Business Economics Elasticity and its applications

Transcription

1 Business Economics Elasticity and its applications Thomas & Maurice, Chapter 6 Herbert Stocker herbert.stocker@uibk.ac.at Institute of International Studies University of Ramkhamhaeng & Department of Economics University of Innsbruck

2 Elasticities Question: How strongly reacts one variable in response of a change in another variable?

3 Elasticities Question: How strongly reacts one variable in response of a change in another variable? slope of a curve.

4 Elasticities Question: How strongly reacts one variable in response of a change in another variable? slope of a curve. e.g. Demand for wheat in the USA: Q d = P where Q d is measured in million bushels per year and P is measured in US$.

5 Elasticities Question: How strongly reacts one variable in response of a change in another variable? slope of a curve. e.g. Demand for wheat in the USA: Q d = P where Q d is measured in million bushels per year and P is measured in US$. Slope: dq d dp = 266 i.e. if the price increases by one dollar the quantity demanded decreases by 266 mio bushels!???

6 Elasticities Problem: For the interpretation of the slope we have to know the dimensions in which the units are measured!

7 Elasticities Problem: For the interpretation of the slope we have to know the dimensions in which the units are measured! Alfred Marshall ( ): proposed the use of relative changes! Price-elasticity = Percentage change in quantity Percentage change in price = % Q d % P

8 Elasticities Problem: For the interpretation of the slope we have to know the dimensions in which the units are measured! Alfred Marshall ( ): proposed the use of relative changes! Price-elasticity = Percentage change in quantity Percentage change in price = % Q d % P e.g. what is the percentage decrease in the quantity demanded of wheat if the price of wheat raises by one percent?

9 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable.

10 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable. Elasticities are a very general concept to express the strength of reaction of one variable in response to the change of another variable.

11 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable. Elasticities are a very general concept to express the strength of reaction of one variable in response to the change of another variable. Main advantage of elsticities: free of dimensions!

12 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable. Elasticities are a very general concept to express the strength of reaction of one variable in response to the change of another variable. Main advantage of elsticities: free of dimensions! Two concepts:

13 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable. Elasticities are a very general concept to express the strength of reaction of one variable in response to the change of another variable. Main advantage of elsticities: free of dimensions! Two concepts: Arc-Elasticity: discrete change between two observed points.

14 Elasticities Elasticity: Percentage change in the dependent variable resulting from a one percent increase in the independent variable. Elasticities are a very general concept to express the strength of reaction of one variable in response to the change of another variable. Main advantage of elsticities: free of dimensions! Two concepts: Arc-Elasticity: discrete change between two observed points. Point-Elasticity: infinitesimal change (function must be known).

15 Arc-Elasticity Y When only two pricequantity pairs are known: (for discrete changes) Y 1 before X 1 X

16 Arc-Elasticity Y When only two pricequantity pairs are known: (for discrete changes) Y 1 Y 2 before after X 1 X 2 X

17 Arc-Elasticity Y When only two pricequantity pairs are known: (for discrete changes) Y 1 Y Y 2 before after X 1 X X 2 X

18 Arc-Elasticity When only two pricequantity pairs are known: (for discrete changes) Y E B = = %-Change of Y %-Change of X Y 2 Y 1 Y 1 X 2 X 1 X 1 = Y X X 1 Y 1 Y Y 1 X X 1 Y X Y 1 X 1 Y 1 Y Y 2 X 1 before after X X 2 X

19 Arc-elasticity For discrete changes: e.g.: price raises from 2$ to 4$ quantity decreases from 20 kg to 15 kg. P P 2 = 4 P P 1 = 2 P = P 1 P 2 = 2 4 = 2 Q d

20 Arc-elasticity For discrete changes: e.g.: price raises from 2$ to 4$ quantity decreases from 20 kg to 15 kg. P P 2 = 4 P P 1 = 2 P = P 1 P 2 = 2 4 = 2 Q d

21 Arc-elasticity For discrete changes: e.g.: price raises from 2$ to 4$ quantity decreases from 20 kg to 15 kg. P P 2 = 4 P P 1 = 2 Q d = Q d1 Q d2 = = 5 P = P 1 P 2 = 2 4 = 2 15 = Q d2 Q d1 = 20 Q d Q d

22 Arc-elasticity For discrete changes: e.g.: price raises from 2$ to 4$ quantity decreases from 20 kg to 15 kg. P Q d = Q d1 Q d2 = = 5 P 2 = 4 P = P 1 P 2 P = 2 4 = 2 P 1 = 2 15 = Q d2 Q d1 = 20 Q d Q d E B Q d,p = Q d Q d1 P P 1 = = 1 4

23 Arc-Elasticity Problem: the values of the arc-elasticity depend on whether the price increases or decreases! E 1 Q d,p = Q d1 Q d2 Q d1 100 P 1 P 2 P E 2 Q d,p = Q d2 Q d1 Q d2 100 P 2 P 1 P 2 100

24 Arc-Elasticity Problem: the values of the arc-elasticity depend on whether the price increases or decreases! E 1 Q d,p = Q d1 Q d2 Q d1 100 P 1 P 2 P E 2 Q d,p = Q d2 Q d1 Q d2 100 P 2 P 1 P Solution: Mid-Point Method E Qd,P = Q d1 Q d2 (Q d1 +Q d2 )/2 100 P 1 P 2 (P 1 +P 2 )/2 100

25 Point-Elasticity For curvilinear demand curves: Slope is calculated by using the derivative ( d). Point Elasticity: P E Qd,P = dq d dp Q d P P 1 = dq d dp P Q d Q d1 Q d

26 Point-Elasticity Example: What is the price elasticity of demand for the following demand function: Q d = P at the price P 1 = 2, ( Q d1 = = 20): E Qd,P = dq d dp P 1 Q d1

27 Point-Elasticity Example: What is the price elasticity of demand for the following demand function: Q d = P at the price P 1 = 2, ( Q d1 = = 20): P 1 E Qd,P = dq d dp Q d1 = = 0.25

28 Point-Elasticity Example Q d = P at a different price P 2 = 4 demand is Q d2 = 15, and the elasticity is therefore P 2 E Qd,P = dq d dp = Q d2 = For linear functions, the value of the elasticity is different at each point!

29 Point-Elasticity Problem: For linear functions the elasticity is not constant along the line! E Qd,P = dq d dp P i Q di

30 Point-Elasticity Problem: For linear functions the elasticity is not constant along the line! E Qd,P = dq d dp P i Q di Solution: the elasticity is often calculated at the mean value of the variable. E Qd,P = dq d dp P Q d mit: P 1 N N i=1 P i und Q d 1 N N i=1 Q di

31 Elasticities An elasticity shows the percentage change in the dependent variable (Y) when the independent variable (X) increases by one percent. Elasticities are positive if the derivative is positive, i.e. if the variables move in the same direction.

32 Elasticities An elasticity shows the percentage change in the dependent variable (Y) when the independent variable (X) increases by one percent. Elasticities are positive if the derivative is positive, i.e. if the variables move in the same direction. Elasticities are negative if the variables move in opposite directions.

33 Elasticities An elasticity shows the percentage change in the dependent variable (Y) when the independent variable (X) increases by one percent. Elasticities are positive if the derivative is positive, i.e. if the variables move in the same direction. Elasticities are negative if the variables move in opposite directions. An elasticity measures how strongly one variable reacts in response of a change in another variable.

34 Rule of Thumb Managers can get a rough estimate of price elasticity by asking two questions: What price P customers you currently pay for the product?

35 Rule of Thumb Managers can get a rough estimate of price elasticity by asking two questions: What price P customers you currently pay for the product? At what price A would customers stop buying my product altogether?

36 Rule of Thumb Managers can get a rough estimate of price elasticity by asking two questions: What price P customers you currently pay for the product? At what price A would customers stop buying my product altogether? The answers to this questions can be used to calculate a rough estimate of the demand elasticity, since E Qd,P = P (P A) where P is the price and A is the vertical intercept of the plotted demand curve (the P-axis).

37 Rule of Thumb Why? P A P Q P = A sq Q = 1 s [A P] dq dp = 1 s E = dq P dp Q = 1 P s 1 s [A P] P = P A

38 Graphical Derivation Elasticity and Angle

39 Slope and Angle Remember: Hypotenuse α Adjacent Opposite leg tanα = Opposite leg Adjacent = Slope

40 Elasticity and Angle Y A Y = f(x) dy dx = tanα α X

41 Elasticity and Angle Y X A A Y = f(x) dy dx = tanα Y A β X A Y A α X Y A X A = tanβ

42 Elasticity and Angle Y X A Y A β X A A Y A α X Y = f(x) dy dx = tanα Y A X A E A = = tanβ dy dx Y A = tanα tanβ X A

43 Elasticity and Angle Y E A = dy dx Y A = tanα tanβ X A A Y = f( X ) Y A β X A α X

44 Elasticity and Angle P E A = dq d dp Q db = tanα tanβ P B α B Q d = f( P ) P B β Q db Q d

45 Elasticity and Angle P Q d

46 Elasticity and Angle P 4 3 α β E 1 = tanα tanβ = Q d = 1 3

47 Elasticity and Angle P α β γ E 2 = tanα tanγ = E 1 = tanα tanβ = Q d = 1 = 1 3

48 Elasticity and Angle P α δ β γ E 3 = tanα tanδ = E 2 = tanα tanγ = = 3 E 1 = tanα tanβ = Q d = 1 = 1 3

49 Elasticity and Angle P E 4 = tanα tan(0) = α δ β γ E 3 = tanα tanδ = = 1 0 = E 2 = tanα tanγ = = 3 E 1 = tanα tanβ = Q d = 1 = 1 3

50 Elasticity and Angle P E 4 = tanα tan(0) = α δ β γ E 3 = tanα tanδ = = 1 0 = E 2 = tanα tanγ = = 3 E 1 = tanα tanβ = Q d = 1 = 1 3 E 0 = tanα tan(90) = = 1 = 0

51 Elasticity and Angle P Positive Intercept: β α A Q d tanα > tanβ dq d dp E A = Q da P A = tanα tanβ > 1 Question: which value has the elasticity of a linear function that goes through the origin?

52 Functions with constant elasticity Y = f(x) = AX b dy dx = baxb 1 Y X = AXb X = AXb 1 E Y,X = dy dx Y X = baxb 1 AX b 1 = b Elasticities of power-functions are always constant!

53 Functions with constant elasticity Example: Y = f(x) = 3X 0.5 dy dx = 0.5 3X0.5 1 = 0.5 3X 0.5 Y X = 3X0.5 X = 3X0.5 1 = 3X 0.5 E Y,X = dy dx Y X = 0.5 3X 0.5 3X 0.5 = 0.5

54 Elasticities of log-linear Functions lny = f(lnx) E Y,X = d lny dy d lnx = Y dx X = dy dx X Y

55 Elasticities of log-linear Functions lny = f(lnx) E Y,X = d lny dy d lnx = Y dx X = dy dx X Y Example: Y = f(x) = 3X 0.5 lny = ln3+0.5lnx E Y,X = d lny d lnx = 0.5

56 Elasticities of log-linear Functions Intuition: d lny dy d lnx dx E Y,X = d lny dy d lnx = Y = 1 Y = 1 X dx X d lny = dy Y d lnx = dx X E Y,X = dy Y dx X = d lny d lnx

57 Elasticities of log-linear Functions Example: Y = AX b lny = lna+blnx E Y,X = d lny d lnx = b

58 Elasticities of log-linear Functions Example: Example: Y = AX b lny = lna+blnx E Y,X = d lny d lnx = b Y = f(x) = 0.25X 2 lny = ln0.25 2lnX E Y,X = d lny d lnx = 2

59 Demand with constant elasticity Elastic: P Q d = 2P 0.5 Q d = 0.25P 2 lnq d = ln0.25 2lnP E Qd,P = 2 Q d = 0.25P 2 Q d Inelastic: Q d = 2P 0.5 lnq d = ln2 0.5lnP E Qd,P = 0.5

60 Applications of Elasticities Theory of Demand

61 Price Elasticity of Demand Demand Function: Q d = Q d (P,M,P S,P C,...) Price Elasticity of Demand: (sometimes called price or demand elasticity) E Qd,P = dq d dp Q d P = dq d dp P % Q d Q d % P

62 Price Elasticity of Demand Demand Function: Q d = Q d (P,M,P S,P C,...) Price Elasticity of Demand: (sometimes called price or demand elasticity) E Qd,P = dq d dp Q d P = dq d dp P % Q d Q d % P The Price Elasticity of Demand shows the percentage decrease of the quantity demanded if price ceteris paribus increases by one percent.

63 Price Elasticity of Demand Demand is elastic if E Qd,P > 1, or % Q > % P (The quantity demanded responds more than proportionally to a a change in price. Since the price elasticity is usually negative it is common to use the absolute value E Qd,P.

64 Price Elasticity of Demand Demand is elastic if E Qd,P > 1, or % Q > % P (The quantity demanded responds more than proportionally to a a change in price. Demand is unit elastic if E Qd,P = 1, or % Q = % P Since the price elasticity is usually negative it is common to use the absolute value E Qd,P.

65 Price Elasticity of Demand Demand is elastic if E Qd,P > 1, or % Q > % P (The quantity demanded responds more than proportionally to a a change in price. Demand is unit elastic if E Qd,P = 1, or % Q = % P Demand is inelastic if 0 < E Qd,P < 1, or % Q < % P (The quantity demanded responds less than proportionally to a a change in price. Since the price elasticity is usually negative it is common to use the absolute value E Qd,P.

66 Linear Demand Function and Elasticity In which point of a linear demand function the elasticity has the value 1? P a 2b E Qd,P = elastic inelastic E Qd,P = 1 a a 2 E Qd,P = 0 Q d Q d = a bp E Qd,P = dq d P dp Q d = bp a bp = 1 bp = a bp P = a 2b ( a ) Q d = a b = 2b

67 Special cases... Perfectly inelastic demand: E Qd,P = 0 P Q d A change in price has no effect on the quantity demanded!

68 Special cases... Perfectly inelastic demand: E Qd,P = 0 P Perfectly elastic demand: E Qd,P = P Q d A change in price has no effect on the quantity demanded! Q d A change in price has an infinitely large effect on the quantity demanded!!

69 Determinants of price elasticity Determinants of price elasticity: ceteris paribus demand tends to be more elastic,... the more and closer substitutes are available.

70 Determinants of price elasticity Determinants of price elasticity: ceteris paribus demand tends to be more elastic,... the more and closer substitutes are available. when the good is rather a luxury than a necessity.

71 Determinants of price elasticity Determinants of price elasticity: ceteris paribus demand tends to be more elastic,... the more and closer substitutes are available. when the good is rather a luxury than a necessity. the higher the proportion of income spent on the good.

72 Determinants of price elasticity Determinants of price elasticity: ceteris paribus demand tends to be more elastic,... the more and closer substitutes are available. when the good is rather a luxury than a necessity. the higher the proportion of income spent on the good. the longer the time period under consideration.

73 Determinants of price elasticity Determinants of price elasticity: ceteris paribus demand tends to be more elastic,... the more and closer substitutes are available. when the good is rather a luxury than a necessity. the higher the proportion of income spent on the good. the longer the time period under consideration. demand for durable goods tends to be more elastic than demand for non-durables (consumers choose to hold on to the good instead of replacing it).

74 Price elasticities for cars Model Price Estimated E Qd,P Mazda 323 $ 5, Nissan Sentra $ 5, Ford Escort $ 5, Honda Accord $ 9, Ford Taurus $ 9, Nissan Maxima $13, Cadillac Sevifle $24, Lexus LS400 $27, BMW 735i $37, Source: Table V in S. Berry, Levinsohn, and A. Pakes, Automobile Prices in Market Equilibrium, Econometrica 63 (July 1995): [aus: D. Besanko & D. Braeutigam, Microeconomics (Wiley)] probably cheaper cars are perceived more as substitutes than luxury cars.

75 Price Elasticity Attention: Even if the demand for the entire product is rather inelastic the elasticity for the individual producer might be quite large.

76 Price Elasticity Attention: Even if the demand for the entire product is rather inelastic the elasticity for the individual producer might be quite large. For example, the demand for eggs or potatoes is rather inelastic, but the elasticity for the eggs or potatoes of an individual farmer might be close to infinity!

77 Price Elasticity of Demand and Total Revenue

78 Elasticity & Total Revenue Elastic Demand: P Inelastic Demand: P Q d Total revenue is P Q d (i.e. the hatched area) Q d

79 Elasticity & Total Revenue Elastic Demand: P Inelastic Demand: P Q d Total revenue decreases when price increases! Total revenue is P Q d (i.e. the hatched area) Q d

80 Elasticity & Total Revenue Elastic Demand: P Inelastic Demand: P Q d Total revenue decreases when price increases! Q d Total revenue increases when price increases! Total revenue is P Q d (i.e. the hatched area)

81 Elasticity & Total Revenue P E = elastic inelastic E = 1 a 2 E = 0 Q d

82 Elasticity & Total Revenue P E = elastic inelastic E = 1 If demand is ineleastic price and total revenue move in the same direction! E = 0 a 2 Q d

83 Elasticity & Total Revenue P E = elastic inelastic E = 1 E = 0 a 2 Q d

84 Elasticity & Total Revenue P E = elastic inelastic E = 1 If demand is elastic price and total revenue move in opposite direction! E = 0 a 2 Q d

85 Elasticity & Total Revenue With Calculus: d(tr) dp TR = P Q(P) d[p Q(P)] = dp = Q +P dq ( dp = Q 1+ dq ) P dp Q = Q(1+E Qd,P) = Q(1 E Qd,P )

86 Elasticity & Total Revenue d(tr) dp = Q(1 E Q d,p ) d(tr) dp = 0 for E Q d,p = 1 Max.!

87 Elasticity & Total Revenue d(tr) dp = Q(1 E Q d,p ) d(tr) dp = 0 for E Q d,p = 1 Max.! d(tr) dp < 0 for E Q d,p > 1 elastic

88 Elasticity & Total Revenue d(tr) dp = Q(1 E Q d,p ) d(tr) dp = 0 for E Q d,p = 1 Max.! d(tr) dp < 0 for E Q d,p > 1 elastic d(tr) dp > 0 for E Q d,p < 1 inelastic

89 Other Elasticities

90 Income Elasticity Demand function: Q d = Q d (P,M,P S,P C,...) Income Elasticity of Demand: E Qd,M = = Percentage change in quantity demanded Percentage change in income dq d dm Q d M = dq d dm M % Q d Q d % M

91 Income Elasticity Demand function: Q d = Q d (P,M,P S,P C,...) Income Elasticity of Demand: E Qd,M = = Percentage change in quantity demanded Percentage change in income dq d dm Q d M = dq d dm M % Q d Q d % M The Income Elasticity of Demand shows the percentage change in quantity demanded if income ceteris paribus increases by one precent.

92 Income Elasticity of Demand Normal goods (necessities): 0 < E Qd,M < 1: income elasticity is between 0 and 1.

93 Income Elasticity of Demand Normal goods (necessities): 0 < E Qd,M < 1: income elasticity is between 0 and 1. Luxury or superior goods: E Qd,M > 1: if income ceteris paribus increases by one percent the quantity demanded will increase by more than one percent! Example: lobster,...

94 Income Elasticity of Demand Normal goods (necessities): 0 < E Qd,M < 1: income elasticity is between 0 and 1. Luxury or superior goods: E Qd,M > 1: if income ceteris paribus increases by one percent the quantity demanded will increase by more than one percent! Example: lobster,... Inferior goods: E Qd,M < 0: the quantity demanded decreases if income increases! Example: second-hand clothes, rice,...

95 Income Elasticity of Demand Income elasticity of demand can be important for firms: Demand for luxuries increases more than proportional with income, markets for luxuries tend to grow more rapidly than markets for normal and inferior goods.

96 Income Elasticity of Demand Income elasticity of demand can be important for firms: Demand for luxuries increases more than proportional with income, markets for luxuries tend to grow more rapidly than markets for normal and inferior goods. Firms can try to target marketing campaigns to consumer groups with higher income elasticity.

97 Income Elasticity of Demand Income elasticity of demand can be important for firms: Demand for luxuries increases more than proportional with income, markets for luxuries tend to grow more rapidly than markets for normal and inferior goods. Firms can try to target marketing campaigns to consumer groups with higher income elasticity. Developing countries are often specialized in primary production with low income elasticities.

98 Income Elasticity of Demand Estimates of the Income Elasticity of Demand for Selected Food Products Product Estimated E Qd,M Product Estimated E Qd,M Cream 1.72 Milk 0.50 Peaches 1.43 Butter 0.37 Apples 1.32 Potatoes 0.15 Fresh peas 1.05 Margarine 0.20 Oranges 0.83 Flour 0.36 Eggs 0.44 Source: Daniel B. Suits, Agriculture, in: The Structure of American Industry, W. Adams and J. Brock, eds. (Englewood, Nj: Prentice Hall), 1995; H. S. Houthhakker and Lester D. Taylor, Consumer Demand in the United States, (Cambridge, MA: Harvard University Press), taken from: D. Besanko & D. Braeutigam, Microeconomics (Wiley)

99 Cross Price Elasticity Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of another Good Y.

100 Cross Price Elasticity Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of another Good Y. Substitute goods have positive cross elasticity.

101 Cross Price Elasticity Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of another Good Y. Substitute goods have positive cross elasticity. Complementary goods have negative cross elasticity.

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

103 Cross Price Elasticity Demand function: Q d = Q d (P,M,P S,P C,...) Cross Price Elasticity of Demand: E Qd,P S = = Percentage change in demand for good A Percentage change in price for good B dq da dp B Q da P B = dq da dp B P B Q da % Q da % P B

104 Cross Price Elasticity Demand function: Q d = Q d (P,M,P S,P C,...) Cross Price Elasticity of Demand: E Qd,P S = = Percentage change in demand for good A Percentage change in price for good B dq da dp B Q da P B = dq da dp B P B Q da % Q da % P B The Cross Price Elasticity of Demand shows the percentage change in the demand for a good, if the price of another good changes by one percent.

105 Cross Price Elasticity Substitutes: (e.g. Cafe and Tea) cross price elasticity is positive if tea becomes more expensive the demand for cafe increases. E Qd,P S = dq d P S > 0 dp S Q d

106 Cross Price Elasticity Substitutes: (e.g. Cafe and Tea) cross price elasticity is positive if tea becomes more expensive the demand for cafe increases. E Qd,P S = dq d P S > 0 dp S Q d Complementary Goods: (e.g. cafe and sugar) cross price elasticity is negative if cafe becomes more expensive the demand for sugar decreases. E Qd,P C = dq d P C < 0 dp C Q d

107 Price and Cross Price Elasticities Demand for Price of Beef Price of Pork Price of Chicken Beef Pork Chicken Source: Daniel B. Suits, Agriculture, in: The Structure of American Industry, W. Adams and J. Brock, eds. (Englewood, Nj: Prentice Hall), 1995 entnommen aus: D. Besanko & D. Braeutigam, Microeconomics (Wiley) Price elasticities are on the main diagonale, off the main diagonal are the cross price elasticities. e.g.: 0.65 is the price elasticity of beef, 0,01 is the cross price elasticity of the demand for beef with respect to the price of pork.

108 Price and Cross Price Elasticities Sometimes useful to judge whether markets are related. Price of Price of Price of Price of Demand for Sentra Escort LS i Sentra Escort LS i Source: S. Berty Levinsohn, and A. Pakes, Automobile Prices in Market Equilibrium, Econometrica 63 (July 1995): entnommen aus: D. Besanko & D. Braeutigam, Microeconomics (Wiley) Diagonal elements: the price elasticity of demand Off-diagonal elements: the cross-price elasticity of demand.

109 Demand for Coca- and Pepsi Cola Econometrically estimated demand functions: Q d c = Pc +2.25Pp +2.60Ac 0.62Ap +0 Q d p = Pp +1.40Pc +2.83Ap 4.81Ac +1 Q d c quantity demanded of Coca-Cola (ten million cases) Q d p quantity demanded of Pepsi (ten million cases) Pc price of Coca-Cola (dollars per ten cases) Pp price of Pepsi (dollars per ten cases) Ac advertising expenditures on behalf of Coca-Cola Ap advertising expenditures on behalf of Pepsi M disposable income in the United States All prices expressed in 1986 U.S. dollars!

110 Elasticities: Coca Cola und Pepsi Cola By inserting the means (e.g. Pc = 12,96, Pp = 8,16; Ac = 5,89;...) one can calculate the elasticities in the mean: Price, Cross-Price, and Income Elasticities of Demand for Coca-Cola and Pepsi Elasticity Coca-Cola Pepsi Price elasticity of demand Cross-price elasticity of demand Income elasticity of demand Source: Gasmi, F., J.J. Laffont and Q. Vuong (1992): Econometric Analysis of Collusive Behaviour in the Soft Drink Market, Journal of Economics and Marketing Strategy, Vol. 1 entnommen aus: D. Besanko & D. Braeutigam, Microeconomics (Wiley)

111 Advertising Elasticity of Demand Advertising elasticity of demand: the percentage change in quantity demanded of a good relative to the percentage change in advertising dollars spent on that good.

112 Advertising Elasticity of Demand Advertising elasticity of demand: the percentage change in quantity demanded of a good relative to the percentage change in advertising dollars spent on that good. Marketing studies: e.g. Tellis, 1988; Sethuraman and Tellis, 1991; Hoch, et al, 1995

113 Advertising Elasticity of Demand Advertising elasticity of demand: the percentage change in quantity demanded of a good relative to the percentage change in advertising dollars spent on that good. Marketing studies: e.g. Tellis, 1988; Sethuraman and Tellis, 1991; Hoch, et al, 1995 Advertising elasticities of demand tend to be much smaller than price elasticities of demand (by a factor 10-15).

114 Supply Elasticity Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. E S,P = ds dp S P = ds dp P S 0 Supply is elastic when E S,P > 1

115 Supply Elasticity Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. E S,P = ds dp S P = ds dp P S 0 Supply is elastic when E S,P > 1 Supply is inelastic when E S,P < 1

116 Supply Elasticity Determinants of Elasticity of Supply: Time period: Supply is more elastic in the long run!

117 Supply Elasticity Determinants of Elasticity of Supply: Time period: Supply is more elastic in the long run! Ability of sellers to change the amount of the good they produce. (Beach-front land is probably inelastic, while books, cars, or manufactured goods are rather elastic)

118 Special cases... Perfectly Inelastic Supply: E S,P = 0 P An increase in price leaves the S quantity supplied unchanged!

119 Special cases... Perfectly Inelastic Supply: E S,P = 0 P Perfectly Elastic Supply: E S,P = P An increase in price leaves the S quantity supplied unchanged! Q s Below the price the quantity supplied is zero, above it is infinite!

120 Price Elasticity in Marketing

121 Managerial Price Sensitivity Analysis The price elasticity of demand (in marketing literature often called price sensitivity) is one of the most important variables for managers. A managerial analysis of price elasticity should be a written document that can be criticized and improved over time. It should include some of the following questions:

122 Reference Price Substitutes and Reference Price: Are there close substitutes to the product, and if so, are the buyers (or a segment of buyers) usually aware thereof when making a purchase? Can they compare prices? Can buyers speed up or delay purchases based on expectations of future prices? How difficult is it for buyers to compare offers of different suppliers?

123 Switching Cost & Expenditure Share To what extent have buyers already made investments (monetary and/or psychological) that they would need to incur again if they switched suppliers? For how long are buyers presumably locked by those expenditures? How significant are buyers expenditures for the product? For end consumers mainly the portion of income is important. For business customers also the absolute price might be important.

124 Fairness Buyers are more sensitive to a product s price when it is outside the range that they perceive as fair or reasonable. How does the current price compare with prices people have paid in the past? What do buyers expect to pay for similar products? Do customers perceive the product as necessity or as a discretionary purchase?

125 Framing Effect Prospect Theory: (D. Kahneman & A. Tversky) Essential idea: people frame purchasing decisions in their minds as a bundle of gains and losses. Consumers tend to be more price sensitive when they perceive the price as a loss rather than a foregone gain. Additionally, they are more price sensitive when the price is paid separately rather than as part of a bundle.

126 Framing Effect Example: (Prospect Theory) Gas station A sells gasoline for $1.20 and gives a $0.10 per liter discount if the buyer pays with cash. Gas station B sells gasoline for $1.10 and charges a $0.10 surcharge if the buyer pays with credit card. Most people choose station A. We ll have to say a lot more about price elasticities when we study optimal pricing on imperfect markets.

127 Any questions? Thanks!