3-1

Quantitative Demand Analysis

 3-2

Overview
I. The Elasticity Concept

Own Price Elasticity

Elasticity and Total Revenue

Cross-Price Elasticity

Income Elasticity
II. Demand Functions

Linear

Log-Linear
III. Regression Analysis
 3-3

The Elasticity Concept

• How responsive is variable “G” to a change
in variable “S”
%G
EG , S 
%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-4

The Elasticity Concept Using

Calculus
• An alternative way to measure the elasticity
of a function G = f(S) is
dG S
EG , S 
dS G
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-5

Own Price Elasticity of

Demand
d
%QX
EQX , PX 
%PX
• Negative according to the “law of demand.”

Elastic: EQX , PX  1
Inelastic: EQ X , PX  1

Unitary: EQX , PX  1
 3-6

Perfectly Elastic &

Inelastic Demand
Price Price
D

Quantity Quantity

Perfectly Elastic ( EQ X ,PX   ) Perfectly Inelastic ( EQX , PX  0)

 3-7

Own-Price Elasticity
and Total Revenue
• Elastic

Increase (a decrease) in price leads to a decrease (an
increase) in total revenue.
• Inelastic

Increase (a decrease) in price leads to an increase (a
decrease) in total revenue.
• Unitary

Total revenue is maximized at the point where demand is
unitary elastic.
 3-8

Elasticity, Total Revenue and Linear

Demand
P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-9

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-10

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-11

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-12

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-13

Elasticity, Total Revenue and Linear

Demand
P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 3-14

Elasticity, Total Revenue and Linear

Demand
P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-15

Elasticity, Total Revenue and Linear

Demand
P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-16

Demand, Marginal Revenue (MR)

and Elasticity
P • For a linear inverse
100
Elastic
demand function,
80 Unit elastic MR(Q) = a + 2bQ,
60
where b < 0.
Inelastic • When
40 
MR > 0, demand is
20
elastic;

MR = 0, demand is unit
elastic;
0 10 20 40 50 Q 
MR < 0, demand is
inelastic.
MR
 Factors Affecting 3-17

Own Price Elasticity


Available Substitutes
• The more substitutes available for the good, the more elastic
the demand.

Time
• Demand tends to be more inelastic in the short term than in
the long term.
• Time allows consumers to seek out available substitutes.

Expenditure Share
• Goods that comprise a small share of consumer’s budgets
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.
 3-18

Cross Price Elasticity of

Demand
d
%QX
EQX , PY 
%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQ < 0, then X and Y are complements.

X,PY
 3-19

Predicting Revenue Changes

from Two Products
Suppose that a firm sells to related goods. If the price of
X changes, then total revenue will change by:

  
R  RX 1  EQX , PX  RY EQY , PX  %PX 
 3-20

Income Elasticity

d
%QX
EQX , M 
%M

If EQ > 0, then X is a normal good.

X,M

If EQX,M < 0, then X is a inferior good.

 3-21

Uses of Elasticities
• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and recessions.
• Impact of advertising campaigns.
• And lots more!
 3-22
Example 1: Pricing and Cash
Flows
• According to an FTC Report by Michael
Ward, AT&T’s own price elasticity of
demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to
meet it’s marketing goals.
• To accomplish this goal, should AT&T
raise or lower it’s price?
 3-23

Answer: Lower price!

• Since demand is elastic, a reduction in price
will increase quantity demanded by a
greater percentage than the price decline,
resulting in more revenues for AT&T.
 3-24

Example 2: Quantifying the

Change
• If AT&T lowered price by 3 percent, what
would happen to the volume of long
distance telephone calls routed through
AT&T?
 3-25

Answer
• Calls would increase by 25.92 percent!
d
%QX
EQX , PX  8.64 
%PX
d
%QX
 8.64 
 3%
 3%    8.64   %QX
d

d
%QX  25.92%
 3-26

Example 3: Impact of a change

in a competitor’s price
• According to an FTC Report by Michael
Ward, AT&T’s cross price elasticity of
demand for long distance services is 9.06.
• If competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?
 3-27

Answer
• AT&T’s demand would fall by 36.24 percent!

d
%QX
EQX , PY  9.06 
%PY
d
% Q X
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%
 3-28

Interpreting Demand Functions

• Mathematical representations of demand curves.
• Example:
d
QX  10  2 PX  3PY  2 M

Law of demand holds (coefficient of PX is negative).

X and Y are substitutes (coefficient of PY is positive).

X is an inferior good (coefficient of M is negative).
 3-29

Linear Demand Functions and

Elasticities
• General Linear Demand Function and Elasticities:

QX   0   X PX   Y PY   M M   H H
d

P PY M
EQX , PX   X X EQX , PY  Y EQX , M   M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
 3-30

Example of Linear Demand

• Qd = 10 - 2P.
• Own-Price Elasticity: (-2)P/Q.
• If P=1, Q=8 (since 10 - 2 = 8).
• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
 3-31

Log-Linear Demand
• General Log-Linear Demand Function:

ln Q X d   0   X ln PX  Y ln PY   M ln M   H ln H

Own Price Elasticity : X

Cross Price Elasticity :  Y
Income Elasticity : M
 3-32

Example of Log-Linear
Demand
• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.
 Graphical Representation of
3-33

Linear and Log-Linear Demand

P P

D D

Q Q
Linear Log Linear
 3-34

Conclusion
• Elasticities are tools you can use to quantify
the impact of changes in prices, income,
and advertising on sales and revenues.
• Managers can quantify the impact of
changes in prices, income, advertising, etc.