UNIT – 2 DEMAND MANAGEMENT

Academic Year 2014- 15 Trimester I

Course Title Micro Economics for Managers Course Code 14MT12

Course Facilitator Dr. Vidya Suresh Credits 3

Total no. of
E-Mail vidyasuresh@tsm.ac.in 25
sessions

Case Study : 1

Engel’s Law and the Plight of the Farmer

In the nineteenth century, a German statistician. Ernst Engel etched his name in economic
history by proposing what has become known as Engel’s law. Engel studied the consumption
patterns of a large number of households and concluded that the percentage of income spent
on food decreases as incomes increase. That is, he determined that food is a necessity. His
finding has repeatedly been confirmed by later researchers. Examples of estimated income
elasticities are shown in the following table. Note that only beef has an estimated elasticity
greater than unity.

Estimates of the Income Elasticity for

Selected Food Products
Food Estimated Income Elasticity
Beef 1.05
Chicken 0.28
Pork 0.14
Tomatoes 0.24
Potatoes 0.15

Sources: D.B. Suits, “Agriculture,” in Structure of American Industry, ed. W. Admas,8 th ed.
(New York: Macmillan,1990):and D.M. Shuffett. The Demand and Price Structure for
Selected Vegetable (Washington, D.C.:U.S. Department of Agriculture, 1954, Technical
Bulletin 1105)

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One of the implications of Engel’s law is that farmers may not prosper as much as those in
other occupation during periods of economic prosperity. The reason is that if food
expenditures do not keep pace with increases in gross domestic product, farm incomes may
not increase as rapidly as incomes in general . However, this tendency has been partially
offset by the rapid increase in farm productivity in recent years. In 1940, each U.S. farmer
grew enough food to feed about 11 other people .Today, the typical farm worker produces
enough to feed 80 people

Key Concepts

 Income elasticity is the percentage change in demand per 1 percent change in income
 Negative income elasticities denote inferior goods. Normal goods are those with
positive income elasticities. If 0<E1≤ 1, the product is defined as a necessity. For
luxuries, E1>1.

Case Study : 2

Empirical Estimated of Production Functions

There are many empirical studies of production functions in the United States and in other
counties. One comprehensive study of a number of manufacturing industries was made by
john R. Moroney. He estimated the production function

Q=AKαLβ1Lδ2

Where K is the dollar value of capital, L 1 is production worker-hours, and L2 is

nonproduction worker-hours. The data were taken form the Census of Manufactures, a
comprehensive cross-section survey of all manufacturing firms in the United States that is
made every five years by the U.S. Department of Commerce.

A summary of the estimated values of the parameters of the production function (i.e.,α,β,
and δ) and R2 , the coefficient of determination, for each industry is shown in the
following table.

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Note that the R2 values are all very high. Even the lowest, 0.951 for the lumber industry,
means that more than 95 percent of the variation in output is explained by variation in the
three inputs. A test of significance was made for each estimated parameter, â, β, and δ ,
using the standard t-test. Those estimated production elasticities that are statistically
significant at the 0.05 level are noted with an asterisk.

Estimated Production Elasticities for 17 Industries

Estimate of

Industry α Β δ α +β+ δ R2
Food and beverages 0.555* 0.438* 0.076* 1.070* 0.987
Textiles 0.121 0.549* 0.335* 1.004 0.991
Apparel 0.128 0.437* 0.477* 1.041* 0.982
Lumber 0.392* 0.504* 0.145 0.041 0.951
Furniture 0.205 0.802* 0.103 1.109* 0.966
Paper and pulp 0.421* 0.367 0.197* 0.984 0.990
Printing 0.459* 0.045* 0.574* 1.079* 0.989
Chemicals 0.200* 0.553* 0.336* 1.090 0.970
Petroleum 0.308* 0.546* 0.093 0.947 0.983
Rubber and plastics 0.481* 1.033* -0.458 1.056 0.991
Leather 0.076 0.441* 0.523 1.040 0.990
Stone and clay 0.632* 0.032 0.366* 1.029 0.961
Primary metals 0.371* 0.077 0.509* 0.958 0.969
Fabricated metals 0.151* 0.512* 0.365* 1.027 0.995
Nonelectrical machinery 0.404* 0.228 0.389* 1.020 0.980
Electrical machinery 0.368* 0.429* 0.229* 1.026 0.983
Transportation equipment 0.234* 0.749* 0.041 1.023 0.972
*Indicates that the estimated parameter is significantly different from zero.

Of somewhat more interest is that the sum of the estimated production elasticities (α +β+
δ) provides as a point estimate of returns to scale in each industry. Although the sum
exceeds unity in 14 of the 17 industries, it is statistically significant only in the following
industries; food and beverages, apparel, furniture, printing, chemicals, and fabricated
metals. Thus only in those six industries can one e confident that there are increasing
returns to scale. For example, in the furniture industry, a 1 percent increase in all inputs is
estimated to results in a 1,109 percent increase in output.

SOURCE:J.R. Moroney,”Cobb-Douglas Production Functions and Returns to Scale in

U.S.
Manufacturing Industry, “ Western Economic journal 6(December, 1967):39-51.

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Key Concepts

 The Cobb-Douglas production function Q = AK αLβ is frequently used to estimate

production relationships.
 To estimate a Cobb-Douglas production function, the must be transformed into a
linear relationship by taking the logarithm of each term (i.e., log Q = log A+ α log
K+ β log L) and then the regression estimation procedure is applied.

Case Study : 3

Texas Calculates Elasticity

In addition to its regular license plates, the state of Texas, as do other states, sells
personalized or “vanity” license plates. To raise additional revenue, the state will sell a
vehicle owner a license plate saying whatever the owner wants as long as it uses six letters
(or numbers), no one else has the same license as the one requested, and it isn’t obscene. For
this service, the state charges a higher price than the price for standard licenses. Many people
are willing to pay the higher price rather than display a license of the standard form such a
387 BRC.

For example, an ophthalmologist announces his practice with the license MYOPIA. Others
tell their personalities with COZY-1 and ALL MAN. A rabid Star Trek fan has BM ME UP.

In 1986, Texas increased the price for such plates from $25 to $75. The Houston Post
(October 19, 1986) reported that before the price increase about 150,000 cars in Texas has
personalized licenses. After the increase in price, only 60,000 people ordered the vanity
plates. As it turned out, demand was rather inelastic over this range. As you can calculate, the
own-price elasticity is -0.86. Thus revenue rose after the price increase, from $3,750,000 to
$4,500,000.

But the Houston Post article quoted the assistant director of the Texas Division of Motor
Vehicles as saying, “Since the demand dropped the state didn’t make money from the higher
fees, so the price for next year’s personalized plates will be $40.” If the objective of the state

It was, of course, quantity demanded that decreased, not demand.

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is to make money from these licenses and if the numbers in the article are correct, this is the
wrong thing to do. It’s hard to see how the state lost money by increasing the price from $25
to $75 – the revenue increased and the cost of producing plates must have decreased since
fewer were produced. So, the move from $25 to $75 was the right move.

Moreover, let’s suppose that the elasticity between $75 and $40 is essentially the same as that
calculated for the movement from $25 to $75 (-0.86). We can use this estimate to calculate
what happens to revenue if the state drops the price to $40.We must first find what the new
quantity demanded will be at $40. Using the arc elasticity formula and the elasticity of -0.86,

ΔQ/ Average Q (60 , 000−Q )/[(60 , 000+Q)/2 ]

E = ΔP/ Average P = (75−40 )/[(75+40 )/2 ] = -0.86

Where Q is the new quantity demanded. Solving this equation for Q, the estimated sales are
102,000 (rounded) at a price of $40. With the quantity demanded and price, total revenue
would be $4,080,000 representing a decrease of $420,000 from the revenue at $75 a plate. If
the state’s objective is to raise revenue by selling vanity plates, it should increase rather than
decrease price.

This application actually makes two points. First even decision makers in organizations that
are not run for profit, such as government agencies, should be able to use economic analysis.
Second, managers whose firms are in business to make a profit should make an effort to
know (or at least have a good approximation for) the elasticity of demand for the products
they sell. Only with this information will they know what price to charge.

Case Study : 4

Empirical Elasticities of Demand

Source : Barbara Boughton, “A License for Vanity”, Houston Post, Oct 19, 1986,
pp.1G, 10G.
For own-price, cross-price, and income elasticities for all agricultural products, see Dale Heien, “The Structure of Food Demand :

Interrelatedness and Duality,” American Journal of Agricultural Economics, May 1982. For automobile own-price and cross-price elasticities, see F.

Owen Irvine Jr., “Demand Equations for Individual New Car Models Estimated Using Transaction Prices with Implications for Regulatory Issues,”

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Using the appropriate data and statistical techniques, it is possible to estimate own-price,
income and cross-price elasticities from actual demand schedules. We have collected a
sample of estimated demand elasticities from a variety of sources and present them in the
accompanying table. In the chapter on empirical demand functions, we will show how to
estimate actual demand elasticities.
Looking at the own-price elasticities presented in the table, note that the demand for basic
agricultural products such as beef and eggs is inelastic. Fruit, for which consumers can
find many substitutes, has a much more elastic demand than beef or eggs. For any
particular make and model of automobile, consumers can find plenty of readily available
substitutes. Consequently, the demand elasticity for General Motors’ Pontiac Catalina is
very large. Another factor affecting own-price elasticity is the length of time consumers
have to adjust to a price change. It is interesting that gasoline demand is inelastic in the
short run but elastic in the long run.
We explained in the text that cross-price elasticities are positive for substitutes and
negative for complements. All three pairs of goods in the table are substitutes (E XY>0).
Beef and chicken are weak substitutes, while margarine and butter seem to be rather
strong substitutes. The extremely high cross-price elasticity of demand between Pontiac
Catalinas and Chervrolet Impalas suggests that these two cars were virtually identical in
the eyes of consumers.

Table of Empirical Elasticities of Demand

Own-price elasticities of demand (E):

Beef -0.956
Eggs -0.263
Fruit -3.021
GM Pontiac Catlina -16.990
Gasoline (short run) -0.430
Gasoline (long run) -1.500
Southern Economic Journal, January 1983. For short-run and long-run gasoline elasticities, see, respectively, Rovert Archibald and Robert

Gillingham, “An Analysis of Short-Run Consumer Demand for Gasoline Using Household Survey Data,” Review of Economics and Statistics,

November 1980, and James Griffin and Henry Steele, Energy Economics and Policy, Academic Press, 1980, p.232. For foreign travel and furniture

income elasticities, see Hendrik Houthakker and Lester Taylor, Consumer Demand in the United States : Analyses and Projections, Harvard

University Press, 1970.

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Cross-price elasticities of demand (EXY)

Beef and chicken 0.350
Margarine and butter 1.526
Catalinas and Impalas 19.300
Income elasticities of demand (EM)
Beef 1.270
Chicken 0.330
Potatoes -0.810
Foreign travel by US citizens 3.090
Furniture 0.530

Normal goods have positive income elasticities of demand (E M), and inferior goods have
negative income elasticities. Potatoes are inferior goods since E M is negative. Beef is more
strongly normal than chicken, indicating that a given percentage increase in income causes an
almost fourfold greater increase in beef consumption than chicken consumption. The high
income elasticity of demand for foreign travel indicates that consumer demand for foreign
travel is quite responsive to changes in income. Furniture demand, on the other hand, appears
to be rather insensitive to changes in income.

Case Study : 5

Cigarette Texas and Demand Elasticity

In 1993, President Clinton appeared to be learning toward a large tax increase on cigarettes,
and possibly alcohol, to finance part of his proposed health care plan. The Wall Street Journal
(April 14, 1993) pointed out a problem with such “sin taxes”. The chairwoman of the
President’s Council of Economic Advisors noted that such taxes are designed to do two
things at once: (1) raise revenue for the government, and (2) discourage drinking, smoking,
and other activities considered harmful to people’s health. As the WSJ pointed out, the two
goals may conflict. If the administration proves too successful in discoursing alcohol and
tobacco consumption, there might not be enough money to pay for the health plan.

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The director of the Congressional Budget Office believed that if the White House imposed a
tobacco tax of $1 to $2 per pack, the tendency would be to “overestimate the amount of
revenue that would come in.” An industry analysis of the federal liquor tax in 1985 concluded
that the government had expected to raise $14 billion in revenue over three years but only
$11 billion came in. The president of the Distilled Spirits Council stated that after the tax on
liquor was raised in 1991, the government actually collected 2.3 percent less in tax revenue.

On the other hand, the director of the Alcohol Policies Project at the Center for Science in the
Public Interest argued that the falloff in revenue after the last tax increase was temporary, and
stated, “To say that raising taxes doesn’t raise more money is nonsense.” A lawyer with the
Nonsmokers’ Rights Association of Canada pointed to the Canadian experience with “sin
taxes” by arguing that tax increases on tobacco over the past decade had lifted the average
price of a pack of cigarettes in Canada to $4.43 (U.S.) from $1.74. At the same tine
Canadians were smoking 40 percent fewer cigarettes and yet, overall tobacco tax revenue
soared to $5.6 billion from $1.6 billion.

As you probably realize, the effect on government revenue from an excise tax on tobacco,
alcohol, or any other good depends in large part on the elasticity of demand for that good.
Consider the above statement saying the idea that raising taxes doesn’t raise more money is
just total nonsense. Obviously, if the government imposes a tax on a good that had not been
previously taxed, tax receipts must rise if sales do not fall to zero after the price increase
resulting from the tax. However, a tax increase over an existing tax may either increase or
decrease tax revenue, depending on demand elasticity.
The accompanying figure illustrates this point. Assume that in this cigarette market there is
already a tax on cigarette of $1 per pack. The relevant current supply is shown by the supply
curve labeled S$1tax. Two possible demand curves in equilibrium are D1 and D2. At the point of
equilibrium, D1 is more elastic than D2, since any given percentage change in price will cause
a larger percentage change in quantity demanded along D 1 than along D2. When a $1-per-
pack tax is levied, equilibrium price is $2 and sales are 700 million packs per month.
Government’s tax receipts from the $1-per-pack tax therefore $700 million.

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Now let the tax increase to $2 per pack, and the cigarette supply curve shifts upward (a
decrease in supply) to the curve labeled S$2tax. If D2 (the less elastic demand) is the relevant
demand curve, price rises to approximately $2.75 and sales fall to 530 million packs per
month. After the tax increase, tax receipts rise to $1,060 million (= $2 * 530 million packs).
Also note that the elasticity of demand over the range of the price increase is

ΔQ/ Average Q −170 /615

E = ΔP/ Average P = 0.75/2. 375 - 0.875

Demand is inelastic over this range.

Now assume that D1 (the more elastic demand) is the relevant demand curve. The shift in
supply after the tax increase causes price to increase to $2.50 and sales to decrease to 300
million. Tax receipts now fall from $700 million at the $1 tax to $600 million (=$2 x 300
million packs) at the $2 tax. Demand elasticity over this range is
ΔQ/ Average Q −400/500
E = ΔP/ Average P = 0 .50/2. 25 - 3.60
This demand is quite elastic over the range.

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This exercise demonstrates two points: (1) The effect on government tax revenue of an
increase in taxes on cigarettes or alcohol depends on the demand elasticity for the good, and
(2) if demand is sufficiently elastic-not just elastic- the tax increase could actually decrease,
not increase, government revenue.

There is substantial empirical evidence that demand for cigarettes is relatively inelastic (see
Grossman et al., 1993). Elasticity estimates vary by age group : -1.20 for youths age 12 to
17, -0.74 for young smokers age 20 to 25, -0.44 for smokers between 26 to 35 years old, and
-0.15 for smokers over 35 years old. Virtually all studies of federal cigarette tax revenues
assume an inelastic demand for cigarettes, and therefore they predict higher tax revenues
from tax hikes. In a recent study, a tax rate of $1.26 a pack was predicted to maximize tax
revenue at $16 billion, while a $2 tax hike was predicted to yield only $11 billion in tax
revenues.
Source: Rick Wartzman, “Clinton’s Proposal for ‘Sin Taxes’ May Stumble by Turning Too
Many Americans into Saints,” The Wall Street Journal, April 14, 1993. Michael Grossman,
Jody Sindelar, John Mullahy, and Richard Anderson, “Alcohol and Cigarette Taxes,” Journal
of Economic-Perspectives, Fall, 1993.

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