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Chapter 2

Chapter 2 EC260.docx

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Karen Huff

EC260 Chapter 2 – Demand Theory Week 2 Demand Theory -Good managers learn to understand the nature of demand for products and effectively manage it -Many other factors besides price affect consumer demand – some of these are controlled by managers, such as advertising, product quality, and distribution -Other factors, like the number of substitute goods, the prices of rival products, and the advertising of rivals are part of the competitive dynamics of the product space -Knowing the sensitivity of demand to changes in environmental factors lets a manager effectively respond to these changes -The sensitivity of one factor to another is called elasticity -Elasticity – elasticity measures the percentage change in one factor given a small (marginal) percentage change in another factor -Elasticity is used by managers to determine a product’s most efficient mix of inputs The Market Demand Curve -Ways to show how sales of a product are affected by its price: -Market demand schedule – table showing the total quantity of the good purchased at each price -Market demand curve – the plot of the market demand schedule on a graph -The vertical axis of the graph measures the price per unit of the good -The horizontal axis measures the quantity of the good demanded per unit of time -Factors that determine the position and shape of a market demand curve: time, tastes of consumers, level of consumer incomes, level of other prices, size of the population Industry and Firm Demand Functions -Market demand function – the relationship between the quantity demanded and the various factors that influence this quantity The Own-Price Elasticity of Demand -The elasticity of a function is defined as the percentage change in the dependent variable in response to a 1 percent change in the independent variable -A market demand curve is a function in which quantity demanded is dependent on a product’s price -Own-price elasticity of demand – more simply referred to as price elasticity of demand, this is the concept managers use to measure their own percentage change in quantity demanded resulting from a 1 percent change in their own price -The word own is used to convey the idea that managers generally measure the price elasticity of demand for a product or service produced by their firm -The price elasticity of demand is defined as the percentage change in quantity demanded resulting from a 1 percent change in price -The price elasticity of demand is expressed as a negative number -For most demand curves, the elasticity varies with price -The magnitude of the ales response to price changes does not remain constant Using the Demand Function to Calculate the Price Elasticity of Demand -Specify the point on the demand cure at which price elasticity is measured: Use Q=-700P + 200I – 500S +0.01A -Substitute the appropriate letters in EC260 Chapter 2 – Demand Theory Week 2 The Effect of Price Elasticity on the Firm’s Revenue -We can use price elasticity to determine how a price change will affect a firm’s total revenue -Suppose at the current price, demand for a product is price elastic; that is, the price elasticity of demand is less than -1. In this situation, if the price is reduced, the percentage increase in quantity demanded is greater than the percentage reduction in price. That is, although all units are now being sold at a lower price, the increase in units sold because of the lower price more than makes up for the slightly lower unit price. Hence, total revenue increases. Similarly, if demand is elastic at the current price and a manager increases the price, total revenue will decrease. Determinants of the Own-Price Elasticity of Demand -Depends heavily on the similarity of available substitute products. A product with many close substitutes generally has elastic demand. If managers increase the product’s price, consumers can easily switch to one of the several other substitutes. -A products price relative to a consumer’s total budget. Products that command a larger percentage of the consumer’s total budget tend to be more price elastic. -Length of the period to which the demand curve pertains. Demand is likely to be more elastic over a long period relative to a short period. This is because the longer the time period, the easier it is for consumers to substitute one good for another. The Strategic Use of th
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