Demand Analysis

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Demand Analysis

• City University 2007

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Demand Analysis

• Market Fundamentals
• The functions of the market
• The decision makers
• Buyers DEMAND
• Sellers SUPPLY
• Market equilibrium
• Elasticity
• Definition
• Classification
• Price elasticity of demand and total revenue
• Yield management
• Factors, affecting price elasticity of demand
• Factors, affecting price elasticity of supply
• Income elasticity of demand
• Cross price elasticity of demand
• Consumer equilibrium
• Income and substitution effect
• Forecasting demand
• Regression analysis

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Market Fundamentals

• Market an institution, coordinating economic
  decisions
• Market decision makers
• - buyers
• - sellers

4
Market Functions

• Allocation of scarce resources
• Motivation of economic decision makers
• Distribution of goods and services

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The Demand for flowers

• P

Q
20
10
5
3
2
1
6
Demand for chocolates Milka
D
A
P
B
C
D
E
D
Q
The Demand Curve
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Demand

• The Demand for a good the quantities buyers
  are willing and able to buy at every different
  price
• The Law of Demand the decrease in the price of
  the good raises the quantity of the good
  demanded, other factors held equal

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FACTORS DETERMINING DEMAND

• Buyers expectations
• Real income
• Prices of the other goods
• Buyers taste and preferences
• Competitiveness of the market structure
• Market size
• Institutions

• P

D
Q
Demand rises the demand curve shifts rightwards
Demand falls the demand curve shifts leftwards
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Supply of Chocolate Milka
P
S
S
The Supply Curve
Q
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Supply

• The Supply of a good quantities of the good
  that sellers are willing to sell at different
  price levels
• The Law of Supply as the price of the good
  rises, sellers are willing to sell greater
  quantities of the good, ceteris paribus.

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FACTORS DETERMINING SUPPLY

• Producers expectations
• Cost of production
• Technology
• Competitiveness of the market structure
• Market size
• Institutions

• P

S
Q
Supply rises the supply curve shifts rightwards
Supply falls the supply curve shifts leftwards
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Market Equilibrium

• The Market is in equilibrium when the quantity
  supplied equals the quantity demanded at the same
  price

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The Dynamics of Market Equilibrium
D
Qd gt Qs Qd Qs shortage

• P

D
E
P
P rises and Qs increases
E
Pe
P rises and Qd falls
S
Qd
Q
Qe
Q
The Equilibrium is restored at E
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Price Ceiling
Shortage (Qd-Qs) x Pc

• P

D
Pb.m.
Profits of the blackmarketeers (Pb.m. Pc) x Qs
Pe
Pc
S
shortage
Q
Qs
Qd
Qe
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Arbitrage and speculation
Zo widget market
Oz widget market
P

• P

S
POz
D
PZo
D
S
Q
Q
QOz
QZo
Supply shifts to Oz market
Demand shifts to Zo market
exports
imports
Shifts in Supply and Demand until price
differences are eliminated
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Quantifying Market Responses Elasticity

• Elasticity the responsiveness of a variable to
  a change in another variable
• Price Elasticity of Demand buyers
  responsiveness to the price changes
• Price elasticity of supply sellers
  responsiveness to the price changes
• Ep change in Quantity change in Price

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Classifying Price Elasticity

• E lt 1 inelastic demand/supply
• E 1 unit elastic demand/supply
• E gt - elastic
• E 0 - perfectly inelastic
• E 8 - perfectly elastic

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Price Elasticity of Demand and Total Revenue

• TR P x Q
• The Law of Demand - If P rises, Q falls
• If the percentage change in price is greater than
  the percentage change in quantity, the demand is
  inelastic
• If the price falls, the change in quantity
  demanded does not compensate for the price
  reduction and TR falls
• If the price rises, TR will increase

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Price Elasticity of Demand and Total Revenue
Q
TR
P
E lt 1
If the price rises, TR increases
E gt 1
If the price rises, TR falls

• If E 1, TR does not change

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FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

• Availability of substitutes/Definition of market
• Time horizon
• Income
• Traditions

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FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY

• Time horizon
• Availability of production factors
• Mobility of production factors
• Inventory levels
• Competitiveness of the market structure
• Institutions

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Income Elasticity of Demand

• Income elasticity of demand the responsiveness
  of buyers to changes in their income
• Ey change in Q change in buyers Y
• Classification of income elasticity of demand
• E gt 1 income elastic demand
• E 1 income unit elastic demand
• E lt 1 income inelastic demand (necessities)
• E 0 perfectly inelastic demand as regard
  income
• E lt 0 negative income elasticity of demand
  (inferior goods)

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Cross Price Elasticity of Demand

• Cross price elasticity the responsiveness of
  buyers of a given good to the changes in the
  price of another good
• Eab change in Qa change in Pb
• Eab gt 0 - substitutes
• Eab lt 0 - complements

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Consumer Decision Making

• Assumptions
• Consumers want to derive maximum satisfaction
  from goods and services in consumption
• Consumers always prefer more satisfaction to less
  satisfaction
• Consumers are aware of their own taste and
  preferences
• Preferences are transitive

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Total and Marginal Utility

• Utility the satisfaction derived from a
  product or service in consumption
• Marginal Utility the extra utility, derived
  from an extra unit of the good in consumption
  (MU)
• TU derived from n units of the good in
  consumption MU1 MU2 MUn

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Consumer Equilibrium

• The consumer maximizes TU, through the comparison
  of MUs
• MUa/Pa MUb/Pb

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Income Effect and Substitution Effect

• Income effect a change in quantity demanded,
  caused by the change in consumers real income
• Substitution effect a change in quantity
  demanded, caused by the change in relative prices

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Income Effect and Substitution Effect
Inferior Goods
P
Normal goods
Giffen goods
regular
Q
Q
Q
Q
Substitution effect
Q
Q
Q
Q
Price effect
Q
Q const
Q
Q

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Consumer Surplus

• Consumer surplus is the difference between the
  maximum amount a person is willing to pay for a
  good and its current market price.

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DEMAND ESTIMATION Regression Analysis

• Regression analysis a statistical technique,
  used in the estimation of future trends
• Finding an equitation to fit to the data,
  collected in the empirical analysis in order to
  estimate the relationship between a dependent
  variable and one or more independent variables.
• The regression equation is usually linear

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A Linear Regression Model
A

• P

a regression line
B
Q
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A Linear Regression Model

• A regression line represents the best linear
  approximation of the relationship of the quantity
  demanded to price
• The best fit the sum of the squares of the
  horizontal distances between the observed data
  points and estimated points lying on the
  regression line are minimized.

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A Linear Regression Model

• The closer the observed data points lie to the
  regression line, the more confidence we can have
  in the predictive accuracy of the regression
  model.
• The coefficient of determination (R2) a measure
  of how closely the estimated relationship
  reflects or accounts for the variation in the
  observed data.
• R2 measures the proportion of the total
  variation in the dependent variable (q) that is
  explained by the variation of the independent
  variable (P).

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A Linear Regression Model

• Large R2 (close to 1) are merely indications that
  the independent variable is correlated with the
  dependent variable the independent variable
  varies together with the dependent one.

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ECONOMIC FORECASTING

• Forecasting a process of analyzing available
  data on economic variables and relationships and
  predicting future values of certain economic
  variables.

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Kinds of data

• Time series data observations of a particular
  variable over a number of time periods
• Cross-section data observations of a variable
  at a specific point of time

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Forecasting Methods

• Trend analysis relies on historical data
• Autoregressive integrating moving average models
• Barometric forecasting uses current values of
  certain variables (indicators) to predict future
  values of other variables
• Econometric models

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Yield Management

• Yield management a pricing strategy to
  allocate the fixed capacity of a service to match
  the highest revenue in the market place
• Yield management is part of the aggregate
  planning process
• Yield management is a revenue management
• Yield management uses historic data and
  mathematical models to predict demand at future
  points of time
• The aim is to increase profitability rather than
  simply increase utilization

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Yield management - techniques

• Yield management uses historic data and
  mathematical models to predict demand at future
  points of time
• It sets different prices at different time points
  according to the predicted demand as well as
  varying prices according to the actual demand

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Conditions for Yield Management

• Fixed capacity
• Perishable capacity
• Segmentable market (the demand function is
  segmented into different revenue/profit classes)
• Capacity sold in advance (if the profitable
  classes fail to fill by a certain time point,
  some of the capacity is then released for the
  next lowest class
• Uncertain demand
• Low marginal sales cost, but high marginal
  capacity addition cost

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Problems Appealing for Yield Management

• Services cannot be inventoried
• Demand is difficult to predict
• Capacity is difficult to predict
• Service capacity must be provided at the
  appropriate place and time
• Labor is usually the most constraining resource
  (mobility, part-timers, temporary employment)

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Problems of Yield Management

• Overbooking
• How to allocate capacity among different classes
  of customers
• Optimal overbooking policies for different
  classes