CHAPTER FOUR

DEMAND AND DEMAND FORECASTING

DEMAND SENSITIVITY ANALYSIS: ELASTICITY
For constructive managerial decision making, the firm must know the sensitivity or
responsiveness of demand to changes in factors that make up the underlying demand function.
The Elasticity Concept
One measure of responsiveness employed not only in demand analysis but throughout
managerial decision making is elasticity, defined as the percentage change in a dependent
variable, Y, resulting from a 1 percent change in the value of an independent variable, X. The
equation for calculating elasticity is

The concept of elasticity simply involves the percentage change in one variable associated with a
given percentage change in another variable. In addition to being used in demand analysis, the
concept is used in finance, where the impact of changes in sales on earnings under different
production levels (operating leverage) and different financial structures (financial leverage) are
measured by an elasticity factor. Elasticity are also used in production and cost analysis to
evaluate the effects of changes in input on output as well as the effects of output changes on
costs.
Factors such as price and advertising that are within the control of the firm are called
endogenous variables. It is important that management know the effects of altering these
variables when making decisions. Other important factors outside the control of the firm, such as
consumer incomes, competitor prices, and the weather, are called exogenous variables.
The effects of changes in both types of influences must be understood if the firm is to respond
effectively to changes in the economic environment. For example, a firm must understand the
effects on demand of changes in both prices and consumer incomes to determine the price cut
necessary to offset a decline in sales caused by a business recession (fall in income). Similarly,
the sensitivity of demand to changes in advertising must be quantified if the firm is to respond
appropriately with price or advertising changes to an increase in competitor advertising.
Determining the effects of changes in both controllable and uncontrollable influences on demand
is the focus of demand analysis.
Point Elasticity and Arc Elasticity
Elasticity can be measured in two different ways, point elasticity and arc elasticity. Point
elasticity measures elasticity at a given point on a function. The point elasticity concept is used
to measure the effect on a dependent variable Y of a very small or marginal change in an
independent variable X. Although the point elasticity concept can often give accurate estimates
of the effect on Y of very small (less than 5 percent) changes in X, it is not used to measure the
effect on Y of large-scale changes, because elasticity typically varies at different points along a
function. To assess the effects of large-scale changes in X, the arc elasticity concept is employed.
Arc elasticity measures the average elasticity over a given range of a function.
Using the lowercase epsilon as the symbol for point elasticity, the point elasticity formula is
Written:

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Advertising Elasticity Example
An example can be used to illustrate the calculation and use of a point elasticity estimate.
Assume that management is interested in analyzing the responsiveness of movie ticket demand
to changes in advertising for the Empire State Cinema, a regional chain of movie theaters. Also
assume that analysis of monthly data for six outlets covering the past year suggests the following
demand function:
Q = 8,500 – 5,000P + 3,500PV + 150I + 1,000A
where Q is the quantity of movie tickets, P is average ticket price (in dollars), PV is the 3-day
movie rental price at video outlets in the area (in dollars), I is average disposable income per
household (in thousands of dollars), and A is monthly advertising expenditures (in thousands of
dollars). (Note that I and A are expressed in thousands of dollars in this demand function.)
For a typical theater, P = $7, PV = $3, and income and advertising are $40,000 and $20,000,
respectively. The demand for movie tickets at a typical theater can be estimated as
Q = 8,500 – 5,000(7) + 3,500(3) + 150(40) + 1,000(20)
= 10,000
The numbers that appear before each variable in the above Equation are called coefficients or
parameter estimates. They indicate the expected change in movie ticket sales associated with a
one-unit change in each relevant variable. For example, the number 5,000 indicates that the
quantity of movie tickets demanded falls by 5,000 units with every $1 increase in the price of
movie tickets,or ΔQ/ΔP = –5,000. Similarly, a $1 increase in the price of videocassette rentals
causes a 3,500-unit increase in movie ticket demand, or ΔQ/ΔPV = 3,500; a $1,000 (one-unit)
increase in disposable income per household leads to a 150-unit increase in demand. In terms of
advertising, the expected change in demand following a one-unit ($1,000) change in advertising,
or ΔQ/ΔA, is1,000. With advertising expenditures of $20,000, the point advertising elasticity at
the 10,000-unit demand level is:

Thus, a 1 percent change in advertising expenditures results in a 2 percent change in movie ticket
demand. This elasticity is positive, indicating a direct relation between advertising outlays
decrease in advertising leads to lower demand.
For many business decisions, managers are concerned with the impact of substantial changes in a
demand-determining factor, such as advertising, rather than with the impact of very small

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(marginal) changes. In these instances, the point elasticity concept suffers a conceptual
shortcoming.
To see the nature of the problem, consider the calculation of the advertising elasticity of demand
for movie tickets as advertising increases from $20,000 to $50,000. Assume that all other
demand-influencing variables retain their previous values. With advertising at $20,000, demand
is 10,000 units. Changing advertising to $50,000 (A= 30) results in a 30,000-unit increase in
movie ticket demand, so total demand at that level is 40,000 tickets. Using the above Equation to
calculate the advertising point elasticity for the change in advertising from $20,000 to $50,000
indicates that:

The advertising point elasticity is EA = 2, just as that found previously. Consider, however, the
indicated elasticity if one moves in the opposite direction—that is, if advertising is decreased
from $50,000 to $20,000. The indicated elasticity point is

The indicated elasticity EA = 1.25 is now quite different. This problem occurs because
elasticities are not typically constant but vary at different points along a given demand function.
The advertising elasticity of 1.25 is the advertising point elasticity when advertising expenditures
are $50,000 and the quantity demanded is 40,000 tickets. To overcome the problem of changing
elasticities along a demand function, the arc elasticity formula was developed to calculate an
average elasticity for incremental as opposed to marginal changes. The arc elasticity formula is

Problem 1. Suppose that the price elasticity of demand for a product is -2. If the price of this
product fell by 5%, by what percentage would the quantity demanded for a product change?
Problem 2. Suppose that the price and quantity demanded for a good are $5 and 20 units,
respectively. Suppose further that the price of the product increases to $20 and the quantity
demanded falls to 5 units. Calculate the price elasticity of demand.
Problem 3. At a price of $25, the quantity demanded of good X is 500 units. Suppose that the
price elasticity of demand is -1.85. If the price of the good increases to $26, what will be the new
quantity demanded of this good?
PRICE ELASTICITY OF DEMAND
The most widely used elasticity measure is the price elasticity of demand, which measures the
responsiveness of the quantity demanded to changes in the price of the product, holding constant
the values of all other variables in the demand function.
Price Elasticity Formula
Using the formula for point elasticity, price elasticity of demand is found as:

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 Or, for a small change,

Problem 4. The demand equation for a product is QD = 50 - 2.25P. Calculate the point-price
elasticity of demand if P = 2.
Solution:

Problem 5. Suppose that the demand equation for a product is QD = 100 - 5P. If the price
elasticity of demand is -1, what are the corresponding price and quantity demanded?
Solution:

PRICE ELASTICITY OF DEMAND: SOME DEFINITIONS

1. ELASTIC DEMAND
Demand is said to be price elastic if |ep| >1 (-∞< ep <1), that is, /%dQd| > /%dP|. Suppose, for
example, that a 2% increase in price leads to a 4%decline in quantity demanded. By definition, |
ep| = 4/2 = 2 >1. In this case,the demand for the commodity is said to be price elastic.
2. INELASTIC DEMAND
Demand is said to be price inelastic if |ep| <1 (-1 < ep <0), that is, |%dQD| < |%dP|. Suppose, for
example, that a 2% increase in price leads to a 1%decline in quantity demanded. By definition, |
ep| = 1/2 = 0.5 <1. In this case,the demand for the commodity is said to be price inelastic.
3. UNIT ELASTIC DEMAND
Demand is said to be unit elastic if |ep| = 1 (ep = -1), that is, |%dQD| = |%dP|. Suppose, for
example, that a 2% increase in price leads to a 2%decline in quantity demanded. By definition, |
ep| = 2/2 = 1. In this case, the demand for the commodity is said to be unit elastic.

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Price Elasticity and Total Revenue
One of the most important features of price elasticity is that it provides a useful summary
measure of the effect of a price change on revenues. Depending on the degree of price elasticity,
a reduction in price can increase, decrease, or leave total revenue unchanged. A good estimate of
price elasticity makes it possible to accurately estimate the effect of price changes on total
revenue.

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PRICE ELASTICITY AND OPTIMAL PRICING POLICY
Firms use price discounts, specials, coupons, and rebate programs to measure the price
sensitivity of demand for their products. Armed with such knowledge, and detailed unit cost
information, firms have all the tools necessary for setting optimal prices.
Optimal Price Formula
As a practical matter, firms devote enormous resources to obtain current and detailed information
concerning the price elasticity of demand for their products. Price elasticity estimates represent
vital information because these data, along with relevant unit cost information, are essential
inputs for setting a pricing policy that is consistent with value maximization. This stems from the
fact that there is a relatively simple mathematical relation between marginal revenue, price, and
the point price elasticity of demand.
Given any point price elasticity estimate, relevant marginal revenues can be determined easily.
When this marginal revenue information is combined with pertinent marginal cost data, the basis
for an optimal pricing policy is created. The relation between marginal revenue, price, and the
point price elasticity of demand follows directly from the mathematical definition of a marginal
relation. In equation form, the link between marginal revenue, price, and the point price elasticity
of demand is

Because EP < 0, the number contained within brackets in the above equation is always less than
one. This means that MR<P, and the gap between MR and P will fall as the price elasticity of
demand increases (in absolute value terms). For example, when P = $8 and EP = –1.5, MR =
$2.67. Thus, when price elasticity is relatively low, the optimal price is much greater than
marginal revenue. Conversely, when P = $8 and EP = –10, MR = $7.20. When the quantity
demanded is highly elastic with respect to price, the optimal price is close to marginal revenue.

Optimal Pricing Policy Example

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The simple relation between marginal revenue, price, and the point price elasticity is very useful
in the setting of pricing policy. To see the usefulness of the above Equation in practical pricing
policy, consider the pricing problem faced by a profit-maximizing firm. Recall that profit
maximization requires operating at the activity level where marginal cost equals marginal
revenue. Most firms have extensive cost information and can estimate marginal cost reasonably
well. By equating marginal costs with marginal revenue as identified by the above Equation, the
profit-maximizing price level can be easily determined. Using the above Equation, set marginal
cost equal to marginal revenue, where
MC = MR
and, therefore,

which implies that the optimal or profit-maximizing price, P*, equals

This simple relation between price, marginal cost, and the point price elasticity of demand is the
most useful pricing tool offered by managerial economics.

To illustrate the usefulness of the above Equation, suppose that manager ABC notes a 2
percent increase in weekly sales following a 1 percent price discount on its product. The
point price elasticity of demand for the product is

What is the optimal retail price for this product if the company’s wholesale cost per unit plus
display and marketing expenses—or relevant marginal costs—total $25 per unit? With marginal
costs of $25 and _P = –2, the profit-maximizing price is

Therefore, the profit-maximizing price on is $50.

FACTORS AFFECTING THE OWN PRICE ELASTICITY

Now that you understand what the own price elasticity is and how it can be used to assess the
impact of price changes on sales volume and revenues, we will discuss three factors that affect
the magnitude of the own price elasticity of a good: available substitutes, time, and expenditure
share.
Available Substitutes
One key determinant of the elasticity of demand for a good is the number of close substitutes
for that good. Intuitively, the more substitutes available for the good, the more elastic the

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demand for it. In these circumstances, a price increase leads consumers to substitute toward
another product, thus reducing considerably the quantity demanded of the good. When there are
few close substitutes for a good, demand tends to be relatively inelastic. This is because
consumers cannot readily switch to a close substitute when the price increases.
A key implication of the effect of the number of close substitutes on the elasticity of demand is
that the demand for broadly defined commodities tends to be more inelastic than the demand for
specific commodities. For example, the demand for food (a broad commodity) is more inelastic
than the demand for beef. Short of starvation, there are no close substitutes for food, and thus the
quantity demanded of food is much less sensitive to price changes than is a particular type of
food, such as beef. When the price of beef increases, consumers can substitute toward other types
of food, including chicken, pork, and fish. Thus, the demand for beef is more elastic than the
demand for food.
Finally, consider the reported estimates of the own price elasticities for motorcycles and
bicycles, motor vehicles, and transportation. Transportation is the most broadly defined group,
followed by motor vehicles and then motorcycles and bicycles. Therefore, we would expect the
demand for motorcycles and bicycles to be more elastic than the demand for motor vehicles and
the demand for motor vehicles to be more elastic than the demand for transportation.
Time
Demand tends to be more inelastic in the short term than in the long term. The more time
consumers have to react to a price change, the more elastic the demand for the good.
Conceptually, time allows the consumer to seek out available substitutes. For example, if a
consumer has 30 minutes to catch a flight, he or she is much less sensitive to the price charged
for a taxi ride to the airport than would be the case if the flight were several hours later. Given
enough time, the consumer can seek alternative modes of transportation such as a bus, a friend’s
car, or even on foot. But in the short term, the consumer does not have time to seek out the
available substitutes, and the demand for taxi rides is more inelastic.
Expenditure Share
Goods that comprise a relatively small share of consumers’ budgets tend to be more inelastic
than goods for which consumers spend a sizable portion of their incomes. In the extreme case,
where a consumer spends her or his entire budget on a good, the consumer must decrease
consumption when the price rises. In essence, there is nothing to give up but the good itself.
When a good comprises only a small portion of the budget, the consumer can reduce the
consumption of other goods when the price of the good increases. For example, most consumers
spend very little on salt; a small increase in the price of salt would reduce quantity demanded
very little, since salt constitutes a small fraction of consumers’ total budgets.
CROSS-PRICE ELASTICITY OF DEMAND
Demand for most products is influenced by prices for other products. Such demand
interrelationships are an important consideration in demand analysis and estimation.
Substitutes and Complements
In general, a direct relation between the price of one product and the demand for a second
product holds for all substitutes. A price increase for a given product will increase demand for
substitutes;
a price decrease for a given product will decrease demand for substitutes. Goods that are
inversely related in this manner are known as complements; they are used together rather than in
place of each other.

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The concept of cross-price elasticity is used to examine the responsiveness of demand for one
product to changes in the price of another. Point cross-price elasticity is given by the following
equation:

where Y and X are two different products. The arc cross-price elasticity relationship is
constructed in the same manner as was previously described for price elasticity:

The cross-price elasticity for substitutes is always positive; the price of one good and the demand
for the other always move in the same direction. Cross-price elasticity is negative for
complements; price and quantity move in opposite directions for complementary goods and
services. Finally, cross-price elasticity is zero, or nearly zero, for unrelated goods in which
variations in the price of one good have no effect on demand for the second.

Example: Given the following demand function:

QY = 25,000 – 5PY – 3PD + 10PH + 0.0001PT – 0.02i + 2.5I

Here, QY is the number of patient days of service per year; PY is the average price; PD is an
industry price index for prescription drugs; PH is an index of the average price of hospital
service, a primary competitor; PT is a price index for the travel industry; iis the interest rate; and
I is disposable income per capita.
The effects on QY caused by a one-unit change in the prices of other goods are:

Example 2:
Surgical Systems, Inc., makes a proprietary line of disposable surgical stapling instruments. The
company grew rapidly during the 1990s as surgical stapling procedures continued to gain wider
hospital acceptance as an alternative to manual suturing. However, price competition in the
medical supplies industry is growing rapidly in the increasingly price conscious new millennium.
During the past year, Surgical Systems sold 6 million units at a price of $14.50, for total

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revenues of $87 million. During the current term, Surgical Systems’ unit sales have fallen from 6
million units to 3.6 million units following a competitor price cut from $13.95 to $10.85 per unit.
A. Calculate the arc cross-price elasticity of demand for Surgical Systems’ products.
B. Surgical Systems’ director of marketing projects that unit sales will recover from 3.6
million units to 4.8 million units if Surgical Systems reduces its own price from $14.50 to
$13.50 per unit. Calculate Surgical Systems’ implied arc price elasticity of demand.
C. Assuming the same implied arc price elasticity of demand calculated in part B, determine
the further price reduction necessary for Surgical Systems to fully recover lost sales (i.e.,
regain a volume of 6 million units).
Solution:

INCOME ELASTICITY OF DEMAND

For many goods, income is another important determinant of demand. Income is frequently as
important as price, advertising expenditures, credit terms, or any other variable in the demand
function. This is particularly true of luxury items such as big screen televisions, elegant homes,
and so on. In contrast, the demand for such basic commodities as salt, bread, and milk is not very
responsive to income changes. These goods are bought in fairly constant amounts regardless of

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changes in income. Of course, income can be measured in many ways—for example, on a per
capita, per household, or aggregate basis.
Gross national product, national income, personal income, and disposable personal income have
all served as income measures in demand studies.
Normal Versus Inferior Goods
The income elasticity of demand measures the responsiveness of demand to changes in
income, holding constant the effect of all other variables that influence demand. Letting I
represent income, income point elasticity is defined as:

Solved Exercise

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EXERCISES FOR CLASS DISCUSSION
EXERCISE ONE

EXERCISE 2

EXERCISE 3

EXERCISE FOUR

CHAPTER EXCERCISES
1. The demand for personal computers can be characterized by the following point elasticities:
price elasticity = –5, cross-price elasticity with software = –4, and income elasticity =2.5.
Indicate whether each of the following statements is true or false, and explain your answer.
A. A price reduction for personal computers will increase both the number of units
demanded and the total revenue of sellers.
B. The cross-price elasticity indicates that a 5% reduction in the price of personal
computers will cause a 20% increase in software demand.
C. Demand for personal computers is price elastic and computers are cyclical normal
goods.
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 D. Falling software prices will increase revenues received by sellers of both computers and
software.
E. A2% price reduction would be necessary to overcome the effects of a 1% decline in
income.
2. In an effort to reduce excess end-of-the-model-year inventory, Harrison Ford offered a 2.5%
discount off the average list price of Focus SE sedans sold during the month of August.
Customer response was enthusiastic, with unit sales rising by 10% over the previous month’s
level.
A. Calculate the point price elasticity of demand for Harrison Ford Focus SE sedans.
B. Calculate the profit-maximizing price per unit if Harrison Ford has an average
wholesale cost of $10,000 and incurs marginal selling costs of $875 per unit.
3. Kitty Russell’s Longbranch Cafe in Sausalito recently reduced Nachos Supreme appetizer
prices from $5 to $3 for afternoon “early bird” customers and enjoyed a resulting increase in
sales from 60 to 180 orders per day. Beverage sales also increased from 30 to 150 units per
day.
A. Calculate the arc price elasticity of demand for Nachos Supreme appetizers.
B. Calculate the arc cross-price elasticity of demand between beverage sales and
appetizer prices.
C. Holding all else equal, would you expect an additional appetizer price decrease to
$2.50 to cause both appetizer and beverage revenues to rise? Explain.
4. Ironside Industries, Inc., is a leading manufacturer of tufted carpeting under the Ironside
brand. Demand for Ironside’s products is closely tied to the overall pace of building and
remodeling activity and, therefore, is highly sensitive to changes in national income. The
carpet manufacturing industry is highly competitive, so Ironside’s demand is also very price
sensitive. During the past year, Ironside sold 15 million square yards (units) of carpeting at
an average wholesale price of $7.75 per unit. This year, income per capita is expected to
surge from $17,250 to $18,750 as the nation recovers from a steep recession. Without any
price change, Ironside’s marketing director expects current-year sales to rise to 25 million
units.
A. Calculate the implied income arc elasticity of demand.
B. Given the projected rise in income, the marketing director believes that the
current volume of 15 million units could be maintained despite an increase in
price of 50¢ per unit. On this basis, calculate the implied arc price elasticity of
demand.
C. Holding all else equal, would a further increase in price result in higher or lower
total revenue?
5. B. B. Lean is a catalog retailer of a wide variety of sporting goods and recreational products.
Although the market response to the company’s spring catalog was generally good, sales of
B. B. Lean’s $140 deluxe garment bag declined from 10,000 to 4,800 units. During this
period, a competitor offered a whopping $52 off their regular $137 price on deluxe garment
bags.
A. Calculate the arc cross-price elasticity of demand for B. B. Lean’s deluxe garment bag.
B. B. B. Lean’s deluxe garment bag sales recovered from 4,800 units to 6,000 units
following a price reduction to $130 per unit. Calculate B. B. Lean’s arc price elasticity
of demand for this product.

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 C. Assuming the same arc price elasticity of demand calculated in part B, determine the
further price reduction necessary for B. B. Lean to fully recover lost sales (i.e., regain a
volume of 10,000 units).
6. Enchantment Cosmetics, Inc., offers a line of cosmetic and perfume products marketed
through leading department stores. Product manager Erica Kane recently raised the suggested
retail price on a popular line of mascara products from $9 to $12 following increases in the
costs of labor and materials. Unfortunately, sales dropped sharply from 16,200 to 9,000 units
per month. In an effort to regain lost sales, Enchantment ran a coupon promotion featuring $5
off the new regular price. Coupon printing and distribution costs totaled $500 per month and
represented a substantial increase over the typical advertising budget of $3,250 per month.
Despite these added costs, the promotion was judged to be a success, as it proved to be
highly popular with consumers. In the period prior to expiration, coupons were used on 40%
of all purchases and monthly sales rose to 15,000 units.
A. Calculate the arc price elasticity implied by the initial response to the Enchantment
price increase.
B. Calculate the effective price reduction resulting from the coupon promotion.
C. In light of the price reduction associated with the coupon promotion and assuming no
change in the price elasticity of demand, calculate Enchantment’s arc advertising
elasticity.
D. Why might the true arc advertising elasticity differ from that calculated in part C?
7. The demand curve for widgets is QD = 10,000 - 25P.
a. How many widgets could be sold for $100?
b. At what price would widget sales fall to zero?
c. What is the total revenue (TR) equation for widgets in terms of output, Q? What is the
marginal revenue equation in terms of Q?
d. What is the point-price elasticity of demand when P = $200? What is total revenue at
this price? What is marginal revenue at this price? Explain your result.
e. Suppose that the price of widgets fell to P = $150. What would be the new point-price
elasticity of demand? What is total revenue at this price? What is marginal revenue at
this price? Explain your result.
f. Suppose that the price of widgets rose to P = $250.What would be the new point-price
elasticity of demand? What is total revenue at this price? What is marginal revenue at
this price? Explain your result.
g. Suppose that the supply of widgets is given by the equation QS = -5,000 + 50P.What is
the relationship between quantity supplied and quantity demanded at a price of $300?
h. In this market, what is the equilibrium price and what is the quantity?

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