’ demand for a com- rnedity ae the price ofthe commodity, consumers’ incomes, the price of related commodities, Consumers’ tastes, and all the other important but more specific forces that affect the demand for a particular commodity. In Chapter 5, we will show how a firm can actually forecast the demand for the product it sells, and in Chapter 6, we will examine how the firm can forecast fare demand for the product, We will see that in order to properly estimate and forecast dlemand, we need to be familiar with the theory of demand presented in the previous chapter ‘a well as with the estimating techniques presented in this and the next chapter. ‘The strength and stability of present and future demand for the.firm’s product are also crucial in determining the most efficient methods of producing and selling the product, as well i ar in planning for the expansion of production facilities, and for entering new markets and Gther product lines. For example, ifthe demand for the firm's product is forecast to grow but to be unstable, the firm might need to build a larger plant (to meet the growing demand) but night also have to cary larger inventories (because of the volatility of demand), and it might | want to inerease its promotional effort to make demand less volatile (e.g, by trying to increase ait ofr season demand, finding new uses for its product, and so on). In any event, demand analysis. facia: , is essential to the firm and to its profitability. . PRICE ELASTICITY OF DEMAND. CHAPTERS Measurement of Demand 85 ‘The responsiveness in the quantity demanded of a commodity to a change in its price is very important to the firm. Sometimes, lowering the price of the commodity increases sales suffi- ciently to increase total revenues. At other times, lowering the commodity price reduces the firm’s total revenues. By affecting sales, the pricing policies of the firm also affect its produc- tion costs, and thus its profitability. In this section, we introduce measures of the responsiveness (elasticity) in the quantity demanded of the commodity to a change in its price. We will show how to measure price elasticity at one point as well as over a range (arc) of the demand curve. ‘We will also examine the relationship among price elasticity, the total revenue of the firm, and its marginal revenue. Finally, we discuss the factors affecting the price elasticity of demand and present some real-world estimates of it, like the one for telephone usage in Box 3-1. Using the technique of regression analysis presented in Chapter 5, Dasa and Srinivasan (1999) estimated the following demand function for telephone usage in India for the period 1964-1997: QD=-346-34P+695+191 [3-1] Where, QD = total telephone call units averaged over tele~ phone users P =constant rupee price of a telephone call unit weighted by the tariff structure ‘5= Share of services in GDP, in percentage terms {I= real per capita personal disposable income, in rupees, log value This estimated demand function indicates that the quan- tity demanded of telephone call units per year in India (QD) declines by 3.4 units for each rupee increase in its price (P), increases by 6.9 units for each 1 per cent increase in service share in GDP, and increases by 1.9 units for each rupee increase in real per capita income (7). ‘Thus, the demand curve for telephone call usage in India is negatively sloped, and it shifts to the right with an increase in service share GDP and in real income. Since the demand for telephone call units increases (.e., shifts to the right) with an increase in income, this is a normal good. ‘Since mobile phones became common in India post year 2001 only, if we extend the period of analysis beyond 1999 and include some of the mobile phone prevalence years also, we will find that the coefficient of price for each mobile telephone call unit has a neg- ative sign. This may imply that QD increases with an increase in price of mobile telephone call units (Pr) and declines with a reduction in Pm; mobile telephone isa substitute commodity to the landline telephone. If we now substitute into Equation 3-1 the actual values of $=51.16, and /= 4.89 (ie., log of 78,400) for India for the year 1999, we get the following equation for India's demand curve for telephone call units per user in 1999: QD = -34.6-3.4P + 6.51.16) +1.9(4.89) 34.6 -3.4P +353.004+9.291 = 327.695 -3.4P B-2] By then substituting the value of %6 for P into Equation 3-2, we get QD = 307.295. If P = 3, QD = 317.495. Finally, if P= 1, QD = 324.295, ‘What do these numbers imply? These numbers sug- {gest that with each fallin average price of each call unit, ‘an average consumer uses more telephonic services, Questions for Discussion 1. Can you take alternate values for P and plot a demand schedule for telephone usage in India? 2. Can you derive the demand curve for telephone usage in India over the years and draw a trend? continued PARTTWO Demand Analysis continued 3. What would happen if two more variables are telephony per unit and overall telephone density? inserted in this equation, representing price of mobile What would be their respective signs and why? “Source: Adapted from: Dasa, Pinaki and PN, Srinivasan “Demand for telephone usage in India" Information Economics and Policy, (1999) pp. 177-194, Point Price Elasticity of Demand ‘The responsiveness in the quantity demanded of a commodity to a change in its price could be measured by the inverse of the slope of the demand curve (i.e., by AQ/AP).! The disadvantage is that the inverse of the slope (AQ/AP) is expressed in terms of the units of measurement, Thus, simply changing prices from rupee to paisa would change the value of AQ/AP one hundredfold. Furthermore, a comparison of changes in quantity to changes in prices across ‘commodities would be meaningless. In order to avoid these disadvantages, we use instead the price elasticity of demand. ‘The price elasticity of demand (E,) is given by the percentage change in the quantity demanded of the commodity divided by the percentage change in its price, holding constant all the other variables in the demand function. That is, 3-3] where AQ and AP refer, respectively, to the change in quantity and the change in price. Note that the inverse of the slope of the demand curve (i.e, AQ/AP) is a component, but only a component, of the elasticity formula and that the value of AQ/AP is negative because price and quantity move in opposite directions (i.e., when P rises, Q falls, and vice versa)? Equation 3-3 gives the point price elasticity of demand, or the elasticity at a given point on the demand curve. For example, for D, in Figure 3-1, AQ/AP = -100/81 at every point on D,, (since D, is linear), and so price elasticity at point B is ‘100 This means that the quantity demanded declines by 5 percent for each 1 percent increase in ,, while holding constant all the other variables in the demand function. At point C on [apps ona i lun on enmity pent ci ricco mend SD wich etme bee ot oman Stes ey, 6, = 22-5 Wetter dae @ ite Fi order to remind ourselves that the other variables included inthe demand function are tobe held constant in measuring the effect of a change in P on Q. CHAPTER3 Measurement of Demand 87 4 3 Dy e=n(3 Je -i> acim G ,=-1(2}= at point H, E, As these calculations show, the price elasticity of demand is usually different at different points on the demand curve.* For a linear demand curve, such as D, in Figure 3-1, the price elasticity of demand has an absolute value (i.e., 1E,)) that is greater than 1 (ie., the demand curve is elastic) above the geometric midpoint of the demand curve; IE, = I at the geometric midpoint (ic., D, is unitary elastic), and IE; < 1 below the midpoint (i.., D, is inelastic). This is confirmed by examining the values of E, found above for D,,* ADE NOOR os (, ap QO % 100 1 0 100 200 300 400 500 600 o FIGURE 3-1 The Point Price Elasticity of Demand At point B on D,. » Sometims the absolute value of B, (1B) is eponted. This creates no dificult as long as we remernber that rca ty mvs in poe det slong the demand cus Nw wat at pint. £, = 2] stpoim a, £, +. Thus, EP can range anywhere from 0 to. while * Since the slope and its inverse are constant for a linear demand curve, but P and Q vary at different points on the demand curve, £, varies at different points on the demand curve. * The point price elasticity of demand can also be obtained geometrically by dividing the price of the commodity (P) atthe point on the demand curve at which we want to find the elasticity, by P— A, where A is the price at which the quantity demanded is zero (ie., the price at which the demand curve crosses the vertical axis). For a curvilinear demand curve, we draw a tangent to the demand curve at the point at which we want to measure E, and then proceed as if we were dealing witha linear demand curve (see Problem 5, with the answer atthe end of the text). eae PARTTWO Demand Analysis Atpoint C, E, = i(4)- 2; at point F, Ep -(3) Gls 5) 5 Note that the value of AQ/AP is given by a, the estimated coefficient of P in regression Equation 2-3.° Therefore, the formula for the point price elasticity of demand can be rewritten as atpointG, E, =-(2 and at point H, E, P E,=a,-> [3-4] Q where a, isthe estimated coefficient of P in the linear regression of Q on P and other explan- atory variables. For example, with a, =~3.41 in regression Equation 3-1, and Q, = 307.295 at P, = %6, E, = -3.4(6/307.295) = -0.0663. This means that a 1 percent increase in P, leads to a 0.066 percent decline in Q,, Arc Price Elasticity of Demand More frequently than point price elasticity of demand, we measure are price elasticity of demand, or the price elasticity of demand between two points on the demand curve, in the real world. If we used Formula 3-3 to measure are price elasticity of demand, however, we would get different results depending on whether the price rose or fell. For example, using Formula 3-3 to measure arc price elasticity for a movement from point C to point F (i.e., for a price decline) on demand curve D, in Figure 3-1, we would obtain 100 4 -%1 200 On the other hand, using Formula 3-3 to measure arc price elasticity for a price increase from point F to point C, we would get MDa Ps aelOD TA AP Q % 300 ‘To avoid this, we use the average of the two prices and the average of the two quantities in the calculations. Thus, the formula for arc price elasticity of demand (E,) can be expressed as AQ (P,+F 2 _ 2-2 hth 7 AP (Q,+0,V2 B-F O,+2, where the subscripts 1 and 2 refer to the original and to the new values, respectively, of price and quantity, or vice versa. For example, using Formula 3-5 to measure the arc price elasticity of D, for a movement from point C to point F, we get _Q,-Q, P+P, _ 300-200 %3+%4 _ P,P, Q,+Q, %3-%4 300+200 ‘We now get the same result for the reverse movement from point F to point C: E, [3-5] Ep “14 “TInterms of calculus, \QIAP = dQ/@P. Since the exponent of P is | in Equation 2-3, 3Q/0P = a, (the coefficient of P). CHAPTER3 Measurement of Demand 89 Q-O P+R _ 200-300 4433-7 P-R O40, %4-%3 2004300 5 This means that between points C and F on D,, a 1 percent change in price results, on average, ina 1.4 percent opposite change in the quantity demanded of commodity X. Note that the value of E, =~1.4 for arc price elasticity of demand is between the values of E, obtained by the use of Formula 3-3 for the point price elasticity of demand. There are some significant advantages of the Arc Elasticity method. It requires annual averages over short periods of time and therefore effectively uses the most recent data, cap- turing the current trends in the price responsiveness of the commodity. Since estimation is over a short period of time, the long-term influences such as changes in consumer taste and Preferences in favour of or against the commodity in question are not likely to play a signifi- cant role. Lastly, in comparison to the alternative Point Elasticity measure, the Arc Elasticity measure always gives a lower (and hence more conservative) estimate at higher price and lower quantity consumed. The principal limitation of the Arc Elasticity measure is that it is a direct method, not capable of separating the influence of some important factors such as price of a close substi- tute or real income of the consumers. However, the influence of some other variables such as seasonal variations, population growth and general inflation on the demand for the commodity can be neutralized by measuring the volume of the commodity as a monthly average on a per capita basis, and the price of the same commodity as a real price which is obtained by deflating the nominal price by any inflation index. While we have been examining the price elasticity of the market demand curve for a commodity, the concept applies equally well to individuals’ and firms’ demand curves. In general, the price elasticity of the demand curve that a firm faces (ie., the absolute value of E,) is larger than the price elasticity of the corresponding market demand curve because the firm faces competition from similar commodities from rival firms, while there are few, if any, close substitutes for the industry's product from other industries. -14 Price Elasticity, Total Revenue, and Marginal Revenue There is an important relationship between the price elasticity of demand and the firm’s total revenue and marginal revenue. Total revenue (TR) is equal to price (P) times quantity (Q), while marginal revenue (MR) is the change in total revenue per unit change in output or sales (quantity demanded), That is, TR=P-O 3-6] Aiea 3-7] AQ With a dectine in price, total revenue increases if demand is elastic (ie., if IE,|> 1); 7R remains ‘unchanged if demand is unitary elastic, and TR declines if demand is inelastic. ‘The reason for this is that if demand is elastic, a price decline leads to a proportionately larger increase in quantity demanded, and so total revenue increases. When demand is unitary ¢lastic, a decline in price leads to an equal proportionate increase in quantity demanded, and * Note that 7RIQ= AR = P, where AR is the average revenve. Thus, the price that the firm receives per unit of the ‘commodity is equal to the average revenue of the firm. 90 PARTTWO Demand Analysis TABLE 3-1 Price Elasticity, Total Revenue, and Marginal Revenue o @ @ @ ) ° Q P 7R=PAQ © MR=ATRIAQ er RTT TTT 6 0 = 0 5 100 a 00 us 4 200 2 800 3 3 300 4 900 1 2 400 -1n 800 - 1 500 us 500 3 ° 00 ° 0 -s so total revenue remains unchanged, Finally, if demand is inelastic, a decline in price leads toa smaller proportionate increase in quantity demanded, and so the total revenue of the firm declines, Since a linear demand curve is elastic above the mid-point, unitary elastic at the midpoint, and inelastic below the midpoint, a reduction in price leads to an increase in TR down to the midpoint of the demand curve (Where total revenue is maximum) and to a decline thereafter, MR is positive as long as TR increases, MR is zero when TR is maximum, and MR is negative when TR declines. For example, suppose that a firm is a monopolist and faces the market demand curve for commodity X shown in Figure 3-1. The market demand schedule that the firm faces is then the one given in the first wo columns of Table 3-1. The price elasticity of demand at various prices is given in column 3 and equals those found above for demand curve D,,. The total revenue of HW the firm is given in column 4 and is obtained by multiplying price by quantity. The marginal revenue of the firm is given in column 5 and is obtained by finding the change in total revenue per unit change in output. Note that TR increases as long as IE,| > 1, TR is maximum when IE.) = 1, and TR declines when IE,|< 1. MRis positive as long as TR increases (ie. as long as demand is elastic) and negative when TR declines (i.e., when demand is inelastic). “The relationship between the price elasticity of demand, the total revenue, and the marginal revenues of the firm given in Table 3-1 is shown graphically in Figure 3-2. Note that since mar- tinal revenue is defined as the change in total revenue per unit change in output or sales, the MR values given in column 5 of Table 3-1 are plotted berween the various levels of output in the bot- tom panel of Figure 3-2. Note also that the MR curve starts atthe same point as D, on the vertical or price axis and at every point bisects (ic. cuts in half) the distance of D, from the price axis “There is an important and often-used relationship among marginal revenue, price, and the price elasticity of demand, given by? Fm terms of calculus, MR = d(TRVdQ. Given demand function Q = 600 100P, P= 6 ~ Q/100, and TR= PQ = dcr) 2 dR) = ur=6- ©; Setting SD a MR= 6-5 Sena 0 ‘TR curve has 2er0 slope at Q'= 300. To ensure that TR isa maximum rather than a minimum of Q = 300, we find ) 100. That is the i (6— ON100)9 = 69 ~ 9100. Therefor, wwe get TR is maximum at Q = 300 (see above). EAR) since isis ean ( de PQ) + singe TR =O. in terms of calutss, MR = 472). po a p[1+22.2) = ae stcrna Postini, sr APD rag ar( SE Dario} dQ dQ a: CHAPTERS Measurementof Demand 91 100 200 300\ 400 500 600 % [a= 600-1007 | oe J MR FIGURE 3-2 Demand, Total Revenue, Marginal Revenue, and Price Elasticity Aslong as demand is price elastic (Le, up to 300 units of output), a price reduction increases total enue (TR), and marginal revenue (MR) is positive. At Q= 300, demand is unitary price elastic, This maximum, and MR = 0, When demand is price inelastic (.e, for outputs greater than 300) «@ price reduction reduces 7R, and MRiis negative. 1 sin o( +2.) [3-8] For example, from Table 3-1 we know that when P= %4, E, = ~2. Substituting these values into Formula 3-8, we get 92 PARTTWO Demand Analysis MR= u(is4)- “(i The value of MR =%2 when P=%4 is confirmed by examining Figure 3-2. At P=%3, E, =—1,and MR= art (see the bottom panel of Figure 3-2). At P= 22, E, 1 MR 21+ 43) 2 (see the bottom panel of Figure 3-2). ‘The above relationships among E,, TR, MR, and P hold for both the firm and the industry under any form of market organization. If the firm is a perfect competitor in the product mar- ket, it faces a horizontal or infinitely elastic demand curve for the commodity. Then the change in total revenue in selling each additional unit of the commodity (i.e., the marginal revenue) equals price. This is confirmed by using Formula 3-8. That is, MR= (+4) =P For example, in Figure 3-3, if the firm sells 3X, its TR = 12. If it sells 4X, TR = 716. Thus, MR = P = %4, and the demand and marginal revenue curves that the firm faces coincide. (The perfectly competitive model will be examined in Chapter 9.) On the other hand, if the firm faced a vertical demand curve (so that the quantity demanded remains the same a) o 1 2 3 4 5 & FIGURE 3-3 The Demand Curve Faced by a Perfectly Competitive Firm The demand curve for the ‘output of a perfectly competitive firm (discussed in Section 9-2) is horizontal or infinitely elastic. Thus, P= MR, and the demand curve and the marginal revenue curve of the firm coincide. 3-2 CHAPTER3. Measurement of Demand 93 regardless of price), E, = 0 throughout the demand curve. This is very rare in the real world.!° Factors Affecting the Price Elasticity of Demand The price elasticity of demand for a commodity depends primarily on the availability of substi- tutes for the commodity and also on the length of time over which the quantity response to the rice change is measured, The closer and greater the number of available substitutes for the com- ‘modity, the larger is the size of the price elasticity of demand. For example, the demand for sugar is more price elastic than the demand for table salt because sugar has better and more substitutes (honey and saccharine) than salt. Thus, a given percentage increase in the price of sugar and salt elicits a larger percentage reduction per time period in the quantity demanded of sugar than of salt. In general, the more narrowly a commodity is defined, the greater is its price elasticity of demand because the greater will be the number of substitutes. For example, the price elasticity for Coke is much greater than the price elasticity for soft drinks in general ari still larger than the price elasticity of demand for all nonalcoholic beverages. If a commodity is defined so that it has very close substitutes, its price elasticity of demand is likely to be large indeed and may be close to infinity. For example, if a producer of aspirin tried to increase the price above the general range of market prices for aspirin, he or she would stand to lose a large portion of his or her sales ers can readily switch most of their purchases to competitors who sell similar products, ‘The price elasticity of demand is also larger when the time period allowed for consumers to respond to the change in the commodity price is longer. The reason is that it usually takes some time for consumers to learn of the availability of substitutes and to adjust their purchases to the price change) For example, during the period immediately following the sharp increase in gasoline prices in the U.S. in 1974, the price elasticity of demand for gasoline was very low. (Over the period of several years, however, the reduction in the quantity demanded of gasoline was much greater (i.e, the long-run price elasticity of demand for gasoline was much larger) than in the short run as consumers replaced their gas guzzlers with fuel-efficient, compact automobiles, switched to car pools and to public transportation, and took other steps to reduce gasoline consumption. Thus, for a given price change, the quantity response is likely to be much larger in the long run than in the short run, and so the price elasticity of demand is likely to be much greater in the long run than in the short run."! Box 3-2 gives the estimated short-run and long-run price elasticities of demand for various commodities. INCOME ELASTICITY OF DEMAND The level of consumer income is also a very important determinant of demand. We can meas- ure the responsiveness in the demand for a commodity to a change in consumer income by "Ifthe demand curve assumes the shape of a rectangular hyperbola (so that total revenue is constant regardless of price) the price elasticity of demand is constant and is equal to 1 throughout the demand curve. For example, if Q = P*, dQIAP = bP™* and E., = (dQ/4P) P/Q) = (bP™*P/Q) = bP'Q; but since Q= P, E,= b= (the exponent of P) and is the same throughout the demand curve. " Ibis also said sometimes thatthe price elasticity of demand is larger the greater is the number of uses of the commodity, the smaller is the weight of the commodity in consumers’ budgets (i.e., the smaller isthe proportion of income that consumers spend on the commodity), and the more in the nature of a durable good is the commodity. ‘Not everyone agrees with these statements, and, infact, they are often contradicted by empirical studies 94 PARTTWO Demand Analysis the income elasticity of demand (E,). This is given by the percentage change in the demand for the commodity divided by the percentage change in income, holding constant all the other variables in the demand function, including price. As with price elasticity, we have point and an 1 where AQ and A/ refer, respectively, nome elasticity. Point income elasticity of demand is given by 4010 AO 1 alm Al O to the change in quantity and the change in income. [3-9] Note that the income elasticity of demand measures the shift in the demand curve at each price level. Table 3-2 gives the estimated absolute value of the short-run and long-run price elasticity of demand (E,) for selected commodities in the United States, India and other countries. The table shows that the long-run price elasticity of demand for most commodities is much larger than the corresponding short-run price elasticity For example, the table shows that the price elastic- ity of demand for clothing (the first row in the table) is 0.90 in the short run but becomes 2.90 in the Jong run, This means that a 1 percent increase in price leads to a reduction in the quantity demanded of clothing of paneer oes Clothing US.) ‘Tobacco products (U.S. Jewelry and watches (U.S.)" Beer (US. (Cheese (UY! Wine (Canada) Household natural gas (US.Y Electricity (household, US.) Public transport (England) Public transport (France)* i 1 Tn terms of calculus, £, = terms of ealoulus, = 57-5 Gasoline US 0.90 percent in the short run but 2.90 percent in the ong run. Although the price elasticity of demand for ‘gasoline (the 13th row in Table 3-2) is about four times hhigher in the long run than in the short run, the demand for gasoline remains price inelastic, Tt should be noted that the estimated price elasticity ‘of demand for any commodity is Tikely to vary (some times widely) depending on the nation under consid- eration, the time period examined, and the estimation technique used. Thus, estimated price elasticity values should be used with caution. Elasticity Short Run Long Run 030 230 0.46 89) oat 067 in. 247 136 = os 17 140 210 013 139 ost 068 032 ost 025 092 continued CHAPTER3 Measurement of Demand 95 continued pe rea ee eee Elasticity Commodity Short Run Long Run Gasoline (Canady 01s 080 Gasoline (Austaliay o1 058 PewoP -0209 -0319 Kerosene! -or 0360 Leo ~0.936 =1.030 Export Demand! “1160 -1039 Public Bus! “0374 053 Gold impor 460 1.010 ‘W Jansen, and. W. Lee, “Advertsing in Complete Demand Systems? Applied Economics, vol 241992), HLS. Houthakher and L.. Taylor, Consuomer Demand inthe United States: Analyses and Projections (Cambridge, Mats; Harvard Univesity Press, 1970). “C.A. Gallet and J. List, "Elasticity of Beer Demand Revisited,” Economie Letters (October 1998), *D. Harvey, "Major Market Response Conceps and Measures” p/iwwwstaff.c.c.uk/ david harvey! AEFII6(1 be “J.A. Johnson, EH. Oksanen, M, R. Veal, and D. Fret, “Shor Run and Long-Run Elsie fr Canadian Con- sumption of Alcoholic Beverages." Review of Economies and Statistics (Rebrury 1992) /G.R. Lakshmanan and W. Anderson, “Residential Energy Demand i the United States,” Regional Science and Urban Economics (August 1980). “B, Hagler, “Transportation Elasticities” TDM Encyclopedia (Victoria BC, Canade: Victoria Transport Policy Insite, 2005), hap: vp orgdmfdmt Lm ‘'R. Ramanathan, “Short an long-run elasticities of gasoline demand in India: An empirical analysis using cointe- tration techniques," Bnergy Economics, Volume 21, Issue 4, August 1999, pp. 321-330. "J. Roy, "The rebound effect: some empirical evidence from Inds,” Energy Policy, Volume 28, Issues 6-7, June 2000, pp. 433-438. 1 Same as‘above * K, Sharia, “Expor Growth in India: Has FDI Played a Role?” Centre Discussion Paper No 816, Economic Growth Cente, Yale University, New Haven, CT (2000), . Kaushik, F. Massimo, “Public Bus Transport Demand Elasticities in Inia” Journal of Transport Economics and Polley, Volume 47, Number 3, Sep 2013, pp. 419-36. *K. Kanal, S. Ghosh, "Income and price elasticity of gold import demand in Indi: Empirical evidence from threshold and ARDL. bounds test cointegration” Resourees Policy, Volume 41, Sep 2014, pp. 135-142, The value of AQ/A/ is given by a,, the estimated coefficient of / in regression Equation 2-3.!° ‘Therefore, the formula for the point income elasticity of demand can be rewritten as i Bmao [3-10] where a, is the estimated coefficient of / in the linear regression of Q on [ and other explana- tory variables. As with point price elasticity of demand, point income elasticity of demand gives different results depending on whether income rises or falls. To avoid this, we usually measure the arc the coefficient of 1) in Equation 2-3, 96 | PARTTWO Demand Analysis income elasticity of demand. This uses the average of the original and new incomes, and the average of the original and new quantities. By doing so, we get the same result whether income rises or falls, Thus, the formula for arc income elasticity of demand can be expressed as 5 200 M419 0-2 Lh , = 42. =O +h Al (Q,+0y2 1,-1, +O, where the subscripts 1 and 2 refer to the original and the new levels of income and quantity, respec- tively, ot vice versa. Thus, arc income elasticity of demand measures the average relative respon- siveness in the demand of the commodity for a change in income in the range between /, and I, ‘For most commodities, an increase in income leads to an increase in demand for the com- modity (i.e., AQIAI is positive), so that E, is also positive. As pointed out on page 41, these are called normal goods. In the real world, most broadly defined goods such as food, clothing, hous- ing, health care, education, and recreation are normal goods. For the first three (necessities), E, is positive but low (ie. between 2er0 and 1). For the lst three classes of goods (luxuries), E is likely to be well above 1. There are some narrowly defined and inexpensive goods, however, of which consumers purchase less as income rises. For these, AOIA/ and hence E are negative. These are called inferior goods. An example of an inferior good might be coarse grains. Its demand decreases as income rises because consumers can then afford to buy wheat flour, which is costlier. Note that the income elasticity of demand is not as clear-cut and precise a measure as the price elasticity of demand. First, different concepts of income can be used in its measure- ment (GNP, national income, personal income, personal disposable income, and so on). More important, a commodity may be normal for some individuals and at some income levels and inferior for other individuals and at other levels of income. Nevertheless, the concept is very ‘useful to a firm in estimating and forecasting the overall demand for the product it sells in a particular market and for a specific range of consumers’ incomes. ‘One important use of the income elasticity of demand is in forecasting the change in the demand for the commodity that a firm sells under different economic conditions. On one hand, the demand for a commodity with low-income elasticity will not be greatly affected (e., will not fluctuate very much) as a result of boom conditions or recession in the economy. ‘On the other hand, the demand for a luxury item, such as vacations abroad, will increase very much when the economy is booming and fall sharply during recessionary periods. Although ‘somewhat sheltered from changing economic conditions, firms selling necessities may want to upgrade their product to share in the rise of incomes in the economy over time. Knowledge of income elasticity of demand is also important for a firm in identifying more precisely the ‘market for its product (ie., which types of consumers are most likely to purchase the product) and in determining the most suitable media for its promotional campaign to reach the targeted ‘audience. Box 3-3 gives the estimated income elasticity of demand for various commodities Bal) ‘The first and sixth rows of Table 3-3 show, respect- wine in Canada and 0.36 for flour in the United States. ively, that the income elasticity of demand is 2.59 for This means that a 1 percent increase in consumer continued CHAPTER3 Measurementof Demand 97 continued SSE ee ee ee Commodity Income Elasticity Commodity Income Elasticity Wine (Canaday 259) Domestic ears US 163 Beef (US. 1.06 Gasoline (US. 120 Cheese (UK) 037 Cigaretes (US.¥ 030 Chicken (U8)° 0.28 Peteolt 2.682 Potatoes (UK 0.32 Kerosene* o.ss4 Flour (US 036 LPG 1.680 Electricity household, U.S.) 194 Public Bus! 0027 European cars (U.S.)¢ 193 Gold Impon* 2230 Asian cars (US. 65 Milk! 0820 *J.A. Johnson, EH. Oksanea, M. R. Veal, and D. Fretz, op. cit 2D. Suits, “Agriculture ia W, Adams and J. Brock, ds. Stractre of American Industry (Englewood Clif, N.1: Prentice Hall, 2000) “D. Harvey, op. cit “H.S. Houthalker and LS. Tiplo. op. cit. (2S: MeCany, "Maret Pice and Elsictis of New Vehicle Demands” Review o Economics and tats (August 196), pp. S44-S47 ‘F Calemaker, “Rational Addictive Behavior and Cigarette Smokin." Journal of Polcal Economy (August 1991), Feonauanetan, “Shor and long-run clastictis of gasoline demand in India: An empiial analysis using cointegration echniques” Energy eonomies, Volume 21, Issue 4, August 1999, pp. 321-330, £3 Roy, “The rebound eet some empirical evidence from India” Bnergy Policy, Volume 28, Issues 6-7, une 2000, p. 438-838 “Same as" above /D. Kaushik, F. Massimo, “Pat Sep 2013, pp, 419-436, “K. Kanal, S. Ghosh, “Income and price elasticity of gold import demand in tn cointegration,” Resources Policy, Volume 41, Sep 2014, pp. 135-142, ‘Bus Transport Demand Elasticities in India" Jounal of Transport Economics and Policy, Volume 47, Number 3, Empirical evidence from threshold and ARDL bounds test income leads to a 2.59 percent increase in expenditures on wine in Canada but to a 0,36 percent reduction in ‘expenditures on flour in the United States. Thus, wine is a (strong) luxury good in Canada while flour is a (weak) inferior good in the United States. The table are necessities. Beef is on the borderline. Similarly, in India, petrol and gold import are (strong) luxury goods, Note that the income elasticities given in Table 3-3 are measured as the percentage change in expenditures ‘on the various commodities (rather than the percentage change in the quantity purchased of the various com- ‘modities). To the extent that prices are held constant, however, we get the same results as if the percentage change in quantities were used. shows that household electricity is also a luxury in the United States and so are European, cue domestic ccars, as well as gasoline, while chicken and cigarettes in the United States and cheese in the United Kingdom 3:3 CROSS-PRICE ELASTICITY OF DEMAND. The demand for a commodity also depends on the price of related (i.., substitute and comple- mentary) commodities. On one hand, if the price of tea rises, the demand for coffee increases (ic. shifts to the right, and more coffee is demanded at each coffee price) as consumers sub. stitute coffee for tea in consumption. On the other hand, ifthe price of sugar (a complement of coffee) rises, the demand for coffee declines (shifts to the left so that less coffee is demanded at each coffee price) because the price of a cup of coffee with sugar is now higher. 98 PARTTWO Demand Analysis We can measure the responsiveness in the demand for commodity X to a change in the price of commodity ¥ with the cross-price elasticity of demand (£,,). This is given by the percentage change in the demand for commodity X divided by the percentage change in the rice of commodity Y, holding constant all the other variables in the demand function, including income and the price of commodity X. As with price and income elasticities, we have point and arc cross-price elasticity of demand. Point cross-price elasticity of demand is given by AQ IAQ, _ AQ, P, APP, AP, Oy xr 3-12] where AQ, and AP, refer, respectively, to the change in the quantity of commodity X and the change in the price of commodity ¥.'4 Note that the value of AQ,/AP, is given by a, the estimated coefficient of P,, in regres- sion Equation 2-3.'* Therefore, the formula for the point cross-price elasticity of demand can be rewritten as x Qy where a, is the estimated coefficient of P, in the linear regression of Q, on P, and other explan- atory variables. ‘As with point price and income elasticities of demand, point cross-price elasticity of demand gives different results, depending on whether the price of the related commodity (P,) rises or falls. To avoid this, we usually measure the are eross-price elasticity of demand with Formula 3-14: E, (3-13) AQ, (B,+P,V2 _ Or, ~ Ox @,+2,)2 B, B+, 2x, + Or, (314) where the subscripts 1 and 2 refer to the original and the new levels of income and quantity, respgetively, or vice versa. If the value of E,,is positive, commodities X and Y are substitutes because an increase in ! P, Ieads to an increase in Q, as X is substituted for Y in Bcknce peteaic of substitute commodities are coffee and tea, coffee and cocoa, Coca-Cola and Pepsi, and electricity and gas. On the other hand, if E,, is negative, commodities X and ¥ are complementary because an inéréase in P, leads to a reduction in Q, and Q,.)Fxamples of complementary commodi- ties are tea and sugar, tea and milk, bread and butter, and cars and petrol. The absolute value (‘e., the value without the sign) of E,,, measures the degree of substitutability and complemen- tarity between X and Y. For example, if the cross-price elasticity of demand between coffee and tea is found to be larger than that between coffee and cocoa, this means that tea is a better sub- stitute for coffee than cocoa. Finally, if E,, is close to zero, X and Y are independent commodi- | ties. This may be the case with books and beer, cars and candy, pencils and potatoes, and so on. The cross-price elasticity of demand is a very important concept in managerial decision making. Firms often use this concept to measure the effect of changing the price of a product 2, ae eee te ae Fa" or 0, "That is, 2Q/@P, = a, (the coefficient of P,) in Equation 2-3. they sell on the demand of other related Cola Company can use the cross-price the price of Coca-Cola on the demand CHAPTERS MeasurementofDemand 99 Products that the firm also sells, For example, the Coca- ¢lasticity of demand to measure the effect of changing for Thums Up. Since Coca-Cola and Thums Up are sub- stitutes, lowering the price of the former will reduce the demand for the latter. However. a man. ufacturer of both razors and razor blades can use cross-price elasticity of demand to mesure the 'merease in the demand for razor blades that would result ifthe firm reduced the price of razors, {high positive cross-price elasticity of demand is often used to define an industry, since i indicates that the various commodities are very similar. For example, the eross-price elas, ticity of demand between Coca-Cola belong to the same (carbonated bevera, and Thums Up is positive and very high and so they iges) industry. This concept is often used by the courts {0 reach a decision in business antitrust cases. For example, in the well-known cellophane case, the DuPont Company was accused of monopolizing the market for cellophane. I defense, DuPont argued that cellophane was just one of many flexible packaging materials that included cellophane, waxed paper, aluminum foil, and many others. Based on the high cross. rice elasticity of demand between cellophane and these other products, DuPont successfully argued that the relevant market was not cellophane but flexible packaging materials. Since DuPont had less than 20 percent of this market, the courts concluded in not monopolized the market, Box 3-4 1953 that DuPont had gives the estimated cross-price elasticity of demand for various commodities, while Box 3-5 examines the substitution between domestic and foreign goods. The first row of Table 3-4 shows that the cross-price elasticity of demand of margarine with respect to the price of butter is 1.53 percent. This means that a 1 percent increase in the price of butter leads to a 1.53 percent increase in the demand for margarine, ‘Thus, margarine and butter are substitutes in the United States. Rows 2 and 3 show that pork and beef in the United States and mutton/lamb and beefiveal in the United Kingdom are also substitutes, although not as nr Commodity X 5s Price Ela Commodity ¥ strong as margarine and butter in the United States. On the other hand, pork and beef/veal are unrelated prod- ucts in the United Kingdom (row 4), while entertain- ‘ment and food in the United States are complementary (row 8). This means that a 1 percent increase in the Price of beefiveal leads to no change in the demand for pork in the United Kingdom, while a 1 percent in the Price of food leads to a 0.72 reduction in the demand for entertainment in the United States, ted Commodities “Margarine (U.S.) Pork (U.S.) Mutton/amb (UK) Pork (UK) ‘Natural gas (U.S.) Coal (Ireland) Bute (US.) Beef (US.) Beef/veal (UK) Beet/veal (UK) Electricity (U.S.) Oil (retand) 400 PARTTWO Demand Analysis continued ‘Commodity X ‘commodity ¥ Elasticity Coal (ieland) ‘Natural gas (ireland) 040" Entertainment (US.) Food (US) or Buropean cars US. domestic & Asian cars 076 ‘Asian cars USS. domestic & European cars oot US. domestic cars nuropean & Asian cars 028 ‘Automobile (Australia) Bos transportation (Australis) on Tp nan “Ti Sree of Fd Demand: Itt snd eal American Journal of Arita Economies (ey 1982) Harvey op. © G ReLakshmanan and W. Anderson, oP it “competition Aor Decision, 30 January 1998, Stato land uss 0:1 Company Lid, Dession No. 490, puter compaiec490. LT aii et al,"An Almost Teal Demand System tor Vor Expenses” Jounal of Transport Ecoomics an ly Mat 1985) £P.S, McCarthy, 09: ct Substitution between domestic and foreign goods and aa yoes has reached an all-time high inthe world and ie expected to continue to increase sharply. Fox nONO: Products such as a particular grade of wheat ae necl and for many industrial products with precise specifications such as computer chips iber opt and Specialized machinery, substitutability Berwee? domes- tic and foreign products is ‘almost perfect. Here, a small price difference can lead quickly large hits in sales ion domestic to foreign sources and vice versa. Even products. Furthermore, with many Pas and compo- prt imported from many nations and with production ities and sales around the world often exceeding wifes at home, even the distinction between domest¢ and foreign products is fast becoming obsolete. Should “onda Accord produced in Ohio be considered Amet ag? What about a Chrysler minivan produced in Can- da, especially now that Chrysler is owned bY Italy's enc) te a Kentucky Toyota or Mazda that contains nearly 50 percent imported Japanese Parts ‘American? trom erentiated products, such as auromobiles and spotoreycles, computers and copiers, wat eras, TV films and TV programs, rettes, soaps and detergents, ‘commercial products is very high and rising. automobiles today are soft drinks and cige~ veal. and most other products that are similar but not ‘dentcal, substitutability between domestic and. foreign ‘Despite the quality problems ofthe past U ‘s-made ‘highly substitutable for Japa- ase and European automobiles, and 0 are most other hes and eam- ican automobile, even after the Labeling Act of 1992, and military Be that as it may, the ssumers, thus increasing their well-being. ‘Broa, “Ave We Underesimating the Cains Tras clearly becoming more difficult to define an AMT ‘American Automobile ‘which requires all automobiles ald in the United States to indicate what percentage sitthe car’ parts are domestic or foreign. Indeed, ont ould even ask if the question is relevant in @ world frowing more and more interdependent and increased availability of for- eign products greatly increases the choices open 10 90° globalized. Soca etn tna roves Troublesome for Fee Tre he New ik Tins (Qobe 9, 1982),p- 1 “ta US, Ca Be US soa the NewYork Tnes (September 18, 1994), 3.3.86: sae Tce auc in Bcnamies and France, Federal Reserve Bak oe York (Ape 2005), pp 1-7; 208 Severe Inernatonal aanmics th ed (Hoboken, N-: Wiley, 2013), set: 64 from Globalization forthe United CHAPTERS Measurementof Demand 107 mr 3-4 USING ELASTICITIES IN MANAGERIAL DECISION MAKING ‘The analysis of the forces or variables that affect demand and reliable estimates of their quan- titative effect on sales are essential for the firm to make the best operating decisions and to plan for its growth. Some of the forces that affect demand are under the control of the firm, while others are not. A firm can usually set the price of the commodity it sells and decide on the level of its expenditures on advertising, product quality, and customer service, but it has no control over the level and growth of consumers’ incomes, consumers’ price expectations, competitors’ pricing decisions, and competitors’ expenditures on advertising, product quality, and customer service. The firm can estimate the elasticity of demand with respect to all the forces or variables that affect the demand for the commodity that the firm sells. The firm needs these elasticity estimates in order to determine the optimal operational policies and the most effective way to respond to the policies of competing firms. For example, if the demand for the product is price inelastic, the firm would not want to lower its price since that would reduce its total revenue, increase its total costs (as more units of the commodity will be sold at the lower Price), and, thus, give it lower profits, Similarly, ifthe elasticity of the firm's sales with respect to advertising is positive and higher than for its expenditures on product quality and customer service, then the firm may want to concentrate its sales efforts on advertising rather than on product quality and customer service. ‘The elasticity of the firm’s sales with respect to the variables outside the firm's control is also crucial to the firm in responding most effectively to competitors’ policies and in planning the best growth strategy. For example, if the firm has estimated that the cross-price elasticity of the demand for its product with respect to the price of a competitor's product is very high, it will be quick to respond to a competitor's price reduction; otherwise, the firm would lose a great deal of its sales. However, the firm would think twice before lowering its price for fear of starting a price war. Furthermore, if the income elasticity is very low for the firm’s product, management knows that the firm will not benefit much from rising incomes and may want to improve its product or move into new product lines with more income-elastic demand. ‘Thus, the firm should first identify all the important variables that affect the demand for the product it sells. Then the firm should obtain variable estimates of the marginal effect of a change in each variable on demand.'* The firm would use this information to estimate the ¢lasticity of demand for the product it sells with respect to each of the variables in the demand function. These are essential for optimal managerial decisions in the short run and in planning for growth in the long run (see Case Insight 3 and Box 3-6). CASEINSIGHT 3 MANAGERIAL ECONOMICS AT WORK Decision Time at the Aromatic Coffee Company Suppose that you are in the management team of the to estimate the demand for its coffee. This means esti- Aromatic Coffee Company in the process of deciding mating the price elasticity of demand for its brand of its sales strategy for the year. To do that, the firm needs coffee, the income elasticity of consumers forthe firm's continued "* This can be accomplished by regression analysis, to be discussed in Chapter 5 a 102 PARTTWO Demand Analysis continued coffee, the cross-price elasticity between the firm's cof- fee and that of the competitive brand, the price elastic- ity of sugar (the complementary good with respect to coffee), and the elasticity of the firm's sales of coffee swith respect to its advertising. Suppose that the statistical department estimated the following regression on the demand for its brand of coffee (X): Q, = 15 ~ 30P, + 0.81 + 2.0P, ~ 0.6P, + 1:24 (3-15) where Q, =sales of coffee brand X in India, in mil- tions of grams per year rice of coffee brand X, in rupees per sonal disposable income, in trillions ‘of rupees per year price of the competitive brand of coffee, in rupees per gram rice of sugar, in rupees per gram \dvertising expenditures for coffee brand X, in hundreds of thousands of rupees per year Suppose also that this year, P, = 2,1 = 25, Py = 1.80, P, =0.50, and A = 1. Substituting these values into Equation 3-15, we obtain Q,=1.5 — 3(2) + 0.8(2.5) + 211.80) — 0.60.50) + 1.20)=2 ‘Thus, this year the firm woutd sell 2 million grams of coffee brand X. ‘The firm can use this information to find the elastic- ity of the demand for coffee brand X with respect 10 its price, income, the price of competitive coffee brand ¥, the price of sugar, and advertising. Thus, “The firm can use these elasticities to forecast the demand for its brand of coffee next year. For example, suppose that next year the firm intends to increase the price ofits brand of coffee by 5 percent and its advertising expen-

    You might also like