BUSINESS ECONOMICS

Sessions 2 & 3: DEMAND ANALYSIS II

2. 2.1 Post Work Learning Objectives In understanding how demand analysis can be the basis for firms decision making, the objectives of this session are: (i) (ii) (iii) to use elasticities as tools for managerial decision to understand demand revenue relationships at the firm level to relate demand factors to pricing decisions

2.2 2.2.1

Summary Impact of changes in demand factors Changes in demand factors influence the quantity demanded of a product. Elasticity assesses the responsiveness of quantity

demanded to a change in any demand factors. Elasticity is a unit less parameter defined in percentage terms. Price elasticity of demand (p) measures the responsiveness of quantity demanded to changes in prices. Based on the absolute

value of p , we differentiate between Price elastic ( p > 1) and Price inelastic ( p < 1) products. p is high for those products

where a number of substitutes are available. Long run p is higher than the short run p because of the possibilities of development of new substitutes. p is low for the products that account for a small share in the consumers budget.

Income elasticity of demand I measures the responsiveness of quantity demanded to changes in incomes of consumers. Based on the value of I, three categories of products are distinguished. These are : (i) > I > 1 (+) : Luxuries Necessities

(ii) 1 > I > 0 (+) : (iii) 0 > I - (-) :

Normal or Superior Goods

Inferior goods

Cross price elasticity of demand () measures the responsiveness of quantity demanded to changes in the prices of related products. Based on the value of , we distinguish between three types of

product relationships. These are : (i) > > 0 ( + ) : Substitutes (ii) ~ 0 : Unrelated (iii) 0 > > - (-) : Complementary goods

2.2.2

Demand Revenue Relationship Changes in prices influences the quantity demand and therefore the total revenues (TR) earned by a firm. Along the demand curve, as price decreases, TR initially increases and then declines. Marginal revenue (i.e. the incremental revenue for one additional unit of output sold) decreases and turns negative when TR is declining.

2.2.3

Demand Factors and Pricing Decisions

The above relationship between Price, TR and MR is a result of varying values of p along the demand curve. The p decreases as we move from left to right along the demand curve. The implications are two fold: high priced products are price elastic and vice-versa. decrease in prices for price elastic products leads to TR and vice- versa. The opposite holds true for low prices or price inelastic products

2. 3

Reading 1. Text Book: Chapter 4

2. 4 1.

Learning Activities The total operating revenues of a public transportation authority are $100 million while its total operating costs are $120 million. The price of a ride is $1, and the price elasticity of demand for public transportation has been estimated to be -0.4. By law, the public transportation authority must take steps to eliminate its operating deficit.

(a)

What pricing policy should the transportation authority adopt? Why? What price per ride must the public transportation authority charge to eliminate the deficit if it cannot reduce costs?

(b)

2.

A researcher estimated that the price elasticity of demand for automobiles in the United States is -1.2, while the income elasticity of demand is 3.0. Next year, U.S. automakers intend to increase the average price of

automobiles by 5 per cent, and they expect consumers disposable income to rise by 3 percent. (a) If sales of domestically produced automobiles are 8 million this year, how many automobiles do you expect U.S. automakers to sell next year? (b) By how much should domestic automakers increase the price of automobiles if they wish to increase sales by 5 per cent next year?