Prof. R. Michelfelder, Ph.D. Outline 2

1. Prof. R. Michelfelder, Ph.D. Outline 2 Demand, Supply, Price, Revenues, Estimation of Demand Function and Prediction of Revenues

2. Outline 2 2.1 Theory of Demand 2.2 Theory of Supply 2.3 Demand, Supply & Price 2.4 Demand, Price Elasticity & Revenue Prediction

3. 2.1 Theory of Demand The functional relationship between the price of a good or service and other variables and the quantity demanded or sales in units by consumers in a given time

4. Non-Price Factors Influencing Demand • Tastes and preferences Affected by socioeconomic factors such as age, sex, race, marital status, and education level • Income The level of income (e.g. GDP) affects demand for normal goods and inferior goods

5. Non-Price Factors Influencing Demand • Prices of related goods Substitute goods – when one good can be used in the place of another Complementary goods – two or more goods that consumers use together • Future expectations • Numberofconsumers • Others (weather for electricity sales)

6. Demand Function QXD = f (PX, T, Y, PY, PZ, EXC, NC, … where QXD = sales in unit s or “quantity demanded” for good X PX= price of good X T= variables representing tastes and preferences Y = income (continued on next slide)

7. The Demand Function QXD = f (PX, T, Y, PY, PZ, EXC, NC, … where PYand PZ= prices of goods Y and Z, which relate to consumption of good X EXC = consumer expectations about future prices NC = number of consumers

8. Price P1 P2 Demand 0 Q1 Q2 Quantity Demand Curves Figure 2.1 The demand curve shows the relationship between price of a good and quantity demanded, all else constant A B

9. More About Demand Curves • Demand shifters: variables held constant when defining a demand curve but would shift if their values changed • Negative (inverse) relationship: where an increase in one variable causes a decrease in another • Slope of demand curve determines degree of competition in an industry (negative slope reflects imperfect competition)

10. Price P1 0 Q1 Q2 Quantity Increase in Demand Figure 2.2 A change in demand occurs when one or more of the factors are held constant in defining a given demand curve change D2 D1

11. Individual Versus Market Demand Curve • Horizontal summation of individual demand curves: for every price, the quantity that each person demands at that price determines market quantity demanded at that price • The market demand curve, DM, considers quantities demand at other prices

12. Price P1 0 Q1 Q2 Q3 Q4 Individual Versus Market Demand Curve Figure 2.3 DM =dA + dB dB dA Quantity

13. Demand Function as an Equation (for copper) QD = 10 - 50PC + 0.31I + 1.5TC + 0.5E where QD = sales of copper in pounds PC= price of copper per pound I = consumer income index TC= index showing uses for copper E= expectations index

14. Managerial Rule of Thumb: Demand Considerations Managers must • Understand what influences demand • Determine which factors they can influence • Determine how to handle factors they cannot influence

15. 2.2 Theory of Supply The functional relationship between the price of a good or service and other variables that affect cost and the quantity that producers are willing to supply in a given time

16. Non-Price Factors Influencing Supply • State of technology • Input prices (labor, capital) • Prices of goods related in production • Future expectations • Number of producers

17. The Supply Function QXS = f (PX, TX, PI, PA, PB, EXP, NP, … where QXS = quantity supplied of good X PX= price of good X TX= state of technology PI = prices of the inputs of production (continued on next slide)

18. The Supply Function QXS = f (PX, TX, PI, PA, PB, EXP, NP, … where PA, PB = price of goods A and B, related to good X EXP= producer expectations about future prices NP= number of producers

19. Price P2 P1 0 Q1 Q2 Quantity Supply Curvefor a Product Figure 2.4 B Supply Relationship between price of a good and quantity supplied A

20. Supply Relationships • Not all supply curves are linear • Supply curve does not show actual price of product but the relationship of alternative prices and quantities • A positive relationship is shown as upward line where increase in one variable causes increase in another variable

21. Changes (Increase)in Supply Figure 2.5 A change in supply occurs when one or more of the factors held constant in defining a given supply curve change S1 Price S2 P1 0 Q1 Q2 Quantity

22. Change inQuantity Supplied A price change causes movement from one point to another • An increase in price of a substitute good causes the supply curve to shift to the left; a decreases shifts it to the right • If the price of a complementary good increases, the supply increases • An increase in the number of producers shifts it to the right

23. Managerial Rule of Thumb: Supply Considerations Managers must • Examine technology and costs of production • Find ways to increase productivity while lowering production costs Supply curve is actually a portion the marginal cost curve

24. 2.3 Demand, Supply,and Price • A price for a good or service is determined when the market reaches equilibrium • The quantity demanded of good X equals the quantity producers are willing to supply • An upset in equilibrium pushes the price back toward equilibrium

25. Price PE 0 QE Quantity QE = equilibrium quantity PE = equilibrium price Market Equilibrium Figure 2.6 Supply Market equilibrium occurs where demand equals supply Demand

26. Lower-Than-Equilibrium Prices • Consumers demand more of a good than producers are willing to supply at that price • Supply and demand become unstable • An adjustment process begins which seeks to again bring equilibrium

27. Changes in Equilibrium Prices and Quantities • Change in demand • Change in supply • Changes on both sides of the market

28. 4. Demand, Price Elasticity, Revenues & Prediction • Mature & Start-up Firms Predict Income Statements and Cash Flows in a Business Plan {see Michelfelder and Morrin (2013) diffusion curves} • Revenues are Driven by Sales: (predicted from demand

29. % ΔQx eP = where % ΔPx Price Elasticity The percentage change in the quantity demanded of a given good relative to a percentage change in its price eP = price elasticity of demand Δ= the absolute change Qx= quantity demanded of good X Px= the price of good X

30. Price P1 P2 Q P Demand 0 Q1 Q2 Quantity Price Elasticity Figure 3.1 Measured as a movement along a demand curve A B

31. Price Elasticity and Decision Making • Tells managers what will happen if product prices change • Helps firms to develop pricing strategies • Helps to develop pricing strategies in the public sector

32. Elasticity • Elastic demand: change in quantity demanded is greater than the change in price • Inelastic demand: change in quantity demanded is less than the change in price • Unitaryelasticity: change in quantity demand is equal to change in price

33. Elasticity andTotal Revenue • If demand is elastic, higher prices result in lower total revenue. Lower prices result in higher total revenue • Changes in price and the resulting total revenue are inversely proportionate • (see Figure 3.2 on next slide)

34. Demand Elasticity • Demand elasticity shows the percentage change in quantity demanded of a product relative to the percentage change in both variables • The coefficient represents the ratio of the two percentage changes

35. 12 (P1)10 (P2) 9 Price Demand 0 12 Quantity 2 (Q1) 3 (Q2) Elastic Demand and Total Revenue Figure 3.2 If prices decrease, revenue increases. If prices increase, revenue decreases. A Y B C Area X = Q1CBQ2 Area Y =P1ACP2 X

36. Inelastic Demand • When units are sold at a lower price, the quantity demanded has not increased proportionately • Total revenue decreases • Changes in price and the resulting total revenue move in the same direction • (See Figure 3.3 on next slide)

37. Price 12 (P1)4 (P2) 3 Demand 0 12 Quantity 8 (Q1) 9 (Q2) Inelastic Demand and Total Revenue Figure 3.3 If prices decrease, revenue decrease. If prices increase, revenue increases. A Area X = Q1CBQ2 Area Y =P1ACP2 Y B C X

38. Managerial Rule of Thumb: Estimating Price Elasticity Managers can estimate price elasticity by asking customers: • What do you currently pay for my product? • At what price would you stop buying my product altogether? Managers should ask themselves: • How much will revenue increase as a result of higher sales? • How much will revenue decrease as a result of lower prices for each unit?

39. Determinants of Price Elasticity of Demand • Number of substitute goods • Percent of a consumer’s income that is spent on the product • Time period under consideration • Nature of the good (durable or non-durable)

40. Calculating Price Elasticities • Arc price elasticity: base quantity (or price) is the average value of the starting and ending points • Point price elasticity: measurement of the price elasticity of demand calculated at a point on the curve using infinitesimal changes in prices and quantities

41. Numerical Examples • Demand function • Shows relationship between quantity demanded and price • Q = 12 – P or P = 12 – Q • Total revenue function • Shows total revenue received by producer as a function of the level of output • TR = (P) (Q) = (12 – Q) (Q) = 12Q – Q2

42. Numerical Examples • Average revenue function: shows how average revenue is related to level of output • AR = TR / Q = [(P) (Q)] / Q = P • Marginal revenue function: shows the additional revenue a producer receives by selling an additional unit of output at different levels • MR = (TR) / (Q) = (TR2–TR1) / (Q2–Q1) MR = dTR / dQ = 12–2Q

43. Demand and Marginal Revenue • Firms are always constrained by demand curve • Top half of the demand curve in Figure 3.4 indicates when managers lower price, total revenue increases • Bottom half indicates a price decrease causes total revenue to fall

44. 12 6 Demand 0 Quantity 6 12 Demand and Marginal Revenue Figure 3.4 Demand, marginal revenue, and total revenue functions are related |eP| > 1 |eP| = 1 |eP| < 1 Marginal Revenue

45. Total Revenue 36 18 Total Revenue 0 6 12 The Total Revenue Function Figure 3.5

46. Extreme Demand Curves • Vertical demand curve • Represents perfectly inelastic demand • Example might be insulin for diabetics • Horizontal demand curve • Represents perfectly elastic demand • Example would be a bushel of wheat from an agricultural producer

47. Vertical demand curve Price Demand 0 Quantity Q1 Horizontal demand curve Price P1 Demand 0 Quantity Extreme Demand Curves

48. Elasticities of Demand • Income elasticity of demand: percentage change in quantity demanded of a given good relative to percentage change in consumer income • Necessities – elasticity between 0 and 1 • Luxuries – elasticity greater than 1

49. Managerial Rule of Thumb: Calculating Income Elasticity • Calculating income elasticity of demand is based on two questions for a consumer: • What fraction of your total budget do you spend on Product X? • If you earned a bonus of $1000, what part of that bonus would you spend on Product X?

50. Elasticities of Demand • Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of Good Y • Substitute goods have positive cross elasticity • Complementary goods have negative cross elasticity • Defines relevant market in which different products compete