1ciTY f demand to changes 1M a rang, ALYsiS: ELAST the sensitivity © DEMAND SENSITIVITY AN suring Demand analysis focuses on meas! of important factors. Elasticity Concept nalysis is elasticity, defined a5 the percents ‘A measure of responsivent ¢ change in the vale of : demand at ie Ue hee from a percentag' Elasticty viable, Y. n ora wpeeenage change ina dependent val ing aiasticity ere ganteciant arable oeThe equation for Cala 38 nant variable, : % in fe ‘percentage Change in ¥ a ancing Elasticity =F rcentage Change in X ‘te enere ; centage change in one Vé associat SAE icon ott my intl he hes ater wed in dea with a given percentage change in another Va ining variables. The elas analysis to measure the effects of changes d HES (hk eet of a i i ‘ion and cost analysis to evaluat a Variables concept is also used in production an Ie ine elsstcity vio Feros: input on output, and the effect of dutput changes on costs. aspric ee : ‘Advertising hat are measure operating leverage. - fas ny Sanuecosra Factors such as price, product quality, and advertising that ue ee the contr re of the firm are endogenous variables. Factors outside the control of the firm, such a5 Exogenous consumer incomes, competitor prices, and the weather, are exogenous variables. Bot, Wavobles types of influences are important. For example, a firm must understand the effects g meee changes in both prices and consumer incomes to determine the price cut ne thefirn,suchas to offset the decline in sales caused by a business recession. Similarly, the sensitivity cums inane of demand to changes in advertising must be quantified if the firm is to respond competitor prices, and the weather. Point Elasticity Point elasticity measures elasticity at a given point on a function. The point ela Ttmeasures Bey 2 vines Concept is used fo measure the effect on a dependent variable, Y, of a very small or appropriately to an increase in competitor advertising. Point Elasticity ma: [2¥,0 Percent to 5 percent) change in an independent variable, X. Using the lo Greek letter epsilon, ¢ a8 the symbol for point elasticity, point elasticity is Point Elasticity Percentage Change in ¥ The Y/dX term in the int ela ici __ Yand X, and shows the effect on Yof et ea by multiplying this marginal rela Therefo:[Ohpter 4 Demand Anaya 25 5 percent decrease in Y. When £x>0, Y changes in the same positive or negative direction as X. Conversely, when €x <0, Y changes in the opposite direction of changes in X. For example, if ¢x=-3, a 1 percent increase in X will lead to a 3 percent decrease in Y, and a 1 percent decrease in X will lead to a 3 percent increase in Y. Arc Elasticity Although the point elasticity concept can give accurate estimates of the effect on Y of small changes in X, it is not used to measure the effect on Y of large-scale (more than 5 percent) changes in X. Because elasticity typically varies at different points along a function, the are elasticity formula was developed to calculate an average elasticity over conse. @ given range, Using the uppercase Roman letter E as the symbol for arc elasticity, arc on elasticity is oe 4 Bercerisee Guapaein Y. Arc Blastiity = Ex= Taree Percentage Change in X Change in Y ‘Average Yicity, price elasticity is nge in Quantity(Q)_ Percentage Chai vant = err Parentage Change in Price =20/0 ‘aP/P =9Q/aP xP/Q 412 Using the formula for point elasti a I-unit change in price, and p ‘on the demand curve. 'd use of the price elasticity is interested in analyzing he past year suggests the uantity following where 2Q/aP is the marginal change in 4 / i and Q are price and quantity, respectively, at a given point An example can be used to illustrate the calculation an formula, Assume that the management of a movie theater peovie ticket demand, Also assume that monthly data for ¢ following demand function: Q=7,000 —5,000P + 6,000Ppyp + 1501 + 1,000A where Qs the quantity of movie tickets, P is average ticket price (in dollars), Ppyp is 3-day new-release movie rental price at DVD outlets in the area (in dollars), I is average is income per household (in thousands of dollars), and A is monthly advertising expenditures (in thousands of dollars). Numbers that appear before each variable in ‘Such a function are called coefficients or parameter estimates. They indicate the e ‘change in movie ticket sales associated with a 1-unit change in each independent - example, the number —5,000 indicates that the quantity of movie tickets 5,000 un ‘ $1 increase in the price of movie tickets, $ in the price of DVD rentals causes a 6,000 6,000. A $1,000 (I-unit) increase i rease in demand, elasticity of demand varies depend of units sold (Q). The price elasticity of‘omer Demand Anais 7 Bra ae crumbet) at higher prices because the price sensitivity of consumers tends to grow as prices increase. The are price elasticity of demand is used to Gemanded to price changes over an extended range arc elasticity, the arc price elasticity is analyze the sensitivity of quantity of prices. Using Ep as the symbol for Percentage Change in Q rarge Percentage Change in B = 40/(2,+0)) APP, +P;) = AQ/AP x (P2 + P,)/(Q)+Q,) 4.13 Arc Price Elasticity In the present example, the arc price elasticity of demand for movie tickets over the price range from $8 to $10 is Between $8 and $10, Ep=AQ/AP x (P+ P,)(Qz-+ Qv 10,000 — 20,000)/($10 — $8) x ($10 + $8/(10,000 +20,000)) =-3 quantity att, om average, a 1 percent change in price lead to a 3 percent change in ‘quantity demanded when movie ticket prices lie within the range from $8 to $10 per ticket. Price Elasticity and Total Revenue a reduction in price can increase, decrease, or nccunatng Bed the total revenue. good estimate of price elasticity makes it possible (9 accurately estimate the effect of price changes on total revenue. For decicion ny Feet re pec ranges of price elasticity have been identified, Using le to denure the absolute value of the price elasticity, three ranges for price elasticity are 1, ler|> 1.0, defined as elastic demand, Example: ep= 3.2 and |ep|=32. 2. lerl=1.0, defined as unitary elasticity. y 5 sy | _Example: ep =~ 1.0 and lep|=1.0. 3. lerl<1.0, defined as inelastic demand. Example: n= ~0.5 and len =0.5. With elastic demand, |ep|>1 and the telative chang Telative in price. A given percentage increase in revenue. Un quantity divided by price and quantity are ae inet tal nen With inelastic demand, a priceXe sharged Revenue unchanged p Revenue increases Revenue decreases jnelastic, where ep = 0, to perfectly elas case in which the quantity demang (Q", is demanded regardless of pr insensitive to price, 30/aP~ P/Q. The demand curve fy rT price elasticity can range from completely where ep = —2 To illustrate, consider an extreme wrindependent of price so that some fixed amount, When the quantity demanded of a product is completely the price elasticity will equal zero, irrespective of the value of such a good or service is perfectly vertical, as shown in Figure 4-7 : ‘The other limiting case, that of infinite price elasticity, describes a product that to price. The demand curve for such a good or service is perfec Figure 4.12. Here the ratio 6Q/0P = —-° and ép = —=, regardles, 3 these limiting eases should be understood. A firm faxPc ee ‘with perfectly elastic demand) all output is soldat a fixed Price " Price per unit (6)vesand dies on the basis of rebates, iti we incentive intensive consumer advertising, ‘or financing package. Price haggling works, especially ann ily, cat dealers buy from the jat@rd the end of each calendar month when dealer goat can invoice price less special seasonal for incon eat Stake, or when sales personne! are eligible peped to push slow-moving stock out the door aah ‘bonus payments. No dealer wants to See a eves humming. Ca dealers also receive Cece ee Sustomer walk out the door, and walking works. je manufacturers, depending upon the total § Price-conscious customers focus more on style, color, cae ness that they've done during the course of a Packages, or the timeliness of delivery, and pay pine sre might average 3 eteent forthe ‘ore for their vehicles. Because a trade-in of a used vehicle ; is typically involved, ss au ‘car buy id sell f f 5 paces Est aoe Watt over the net pie ater Ree aienivararetas ire ible for manufacturers toreyordihey (he PIKE of @ new or used car Even if everyday low pricing aa cond give odealag 8 oan rie becomes popular in the car business there can never be i say intheaitebusiness riive to. the same degree of price certainty possible in a true’one pe isalso an intrinsic part of car buying, pric environment So long as trade-ins re involved, price oe scious consumers consult car p Bia pciertrer or ined cx Tenens and rebate Opportunities on the Internet, dealer to dealer seeking the best janavel fom _ pees Price elasticity of demand data along with detailed cost information gives firms the tools necessary for setting optimal prices. Optimal Price Formula Because demand curves slope downward, two effects on revenue follow a price reduction: (1) By selling an additional unit, total revenue goes up by P; (2) However, by charging a lower price, some revenue is lost on units sold previously at the higher price. This effect is captured by QxP/2Q. Therefore, when price is a function of output, the change in total revenue following a change in output (marginal revenue) is given by the expression MR = dTR/Q =alP x Q)/0Q =P+Qx0P/dQ When the above expression is is multiplied by P/P, a simple relationship between marginal Tevenue and the point price elasticity:of demand is ete ‘ MR=P+QxaP/0Q =P +P(Q/PxeP/0Q) P+P(i/ep) =P[1 + (1/ép)1part 2:Demen’ R Small Percentage Change in 1) =-2 ity (D e (P) If relevant marginal costs are $25 per unit, and given e,=—2, from Equation (4.14) the profit-maximizing price is Pr=$25/[1 + (1/(-2))1 = $50 Therefore the optimal retail pri f d ail price for The Kingfish fishi To see hi it ‘ ingfish fis ‘ ee tent gpa price formula canbe Renae Silene cn onder el though diferent distributor and reduce ing purposes, $4 ircumstances, the new optimal retail marginal costs by a price is ' Pr= 924 sa/(—2y)] = $48vs Table 4.7 Price Elasticity and Optimal Pricing Policy mina Con In practice, there are three major influences on price elasticities: (1) the extent to which a good is considered a necessity; (2) the availability of substitute goods; and (3) the proportion of income spent on the product. A relatively constant quantity of electricity for residential lighting will be purchased almost irrespective of price, at ieas| in the short run. There is no close substitute for electric service. However, goods suct as men’s and women’s clothing face considerably more competition, and the quantit demanded depends more on price. The quantity demanded of “big ticket” items such a automobiles, homes, and vacation travel accounts for a large share of consumer incom and is relatively sensitive to price. The quantity demanded for less expensive product such as soft drinks, candy, and cigarettes, can be relatively insensitive to price. Give the low percentage of income spent on “small ticket” items, consumers often find th searching for the best deal available is not worth the time and effort. Demand for most products is also influenced by changes in the prices of other product: Cross-Price Elasticity Formula ‘The concept of cross-price elasticity is used to examine the responsiveness of di ‘one product to changes in the price of another. Point Oe pace custiity is Ea f° : G “Point ross rice Easicity = épy = Percentage Change in Quantity of Y(Qy) ae * Small Percentage Change in Price of X (P,) : ~ 2QyIQy : t +) OPP ‘ = 0Qy/PPxxPx/Qy 4“ehapter Demand Anaya us 5 percent decrease in Y. When €>0, Y changes in the same positive or negative direction as X. Conversely, when €x~<0, Y changes in the opposite direction of changes in X. For ‘example, if £x=-3, a 1 percent increase in X will lead to a 3 percent decrease in Y, and a 1 percent decrease in X will lead to a 3 percent increase in Y. Arc Elasticity Although the point elasticity concept can give accurate estimates of the effect on Y of small changes in X, it is not used to measure the effect on Y of large-scale (more than 5 percent) changes in X. Because elasticity typically varies at different points along a function, the are elasticity formula was developed to calculate an average elasticity over musty a given range. Using the uppercase Roman letter E as the symbol for arc elasticity, arc oS elasticity is Change in Y Areal Ex= raerenenogsComgE TEsimilarly, ate income elasticity i lefined ag Arc Income Elastic Hlasticty = p, = Tapers ‘Change in Quantity (Q) reentage AQ Reet FAQ AL (+ 1122+ 2). tively related to income. direction; that is, incomeSports Watch Advertising Sports Watch Expenditures © Price,P July August September October November December Dr ree Match , 50 50 50 6 50 50, 50 50. 55 51 a 7watches. sverage advertising arc elasticity of demand for sports C. Calculate and interpret ‘the average arc price elasticity of demand for sports watches. Calculate and interpret P ics Watiek: the average arc cross-price elasticity of demand between sports and 574.2. SOLUTION A¥ Pan Demand Rahs ng In calculating the are price elasticity of demand, consider only consecutive months 9 ts watches, but no change in advertising nor the rea July-August = AQ, Pr+Py Fo" PX 0,40) = 5500-4500, $24 +526 $24-$26 “5,500 +4,500 = 15,000~5,000,,__$20+$25 _ ~$20—§25 15,0007 5,000 =-45 April-May ? — AQ PatP). §o= PO; 40; mie = 4000-6000 $26 + $24 © $26—$24 “4000+6,000 =-5