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Understanding Demand Elasticity for Better Market Decisions

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Learn about the importance of demand elasticity in market competition and pricing strategies. Explore different types of elasticity and their impact on consumer behavior and market dynamics. Develop a deeper understanding of demand responsiveness for informed business decisions.

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Understanding Demand Elasticity for Better Market Decisions

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  1. Chapter 6 Demand and Elasticity A high cross elasticity of demand [between two goods indicates that they] compete in the same market. [This can prevent a supplier of one of the products] from possessing monopoly power over price. DUPONT CELLOPHANE DECISION

  2. Elasticity: Measure of Responsiveness • Price Elasticity of demand • Ratio of • Percentage change in quantity demanded • To: percentage change in price • Responsiveness of quantity demanded • To price changes

  3. Figure 1 Hypothetical demand curves for film Df Ds b a B A Df Ds 0 0 1.5 3 4 4 10 10 $20 $20 Price per package Price per package Quantity demanded Quantity demanded (b) (a)

  4. Elasticity: Measure of Responsiveness • Demand – elastic • 10% rise in price • >10% drop in quantity demanded • Elasticity > 1 • Demand – inelastic • 10% rise in price • <10% drop in quantity demanded • Elasticity < 1

  5. Figure 2 Sensitivity of slope to units of measurement at Paul’s pizza parlor D D $16 $16 15 15 14 14 13 13 12 12 11 11 10 10 9 9 B B A A 8 8 7 7 Price per Pizza Price per Pizza D 6 6 5 5 D 4 4 0 0 2000 2000 2500 2500 3000 3000 500 500 1000 1000 1500 1500 3 3 2 2 Pizzas per week (a) Slices of Pizzas per week (b) 1 1 2880 2240 280 360

  6. Elasticity: Measure of Responsiveness • Elasticity formula • Each change: percentage change • Each percentage change • Average values (before & after) • Absolute value • Price elasticity of demand =

  7. Elasticity: Measure of Responsiveness • Perfectly elastic demand curve • Horizontal demand curve • Infinitely elastic • Perfectly inelastic demand curve • Vertical demand curve • Zero elasticity

  8. Figure 3 (a), (b) Demand curves with different elasticities D “Perfectly inelastic” demand curve “Perfectly elastic” demand curve D D D 0 0 90 Price $0.75 Price Quantity demanded Quantity demanded (a) (b)

  9. Elasticity: Measure of Responsiveness • Straight-lines demand curves • Slope – same • From left to right • Elasticity – smaller • Unit-elastic demand curves • Elasticity = 1 • 10% rise in price • 10% drop in quantity demanded

  10. Figure 3 (c), (d) Demand curves with different elasticities D D Straight-line demand curve A Unit-elastic demand curve B 4 C A’ U S T 10 D B’ 1 C’ D 3 0 0 4 7 5 2 20 U’ 7 14 $6 $30 Price Price Quantity demanded Quantity demanded (d) (c)

  11. Table 1 Estimates of price elasticities

  12. Total Revenue and Total Expenditure • Total revenue = PˣQ • Total expenditure = PˣQ • Effects of price decrease • Total revenue – decrease • Quantity – increase • Total revenue – increase

  13. Total Revenue and Total Expenditure • Increase in price • Demand – elastic • Total revenue - decrease • Demand – unit elastic • Total revenue – no change • Demand – inelastic • Total revenue – increase

  14. Figure 4 An elastic demand curve D 5 D 3 V U R T S W 2 1 4 0 $6 4 12 Quantity demanded Price

  15. What Determines Demand Elasticity? • Nature of good • Necessities – inelastic demand • Luxury goods – elastic demand • Availability of close substitutes • Close substitutes: demand – more elastic • No close substitutes: demand – inelastic • Narrowly defined: more elastic

  16. What Determines Demand Elasticity? • Share of consumer’s budget • Small – inelastic demand • Large – elastic demand • Passage of time • Short run – inelastic demand • Long run – elastic demand

  17. Elasticity as a General Concept • Income elasticity of demand • Ratio of • Percentage change in quantity demanded • To: percentage change in income • Price elasticity of supply • Ratio of • Percentage change in quantity supplied • To: percentage change in price

  18. Elasticity as a General Concept • Complements • Increase: quantity consumed of one good • Increase: quantity demanded of other good • Substitutes • Increase: quantity consumed of one good • Decrease: quantity demanded of other good

  19. Elasticity as a General Concept • Cross elasticity of demand for X • To change in price for Y • Ratio of: • Percentage change in quantity demanded of X • To: percentage change in price of Y • Positive • Substitutes • Negative • Complements

  20. Time Period of Demand Curve • Demand curve • During a particular time period • An optimal decision • Best serves objectives • Explicit or implicit comparison

  21. Time Period of Demand Curve • Demand curve • Set - hypothetical quantity responses • To: set - potential prices • Firm – can charge one price • All points on demand curve • Alternative possibilities • Same time period

  22. Application: Polaroid vs. Kodak • 1989, trial, U.S. district court • Judgment against Eastman-Kodak • Patent infringement of technology • Designed by Polaroid • 10-year period (1976-1986) • Amount of money Kodak owed Polaroid • Profit loss by Polaroid • Price elasticity of demand • Cross elasticity of demand

  23. Application: Polaroid vs. Kodak • Price elasticity of demand • Sales – increase (instant camera) • Fall in price • Kodak’s good reputation • Rise in consumer confidence • After 1980 • Sales of instant cameras - drop sharply • Price of conventional cameras - drop

  24. Application: Polaroid vs. Kodak • Cross elasticity of demand • Instant cameras • Conventional cameras • Elasticity calculations • Polaroid • $9 billion • Kodak • $450 million

  25. How can we find a legitimate demand curve from historical statistics? • Estimating demand curve statistically • Collect - set of figures • Prices • Quantities sold • Different periods • Plott points • Draw a line – demand curve

  26. Table 2 Historical data on price and quantity

  27. Figure 5 Plot of historical data on price and quantity T $8.20 8.00 7.80 7.60 Average Price 7.40 Feb. March May Jan. S R 7.20 April T 7.00 0 90 91 92 93 94 95 97 98 96 Quantity Demanded in thousands

  28. Demand curve from historical statistics • Problems • Different periods of time • Actual sales figures • Actual demand curve • May have shifted

  29. Figure 6 Plot of historical data and true demand curves for January, February, and March T $8.20 8.00 F 7.80 7.60 Average Price 7.40 M M F W March Feb. J Jan. S R 7.20 T 7.00 J 0 90 91 92 93 94 95 97 98 96 Quantity Demanded in thousands

  30. Illustration: Did the Advertising Program Work? • Historical data - Relationship • Quantity demanded always rose • As advertising rose • Too perfect • Advertising spending • Based on sales

  31. Legitimate demand curve from historical data • Demand for umbrellas • Price changes • Movement along • Amount of rainfall changes • Shift of demand • Data • Demand curve – no change • Supply curve – shifted

  32. Table 3

  33. Figure 7 Legitimate demand curve estimation from statistical data

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