Managerial Economics &

Business Strategy
Chapter 3
Quantitative Demand Analysis

Michael R. Baye, Managerial Economics and Business Strategy, 5e.

McGraw-Hill/Irwin Copyright ©Copyright © 2006
2006 by The by The McGraw-Hill
McGraw-Hill Companies,
Companies, Inc. Inc.
AllAll rightsreserved.
rights reserved.
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Own Price Elasticity of
Demand
d
%QX
EQX , PX 
%PX
• Negative according to the “law of demand.”

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

Unitary: EQX , PX  1

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Perfectly Elastic &
Inelastic Demand
Price Price
D

Quantity Quantity

Perfectly Elastic ( EQ X ,PX   ) Perfectly Inelastic ( EQX , PX  0)

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Elasticity, Total Revenue and Linear
Demand
P
TR
100

0 10 20 30 40 50 Q 0 Q

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Factors Affecting
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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Cross Price Elasticity of
Demand
d
%QX
EQX , PY 
%PY

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

If EQ < 0, then X and Y are complements.

X,PY

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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  

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Income Elasticity

d
%QX
EQX , M 
%M

If EQ > 0, then X is a normal good.

X,M

If EQX,M < 0, then X is a inferior good.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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!

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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?

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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?

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Answer
• Calls would increase by 25.92 percent!
d
%QX
EQX , PX  8.64 
%PX
d
%QX
 8.64 
 3%
 3%    8.64   %QX
d

d
%QX  25.92%
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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?

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Answer
• AT&T’s demand would fall by 36.24 percent!

d
%QX
EQX , PY  9.06 
%PY
d
% Q X
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Interpreting Demand Functions
• Mathematical representations of demand curves.
• Example:
d
QX  10  2 PX  3PY  2 M
• X and Y are substitutes (coefficient of P Y is
positive).
• X is an inferior good (coefficient of M is
negative).
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Linear Demand Functions
• General Linear Demand Function:

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

P PY M
EQX , PX   X X EQX , PY  Y EQX , M   M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Log-Linear Demand
• General Log-Linear Demand Function:

ln Q X 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
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Example of Log-Linear
Demand
• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Graphical Representation of
Linear and Log-Linear Demand
P P

D D

Q Q
Linear Log Linear

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Regression Analysis
• One use is for estimating demand functions.
• Important terminology and concepts:

Least Squares Regression: Y = a + bX + e.

Confidence Intervals.

t-statistic.

R-square or Coefficient of Determination.

F-statistic.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 An Example

• Use a spreadsheet to estimate the following

log-linear demand function.

ln Qx   0   x ln Px  e

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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
Re gression 1.00 3.65 3.65 7.85 0.01
Re sidual 39.00 18.13 0.46
Tota l 40.00 21.78

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

Interce pt 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

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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 .17 indicates we explained only 17 percent of the
variation in ln(Qx).

F-statistic significant at the 1 percent level.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.