Managerial Economics &

Business Strategy
Chapter 3
Quantitative Demand Analysis

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
 3-2

Overview
I. The Elasticity Concept
 Own Price Elasticity
 Elasticity and Total Revenue
 Cross-Price Elasticity
 Income Elasticity
II. Demand Functions
 Linear
 Log-Linear
III. Regression Analysis
 Some general questions for a manager:
• How much do we have to cut our price to achieve 3.2 percent sales
growth?
• If we cut prices by 6.5 percent, how many more units will we sell?
• Do we have sufficient inventories on hand to accommodate this
increase in sales?
• If not, do we have enough personnel to increase production?
• How much will our revenues and cash flows change as a result of this
price cut?
• How much will our sales change if rivals cut their prices by 2
percent or a recession hits and household incomes decline by 2.5
percent?
 3-4

The Elasticity Concept

• How responsive is variable “G” to a change
in variable “S”
%G
EG , S 
%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-5

The Elasticity Concept Using

Calculus
• An alternative way to measure the elasticity
of a function G = f(S) is
dG S
EG , S 
dS G
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 3-6

Own Price Elasticity of

Demand
%QX
d
EQX , PX 
%PX
• Negative according to the “law of demand.”

Elastic: EQX , PX  1
Inelastic: EQX , PX  1

Unitary: EQX , PX  1
 3-7

Perfectly Elastic &

Inelastic Demand
Price Price
D

Quantity Quantity

PerfectlyElastic ( EQX ,PX  ) PerfectlyInelastic( EQX , PX  0)

 3-8

Own-Price Elasticity
and Total Revenue
• Elastic
 Increase (a decrease) in price leads to a decrease (an
increase) in total revenue.
• Inelastic
 Increase (a decrease) in price leads to an increase (a
decrease) in total revenue.
• Unitary
 Total revenue is maximized at the point where demand
is unitary elastic.
 3-9

Elasticity, Total Revenue and Linear

Demand
P
TR
100

0 10 20 30 40 50 Q 0 Q
 3-10

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-11

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-12

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-13

Elasticity, Total Revenue and Linear

Demand
P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 3-14

Elasticity, Total Revenue and Linear

Demand
P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
 3-15

Elasticity, Total Revenue and Linear

Demand
P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-16

Elasticity, Total Revenue and Linear

Demand
P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-17

Demand, Marginal Revenue (MR)

and Elasticity
P • For a linear inverse
100
Elastic
demand function,
80 Unit elastic MR(Q) = a + 2bQ,
60
where b < 0.
Inelastic • When
40
 MR > 0, demand is
20
elastic;
 MR = 0, demand is unit
elastic;
0 10 20 40 50 Q  MR < 0, demand is
inelastic.
MR
 Factors Affecting 3-18

Own Price Elasticity

 Available Substitutes
• The more substitutes available for the good, the more elastic
the demand.
 Time
• Demand tends to be more inelastic in the short term than in
the long term.
• Time allows consumers to seek out available substitutes.
 Expenditure Share
• Goods that comprise a small share of consumer’s budgets
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.
Elasticity: some practical estimates
 3-20

Cross Price Elasticity of

Demand

%QX
d
EQX , PY 
%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

Cross Price Elasticities: some illustrations
 3-22

Predicting Revenue Changes

from Two Products
Suppose that a firm sells to related goods. If the price of
X changes, then total revenue will change by:

  
R  RX 1  EQX , PX  RY EQY , PX  %PX 
 3-23

Income Elasticity

% Q X
d
EQ X , M 
% M

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.
Income elasticities: Some estimates
 3-25

Uses of Elasticities
• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and recessions.
• Impact of advertising campaigns.
• And lots more!
 3-26
Example 1: Pricing and Cash
Flows
• According to an FTC Report by Michael
Ward, AT&T’s own price elasticity of
demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to
meet it’s marketing goals.
• To accomplish this goal, should AT&T
raise or lower it’s price?
 3-27

Answer: Lower price!

• Since demand is elastic, a reduction in price
will increase quantity demanded by a
greater percentage than the price decline,
resulting in more revenues for AT&T.
 3-28

Example 2: Quantifying the

Change
• If AT&T lowered price by 3 percent, what
would happen to the volume of long
distance telephone calls routed through
AT&T?
 3-29

Answer
• Calls would increase by 25.92 percent!
% Q X
d
EQ X , PX  8.64 
% PX
% Q X
d
 8.64 
 3%
 3%   8.64  % Q X
d

% Q X  25.92%
d
 3-30

Example 3: Impact of a change

in a competitor’s price
• According to an FTC Report by Michael
Ward, AT&T’s cross price elasticity of
demand for long distance services is 9.06.
• If competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?
 3-31

Answer
• AT&T’s demand would fall by 36.24 percent!

% Q X
d
EQ X , PY  9.06 
% PY
% Q X
d
9.06 
 4%
 4%  9.06  % Q X
d

% Q X  36.24%
d
 3-32

Interpreting Demand Functions

• Mathematical representations of demand curves.
• Example:

QX  10  2PX  3PY  2M
d

 Law of demand holds (coefficient of PX is negative).

 X and Y are substitutes (coefficient of PY is positive).
 X is an inferior good (coefficient of M is negative).
 3-33

Linear Demand Functions and

Elasticities
• General Linear Demand Function and Elasticities:

QX   0   X PX  Y PY   M M   H H
d

PY M
EQ X , PX   X
PX EQ X , PY  Y EQ X , M   M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
 3-34

Example of Linear Demand

• Qd = 10 - 2P.
• Own-Price Elasticity: (-2)P/Q.
• If P=1, Q=8 (since 10 - 2 = 8).
• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
 3-35

Log-Linear Demand
• General Log-Linear Demand Function:

ln QX d  0   X ln PX  Y ln PY   M ln M   H ln H

Own Price Elasticity : X

Cross Price Elasticity :  Y
Income Elasticity : M
Non-linear model: a practical example
 3-37

Example of Log-Linear
Demand
• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.
 3-38
Graphical Representation of
Linear and Log-Linear Demand
P P

D D
Q Q
Linear Log Linear
 3-39

Regression Analysis
• One use is for estimating demand functions.
• Important terminology and concepts:
 Least Squares Regression model: Y = a + bX + e.
 Least Squares Regression line: Yˆ  aˆ  bˆX
 Confidence Intervals.
 t-statistic.
 R-square or Coefficient of Determination.
 F-statistic.
 3-40

An Example

• Use a spreadsheet to estimate the following

log-linear demand function.

ln Qx  0   x ln Px  e
 3-41

Summary Output
Regression Statistics
Multiple R 0.41
R Square 0.17
Adjusted R Square 0.15
Standard Error 0.68
Observations 41.00

ANOVA
df SS MS F Significance F
Regression 1.00 3.65 3.65 7.85 0.01
Residual 39.00 18.13 0.46
Total 40.00 21.78

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 7.58 1.43 5.29 0.000005 4.68 10.48
ln(P) -0.84 0.30 -2.80 0.007868 -1.44 -0.23
 3-42

Interpreting the Regression

Output
• The estimated log-linear demand function is:
 ln(Qx) = 7.58 - 0.84 ln(Px).
 Own price elasticity: -0.84 (inelastic).
• How good is our estimate?
 t-statistics of 5.29 and -2.80 indicate that the estimated coefficients
are statistically different from zero.
 R-square of 0.17 indicates the ln(PX) variable explains only 17
percent of the variation in ln(Qx).
 F-statistic significant at the 1 percent level.
 3-43

Conclusion
• Elasticities are tools you can use to quantify
the impact of changes in prices, income, and
advertising on sales and revenues.
• Given market or survey data, regression
analysis can be used to estimate:
 Demand functions.
 Elasticities.
 A host of other things, including cost functions.
• Managers can quantify the impact of
changes in prices, income, advertising, etc.