DEMAND ANALYSIS AND

OPTIMAL PRICING
Presented by:
ROY B. GACUS
Faculty, AgEcon Dept.
OBJECTIVES
 This chapter considers the following:
1. Determinants of demand
2. Elasticity of demand
3. Price elasticity, revenue and marginal
revenue
4. Maximizing revenue
5. Optimal markup pricing
6. Price discrimination and Information goods
7. Consumer preference and demand
DETERMINANTS OF DEMAND
  
Demand function shows the relationship between the
quantity sold of a good or service and one or more
variables.

where: Q = quantity sold of a good/service

x’s = determinants of demand
 Suppose that

where: P = price of a good/service

= price of related good/service
Y = income
DETERMINANTS OF DEMAND
 Example: Given the demand for air travel

Q = 25 + 3Y + PO – 2P

Where: Q = number of airline’s coach seats sold per flight

P = airline’s coach fare
PO = competitor’s price
Y = income in the region

 Currently your airline and your competitor are charging the

same one-way fare, $240. The current level of income in the
region is 105..
 Determinants of Demand
• We find that
Q = 25 + 3(105) + 1(240) – 2(240) = 100 seats
• The demand equation can be used to test the
effect of changes in any of the explanatory
variables. From Equation we see that
1. For each point increase in the income index,
3 additional seats will be sold.
2. For each $1 increase in the airline’s fare, 2
fewer seats will be sold.
3. For each $1 increase in the competitor’s fare,
1 additional seats will be sold.
 Determinants of Demand
• Each of these results assumes the only
change that occurs; that is, all other factors
are held constant. In fact, the total change in
demand caused by simultaneous changes in
the explanatory variables can be expressed as
∆Q = 3∆Y + 1∆PO - 2∆P
• Thus, if income increases by 5 index points
while both airline prices are cut by $15, we
find ∆Q = 3(5) + 1(-15) – 2(-15) = 30 seats.
Your airline would expect to sell 30 additional
seats on each flight.
THE DEMAND CURVE
AND SHIFTING DEMAND
 Suppose that in the future that the regional income (Y) =
105 and the competitor’s fare (PO) = $240. However, your
airline’s fare (P) is not set in stone, and you are interested
in testing the effect of different possible coach prices.

 Substituting the values of Y and PO into demand function,

we find that
Q = 25 + 3(105) + 1(240) – 2P
Q = 580 – 2P (movement along the demand curve)
 The equation relates the quantity of the good or service
sold to its price, holding all other factors affecting demand
constant (Y and PO)
 We can graph this demand equation as demand curve that
describes a downward sloping curve.
 The Demand Curve and
Shifting Demand
• But what happens if there is a change in one
of the other factors that affect demand? Such
a change causes a shift in the demand curve.
• Suppose that a year from now P is expected
to be unchanged but Y is forecast to grow to
119. What will the demand curve look like a
year hence?
• Substitute the new value, Y = 119 (along with
P = 240), into the demand function to obtain
Q = 25 + 3(119) + 1(240) – 2P
Q = 622 – 2P (shift the demand curve)
THE DEMAND CURVE
AND SHIFTING DEMAND
Q = 580 – 2P or P = 311 – Q/2
Q = 622 – 2P or P = 290 – Q/2
 The constant term of the new demand curve is larger
than that of the old. The figure underscores this point
by graphing both the old and new demand curves.
 The Demand Curve and
Shifting Demand
• The new demand curve constitutes a
parallel shift to the right (toward greater
sales quantities) of the old demand curve.
• At P $240, current demand is 100 seats per
flight. At the same fare, coach demand one
year from now is forecast to be 142 seats
(due to the increase in regional income), a
gain of 42 seats.
Q = 580 – 2P = 580 – 2(240) = 100
Q = 622 – 2P = 622 – 2(240) = 142
GENERAL
DETERMINANTS OF
DEMAND
 Good’s own price (P) is the key determinant of
demand
 Other determinants of demand:

1. Level of income (Y) of the potential purchasers of

the good or service.
a. Normal good – a good in which an increase in income
raises its sales.
b. Inferior good – a good in which an increase in income
causes a reduction in spending.
GENERAL
DETERMINANTS OF
DEMAND
2. Prices of related goods
a. Substitute good – a good in which can
substitute for another good (competitor’s
good). An increase in the price of the substitute
good or service causes an increase in demand
for the another good.
b. Complementary good – a good that
complements with another good. That is, an
increase in demand for one causes an increase
in demand for the other. An increase in the
price of a complementary good reduces demand
for the another good.
General Determinants of
Demand
3. Population (number of consumers that
consume goods/services)
4. Tastes and preferences
5. Consumer’s expectation towards future
market condition (future price, product
availability and future income)
ELASTICITY OF DEMAND
  
Price elasticity measures the responsiveness of a
good’s sales to changes in its price.
 Price elasticity of demand is the ratio of the
percentage change in quantity and the percentage
change in the good’s price, all other factors held
constant.

 Point elasticity formula:

ELASTICITY OF DEMAND
  
For example, consider the airline’s demand
curve as described in equation. At the
current fare of $240, 100 coach seats are
sold. If the airline cut its price to $235, 110
seats (Q = 580 – 2P = 580 – 2(235) )would be
demanded.

 Therefore, we find
ELASTICITY OF DEMAND
   this example, price was decreased by 2.1%,
In
quantity increased by 10 percent, other factors that
affect sales (income and the competitor’s price) did
not change. Thus, demand is very responsive to
changes in price.
 Types of elasticity

1. Unitary elastic :
2. Inelastic :
3. Elastic :
4. Perfectly inelastic :
5. Perfectly elastic :
ELASTICITY OF DEMAND
•  We can write point price elasticity as

• The elasticity (measured at price P) depends

directly on dQ/dP, the derivative of the
demand function with respect to P (as well as
on the ratio of P to Q).
 ELASTICITY OF DEMAND
•  Arc Elasticity formula:
FACTORS AFFECTING
PRICE ELASTICITY

1. The degree to which the good is

a necessity.
2. The availability of substitutes.
3. The proportion of income a
consumer spends on the good
in question.
4. Time of adjustment
OTHER ELASTICITIES
 

Income Elasticity links the
percentage changes in sales
(Q) to changes in income (Y),
all other factors held constant.

 Ey> 0 – normal, necessity good

 Ey> 1 – normal, luxury good
 Ey< 0 – inferior good
Other Elasticities
• Cross-price
  elasticity links the changes in a
good’s sales (Q) to changes in the prices of
related good (PO)

• > 0 – substitute good

• < 0 – complementary good
OTHER ELASTICITIES
   instance, if a 5 percent cut in a competitor’s fare
For
PO is expected to reduce the airline’s ticket sales (Q)
by 2 percent, we find

 The competitor’s airline is a substitute good.

 Perfect substitutes – very large with a constant

slope demand curve.
 Perfect complements – negative with an L-shaped
demand curve.
Other Elasticities
 Price Elasticity and Prediction
• Price
  elasticity is an essential tool for
estimating the sales response to possible
price changes.
• A simple rearrangement of the elasticity
definition gives the predictive equation:
 Price Elasticity and Prediction
• For
  instance, (in the table)the short-term
(i.e., one-year) price elasticity of demand for
gasoline is approximately -0.32.
• If the average price of gasoline were to
increase from $2.50 to $3.00 per gallon (a
20% increase), then consumption of
gasoline (in gallons) would fall by only 6%
PRICE ELASTICITY AND
PREDICTION
 How does one estimate the impact on sales from
changes in two or more factors that affect demand?
 In the Table, the price and income elasticities for
nonbusiness air travel are estimated to be EP = .38 and
EY = 1.8, respectively.
 In the coming year, average airline fares are expected
to rise by 8% and income by 5%. What will be the
impact on the number of tickets sold to nonbusiness
travelers?
PRICE ELASTICITY AND
PREDICTION
  

 Therefore, sales are expected to increase by about

6%.
Price Elasticity, Revenue, and
Marginal Revenue
• What can we say about the elasticity along any
downward-sloping, linear demand curve?
• Suppose that a software firm that is trying to
determine the optimal price for one of its
popular software programs. Management
estimates this product’s demand curve to be
Q = 1,600 – 4P
where: Q = copies sold per week
P = in dollars
• Is there any relationship between price
elasticity, revenue and marginal revenue?
 Price Elasticity, Revenue, and
Marginal Revenue
1. Graph a demand curve.
2. Compute and graph the Marginal Revenue
3. Compute and graph the Total Revenue.
4. Identify the types of elasticity in the
demand curve.
5. At what level of Q and P achieves the
unitary elastic demand? Elastic demand?
Inelastic demand?
Maximizing Revenue
• How does the firm determine its
revenue-maximizing price and output?

• Ans: Revenue is maximized at the price

and quantity for which marginal
revenue is zero (MR = 0) or,
equivalently, the price elasticity of
demand is unity (-1).
OPTIMAL MARKUP
PRICING
  
Markup Rule: The size of a firm’s markup
(above MC and expressed as a percentage
of price) depends inversely on the price
elasticity of demand.
 Markup Equation: P =[/1 + ]MC

 Problem: What P to charge?

 Contribution = (P – MC)

 Assume MC constant = 100

 Higher prices mean higher contribution per

unit, but lower Q.
- 1.5 -2 -3 -5
/1 + 3 2 1.5 1.25
P 300 200 150 125