DETERMINANTS OF DEMAND
A firm’s quantity of sales depends
on multiple economic factors.
For instance, an airline’s seat demand
might be described by the equation:
Q = 25 + 3Y + P – 2P.
Here, demand depends on:
customer income (Y),
the rival’s price (P),
and the airline’s price (P).
Chapter 3
slide 1
3.2
SHIFTS IN DEMAND
Any change in the firm’s own price
shows up as a movement along the
firm’s demand curve.
A change in any other variable
constitutes a shift in the position
of the demand curve
For instance, an increase in a
competitor’s price would cause
a favorable demand shift as shown.
ELASTICITY OF DEMAND
How Responsive are Sales to Changes in Price?
The Concept of Elasticity Supplies the Answer.
EP = [% Change Q]/[% Change P] = [Q/Q]/[P/P].
Example: P0 = 100 & Q0 = 1200
P1 = 110 & Q1 = 1160
EP = [(1160 – 1200)/1200]/[(110 – 100)/100]
= -3.33%/10%
= -.333.
3.3
PROPERTIES OF ELASTICITY
3.4
Elasticity Varies along
a Linear Demand Curve.
Unitary Elastic: EP = -1
Inelastic: -1 < EP < 0
Elastic: - < EP < -1
400
300
= (-4)(100/1200) = -.333 B
Demand is
Elastic
A
= (-4)(300/400) =
-3
A
Q = 1600 - 4P
EP = -1
200
100
EP = (Q/P)(P/Q)
B Demand is
Inelastic
MR
MR = 0
400
800
1200
1600
3.5
USING ELASTICITY
Other Elasticities:
Income Elasticity:
EY = (% change Q)/(% change Y)
Cross Price Elasticity:
EP = (% change Q)/(% change P)
Necessities: 0 < EY < 1
Discretionary: EY > 1
Predicting Sales:
Q/Q = (EP)(P/P) + (EY)(Y/Y) + (EP)(P/P) .
3.6
USING ELASTICITY
Maximizing Profit and Revenue in
Pure Selling Problems (MC = 0).
Optimal Solution: MR = 0
or equivalently: EP = -1.
Examples:
Selling Software
Selling a CD
Revenue
Utilizing a Sports Stadium
With high demand, price to fill stadium.
With low demand, do not cut price
to fill stadium.
Capacity
3.7
OPTIMAL PRICING
1. The Markup Rule
[P - MC]/P = -1/EP
or P = [EP /(1+ EP )] MC
2. Price Discrimination
MC = 100
EP
P
-2
-3
-4
-6
200
150
133
120
Apply Markup rule to separate
segments. More inelastic segments
get the higher markups (over common MC).
Equivalently, Set MR1 = MR2 = MC.
MAXIMIZING REVENUE W/
LIMITED CAPACITY
Airline Yield Management:
Maximizing Revenue utilizing
Business Class and Economy Class seats.
The key is to set: MRB = MRE.
Example: Airline has 180 seats and faces demand:
PB = 330 – QB and PE = 250 – QE. Therefore,
MRB = 330 - 2QB = MRE = 250 – 2QE.
We also know that: QB + QE = 180.
The solution to these simultaneous equations is:
QB = 110 seats and QE = 70 seats.
In turn, PB = $220 and PE = $180.
3.8