Managerial Economics Week 3 (Aug. 19 to 25, 2024) PDF

Managerial Economics Demand Analysis and Elasticity Week 3 (Aug. 19 to 25, 2024) Demand Analysis and Elasticity I. Law of demand and determinants of demand. II. Price, income, and cross-price elasticities. III. Applications of elasticity in pricing and revenue management. I. Law of demand and dete...

Managerial Economics Demand Analysis and Elasticity Week 3 (Aug. 19 to 25, 2024) Demand Analysis and Elasticity I. Law of demand and determinants of demand. II. Price, income, and cross-price elasticities. III. Applications of elasticity in pricing and revenue management. I. Law of demand and determinants of demand. The law of demand is one of the most fundamental concepts in economics. Alongside the law of supply, it explains how market economies allocate resources and determine the prices of goods and services. The law of demand states that the quantity purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded. This occurs because of diminishing marginal utility. Consumers use the first units of an economic good they purchase to serve their most urgent needs first, then they use each additional unit of the good to serve successively lower-valued ends.  The law of demand is a fundamental principle of economics that states that at a higher price, consumers will demand a lower quantity of a good. Demand is derived from the law of diminishing marginal utility, the fact that consumers use economic goods to satisfy their most urgent needs first. A market demand curve expresses the sum of quantity demanded at each price across all consumers in the market. Changes in price can be reflected in movement along a demand curve, but by themselves, they don't increase or decrease demand. The shape and magnitude of demand shifts in response to changes in consumer preferences, incomes, or related economic goods, not usually to changes in price. Understanding the Law of Demand Economics involves the study of how people use limited means to satisfy unlimited wants. The law of demand focuses on those unlimited wants. Naturally, people prioritize more urgent wants and needs over less urgent ones in their economic behavior, and this carries over into how people choose among the limited means available to them. For any economic good, the first unit of that good that a consumer gets their hands on will tend to be used to satisfy the most urgent need the consumer has that that good can satisfy.  For example, consider a castaway on a desert island who obtains a six-pack of bottled fresh water that washes up onshore. The first bottle will be used to satisfy the castaway’s most urgently felt need, which is most likely drinking water to avoid dying of thirst. The second bottle might be used for bathing to stave off disease, an urgent but less immediate need. The third bottle could be used for a less urgent need, such as boiling some fish to have a hot meal, and on down to the last bottle, which the castaway uses for a relatively low priority, such as watering a small potted plant to feel less alone on the island. Because each additional bottle of water is used for a successively less highly valued want or need by our castaway, we can say that the castaway values each additional bottle less than the one before.  Similarly, when consumers purchase goods on the market, each additional unit of any given good or service that they buy will be put to a less valued use than the one before, so we can say that they value each additional unit less and less. Because they value each additional unit of the good less, they aren't willing to pay as much for it.  By adding up all the units of a good that consumers are willing to buy at any given price, we can describe a market demand curve, which is always sloping downward, like the one shown in the chart below. Each point on the curve (A, B, C) reflects the quantity demanded (Q) at a given price (P). At point A, for example, the quantity demanded is low (Q1) and the price is high (P1). At higher prices, consumers demand less of the good, and at lower prices, they demand more. Demand vs. Quantity Demanded In economic thinking, it is important to understand the difference between the phenomenon of demand and the quantity demanded. In the chart above, the term “demand” refers to the light blue line plotted through A, B, and C. It expresses the relationship between the urgency of consumer wants and the number of units of the economic good at hand. A change in demand means a shift of the position or shape of this curve; it reflects a change in the underlying pattern of consumer wants and needs vis-à-vis the means available to satisfy them.  On the other hand, the term “quantity demanded” refers to a point along the horizontal axis. Changes in the quantity demanded strictly reflect changes in the price, without implying any change in the pattern of consumer preferences. Changes in quantity demanded just mean movement along the demand curve itself because of a change in price. These two ideas are often conflated, but this is a common error—rising (or falling) prices don't decrease (or increase) demand; they change the quantity demanded. Factors Affecting Demand The shape and position of the demand curve can be affected by several factors. Rising incomes tend to increase demand for normal economic goods, as people are willing to spend more. The availability of close substitute products that compete with a given economic good will tend to reduce demand for that good because they can satisfy the same kinds of consumer wants and needs. Conversely, the availability of closely complementary goods will tend to increase demand for an economic good because the use of two goods together can be even more valuable to consumers than using them separately, like peanut butter and jelly.  Demand in terms of economics may be explained as the consumers’ willingness and ability to purchase or consume a given item/good. Furthermore, the determinants of demand go a long way in explaining the demand for a particular good. For instance, an increase in the price of a good will lead to a decrease in the quantity that may be demanded by consumers. Similarly, a decrease in the cost or selling price of a good will most likely lead to an increase in the demanded quantity of the goods.  This indicates the existence of an inverse relationship between the price of the article and the quantity demanded by consumers. This is commonly known as the law of demand and can be graphically represented by a line with a downward slope. The graphical representation is known as the demand curve. The determinants of demand are factors that cause fluctuations in the economic demand for a product or a service Determinants of Demand 1. Price of the Product People use price as a parameter to make decisions if all other factors remain constant or equal. According to the law of demand, this implies an increase in demand follows a reduction in price and a decrease in demand follows an increase in the price of similar goods. The demand curve and the demand schedule help determine the demand quantity at a price level. An elastic demand implies a robust change quantity accompanied by a change in price. Similarly, an inelastic demand implies that volume does not change much even when there is a change in price.  The law of demand states that when prices rise, the quantity of demand falls. This means that when prices drop, demand will grow. People base their purchasing decisions on price if all other things are equal. The exact quantity bought at each price level is described in the demand schedule. It's then plotted on a graph to show the demand curve. The demand curve shows the relationship between price and quantity only. If one of the other determinants changes, the entire demand curve shifts.  If the quantity demanded responds a lot to price, then it's known as elastic demand. If demand doesn't change much, regardless of price, that's inelastic demand. 2. Income of the Consumers Rising incomes lead to a rise in the number of goods demanded by consumers. Similarly, a drop in income is accompanied by reduced consumption levels. This relationship between income and demand is not linear in nature. Marginal utility determines the proportion of change in the demand levels. When income rises, so too will the quantity demanded. When income falls, so will demand. But if your income doubles, you won't always buy twice as much of a particular good or service. There are only so many pints of ice cream you'd want to buy, no matter how wealthy you are, and this is an example of marginal utility.  Marginal utility is the concept that each unit of a good or service is a little less useful to you than the first. At some point, you won’t want it anymore, and the marginal utility drops to zero. The first pint of ice cream tastes delicious. You might have another. But after that, the marginal utility starts to decrease to the point where you don't want any more. 3. Prices of related goods or services Complementary products – An increase in the price of one product will cause a decrease in the quantity demanded of a complementary product. Example: Rise in the price of bread will reduce the demand for butter. This arises because the products are complementary in nature. Substitute Product – An increase in the price of one product will cause an increase in the demand for a substitute product. Example: Rise in price of tea will increase the demand for coffee and decrease the demand for tea.  The prices of complementary goods or services raise the cost of using the product you demand, so you'll want less. For example, when gas prices rose to $4 a gallon in 2008, the demand for gas-guzzling trucks and SUVs fell. Gas is a complementary good to these vehicles. The cost of driving a truck rose along with gas prices. The opposite reaction occurs when the price of a substitute rises. When that happens, people will want more of the good or service and less of its substitute. That's why Apple continually innovates with its iPhones and iPods. As soon as a substitute, such as a new Android phone, appears at a lower price, Apple comes out with a better product. Then Android is no longer a substitute. 4. Consumer Expectations Expectations of a higher income or expecting an increase in prices of goods will lead to an increase the quantity demanded. Similarly, expectations of a reduced income or a lowering in prices of goods will decrease the quantity demanded.  When people expect that the value of something will rise, they demand more of it. That helps explain the housing asset bubble of 2005. Housing prices rose, but people kept buying houses because they expected the price to continue to increase. Prices continued increasing until the bubble burst in 2007. New home prices fell 22% from their peak of $262,200 in March 2007 to $204,200 in October 2010. However, the quantity demanded didn't increase—even as the price decreased—and sales fell from a peak of 1.2 million in 2005 to a low of 306,000 in 2011.  So why didn't the quantity demanded increase as the price fell? It's in part because the broader economy was experiencing a recession. People expected prices to continue falling, so they didn't feel an urgency to buy a home. Record levels of foreclosures entered the market due to the subprime mortgage crisis. Demand for homes didn't increase until people expected future home prices would, too. 5. Number of Buyers in the Market The number of buyers has a major effect on the total or net demand. As the number increases, the demand rises. Furthermore, this is true irrespective of changes in the price of commodities.  The number of consumers affects overall, or “aggregate,” demand. As more buyers enter the market, demand rises. That's true even if prices don't change. The U.S. saw this during the housing bubble of 2005. Low-cost and sub-prime mortgages increased the number of people who could afford a house. The total number of buyers in the market expanded. This increased demand for housing. When housing prices started to fall, many realized they couldn't afford their mortgages. At that point, they foreclosed. That reduced the number of buyers and drove down demand. Types of Demand Few important different types of demand are as follows: 1. Price demand: It refers to various types of quantities of goods or services that a customer will buy at a quoted price and given time, considering the other things remain constant. 2. Income demand: It refers to various types of quantities of goods or services that a customer will buy at different stages of income, considering the other things remain constant. 3. Cross demand: This means that the product’s demand does not depend on its own cost but depends on the cost of the other related commodities. 4. Direct demand: When goods or services satisfy an individual’s wants directly, it is known as direct demand. 5. Derived demand or Indirect demand: The goods or services demanded or needed for manufacturing the goods and satisfying the consumer indirectly is known as derived demand. 6. Joint demand: To produce a product there are many things that are related to each other, for example, to produce bread, we need services like an oven, fuel, flour mill, and more. So, the demand for other additional things to produce a product is known as joint demand. 7. Composite demand: A composite demand can be described when goods and services are utilised for more than one cause. Example: Coal II. Price, income, and cross-price elasticities. A) Understanding of price, income and cross elasticities of demand Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Income elasticity of measures the responsiveness of quantity demand to a change in income. Cross price elasticity of demand measures the responsiveness of quantity demanded for good A to the change in the price of good B. B) Use formulae to calculate price, income and cross elasticities of demand C) Interpret numerical values of Price elasticity of demand: unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic Income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic Cross elasticity of demand: substitutes, complementary and unrelated goods D) Factors influencing price elasticities of demand: The availability of substitutes – If there are lots of substitutes available to the consumer then the PED of the good is likely to be relatively elastic. This is due to the fact that if the price of the good increases then consumers can easily switch to another good that is now cheaper that preforms a similar function. For example, if the price of Coca cola increased then the percentage decrease in quantity demanded is likely to be greater than the percentage increase in price. This is because Coca Cola customers can easily switch their consumption to Pepsi as it is a similar product.  Percentage of income – The greater percentage of income that a good takes up, the more elastic demand for the good is likely to be. For example, a 10% increase in the price of bread is unlikely to have a big effect on demand. This is due to the fact that bread is a cheap product therefore although the price may have increased; the percentage of a person’s income that it takes up is still very small. If the price of a car increased by 10% then this is likely to have a much greater impact on demand. This is due to the fact that cars are very expensive and therefore a 10% increase in price will have a much bigger impact on the percentage of a person income that the good takes up. Overall this means that demand for cars is likely to be more inelastic.  Luxury or necessity – Luxury goods are not essential in achieving a basic standard of living for an individual. For example, designer clothes would not be considered essential. As a result of this, the price elasticity of demand for this product would be relatively elastic. If the price of the good increases then the consumer may change their consumption habits to exclude this good as they can do without it. However, this is in contrast to a necessity good such as bread/basic food which is essential for survival. As a result of this, an increase in the price of bread will have little impact on demand.  Time period – In the short run the price elasticity of demand for a good is likely to be relatively inelastic. This is due to the fact that consumers take time changing their consumption habit or do not notice the price change. In the long run the price elasticity for the good turns more elastic as consumers are given more time to change their consumption habits. Furthermore, they are more likely to notice the price difference in the long run and therefore are more likely to not buy the product in the future or reduce their consumption of the good. E) The significance of elasticities of demand to firms and government in terms of:  The imposition of indirect taxes and subsidies – The elasticity of the product is one of the main factors to consider when governments decide to implement indirect taxes and subsidies. This is due to the fact that the elasticity of the product has a massive effect on who takes the majority of the burden of the tax and the effectiveness of the tax in solving its objective. For example, taxes on de merit goods such as cigarettes are aimed at reducing the consumption of the good.  As shown on the diagram, an increase in the price of cigarettes (P-P1) reduces the demand for cigarettes from Q to Q1. Due to the fact that it is an addictive product it has a relatively price inelastic demand. The tax isn’t as effective as it would be for a product with a more price elastic demand. In addition to this, subsidising a product in order to increase consumption would only be effective if the demand for that product was relatively price elastic. This is because the increase in quantity demanded would be more than proportionate to the decrease in price. Only a small subsidy would have to be provided in order to have a big impact on consumption. III. Applications of elasticity in pricing and revenue management. Elasticity and Its Application You design websites for local businesses. You charge $200 per website and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?  These questions can be answered by using the concept of elasticity, which measures how much one variable responds to changes in another variable. In other words, elasticity measure how much buyers and sellers respond to changes in market conditions I. Price Elasticity of Demand 1. Definitions Price elasticity of demand measures how much QD responds to a change in P. Loosely speaking, it measures the price-sensitivity of buyers’ demand. Example: The price of ice cream rises by 10% and quantity demanded falls by 20%. Price elasticity of demand = (20%)/(10%) = 2 2. What Determines Price Elasticity? Availability of Close Substitutes Goods with close substitutes (e.g. breakfast cereal) tend to have more elastic demand because it is easier for consumers to switch. Necessities versus Luxuries Necessities (e.g. foods) tend to have inelastic demands, whereas luxuries (e.g. sailboat) have elastic demands. Definition of the Market Narrowly defined markets (e.g. blue jean) tend to have more elastic demand than broadly defined markets (e.g. cloth) because it is easier to find close substitutes for narrowly defined goods. Time Horizon Goods tend to have more elastic demand over longer time horizons (e.g. short-run versus long-run effect of increase in gasoline price on demand for gas). 3. Variety of Demand Curves Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves.… Perfectly inelastic Inelastic Unit elastic Elastic Perfectly elastic 1) Perfectly inelastic: regardless of the price, the quantity demanded stays the same (e.g. a life saving drug) 2) Inelastic: changes in price cause less proportional changes in quantity demanded 3) Unit elastic: changes in price cause equal proportional changes in quantity demanded 4) Elastic: changes in price cause more proportional changes in quantity demanded 5) Perfectly elastic: very small changes in the price lead to huge changes in the quantity demanded (e.g. money) 6) Elasticity of a Linear Demand Curve  The slope of a linear demand curve is constant, but its elasticity is not. Elasticity falls as you move downward along a linear demand curve. Pricing and Revenue Management Pricing is a factor that gears up profits in the supply chain through an appropriate match of supply and demand. Revenue management can be defined as the application of pricing to increase the profit produced from a limited supply of supply chain assets. Ideas from revenue management recommend that a company should first use pricing to maintain balance between the supply and demand and should think of further investing or eliminating assets only after the balance is maintained. Capacity assets in the supply chain are present for manufacturing, shipment, and storage while inventory assets are present within the supply chain and are carried to develop and improve product availability.  We can further define revenue management as the application of differential pricing on the basis of customer segment, time of use and product or capacity availability to increment supply chain surplus. Revenue management plays a major role in supply chain and has a share of credit in the profitability of supply chain when one or more of the following conditions exist. The product value differs in different market segments, highly perishable or product tends to be defective, demand has seasonal and other peaks and sold both in bulk and the spot market.  The strategy of revenue management has been successfully applied in many streams that we often tend to use but it is never noticed. For example, the finest real life application of revenue management can be seen in the airline, railway, hotel and resort, cruise ship, healthcare, printing and publishing. The main aim of revenue management is to maximize the number of profits you’re able to earn through market demand forecasting. Revenue management takes a qualitative approach to price and inventory. Performance Task #3