Managerial Economics

Justyna Sokołowska - Woźniak

Department of Economics WSB-NLU, 022C

Market. Demand and Elasticity

Materials based on:
Chapter 1 and 2 of the book: Managerial Economics, William F. Samuelson & Stephen G.
Marks, JOHN WILEY & SONS, INC.
Chapter 2 of the book: Economics, J. Sloman and:
http://wps.pearsoned.co.uk/ema_uk_he_sloman_economics_6/41/10678/2733799.cw/index.html
 Supply and Demand model
2
Revision

semestr zimowy 2
2008/2009
 Price and output determination 3

Assumptions:
• Free market – there is an absence of government intervention
• Price taker - a person or a firm with no power to be able to
influence the market price
• Perfectly competitive market – a market in which all
producers and consumers of the product are price takers
(other features very many firms and consumers, complete
freedom of entry, homogeneous product, perfect knowledge)
• The price mechanism – the system in a market economy
whereby changes in price in response to changes in demand
or supply have the effect of making demand equal supply
 Demand 4

• Relationship between demand and price:

• the law of demand – the quantity of a good demanded per
period of time will fall as the price rises and rises as the
price falls (ceteris paribus)
Two reasons for this law:
• the income effect (changes in purchasing power of income –
real income) – the effect of a change in price on quantity
demanded arising from the consumer becoming better or
worse off as a result of the price change
• the substitution effect (changes in relation of prices of two
goods) – the effect of a change in price on quantity
demanded arising from the consumer switching to or from
alternative (substitute) products
 Demand 5

• Be careful about the meaning of:

• Quantity demanded – the amount of a good that a
consumer is willing and able to buy at a given price over a
given period of time
It does not refer to what people would simply like to
consume
 Demand 6

• Individuals and market demand:

• Demand schedule for an individual- a table showing the different
quantities demanded (Qd), quantities of a good that a person is
willing and able to buy at various prices over a given period of time

• Market demand schedule - a table showing the different quantities

of a good that all consumers are willing and able to buy at various
prices over a given period of time
 Demand 7

• The demand curve – a graph showing the

relationship between the price of a good and
quantity of the good demanded over a given
period of time (it can be for an individual
consumer or a group of consumers, or usually for
the whole market)
• Assumptions:
• other things being equal (ceteris paribus)
• a given time period
• the axes
 The demand curve:
8
The demand for potatoes (monthly)

(1) (2) (3) (4)

Price Tracey's Darren's Total market
(pence per kg) demand demand demand
(kg) (kg) (tonnes: 000s)

A 20 28 16 700
B 40 15 11 500
C 60 5 9 350
D 80 1 7 200
E 100 0 6 100
 Market demand for potatoes (monthly) 9

100 E
Point Price Market demand
(pence per kg) (tonnes 000s)
D A 20 700
Price (pence per kg)

80
B 40 500
C 60 350
C
60 D 80 200
E 100 100
B
40

A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)
 Demand 10

• Other determinants of demand

• Tastes (affected by advertising, by fashion, by observing other consumers, by
consideration the health, previous experience from consuming the good)

• Number and price of substitute goods (competitive goods) –

goods considered to be alternatives to each other
• Number and price of complementary goods (a pair of goods
consumed together)
• Income (normal versus inferior goods)
• Distribution of income
• Expectations of future price changes
• Demography
• Advertising
• Other (e.g. the weather)
 Demand 11

• Movements along and shifts in the demand curve

• change in price
 movement along D curve (change in quantity demanded)

• change in any other determinant of demand (change in

demand)
 shift in D curve
• increase in demand  rightward shift
• decrease in demand  leftward shift
 An increase in demand 12

P
Price

D0 D1

O Q0 Q1
Quantity
 Demand 13

• Demand functions
• simple demand functions
Qd = a – bP

• more complex demand functions

Qd = a – bP + cY + dPs – ePc

• estimated demand equations

• problems of estimating demand equations
• demand functions and the demand curve
 Demand curve for equation: Qd = 10 000 – 200P 14

50 P Qd (000s)
5 9
10 8
40 15 7
20 6
P
30

20

10

0
0 2 4 6 8 10
Q (000s)
 Supply 15

• Relationship between supply and price

• The law of supply – when the price of a good rises, the quantity
supplied will also rise
The reason for this law:
• in the short-run :
• beyond a certain level of output costs rise more and more rapidly, thus a
higher price encourages producers to incur the higher cost per unit and to
produce more
• a higher price encourages producers to switch to producing this products
as it becomes relatively more profitable

• long-run supply - new producers are attracted to the market

 Supply 16

• The supply curve

• assumptions
• other things remain equal (ceteris paribus)
• a given time period

• the axes
• individual's and market supply curves
 The supply curve:
17
The supply of potatoes (monthly)

Price of Farmer X's Total Market

potatoes supply supply
(pence per kg) (tonnes) (tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

 Market supply of potatoes (monthly) 18

100 e
Supply P Q
d a 20 100
80
b 40 200
c 60 350
Price (pence per kg)

c d 80 530
60 e 100 700

b
40

a
20

Q (tonnes: 000s)
0
0 100 200 300 400 500 600 700 800
 Supply 19

• Other determinants of supply

• costs of production (affected by changes in input prices,
technology, government policy)
• profitability of alternative products (substitutes in supply)
• profitability of goods in joint supply (production of more one
good leads to production of more of the other goods) e.g. petrol and
other fuels
• nature and other random shocks
• aims of producers
• expectations of producers (of future price changes)
• the number of suppliers
• import/export
• taxes
 Supply 20

• Movements along and shifts in the supply curve

• change in price
 movement along S curve (change in quantity supplied)

• change in any other determinant of supply

 shift in S curve (change in supply)
• increase in supply  rightward shift
• decrease in supply  leftward shift
 Shifts in the supply curve
21

P S2 S0 S1

Decrease Increase

O Q
 Price and output determination 22

• Equilibrium price and output

• response to shortages and surpluses
• shortage (D > S)
 price rises
• surplus (S > D)
 price falls

• significance of ‘equilibrium’
 Equilibrium price and output:
23
The Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes Total Market Demand Total Market Supply

(pence per kilo) (Tonnes: 000s) (Tonnes: 000s)

20 700 (A) 100 (a)

40 500 (B) 200 (b)
60 350 (C) 350 (c)
80 200 (D) 530 (d)
100 100 (E) 700 (e)
 The determination of market equilibrium 24
(potatoes: monthly)

E e
100
Supply
D d
80
Price (pence per kg)

Cc
60

b B
40

a A
20

Demand
0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)
 The determination of market equilibrium 25
(potatoes: monthly)

E e
100
Supply
D d
80
Price (pence per kg)

Cc
60

b SHORTAGE B
40
(300 000)
a A
20

Demand
0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)
 The determination of market equilibrium 26
(potatoes: monthly)

E e
100
Supply
D SURPLUS d
80
Price (pence per kg)

(330 000)
Cc
60

b B
40

a A
20

Demand
0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)
 The determination of market equilibrium 27
(potatoes: monthly)

E e
100
Supply
D d
80
Price (pence per kg)

60

b B
40

a A
20

Demand
Q
0
(tonnes
0 100 200 300 Qe 400 500 600 700 800
 Price and output determination 28

• Effects of shifts in the demand curve

• movement along the supply curve and the new demand
curve
 Effect of a shift in the demand curve 29

P S

g
Pe1

D2

D1

O Qe1 Q
 Effect of a shift in the demand curve 30

P S

i
New equilibrium at
Pe2 point i

g h
Pe1

D2

D1

O Qe1 Qe2 Qe Q
’
 Price and output determination 31

• Effects of shifts in the demand curve

• movement along the supply curve and the new demand
curve

• Effects of shifts in the supply curve

• movement along demand curve and new supply curve
 Effect of a shift in the supply curve 32

P S2
S1

g
Pe1

O Qe1 Q
 Effect of a shift in the supply curve 33

S2
P
S1

k
Pe3

j g New equilibrium at
Pe1 point k

O Qs’ Qe3 Qe1 Q

 Supply and Demand 34

semestr zimowy 34
2008/2009
 Questions 35

• How can demand analysis help the company win the

game of yield management?
• What does the concept of elasticity explain?

• How to measure elasticity?

• What are the determinants of price elasticity of
demand?
• What is the relation between elasticity and revenue?

• What are other types of elasticity?

 DEMAND 36

• Market demand:
• Market demand schedule - a table showing the different quantities
of a good that all consumers are willing and able to buy at various
prices over a given period of time

• The demand curve – a graph showing the relationship between the

price of a good and quantity of the good demanded over a given
period of time (it can be for an individual consumer or a group of
consumers, or usually for the whole market)

• simple demand functions: Qd = a – bP

• Assumptions:
• other things being equal (ceteris paribus)
• a given time period
 DEMAND 37

• Other determinants of demand

• Tastes
• Number and price of substitute goods
• Number and price of complementary goods
• Income Distribution of income
• Expectations of future price changes
• Demography
• Advertising
• Other (e.g. the weather)
• more complex demand functions
(when multiple determinants of demand considered):
• Qd = a – bP + cY + dPs – ePc
 Effect of a shift in the demand curve 38

g
Pe1

D2

D1

O Qe1 Qe1 Q
 Elasticity 39

the responsiveness of demand and supply to a change in one of

the determinants
the proportionate (percentage) change in quantity demanded or
supplied divided by the proportionate (percentage) change in the
determinant (X)

Î = Q/Q ÷ X/X

X is a determinant of : demand (P ,Y, Ps, Pc)

or
supply (P ,C, Ps, Pj)
The more elastic variables are, the more responsive is the market to
changing circumstances
 Price elasticity of demand 40

the responsiveness of demand to a change in price of the

product

Ped = Q/Q ÷ P/P

proportionate (percentage) change in quantity demanded for

a product divided by proportionate (percentage) change in
the price of this product
 The use of proportionate or percentage measures 41

• It allows comparison of changes in two qualitatively

different things
(i.e. quantity, price, income)

• It is the only sensible way of deciding how big a

change is
(a change in price by 1$ - is it a big or small
increase?)
 Price elasticity of demand 42

P2

P1 DB

DA

QB QA Q1
 Market supply and demand 43

The effect on price of a

shift in supply depends
on the responsiveness of S1
demand to a change in
price.

P1

DA

Q1
 Market supply and demand 44

S2

S1
b

P2

P1

DA

Q2 Q1
 Market supply and demand 45

S2

S1
a

PA

b
PB

P1 DB

DA
QB QA Q1
 ELASTICITY 46

• Price elasticity of demand

• measurement
proportionate (%) Qd / proportionate (%) P

• use of proportionate or percentage changes

• the sign (positive or negative)
• the value (greater or less than one)
 The value of elasticity 47

Ignoring the sign (in the absolute value):

• elastic demand (PÎD > 1)

• inelastic demand (PÎD <1)

• unit elastic demand (PÎD = 1)

• totally inelastic demand (PÎD = 0)

• infinitely elastic demand (PÎD = ¥)

 ELASTICITY 48

• Determinants of price elasticity of demand:

• the degree to which the good is a necessity
• the availability of substitutes
• the proportion of income spent on the good
• time period
 Different elasticity along different portions
49
of a demand curve

Elastic
Δp/p- demand
small value

Unit elastic demand

(PÎD = –1)

Δp/p - Inelastic
high value demand

Δq/q- Δq/q- Δp/p- Q

high value small value

 Measurement of elasticity 50

• Measurement of elasticity: arc elasticity

• the formula for price elasticity of demand

Ped = Q/Q ÷ P/P

• using the average or 'mid-point' method

Ped = Q/midQ ÷ P/midP

The main advantage of the arc elasticity measure is that it treats the
prices and quantities symmetrically; that is, it does not distinguish
between the “initial” and “final” prices and quantities.
 Measuring elasticity using the arc method 51
10

m
8 DQ DP
Ped = ¸
mid Q mid P
7 P = –2
n
= 10 ¸
-2
6 15 7
Q = 10 = 10/15 x (-7)/2
P (£) Mid P
= -70/30
4 = 7/3 = -2.33

2
Demand

15
0
0 10
Mid Q 20 30 40 50
Q (000s)
 Measuring point elasticity using
52
differentiation technique method

• Measurement of elasticity: point elasticity

• it is useful to measure elasticity with respect to an infinitesimally
small change in pricewe, we want to know how quantity demanded
would react to an infinitesimally small change in price

• the formula for price elasticity of demand

Ped = Q/Q ÷ P/P = Q/P ÷Q/P = Q/Px P/Q
An infinitesimally small change is signified by letter d
Ped = dQ/dP x P/Q
dQ/dP is the differential calculus term for the rate of Q with
respect to a P, derivative of the demand function with respect to
P
The elasticity (measured at price P) depends directly on dQ/dP, the
derivative of the demand function with respect to P (as well as on
the ratio of P to Q).
 Measuring point elasticity using
53
differentiation technique method

• And conversely: dP/dQ is the differential calculus term for

the rate of P with respect to a Q
• At any given point on the demand curve dP/dQ is given by
the slope of the curve (its rate of change)

• So:
Ped = dQ/dP x P/Q means Ped = (1 / slope) x P/Q
• What’s the elasticity of a straight-line demand ‘curve’
(constant dQ/dP – as the slope is constant)
• What’s the elasticity of a curved demand curve
dP/dQ is the tangent to the curve
- In order to calculate Ped, the differentiation technique
can be used
 Measuring point elasticity using
54
differentiation technique method

Ped = (1 / slope) x P/Q

P r

0
Q
 Measuring point elasticity using
55
differentiation technique method

50 Ped = (1 / slope) x P/Q

= -100/50 x 30/40
= -60/40
= -1.5
30 r
P

0 40 Q 100
 different elasticities along a straight-line demand 56
10 curve
n
8 Ped = (1 / slope) x P/Q
1 / slope) is constant
m = -50/10 = -5
6 But P/Q varies:
P at n, P/Q = 8/10
l at m, P/Q = 6/20
4 at l, P/Q = 4/30
Demand

k
2

0
0 10 20 30 40 50
 Measuring point elasticity using
57
differentiation technique method

• We write y f(x), where f(x) represents the (unspecified) functional relationship between
the variables. The notation dy/dx represents the derivative of the function, that is, the
rate of change or slope of the function at a particular value of x. (The d in this notation
is derived from the Greek letter delta, which has come to mean “change in.”)
• We list the following basic rules:
• Rule 1. The derivative of a constant is zero. If y = 7, for example, dy/dx = 0. Note that y=7 is graphed
as a horizontal line (of height 7); naturally this has a zero slope for all values of x.
• Rule 2. The derivative of a constant times a variable is simply the constant. If y= bx, then dy/dx = b.
For example, if y= 13x, then dy/dx = 13. In words, the function y = 13x is a straight line with a slope of
13.
• Rule 3. A power function has the form y= ax²,
where a and n are constants. The derivative of a power function is
• Example:

• Ped = dQ/dP x P/Q

• Eg. Given Q = 60-15P+P²
• Then dQ/dP = -15 + 2P
• Thus at Price of 3: dQ/dP = -15 + 2*3 = -9
• Thus price elasticity of demand at price 3: Ped = -9 * (3/ (60-15*3+3²) = -9*3/24 = -9/8 (elastic)
 Income and cross-price elasticity of demand 58

• Cross-price elasticity of demand

The responsiveness of demand for one good to a change in the
price of another.
• measurement
• The percentage (or proportionate) change in demand for
good a divided by the percentage (or proportionate) change
in price of good b: %ΔQDA ÷%ΔPB.
• QDa/QDa ÷ Pb/Pb (in %)
• determinants
• closeness as substitutes or complements
• applications
• If good B is a substitute for good A, cross elasticity will be a
positive figure.
• If good B is complementary to good A, cross elasticity of
demand will be a negative figure.
 An increase in demand 59

P
Price

D0 D1

O Q0 Q1
Quantity
 Income and cross-price elasticity of demand 60

• Income elasticity of demand

the responsiveness of demand to a change in consumer incomes
• Measurement
• The percentage (or proportionate) change in demand divided by the
percentage (or proportionate) change in income (%ΔQD ÷%ΔY)
• Qx/Qx ÷ I/I (in %)
• determinants
• degree of necessity
• proportion of income spent on the good
• applications
• Normal goods (PeY > 0) - whose demand increases as consumer incomes
increase, have a positive income elasticity of demand.
Luxury goods (PeY > 1) will have a higher income elasticity of demand
than more basic goods.
• Inferior goods - whose demand decreases as consumer incomes increase.
Such goods have a negative income elasticity of demand - PeY < 0
 An increase in demand 61

P
Price

D0 D1

O Q0 Q1
Quantity
 ELASTICITY 62

• Price elasticity of supply

• measurement
• QS/QS ÷ P/P

• determinants
• the amount that costs rise as output rises – the less the
additional costs of producing additional output the more
firms will be encouraged to produce for a given price rise:
the more elastic the supply
• time period (immediate time period, short run, long run)
 Supply in different time periods 63
P

Si
b
P2

P1
a

D2

D1

O Q1 Q
 Supply in different time periods 64
P
SS
Si
b
P2
c SL
P3 d
P4
P1
a

D2

D1

O Q1 Q3 Q4 Q
 Elasticity 65

semestr zimowy 65
2008/2009
 66

• Maximizing profit
The main principle of theory of the firm is that management strives to
maximize the firm’s profits - the analysis of pricing and output
decision of the firm under various market conditions is under
assumption that the firm wishes to maximise profits

• Profit:
TP = TR - TC
TP - total profit
Total revenue (TR) - the amount a firm receives for the sale of
its output: p*q
Total economic cost (TC) - the market value of the inputs a firm
uses in production (explicit costs + implicit costs).
In short term analysis: fixed costs and variable costs)
 The goals of maximizing revenue
67
and maximizing profit

• Maximizing revenue
The other decision models should be noted:
The firm attempts to maximize total sales subject to
achieving an acceptable level of profit.

Revenue
• Defining total, average and marginal revenue
• total revenue (TR) = p*Q
• average revenue (AR =average price) = TR/Q
• marginal revenue (MR) = TR/Q
 The goals of maximizing revenue
68
and maximizing profit

There generally is a conflict between the goals of maximizing revenue

and maximizing profit. Clearly, maximizing profit is the appropriate
objective because it takes into account not only revenues but also
relevant costs.

In some important special cases the two goals coincide or are

equivalent.
This occurs when the firm faces what is sometimes called a pure selling
problem: a situation where it supplies a good or service while incurring
no variable cost (or a variable cost so small that it safely can be
ignored). It should be clear that, without any variable costs, the firm
maximizes its ultimate profit by setting price and output to gain as
much revenue as possible (from which any fixed costs then are paid).
TP = TR - TC
 The goals of maximizing revenue
69
and maximizing profit

The following pricing problems serve as examples:

• A software firm is deciding the optimal selling price for its
software.
• A manufacturer must sell (or otherwise dispose of) an inventory
of unsold merchandise.
• A professional sports franchise must set its ticket prices for its
home games.
• An airline is attempting to fill its empty seats on a regularly
scheduled flight.
 Total expenditure and elasticity 70

P(£)

Consumers’ total expenditure

= D
1 firms’ total revenue = p*q
=
£2 x 3m = £6m

0
0 1 2 of units per period
Q (millions 3 of time) 4 5
 Elastic demand between two points 71

Expenditure falls
as price rises

P(£)
b
5
a
4

10 20
Q (millions of units per period of time)
 Inelastic demand between two points 72

b Expenditure rises
as price rises
8

P(£)

a
4

15 20
Q (millions of units per period of time)
 Totally inelastic demand (PÎD = 0) 73

P D

P2 b

P1 a

O Q1 Q
 Infinitely elastic demand (PÎD = ¥) 74
P

a b
P1 D

Q1 Q2
Q
 Unit elastic demand (PÎD = –1) 75

P
Expenditure
stays the same
as price changes
a
20

b
8
D

O 40 100 Q
 Price elasticity of demand 76

E2B E2A
P2

E1 (A&B)
P1 DB

DA

QB QA Q1
 Different elasticity along different portions
77
of a demand curve

Elastic
Δp/p- demand
small value

Unit elastic demand

(PÎD = –1)

Δp/p - Inelastic
high value demand

Δq/q- Δq/q- Δp/p- Q

high value small value

 Price Elasticity
78
and Maximizing Revenue

Consider a software firm that is trying to determine the optimal price for one
of its popular software programs. Management estimates this product’s
demand curve to be
QD = 1,600 - 4P,
where Q is copies sold per week and P is in dollars

The slope of D curve:

dP/dQ = -1/4
dQ/dP = 4
EP = (dQ/dP)(P/Q)

EP in M = - 4*(200/800) = -1

EP in B = - 4*(100/1200) = -0,33

EP in A = - 4*(300/400) = -3
 Price Elasticity
79
and Maximizing Revenue

Demand curve:
QD = 1,600 - 4P
Inverse of demand curve:
P = 400-0.25Q

TR – P*Q
TR = P*(1600-4P) = 1600P – 4 P
or
TR = Q* (400-0.25Q)
TR = 400Q–0.25Q²
EP in M = -1 TR in M = $-160.000

EP in B = -0,33 TR in B = $-120.000

EP in A = -3 TR in A = $-120.000
 Price Elasticity
80
and Maximizing Revenue

Marginal Revenue (MR)

Marginal revenue is equal to the ratio
of the change in revenue for some
change in quantity sold to that change
in quantity sold
MR = TR/Q
This can also be represented as a
derivative when the change in quantity
sold becomes arbitrarily small.
MR = dR/dQ = TR’(Q)
TR max when MR = 0
 Price Elasticity
81
and Maximizing Revenue

Demand curve:
QD = 1,600 - 4P
Inverse of demand curve:
P = 400-0.25Q

TR = Q* (400-0.25Q)
TR = 400Q–0.25Q²
Marginal Revenue (MR)
MR = TR/Q
MR = dR/dQ
TR max when MR = 0
MR = 400–0.5Q
0 = 400-0.5Q
Q = 800 TR MAX
 Questions 82

semestr zimowy
2008/2009
 Wyższa Szkoła Biznesu
National-Louis University

ul. Zielona 27
33-300 Nowy Sącz

sokolowj@wsb-nlu.edu.pl