International Business Negotiations and Dimplomacy

1
Chapter 3Demand Theory
2
Objectives and Readings

• The market demand curve
• The price elasticity of demand
• Determinants of price elasticity
• Price elasticity and Pricing Policy
• Material is covered in chapter 3 of your textbook
  pages 85-111
• Not responsible for the following material
• Point and arc elasticities (pp 94-95)
• Price elasticity and total price expenditure (pp
  98-100)
• Total revenue, marginal revenue and price
  elasticity (pp 100-105)
• The constant elasticity demand function (pp 113
  -116)

3
The Market Demand Schedule

• Shows the total quantity of the good that would
  be purchased at each price. The following table
  shows a market demand schedule.

4
The Market Demand Curve
5
Other Determinants of Market Demand

• Consumer tastes and preferences.
• Consumer incomes.
• Level of other prices.
• Size of consumer population.

6
Demand Functions

• Q of good X f ( Price of X,
• Incomes of consumers,
• Prices of other goods,
• Population,
• Advertising expenditures,
• Etc.)
• If good X is personal computers, an example of
  the demand function would be
• Q b1P b2I b3S b4A
• where Q number of computers P average price
  of computers I per capita income S price of
  software A advertising expenditure bs are
  parameters that are estimated numerically

7
A Numerical Example

• The business economics department might have
  used statistical tools to estimate the bs in the
  previous equation
• Q -700P 200I - 500S 0.01A
• What is the relationship between this demand
  function and the demand curve?
• In other words, can we derive and plot the demand
  curve using the above equation?
• Suppose S0 and A0 (no advertising and free
  software).

8
A Numerical Example

• Then the demand for personal computers is
• Q -700xP 200xI
• Suppose further that income per capita is
  I13,000 then the demand function becomes
• Q -700xP 200x13,000 -700P 2,600,000
• By solving this equation for P, we can have a
  linear equation of the inverse demand function
• P - (1/700)Q (2,600,000/700) - 0.001429Q
  3,714

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Income Change and the Demand Curve
P price
Income I 13,000
4285
Income I 15,000
3714
Q quantity demanded
3,000,000
2,600,000

• Suppose that I increases from 13,000 to 15,000.
  What is the effect on the demand curve?
• If income I15,000, then Q- 700P 200(15,000)
  - 700P 3,000,000
• The new horizontal intercept is 3,000, 000 and
  the new vertical intercept is 3,000,0000/700
  4285

10
Case Study

• Suppose that IBMs research department has
  estimated the following demand function for
  personal computers Q -700P 2,600,000 0.01A,
  where A is advertising expenditure.
• The CEO has decided to maintain the same price
  P2,500 and asks the managerial- economics team
  to calculate the increase in advertising
  expenditure that is needed to raise sales by
  150,000 units.

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Case Study

• How much revenues (sales) will increase? You can
  assume that the initial level of advertising
  expenditure is zero.
• If the unit cost per personal computer are
  2,400 which are constant no matter how many
  personal computers IBM produces. Will your
  recommendation be profitable? How would your
  answer to this last question change if the
  coefficient on advertising is 0.02 instead of
  0.01? Why is your answer different?

12
Price Elasticity of Demand

• The price elasticity of demand is the percentage
  change in quantity demanded resulting from a 1
  percent change in price
• The formula for the price elasticity of demand is

13
Demand Functions and Elasticities

• Suppose the demand function for personal
  computers is Q -700P 200I - 500S 0.01A
• How do we calculate the price elasticity of
  demand at say P 3,000.
• We need specific values for I, S, and A.

14
Demand Functions and Elasticities

• If I13,000 S400 and A 50,000,000 then
  the demand function becomes Q 2,900,000 - 700P
• If P 3,000 the quantity demanded is Q
  2,900,000 - 700x3,000 800,000.
• The change in quantity due to a change in price
  is -700.
• The price elasticity is calculated as follows

15
Determinants of Price Elasticity of Demand

• The price elasticity of demand is greater when
• there are more substitutes for the product.
• the product is a more important part of a
  consumers budget.
• the time period under consideration is greater.

16
Own Price Elasticities of Demand
17
Own Price Elasticities of Demand
18
Price Elasticity and Pricing Policy

• One use of the price elasticity of demand is to
  determine the profit maximizing price according
  to the rule
• Marginal cost marginal revenue

• Suppose that the marginal cost of a particular
  car is 10,000 and its price elasticity of demand
  is equal to -5.
• The profit maximizing price is given by

19
Summary

• The market demand function of a product is an
  equation that shows the dependence of the
  quantity demanded on the commoditys own price
  and other factors.
• Demand functions can be used to derive demand
  curves and to quantify various shifts in the
  demand curve.
• The price elasticity of demand is the percentage
  change in quantity demanded associated with one
  percent change in price.
• Demand function can be used to calculate the
  price elasticity of demand.

20
Summary

• How could one estimate the coefficients of a
  linear demand function? Chapter 5 undertakes this
  task by introducing the relevant statistical
  techniques.