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Table of Content

1.0 Problems/Issues 2.0 Relevant Theories related to the case 2.1 Understanding Elasticity 2.2 Price Elasticity of Demand 2.3 Arc Price elastic of Demand 2.4 Description of Elasticity 2.5 Elasticity; Impact on Total Revenue 2.6 Arc Income Elasticity of Demand 3.0 Solution 3.1 Question 1 (Arc Income Elasticity of Demand) 3.2 Question 2 (Arc Price Elasticity of Demand) 3.3 Question 3 (Total Revenue) 4.0 Appendix pg 7 pg 8 pg 9 pg 10 pg 2 pg 3 - 6 pg 3 pg 3 pg 3 pg 4 pg5 pg 6

Managerial Economics Demand Analysis: Elasticity

1.0 Problem/Issue
A brief overview of the case which are looking to understand and work on: Interior Landscapes, Inc. is a leading distributor of potted plant and their maintenance for business environments. Demand for Interiors services is tied to the overall pace of business activity and, therefore is sensitive to changes in national income. The greenery service sector is highly competitive, so Interiors demand is also very price-sensitive. During the past year, Interiors sold 10,500 potted plants at an average wholesale price of \$25 per plant. This year, per capita income is expected to fall from \$34,200 to \$30,600 as the nation enters a steep recession. Without any price change, Interiors expects current year sales to fall to 7,500 potted plants. Highlighting some of the crucial points and ability to make rightful assumptions will help us to understand the actual content of this case. First to look at is the crucial points as per below: Demand for Interiors services is tied to the overall pace of business activity and, therefore is sensitive to changes in national income. Interiors demand is also very price-sensitive.

From these points, we would be able to make rightful assumptions as per below: Inferiors product is elastic. Lets prove it. The type of goods that Inferior has engaged on is either normal or luxury good.

We will be discussing on some of the related theories to show how we derived to these assumptions and how its going to help us to solve the arising questions.

2.0 Relevant Theories related to the case

2.1 Understanding elasticity Basically, elasticity is a measure of responsiveness between two(2) different variables. It measures how responsive is one variable due to the change of another. We are having this situation because one variable is dependent on another variable. The changes normally will be shown in the form of percentage(%). For the purpose of the case study, were only going to look at effect on quantity demanded due to the change in the price of a product and also change in income level of the people using the arc model. 2.2 Price Elasticity of Demand Known as Price Elasticity in shorter terms, this one measure the percentage change in quantity demanded due to one percent change in price of a product. Normally this can be surmised to the formula below.

2.3 Arc Price Elasticity of Demand

% Q % P

The actual problem with the standard extension of the formula above is that the elasticity figure will be different from each start and end point that were measuring from. To have one solid answer, the formula should be expanded as per below:

% Q % P Q1 Q0 100 Q1 + Q0 ( ) 2 = P1 P0 100 P1 + P0 ( ) 2 Q Q P + P = 1 0 1 0 Q1 + Q0 P1 P0 =

Applying the formula above will ensure a single answer regardless from which point the elasticity is being calculated from.

Managerial Economics Demand Analysis: Elasticity

2.4 Description of Elasticity Interpreting the elasticity is vital to make necessary judgments on an issue. There are five(5) ways available for us to interpret elasticity as per below:
a. Perfectly Inelastic, e = 0 b. Inelastic, 0 < e < 1 c. Unit elastic, e = 1 d. Elastic, 1 < e <

e. Perfectly elastic, e =

To surmise, the demand graph for products with elasticity value less than 1 moves towards a straight vertical line and elasticity value above 1 move towards a straight horizontal line. This can be illustrated in the diagram below: Price, P
0

Quantity, Q As you can see, this graph might as well help us to draw the demand curve correctly to conceptually understand an issue. The curves between 0 and 1 represent inelastic products and the curves between 1 and represents elastic products. By drawing these curves correctly, youll be able to virtually see the difference in percentage changes in demand caused by 1% change in the price of the product. The more elastic is the product; the percentage change in quantity would be bigger than the percentage change in price. For inelastic products, percentage change in quantity would be smaller than the percentage change in price.

Managerial Economics Demand Analysis: Elasticity

2.5 Elasticity; Impact on Total Revenue This one can be better explained using the diagrams below: Price, P e= 1<e< e=1 0<e<1 e=0 Quantity, Q

0 Total revenue, TR

0 Elastic Inelastic

Quantity, Q

The first graph shows the relationship between price and quantity. As you can see the elasticity reduces as we move downwards along the demand curve until it reaches zero (0). This translates to total revenue graph. Pretty obvious that when price decreases, total revenue increases for elastic products, however, total revenue decreases when price increases. Important note: Firms with product classified to be elastic, can only increase revenue by reducing the price, this because percentage increase in Quantity demanded is bigger than percentage decrease in Price (vice versa if its an inelastic product). If its an unit elastic product (e = 1), there will not be any changes in total revenue because percentage change in quantity demanded will be the same as percentage change in price. This formula is used to calculate total revenue generally; TR = Price x Quantity (P.Q)
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Managerial Economics Demand Analysis: Elasticity

2.6 Arc Income Elastic of Demand Income elasticity measures percentage change in quantity demanded due to 1 percent change in income level. The formula applied is similar to price elasticity but only the symbol used is different as shown below:

% Q % Y Q1 Q0 100 Q1 + Q0 ( ) 2 = Y1 Y0 100 Y1 + Y0 ( ) 2 Q Q Y +Y = 1 0 1 0 Q1 + Q0 Y1 Y0 =

One significant difference in price elasticity and income elastic is that when price reduces quantity demanded increases (inverse relationship), however when Income reduces, quantity demanded also reduces (not applicable on inferior goods as it has inverse relationship). The portion of the reduction though largely depends on the type of good which can be classified into superior/luxury goods, necessity/normal goods and inferior goods. The reaction of consumers towards these types of goods can be portrayed in the diagram below: Price, P inferior normal superior

0< y < 1, necessity / normal good y > 1, superior / luxury good y < 0 (negative), refers to inferior goods Good that is purchased in smaller absolute quantity as the income of consumer increases

Quantity, Q

Managerial Economics Demand Analysis: Elasticity

As we have now gone through the relevant concepts/theories, lets look at the questions relating to our problem/issue earlier and solve it.

3.0 Solution
3.1 Question 1 (Arc Income Elasticity of Demand) Calculate the income elasticity of demand and explain Given: Q0= 10,500 potted plants, Q1= 7,500 potted plants, Y0 = \$34,200 Y1= \$30,600

By using Arc Income Elasticity formula:

y =
%Q %Y Q1 Q0 100 Q + Q0 ( 1 ) 2 = Y1 Y0 100 Y1 + Y0 ( ) 2 Q Q0 Y1 + Y0 = 1 Q 1 + Q0 Y1 Y0 7500 10500 30600 + 34200 = 7500 + 10500 30600 34200 = 0.167 18 = 3.00

Income, Y d0 d1 Y0 Y1 s 0 Q1 Q0 d1 Quantity, Q e1 d0 e0 s

Income reduction from Y0 to Y1 shifts the demand curve to left from d0 to d1. Quantity reduced to Q1 and new equilibrium at e1

Interpretation: The income elasticity is 3.0. This means that a 10% increase in income will lead to 30% increase in the quantity demanded in interiors products (potted plants). As the value for income elasticity is greater than 1 (Ey>1), this implies that potted plants sell in Interiors landscape is a superior/luxury good.

Managerial Economics Demand Analysis: Elasticity

3.2 Question 2 (Arc Price Elasticity of Demand) Given the projected fall in income, the sales manager believes that current volume of 10,500 plants could only be maintained with a price cut of \$5 per unit. On this basis, calculate the price elasticity of demand and explain. Given: By using Arc Price Elasticity formula: Q0= 7,500 potted plants, Q1= 10,500 potted plants, P0 = \$25 P1= \$20 Price, P(\$) d s0

% Q = % P Q1 Q0 100 Q1 + Q0 ( ) 2 = P1 P0 100 P1 + P0 ( ) 2 Q Q0 P1 + P0 = 1 Q1 + Q0 P1 P0 10500 7500 20 + 25 = 10500+ 7500 20 25 = 1.53(absolute value)

s1

P0 P1 s0 0

e0 e1 d s1 Q0 Q1 Quantity, Q

Price reduction from P0 to P1, increases demand from Q0 to Q1. Supply curve shifts to right to s1 and new equilibrium at e1.

Interpretation: The price elasticity is (-)1.53 which means demand and price have inverse relationship. Here we can conclude that, 10% increase in price, will reduce demand for Interior product (potted plants) by 15.3%.

Managerial Economics Demand Analysis: Elasticity

3.3 Question 3 (Total Revenue) Holding all else equal, would a further increase in price result in higher or lower total revenue? Using the elasticity derived in Question 2; lets work out the total revenue At equilibrium (e0), P0 = \$25.00, Q0 = 7,500 units Applying 10% increase in price and 15.3% reduction in quantity demanded. So at new equilibrium (e1), P1 = \$27.50, Q1 = 6,353 units Total revenue = P*Q At e0, TR = \$187,500.00 (\$25*7500) At e1, TR = \$174,707.50 (\$27.50*6353), loss in revenue of \$12,792.50 (\$187,500 \$174,707.50) Answer: Further increase in price will not benefit Interiors product as would result in lower total revenue. As discussed earlier, given an elastic product, total revenue can only be increased if price reduced. This can be seen in the diagram below where loss in revenue due to lower Quantity is higher than increase in revenue due to higher Price. Price, P(\$)

s1 s0

27.50 25
Increase in revenue due to higher P.

e1 e0 d s1 s0

Loss revenue due to decline in quantity demanded

0 6353

7500

Quantity, Q (unit)
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Managerial Economics Demand Analysis: Elasticity

4.0 Appendix
Group 4 Rules: i. ii. iii. iv. v.
Question :

Read questions carefully. The group needs to solve the given problems. You need to identify the problem in the question. Explain a relevant theory Present in the class how you get the answer. (5%) You also have to submit the report. (10%)

Interior Landscapes, Inc. is a leading distributor of potted plant and their maintenance for business environments. Demand for Interiors services is tied to the overall pace of business activity and, therefore is sensitive to changes in national income. The greenery service sector is highly competitive, so Interiors demand is also very price-sensitive. During the past year, Interiors sold 10,500 potted plants at an average wholesale price of \$25 per plant. This year, per capita income is expected to fall from \$34,200 to \$30,600 as the nation enters a steep recession. Without any price change, Interiors expects current year sales to fall to 7,500 potted plants. a. Calculate the income elasticity of demand and explain b. Given the projected fall in income, the sales manager believes that current volume of 10,500 plants could only be maintained with a price cut of \$5 per unit. On this basis, calculate the price elasticity of demand and explain. c. Holding all else equal, would a further increase in price result in higher or lower total revenue?

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