Understanding Demand Elasticity and Its Impact on Marketing and Consumer Behavior, Lecture notes of Marketing

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ECO 610: Lecture 2

Theory of Demand; Elasticity; and

Marketing and Consumer Behavior

Theory of Demand; Elasticity; and Marketing

and Consumer Behavior: Outline

• Demand Theory and Marketing Research Households’ demand for final goods and services Firms’ demand for factors of production
• Elasticity Own-price elasticity of demand  Calculating elasticity  Own-price elasticity and total revenue  Factors affecting own-price elasticity Income elasticity of demand Cross-price elasticity of demand
• Estimating demand relationships

Households’ demand for final goods and

services

• Why do households demand final goods and services?
• Because households get utility from consuming goods and services.
• Quantity Demanded (Q (^) D ): total amount of a commodity that all households wish to purchase.
• Factors affecting Q (^) D :
  1. tastes or preferences
  2. income
  3. price of the product
  4. prices of other products a) substitutes in consumption b) complements in consumption

5. other things?

Firms’ demand for factors of production

• Why do firms demand inputs (factors of production)?

Because firms use inputs to produce outputs that can be sold for profits.

• Demand for an input is derived from the demand for the final good or service the input is used to produce.
• Two key economic factors in a firm’s demand for an input:

Household demand for the final good or service Extent to which the firm is able to substitute one input for another in its production process

Elasticity

• Demand function: quantity demanded of good X depends consumers’ tastes or preferences, incomes, the price of good X, and the prices of other goods (like good Y, a substitute, and good Z, a complement).
• Algebraically: X (^) D = dx (Tastes, Incomes, PX , PY , PZ)
• We are interested in the relationship between quantity demanded of X and each of the economic factors which influence it. We have already discussed conceptually the direction of the effect of each variable that affects X (^) D
• Now we want to consider the magnitude. If the price of X changes by a given amount, by how much will the quantity demanded of X change, i.e. how sensitive is quantity demanded to a change in price?

Three elasticities

• Own price elasticity of demand : measures the sensitivity of quantity demanded of good X to a change in the price of good X
• εx, Px = - (%ΔX (^) D ) / (%ΔPx )
• Income elasticity of demand : measures the sensitivity of quantity demanded to a change in income
• εx, Income = (%ΔX (^) D ) / (%ΔIncome)
• Cross-price elasticity of demand : measures the sensitivity of quantity demanded of good X to a change in the price of good Y
• εx, Py = (%ΔXD ) / (%ΔPY )

Calculating Price Elasticity of Demand for Tennis Lessons

Q (# of Students per week)

B

Price per Lesson ($/hr)

5 10 15 20 25 30

10 8

4 2

C D

A

D

Examples calculating arc elasticity

• Calculating εx, Px from

point A to point B:

P 0 =10, P 1 =8, Q 0 =5, Q 1 =

• Calculating εx, Px from

point C to point D: P 0 =4, P 1 =2, Q 0 =25, Q 1 =

- 2

E d = −

11

3 ) 3 11

1 ) ( 2

6 )( 55

5 (

6

2

55

5

4 2

2 4

25 30

30 25

= = =

-

=

- -

E (^) d = −

− +

Own-price elasticity and total revenue

• “Thrill parks try to boost attendance: Some lower their fees to attract crowds,” Lexington Herald-Leader , 5/27/06. http://bit.ly/odthLq
• https://www.cedarpoint.com/play/rides-coasters
• Case study: you own and operate an amusement park. Your costs are primarily fixed—once you decide on a schedule your costs do not vary much with the number of patrons in the park.
• Challenge is to maximize total revenues, in so doing you will maximize profits.
• If you want to increase total revenues, should you raise price or lower the price of admission?

Total Revenue = Price * Quantity [TR = P*Q]

• Suppose you raise price by 5% and the number of customers falls by 10% in response. What is own-price elasticity of demand? Does total revenue go up or down?
• Suppose you lower price by 5% and the number of customers increases by 10% in response. What is own-price elasticity of demand? Does total revenue go up or down?
• Suppose you raise price by 10% and the number of customers falls by 5% in response. What is own-price elasticity of demand? Does total revenue go up or down?
• Suppose you lower price by 10% and the number of customers increases by 5% in response. What is own-price elasticity of demand? Does total revenue go up or down?

Determinants of Price Elasticity

• Are there economic characteristics of the product that might help us predict whether demand will be elastic or inelastic? Under what conditions will consumers be sensitive or insensitive to a change in price?

 Availability of substitutes : if there are many good close substitutes for a product and its price increases, then consumers will be more likely to choose an alternative to this product.  Definition of the product : the more narrowly defined is the product, the more good close substitutes there are and the more elastic demand will be.

 Share of the budget : the greater the share of their budget consumers spend on an item, the more sensitive they will be to a price change.

 Time to adjust : the more time that consumers have to adjust to a price change, the more sensitive they will be to a price change.

Examples using own-price elasticity

• Residential demand for electricity—availability of substitutes. Lighting? Space heating?
• Forecasting energy demand for KU/LG&E—short run vs. long run?
• Supermarket advertising and loss leaders—milk or salt?
• How to set excise taxes if the goal is to raise revenue—excise tax on cigarettes? Sales tax on thoroughbreds at Keeneland?

Examples using Income Elasticity of Demand

• Kentucky Lottery Commission: what are your products? Who are your customers, i.e. what is the income elasticity of demand for the different products you sell? How would you market the different products?
• Instant scratch-off games?
• Daily numbers games?
• Lotto games: e.g. Pick Six, Powerball?
• How would you go about estimating income elasticity of demand for different lottery products?

Cross-price Elasticity of Demand

• εx, Py = (%ΔXD ) / (%ΔPY ) = [ΔQ / (Q 0 + Q 1 )] / [ΔPY / (PY0 + PY1)]
• εx, Py > 0 when an increase in the price of good Y leads to an increase in the demand for good X and vice versa. Goods X and Y are Substitutes.
• εx, Py < 0 when an increase in the price of good Y leads to an decrease in the demand for good X and vice versa. Goods X and Y are Complements.
• How do we interpret the magnitude of the cross-price elasticity? i.e. what is the cross-price elasticity between Coke and Pepsi? Coke and Snapple iced tea? Coke and Dean’s chocolate milk? Coke and Bud Lite?