MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield

Chapter 2

DEMAND THEORY
 OBJECTIVES

• Explain the importance of market demand in the

determination of profit.
• Understand the many factors that influence
demand.
• Elasticity: Measures the percentage change in one
factor given a small (marginal) percentage change in
another factor
• Demand elasticity: Measures the percentage change
in quantity demanded given a small (marginal)
percentage change in another factor that is related to
demand
 OBJECTIVES

• Explain the role of managers in controlling and

predicting market demand.
• Managers can influence demand by
controlling, price, advertising, product quality,
and distribution strategies.
 OBJECTIVES

• Role of managers (cont’d)

• Managers cannot control, but need to understand,
elements of the competitive environment that
influence demand.
• This includes the availability of substitute goods, their pricing,
and advertising strategies employed by sellers.
• Managers cannot control, but need to understand how
the macroeconomic environment influences demand.
• This includes interest rates, taxes, and both local and global
levels of economic activity.
 THE MARKET DEMAND CURVE

• Market demand schedule: Table showing the

total quantity of the good purchased at each
price
• Market demand curve: Plot of the market
demand schedule on a graph
• Price (the X variable) is on the vertical and quantity
demanded (the Y variable) is on the horizontal axis.
© 2013 W. W. Norton Co., Inc.
DEMAND CURVE FOR TABLETS

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 THE MARKET DEMAND CURVE

• Characteristics of the market demand curve

• Quantity demanded is for output of the entire market,
not of a single firm.
• For most products and services, the market demand
curve slopes downward and to the right.
• Quantity demanded is defined with regard to a
particular time period.
• any demand curve pertains to some particular time
• its shape and position depend on the length of the
period and other characteristics of this period.
 MARKET DEMAND CURVE

• If we were to estimate the market demand curve for

tablets for the first week in 2012, it would probably differ
from the one in the figure.
• This difference arises partly because consumers adapt
their purchases more fully to changes in the price of
tablets in a year relative to a week.
 THE MARKET DEMAND CURVE

• Determinants of the position and shape of the

market demand curve
• Consumer tastes
• Example: Increase in preference for tablets causes
an increase in demand for tablets.
• the demand curve shifts to the right; that is, at
each price consumers want to buy more than they
did previously.
• Alternatively, for each quantity consumers are
willing to pay a higher price.
 THE MARKET DEMAND CURVE

• If consumers show a decreasing preference for

a product, the demand curve shifts to the left
because at each price consumers buy less than
previously.
• Alternatively, for each quantity consumers are
willing to pay only a lower price.
• The greater the shift in preferences, the farther
the demand curve shifts.
EFFECT OF AN INCREASED PREFERENCE ON THE
MARKET DEMAND CURVE FOR TABLETS

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 THE MARKET DEMAND CURVE

• Consumer income
• For some products the demand curve shifts to the right
if per capita income increases, whereas for other
products it shifts to the left if per capita income rises.
• Normal and inferior goods
• Example: Increase in income causes an increase in
demand for tablets.
• Level of other prices
• quantity of tablets demanded to increase if the price of
applications falls drastically.
 THE MARKET DEMAND CURVE

• Population Size
• position and shape of a product’s market
demand curve are affected by the size of the
population in the relevant market.
• If the number of consumers increases, we
expect that, if all other factors are held equal,
the quantity of tablets demanded will
increase.
• Population generally changes slowly—little
effect in the short run.
EFFECT OF AN INCREASE IN PER CAPITA INCOME
ON THE MARKET DEMAND CURVE FOR TABLETS

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INDUSTRY AND FIRM DEMAND FUNCTIONS

• Market demand function: the relationship

between the quantity demanded and the various
factors that influence this quantity
• Quantity of X (Q) = f (factors)
• Factors include
• price of X
• incomes of consumers
• tastes of consumers
• prices of other goods
• population
• advertising expenditures
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Example: Q = b1P + b2I + b3S + b4A

• Assumes that population is constant and that the
demand function is linear
• P = price of tablets
• I = per capita disposable income
• S = average price of software
• A = amount spent on advertising
• b1, b2, b3 , and b4 are parameters that are estimated
using statistical methods
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Parameters: Constant or variable terms used in

the function that helps managers determine the
specific form of the function but not its general
nature
• Example: Q = -2,000P + 70I - 375S + 0.0001A
• A $1 increase in the price of a tablet computer
decreases the quantity demanded by 2,000 units
per year
INDUSTRY AND FIRM DEMAND FUNCTIONS

• a $1 increase in per capita disposable income

results in a 70 unit increase in quantity
demanded per year;
• $1 increase in the average price of applications
reduces the quantity demanded by 375 units per
year; and
• $1 increase in advertising raises the quantity
demanded by 0.0001 units per year.
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Relationship between the market demand

function and market demand curve
• Market demand curve shows the relationship between
Q and P when all other variables are held constant at
specific values.
• Market demand function does not explicitly hold any
values constant.
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Example: Suppose I = 13,000, S = 400, and A = 50

million.
Q = –700P + 200(13,000) – 500(400) + 0.01(50,000,000)
Q = 2,900,000 – 700P (Direct Demand Function)
• Solving for P in terms of Q gives the inverse demand
function
P = 4,143 – 0.001429Q (Inverse Demand Function)
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Example: Shifting the demand curve

• Suppose the price of software falls from $400 to $200.
Q = –700P + 200(13,000) – 500(200) + 0.01(50,000,000)
Q = 3,000,000 – 700P
• Solving for P gives
P = 4,286 – 0.001429Q
DEMAND CURVE FOR TABLETS

Managerial Economics, 8e
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INDUSTRY AND FIRM DEMAND FUNCTIONS

• The firm’s demand curve

• Negative slope with regard to price
• Slope may not be the same as that of the market
demand curve
• Represents a portion of market demand
• Market share
• Responds to same market and macroeconomic
factors as the market demand curve
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Directly related to the prices of substitute goods

provided by competitors
• Increase in competitor’s price will cause an increase
in a firm’s demand.
• Decrease in competitor’s price will cause a decrease
in a firm’s demand.
INDUSTRY AND FIRM DEMAND FUNCTIONS

• Inversely related to the prices of substitute

goods provided by competitors
• Increase in competitor’s price will cause a decrease in
a firm’s demand.
• Decrease in competitor’s price will cause an increase
in a firm’s demand.
THE OWN-PRICE ELASTICITY OF DEMAND

• Own-price elasticity of demand

• The elasticity of a function is the percentage change
in the dependent (Y) variable in response to a 1
percent increase in the independent (X) variable.
• In y = ax, y is the dependent variable because by
specifying x, we can determine y.
• The price elasticity of a demand function is the
percentage change in quantity demanded in response
to a 1 percent increase in price.
THE OWN-PRICE ELASTICITY OF DEMAND

• Market demand curves vary with regard to the

sensitivity of quantity demanded to price.
• For some goods, a small price change results in
a big change in quantity demanded; for other
goods, a big price change results in a small
change in quantity demanded.
• To indicate how sensitive quantity demanded is
to price changes, economists use a measure
called the own-price elasticity of demand.
 THE OWN-PRICE ELASTICITY OF DEMAND

•  
THE OWN-PRICE ELASTICITY OF DEMAND

• Suppose a 1% reduction in the price of Apple

tablet computers results in a 1.3% increase in
U.S. sales.
• If so, the price elasticity of demand for Apple
tablets is -1.3.
• The price elasticity of demand generally
changes as price varies along the demand
curve.
THE OWN-PRICE ELASTICITY OF DEMAND

• For instance, the price elasticity of demand may

be higher in absolute value when the price of
tablets is relatively high than when it is low.
• Similarly, the price elasticity of demand varies
from market to market.
THE OWN-PRICE ELASTICITY OF DEMAND

• When a 1% change in price leads to a more than

1% change in quantity demanded, we say
demand is elastic.
• When a 1% change in price leads to a less than
1% change in quantity demanded, we say
demand is inelastic.
• And when a 1% change in price leads to a 1%
change in quantity demanded, we say demand
is unitary elastic.
THE OWN-PRICE ELASTICITY OF DEMAND

•  
THE OWN-PRICE ELASTICITY OF DEMAND

•  
 DEMAND CURVES WITH ZERO AND
INFINITE PRICE ELASTICITIES OF DEMAND

Managerial Economics, 8e
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THE OWN-PRICE ELASTICITY OF DEMAND

• Linear demand curves

• The slope of a linear demand curve is constant.
• If the demand curve is neither vertical nor horizontal,
the price elasticity will differ depending on price.
• At the midpoint of a linear demand curve,  = –1, with 
approaching zero as price approaches zero.
• At prices above the midpoint, demand is elastic, with 
approaching negative infinity as quantity approaches zero.
• At prices below the midpoint, demand is inelastic.
VALUES OF THE PRICE ELASTICITY OF DEMAND AT
VARIOUS POINTS ALONG A LINEAR DEMAND CURVE

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 POINT AND ARC ELASTICITY

• The point price elasticity formula should be used

working with an estimated demand curve or
when the change in price is very small.
 POINT AND ARC ELASTICITY

• Point price elasticity (cont’d)

• Calculated value for small changes will differ
depending on whether P and Q are the starting values
or the ending values after the price change. The
difference will be small if the change is small.
• Example: P1 = 99.95, P2 = 100.00, Q1 = 20,002, and Q2 =
20,000
•  = [(20002 – 20000)/(99.95 – 100)][99.95/20002] = –0.1999
•  = [(20000 – 20002)/(100 – 99.95][100/200000] = –0.22
 POINT AND ARC ELASTICITY

• Point price elasticity (cont’d)

• If the price change is large, then the direction of
change will influence the calculated elasticity.
• Example: P1 = 5, P2 = 4, Q1 = 3, and Q2 = 40
•  = [(40 – 3)/(4 – 5)][5/3] = –61.67
•  = [(3 – 40)/(5 – 4)][4/40] = –3.70
• This problem is corrected by using the arc
midpoints formula.
© 2013 W. W. Norton Co., Inc.
 POINT AND ARC ELASTICITY

• The midpoints arc elasticity formula should be

used to estimate the price elasticity of demand
from a demand schedule where price differences
are not very small.

• Example: P1 = 5, P2 = 4, Q1 = 3, and Q2 = 40
•  = [(40 – 3)/(4 – 5)][(5 + 4)/(3 + 40)] = –7.74
© 2013 W. W. Norton Co., Inc.
 USING THE DEMAND FUNCTION TO
CALCULATE THE PRICE ELASTICITY

• Given
• Q = – 700P + 200I – 500S + 0.01A
• Q = Quantity demanded of computers
• Price = P = 3,000
• Income = I = 13,000
• Software = S = 400
• Advertising = A = 50,000,000
 USING THE DEMAND FUNCTION TO
CALCULATE THE PRICE ELASTICITY

• Derive the demand curve

• Q = – 700P + (200)(13000) – (500)(400) + (0.01)
(50000000)
• Q = 2900000 – 700P
• Determine Q
• Q = 2900000 – (700)(3000) = 800000
•  = (–700)(3000/800000) = –2.62
• For P = 2000, Q = 2900000 – (700)(2000) =
1500000,
• so  = (–700)(2000/1500000) = –0.93
 EFFECT OF PRICE ELASTICITY OF
DEMAND ON FIRM REVENUE

•• Let
  TR = PQ

Hence,
 THE EFFECT OF PRICE ELASTICITY ON
THE FIRM’S REVENUE

• Implications:
• If  = –1, dTR/dP = 0, so total revenue is at a
maximum and a change in P will have no effect on
total revenue.
• If  > –1 (inelastic), dTR/dP > 0, so an increase in P
(and consequent decrease in Q) will increase total
revenue.
• If  < –1 (elastic), dTR/dP < 0, so an increase in P
(and consequent decrease in Q) will decrease total
revenue.
 THE EFFECT OF PRICE ELASTICITY ON
THE FIRM’S REVENUE

• If the price elasticity is unitary, any price change

will cause an equal and opposite percentage
change in quantity. Total revenue will remain
constant.
• If the price elasticity is in the inelastic range,
then a 1% change in P will cause less than a 1%
change in quantity in the opposite direction.
Therefore, total revenue will change in the same
direction as price.
 THE EFFECT OF PRICE ELASTICITY ON
THE FIRM’S REVENUE

• If the price elasticity is in the elastic range, then

a 1% change in P will cause more than a 1%
change in quantity in the opposite direction. Total
revenue will change in the opposite direction
from price.
 CASE : PHILIP MORRIS

• In 1993 Philip Morris cut cigarette prices by

18%. Its major competitor (RJ Reynolds)
matched the price cut.
• Not surprisingly, the quantity sold of Philip Morris
cigarettes increased (by 12.5%).
• In a June 13, 1994, article referring to the perils
of a price cut, Fortune reported that Philip Morris
profits fell by 25% as the result of a bad pricing
strategy.
 CASE: PHILIP MORRIS

• Is there any evidence to determine whether this

decision by Philip Morris managers decreased
firm performance?
• We estimate the price elasticity of demand for
Philip Morris brands as revealed by the market
to be -0.694
• Demand is inelastic, so any drop in price should
surely decrease firm revenue.
• Total revenue decreased and total costs
increased so profit was destined to fall.
 PHILIP MORRIS

• The decline in total revenue from cigarette sales

in 1993 is attributed to Philip Morris’s cut in the
price of cigarettes. Are there other factors that
might have contributed to this decline in
revenue?
 FUNDING PUBLIC TRANSIT

• Given
• Price (fare) elasticity of demand for public transit in
the United States is about –0.3.
• All public transit systems in the United States lose
money.
• Public transit systems are funded by federal, state,
and local governments, all of which have budget
issues.
 FUNDING PUBLIC TRANSIT

• Which transit systems have the most difficult

time getting public funding?
• Revenue from sales will increase if fares are
increased, because demand is inelastic.
• Costs will likely decrease if fares are increased,
because quantity demanded (ridership) will fall.
• Managers of public transit will therefore increase fares
if they do not receive enough public funds to balance
their budgets.
 DETERMINANTS OF OWN-PRICE
ELASTICITY OF DEMAND

• Number and similarity of available substitutes

• Fact: A product with many close substitutes generally has elastic
demand.
• Product price relative to a consumer’s total budget
• Facts:
• Products for which the typical consumer spends only a very small fraction of her
income are quite elastic.
• Examples: Thimbles, rubber bands, salt
• Products that command a larger percentage of the consumer’s total budget tend
to be more price elastic.
• Examples: Kitchen appliances, automobiles
 OWN-PRICE ELASTICITY OF DEMAND

• Time Period Available for Adjustment to a Price Change

• Fact: For nondurable goods, demand is likely to be more elastic

over a long period relative to a short period.
• Rationale: The longer the time period, the easier it is for
consumers to substitute one good for another.
© 2013 W. W. Norton Co., Inc.
 STRATEGIC USE OF PRICE
ELASTICITY OF DEMAND
• Managers can change the price elasticity of demand
for their products.
• A Useful Tool: Product differentiation
• Differentiation strategies convince consumers the
product is unique; hence it has fewer substitutes.
• Caution: Differentiation is not effective if consumers
do not perceive it.

© 2013 W. W. Norton Co., Inc.

 THE STRATEGIC USE OF THE PRICE
ELASTICITY OF DEMAND

• Example: Strategic pricing of first class ( = –

0.45), regular economy ( = –1.30) and
excursion ( = –1.83) airline tickets between the
United States and Europe
• First class prices should be relatively high because
demand is inelastic.
• Regular economy and excursion prices should be
relatively low because demand is elastic.
© 2013 W. W. Norton Co., Inc.
 THE STRATEGIC USE OF PRICE
ELASTICITY OF DEMAND

• Example: Using differentiation strategies to

change the price elasticity of demand for a
product
• Differentiation strategies convince consumers that a
product is unique, and therefore has fewer
substitutes.
 THE STRATEGIC USE OF PRICE
ELASTICITY OF DEMAND

• Example (cont’d)
• If consumers perceive that a product has fewer
substitutes, then their price elasticity of demand for
the product will decrease (become less elastic) in
absolute value.
• Differentiation strategies do not require actual
differences in products, only a perceived difference.
 TOTAL REVENUE, MARGINAL REVENUE,
AND PRICE ELASTICITY

• A firm’s total revenue (TR) is equal to the total

amount of money consumers spend on the
product in a given time period.
• Linear demand curve: P = a – bQ
• Corresponding total revenue curve: TR = PQ = aQ –
bQ2
 TOTAL REVENUE, MARGINAL REVENUE,
AND PRICE ELASTICITY

• Marginal revenue: the incremental revenue

earned from selling the nth unit of output
• MR = TR/Q = ( aQ – bQ2)/Q = a – 2bQ
•  = (–1/b)[(a – bQ)/Q]
• If Q = a/2b, then  = -1
• If Q > a/2b, then  is inelastic
• If Q < a/2b, then  is elastic
 TOTAL REVENUE, MARGINAL REVENUE,
AND PRICE ELASTICITY

• Marginal revenue (cont’d)

• MR = TR/Q = (PQ)/Q = P(Q/Q) + Q(P/Q) =
P[1 + (Q/P)(P/Q)]
• But (Q/P)(P/Q)=1+ 
• Hence, MR = P(1 + 1/)
•  < -1 (elastic) implies MR > 0
•  > -1 (inelastic) implies MR < 0
•  = -1 (unitary) implies MR = 0
RELATIONSHIP BETWEEN PRICE ELASTICITY,
MARGINAL REVENUE, AND TOTAL REVENUE

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RELATIONSHIP BETWEEN PRICE ELASTICITY,
MARGINAL REVENUE, AND TOTAL REVENUE

Managerial Economics, 8e
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 ELASTICITY IN USE

• Suppose that a manufacturer sells a product through an upscale boutique

•  and, with a different brand name, through a discount retailer.
• The elasticity of demand at the boutique is -1.2, and at the discount retailer
it is -2.6.
• If the optimal price at the boutique is $85, what price () should be charged
at the discount retailer?
• The prices should be such that the marginal revenues are the same at the
boutique and the discount retailer
 ELASTICITY IN USE

• A consulting firm charges $250 per hour to Fortune 500 companies. The
•  estimated elasticity of demand for consulting services is -3.1.
• The firm is planning to spin off a subsidiary firm that will work with
smaller businesses. The estimated elasticity of demand for these firms is
-7.3.
• What price per hour (), to the nearest dollar, should be charged by the
subsidiary?
• Equating marginal revenues, we get

• Hence,
 THE INCOME ELASTICITY OF DEMAND

• Income elasticity of demand (I): the percentage

change in quantity demanded (Q) resulting from
a 1% change in consumers' income (I)
• Income can be defined as aggregate consumer
income or as per capita income, depending on
circumstances.
 THE INCOME ELASTICITY OF DEMAND

• Income elasticity of demand (cont’d)

• I > 0 for normal goods.
• On average, goods are normal, since increases in
aggregate income are associated with increases in
aggregate consumer spending.
• I < 0 for inferior goods.
 INCOME ELASTICITY OF DEMAND

• Strategic management and the income elasticity

of demand
• The demand for a product that has an income
elasticity of demand that is large in absolute value will
vary widely with changes in income caused by
economic growth and recessions.
 INCOME ELASTICITY OF DEMAND

• Strategic management (cont’d)

• Managers can lessen the impact of economic
changes on such products by limiting fixed costs so
that changes in production capacity can be made
quickly.
• Managers can forecast demand for products using
the income elasticity of demand combined with
forecasts of aggregate income.
© 2013 W. W. Norton Co., Inc.
 INCOME ELASTICITY OF DEMAND

•  

© 2013 W. W. Norton Co., Inc.

 INCOME ELASTICITY OF DEMAND

• If the income elasticity of demand for a product is unitary,

then a 1% change in income will change demand in the same
direction by 1%.
• If price remains constant, then spending on the product will
change by 1% and, consequently, spending on the product will
be the same percentage of income after the income change as
it was before.
• If the income elasticity of demand is greater than one, then
spending will increase as a percentage of income as income
increases.

© 2013 W. W. Norton Co., Inc.

 INCOME ELASTICITY OF DEMAND

• If it is less than one, spending will decrease as a percentage of

income as income increases.
• How do you think the percentage of income spent on jewelry,
food, clothing, housing, and automobiles responds to a 1%
increase in income?

© 2013 W. W. Norton Co., Inc.

 CROSS-PRICE ELASTICITIES OF DEMAND

• Cross-price elasticity of demand (XY): the

percentage change in quantity demanded of one
good (QX) resulting from a 1% change in the
price of a related good (PY)
CROSS-PRICE ELASTICITIES OF DEMAND

• Cross-price elasticity of demand (cont’d)

• XY > 0 if the two products are substitutes.
• Example: Wheat and corn
• XY < 0 if the two products are complements.
• Example: Computers and computer software
 CROSS-PRICE ELASTICITIES OF DEMAND

• Cross-price elasticity of demand (cont’d)

• XY = 0 if the two products are independent.
• Example: Butter and airline tickets
• Example: A linear demand function
• Given: QX = 1,000 – 0.2PX + 0.5PY + 0.04I, QX =
2,000, and PY = 500
• XY = 0.5(500/2000) = 0.125, so the two products
are substitutes.
 CROSS-PRICE ELASTICITIES OF DEMAND

• Strategic management
• Managers can use information about the cross-price
elasticity of demand to predict the effect of
competitors’ pricing strategies on the demand for their
product.
• Antitrust authorities use the cross-price elasticity of
demand to determine the likely effect of mergers on
the degree of competition in an industry.
 CROSS-PRICE ELASTICITIES OF DEMAND

• Strategic management
• Antitrust authorities (cont’d)
• A high cross-price elasticity, indicating that two goods
are strong substitutes, suggests that a merger would
significantly reduce competition in the industry.
• A low cross-price elasticity, indicating that two goods
are strong complements, suggests that a merger might
give the merged firm excessive control over the supply
chain.
 THE ADVERTISING ELASTICITY OF
DEMAND

• Advertising elasticity of demand (A): the

percentage change in quantity demanded (Q)
resulting from a 1 percent change in
advertising expenditure (A)
•
• Example Calculation
• Given: Q = 500 – 0.5P + 0.01I + 0.82A and A/Q = 2
• A = 0.82(2) = 1.64
© 2013 W. W. Norton Co., Inc.
THE CONSTANT-ELASTICITY AND UNITARY
ELASTIC DEMAND FUNCTION

• Constant-elasticity demand function:

Mathematical form of a demand function that always yields
that same elasticity, regardless of the product’s price and
consumers’ income and other factors that influence
demand
• Example: Q = 200P-0.3I2
• Price elasticity of demand = –0.3
• Income elasticity of demand = 2.0
 CONSTANT ELASTICITY DEMAND
FUNCTION

•  
THE CONSTANT-ELASTICITY AND UNITARY
ELASTIC DEMAND FUNCTION

• Unitary elastic demand function and total

revenue (TR)
• TR = PQ so if TR is constant, Q = (TR)(P-1)
• Price elasticity of demand = –1
• Graph: Rectangular hyperbola
DEMAND CURVE WITH UNITARY
ELASTICITY AT ALL POINTS

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 HOMEWORK

• Problems 1, 3, 4, 5, 9, 10