Lecture 1

MBA 8000
Managing in the Global Economy

Managerial Economics
Firms and Market Dynamics
Lecture 1
Demand (consumer theory)
Objective of the Lecture
• Explain the role of managers in controlling and predicting market
demand.
– Managers can influence demand by controlling, price,
advertising, and product quality (type).
Objective of the Lecture
– 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 other 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 Demand Curve
• The Law of Demand is the relationship between quantity
demanded and the price of a good or service.
• More generally demand is the solution to the problem of the
consumer.
– Maximize utility subject to a budget constrain
• Represents the willingness to pay for a good or service
The Market Demand Curve
• Horizontal Sum of individual demand curves
• 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 Y variable) is on the vertical and quantity demanded (the X
variable) is on the horizontal axis.
Demand Curve For Tablets
Managerial Economics, 8e
Copyright @ W.W. & Company 2013
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.
The Demand Curve
• Lets draw a demand curve.
• Why is it downward sloping?
– Another economic concept—diminishing marginal utility
• Determinants of demand:
– Movements along the demand curve
• Changes in own price
– Demand Shifters
• Influenced by you the manager
• Influenced by your competition
• Influenced by the environment
Determinants of Demand
• Influenced by you
– Advertisement
• Influenced by other managers (firms)

– Price of substitutes
– Price of complements
• Economic Environment
– Macroeconomics factors
– Taste of consumers
– Population
– Income
– Weather
Effect Of An Increased Preference On The Market Demand Curve For Tablets
Effect Of An Increase In Per Capita Income On
The Market Demand Curve For Tablets
Lets think about magnitudes
Gasoline prices tend to have little effect on demand for car travel
http://www.eia.gov/todayinenergy/detail.cfm?id=19191
The Own-price Elasticity Of Demand
• General”
– The elasticity of a function is the ratio of the percentage change in the
dependent (Y) variable to the percentage change in the independent (X)
variable.
• Own price elasticity
– The price elasticity of a demand function is the ratio of the percentage
change in quantity demanded to the percentage increase in price.
– Why go through all this trouble ?
– This measure is unit free
• Own-price elasticity of demand (cont’d)
– Equation:
How do we interpret this number
• Own-price elasticity of demand (cont’d)
• When |E| > 1, demand is elastic.
• When |E| < 1, demand is inelastic.
• When |E| = 1, demand is unitary.
Demand Curves Elasticities 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, E= –1, with E approaching zero as price
approaches zero.
• At prices above the midpoint, demand is elastic, with E 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
Relationship Between Total Revenue &
Elasticity (Intuition)
Lets draw
Relationship Between Price Elasticity, Marginal Revenue, And
Total Revenue
More Formally:
• Derivation of relationship between marginal revenue and the price
elasticity of demand
– TR = PQ
– dTR/dP = Q(dP/dP) + P(dQ/dP)
– (1/Q)(dTR/dP) = (dP/dP) + (P/Q)(dQ/dP)
– dTR/dP = Q(1 + E)
What does this mean
• Implications:
– If E= –1, dTR/dP = 0, so total revenue is at a
maximum and a change in P will have no effect on
total revenue.
– If E> –1 (inelastic), dTR/dP < 0, so an increase in P
(and consequent decrease in Q) will increase total
revenue.
– If E< –1 (elastic), dTR/dP > 0, so an increase in P
(and consequent decrease in Q) will decrease total
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
• Product price relative to a consumer’s total budget
• Time period available for adjustment to a price change
Some elasticities for food
https://www.cdfa.ca.gov/files/pdf/Demand&SupplyElasticityMajorCACrops.pdf
The Strategic Use Of Price
• Example: Strategic pricing of first class (E= –0.45), regular
economy (E= –1.30) and excursion (E= –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.
• 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.
• 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.
Income Elasticity Of Demand
• Income elasticity of demand: the ratio of the percentage change in
quantity demanded (Q) to the percentage 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)
– Ei > 0 for normal goods.
• On average, goods are normal, since increases in aggregate income are
associated with increases in aggregate consumer spending.
– Ei < 0 for inferior goods.
• 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.
• 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.
– Multi-output: firm can you diversify?
• Think about Unilever
Cross-price Elasticities Of Demand
• Cross-price elasticity of demand (EXY): the ratio of the percentage
change in quantity demanded of one good (QX) to the percentage
change in the price of a related good (PY)
• Cross-price elasticity of demand (cont’d)
– EXY > 0 if the two products are substitutes.
• Example: Wheat and corn
– EXY < 0 if the two products are complements.

• Example: Computers and computer software
• 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.
• United States v. Dupont
• 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 (EA): the ratio of the
percentage change in quantity demanded (Q) to the percentage
change in advertising expenditure (A)
We said Demand was a solution
• Demand comes from consumers making good decisions

• Formally: Rational behavior in economic terms: Consumers
maximize their well-being given their budget constraint.
• Need to allocate limited budgets: Consumer constraints
• Internal classification scheme: Consumer preference orderings
The Budget Line
– Example: For product Y = food with price Pf
measured on the vertical axis and product X =
clothing with price Pc measured on the
horizontal axis, and budget I, the budget line
is
• I = YPf + XPc
• Graphed as Y = I/Pf - (Pc/Pf)X
Example
• I=600
• Pf =3
• Pc=60
Budget Line
What Happens When Income Increases
FOOD PRICES Increase $3 AND $6 PER POUND
Indifference Curves
• Indifference curve: Contains points representing market
bundles among which the consumer is indifferent
– Utility refers to the happiness or satisfaction that a person
derives from consumption of a good or service.
– If two combinations of two goods yield the same level of utility,
and are hence equally desirable, then they are on the same
indifference curve.
Indifference Curves
• Assumption 1:
• More is preferred to less
• A consumer has many different indifference curves
• Indifference curves farther from the origin represent
higher levels of utility.
Indifference Curves
• Assumption 2:
• Consumers dislike extremes
• Every indifference curve must slope downward and to the
right, so long as the consumer prefers more of each
commodity to less.
• If a consumer loses some of one commodity, then in order to maintain a
constant level of utility, the consumer must get more of the other commodity.
Two Indifference Curves
• Indifference curves cannot intersect.
– It would imply that the same combination of two goods has two
different levels of utility.
– Don’t draw them like that
It’s A Contradiction
How much will you consume?
Food Prices Increase $3 And $6 Per Pound
Change In Price Equilibrium Market Bundle
Individual Demand Curve For Food
Deriving The Market Demand Curve
• The market demand curve is a summary of all the demand curves
of individual consumers for a good. It is obtained by horizontal
summation.
• Horizontal summation adds the quantities demanded by all
consumers at each market price.
• An increase (shift) in the number of consumers in a market will
cause market demand to increase.
© 2013 W. W. Norton Co., Inc.
Individual Demand Curves And
Market Demand Curve For Food
Deriving The Market
Demand Curve
• The market demand curve is the same as a firm’s
demand curve only in the case of monopoly, because
there is only one seller in the market.
• The market demand curve is not the same as a firm’s
demand curve if the firm is not a monopolist.
Exercise: What happens when income increases ?
Draw demand curve when income increases
Lets get technical: Why is demand a solution?
• Our intuitive proposed solution: choose the basket where the
indifference curve is tangent to the budget constrain.
• Or could also be stated: where the slope of the budget constrain
is equal to the slope of the indifference curve
• Turns out: the first order conditions of the consumer problem
lead to the same solution

Lecture 1

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MBA 8000

Managing in the Global Economy

• Influenced by other managers (firms)

– EXY < 0 if the two products are complements.

• Demand comes from consumers making good decisions

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