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Class Notes for Economics for Managers, 3rd Edition

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    Chapter 1: Managers and Economics 1 CHAPTER 1: MANAGERS AND ECONOMICS OVERVIEW This chapter introduces students to economics and how managerial decisions are affected by both microeconomics and macroeconomic factors. Microeconomics is the study of how consumers, firms and industries make decisions regarding the products that they buy and sell. Macroeconomics is the study of the overall level of economic activity, including topics such as changes in the price level, unemployment and economic growth. The case study on the global automobile industry demonstrates how managerial decisions are influenced by changing microecono mic and macroeconomic variables . Microeconomic influences include how consumer behavior affects revenues, and how technology and the market structure affect the costs of production. Macroeconomic influences include changes in aggregate spending in the economy, monetary and fiscal policies as well as outside influences in the rest of the world. O UTLINE OF TEXT MATERIAL I. Managers and Economics A. Motivate why managers should study economics. B. Managers need to understand both microeconomics and macroeconomics as they make decisions. C. The textbook presents both areas and integrates them from a managerial standpoint. II. Case for Analysis : Micro - and Macroeconomic Influences on the Global Automobile Industry . The case illustrates how microeconomic and macroeconomic factors influence managerial decisions. A. Macroeconomic points: 1. The case demonstrates how a manufacturing industry is influenced by the currency exchange rate (a) A strong Japanese yen and a weak US dollar motivate the Japanese auto makers to shift their production to the US 2. The case demonstrates the impact of foreign investment on the economy

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    Chapter 1: Managers and Economics 2 (a) Investments by the Japanese auto makers into the US economy helped expedite the economic recovery and employment growth in the US 3. The case illustrated how the recovery of the US economy impacts the demand for new vehicles (implying that new cars are a normal good). B. Microeconomic points: 1. The case uses the example of China to demonstrate how consumer preferences influence production differentiation. 2. The case also shows how competition induces businesses to innovate and introduce new product characteristic (the use of Sync entertainment systems) . 3. The case shows how competition between the auto makers influences the market for the inputs (auto parts). III. Two Perspectives: Microeconomics and Macroeconomics A. Microeconomics : Branch of economics that analyzes the decisions of individual consumers, firms and industries . Microeconomics is analogous to viewing a detailed picture of the economy under the microscope. 1. Prices , amounts of money charged for goods and services in the economy, influence the behavior of consumers and producers. 2. Prices of outputs and inputs (land, labor capital, raw materials, entrepreneurship) affect production decisions of firms. 3. Managerial Economics : Microeconomics applied to managerial decisions of businesses. B. Macroeconomics : Branch of economics that focuses on overall economic activity . Macroeconomics is analogous to viewing a big picture of the economy from 30,000 feet in the air. 1. Changes in the overall price level and a mount of unemployment affect consumers and producers at the aggregate level . Teaching Tip: Point out to the students that the study of economics starts with learning a whole new vocabulary. Make sure that students understand the distinction of micr oeconomics and macroeconomics. Use the case of analysis at the

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    Chapter 1: Managers and Economics 3 start of the chapter to ask them whi ch factors are microeconomic or macroeconomic. IV. Microeconomic Influences on Managers A. Relative Price: The price of one good in relation to the price of another good. 1. Consumers respond to relative prices (prices of Japanese cars relative to those of their US competitors) 2. Businesses choose their input combinations based on the relative prices of the inputs (wages in Japan relative to wages in the US; the price of one material versus the price of a substitute material and so on) 3. Non - price factors and their impact on the cost to the consumer (the cost of financing a car purchase) B. Product specifications and the consumer preferences (Chinese market versus US market) Teaching Tip: Make sure the students understand what relative prices are rather than absolute prices. A good example is a trip to Wal - Mart or any grocery store when one decides how expensive a particular product is by comparing pri ces of similar products. An example is the comparison of the prices of oranges to grapefruit. C. The strategic decisions of managers depend on the market structure. 1. Mark ets : The mechanisms used for the buying and selling of products. There are four mar kets used in microeconomics, ranging from perfect competition, monopolistic competition, oligopoly, to monopoly. 2. Perfect Competition : Market structure characterized by a large number of firms that sell an undifferentiated product, with easy entry into the market and complete information available for all participants. (a) Each firm is considered a “price - taker” that has no influence on the market price of the product. (b) Profits signal new firms to enter the market until all profits are competed away as new firms enter the market to capture the excess profit. (c) Profit: Total revenue to the firm from the sales of its product minus the total cost of production.

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    Chapter 1: Managers and Economics 4 3. Market Power : Ability of a firm to influence the market price of its product and strategies to earn large profits over time. 4. Imperfect Competi ti on : Market structures of monopoly, oligopoly and monopolisti c competition in which firms have some market power. 5. Monopoly : Market structure characterized by a single firm producing a good with no close substitutes. (a) Barriers to entry (structural, legal or regulatory) exist that prevent other firms from entering the market easily. (b) A firm with market power is considered a “price maker” and has to lower prices to sell more output. 6. Monopolistic Competition : Market structure in which many firms have some degree of market power and produce differentiated products. 7. Oligopoly : Market structure in which a small number of large firms dominate the market. These firms have market power but must consider their rivals’ actions into account when developing strategies. 8. In the case of analysis , Ford, GM, Honda, Toyota and their major competitors are multinational firms that have significant market power and are not perfectly competitive. Teaching Tip: Discuss the different markets in our economy and have the students decide which of the four market structures each belongs to. For example, what market structures do the following belong to: wheat, clothing, cereal, soft drink, auto, and local electricity ? D. Th e goal of firms is profit maximization . Firms develop strategies to earn the highest profits possible. V. Macroeconomic Influences on Managers A. The circular flow model demonstrates the flow of expenditures between households and firms at the aggregate level. 1. Consumers buy goods and services produced by firms in the output market. 2. Consumers supply inputs (land, labor, capital equipment and entrepreneurship) to firms in the resource market. They receive payments for these inputs in the form of wages, rent, interest and profits. 3. Absolute Price Level : Measure of the overall price level in the economy.

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    Chapter 1: Managers and Economics 5 Teaching Tip: Make sure the students understand what the absolute price level is. The Consumer Price Index is one such measure that is constructed from the prices of various goods and services. B. The circular flow model is used to analyze spending behavior in the economy. 1. Gross Domestic Product (GDP) : The comprehensive measure of the total market value of all currently produced final goods and services within a country in a given period of time by domestic and foreign supplied resources : (a) Personal Consumption Expenditures (C) by households on durable and non - durable goods and services. (b) Gross Private Domestic Investment Spending (I) on non - residential structures, equipment, and software in addition to residential structures and inventories. (c) Government Consumption Expenditures and Gross Investment (G) at the federal, state and local levels. (d) Net Export Spending (F) , or Export Spending (X) minus Import Spending (M). 2. GDP=C+I+G+F or GDP=C+I+G+(X - M) C. Factors affecting macro spending behavior . 1. Changes in consumption and investment behavior in the private sector. 2. Monetary policy and fis cal policy . (a) Monetary Policy : Policies adapted by the country’s central bank that influence the money supply, interest rates, and the amount of funds available for loans, which , in turn, influence consumer and business spending. (b) Fiscal Policy : Changes in taxing and spending by the executive and legislative branches of a country’s national government that can be used to either stimulate or restrain the economy. 3. Changes in the foreign sector including the exchange rate (the US dollar exchange rate against the Japanese yen and the implications on the behavior of the Japanese auto makers).

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    Chapter 2: Demand, Supply and Equilibrium Prices 6 C HAPTER 2: DEMAND, SUPPLY AND EQUILIBRIUM PRICES OVERVIEW This chapter introduces students to the important concepts of demand and supply. The chapter uses examples to illustrate how changes in non - price factors impact demand, supply, and the resulting market equilibrium. Demand is the relationship between price and the quantity demanded of a good by consumers in a given period of time, all other factors held constant. Supply is the relationship between price and the quantity supplied of a good by producers in a given period of time, al l other factors held constant. The discussion uses graphical and algebraic methods. The chapter begins with a case of analysis (Demand and S upply in The Copper I ndustry ) which demonstrates how demand and supply factors influence d the copper supply and demand and how changes in these functions impact the market price of copper . O UTLINE OF TEXT MATERIAL I. Introduction (outlines the chapter content and defines the main concepts: Demand and Supply) A. Demand : Functional relationship between the price and quantity demanded of goods and services by consumers in a given period of time, all else equal. B. Supply : Functional relationship between the price and quantity supplied of goods and services by producers in a given period of time, all else equal. C. Man a gers need to understand demand and supply to develop competitive strategies and respond to the actions of competitors. D. The chapter covers verbal, graphical and mathematical analyses of demand and supply. II. Case for Analysis : Demand and Supply in the Copper Industry A. The case uses the global copper market during 1997 – 2011 as an illustration of how various factors influence the copper demand, supply, and equilibrium . The objective

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    Chapter 2: Demand, Supply and Equilibrium Prices 7 of the case is to illustrate how the non - price factors can cause demand and/or supply to change s . Two important points are being emphasized. One, identifying whether the factor is on the demand side or the supply side of the market . Two, whether the factor causes the relevant function to increase or decrease. The discussion also contrasts changes in demand/supply with changes in quantity demanded/supplied. (Teaching Tip: after the chapter is covered, the students can be asked to find examples in the case that cause changes in quantity demanded [any factors changing the supply]). B. Changes in q uantity demanded - a response in consumer behavior to a change in the price. The case shows (page 17, paragraph 3) that a higher price of copper encourages copper consumers to switch to other substitutes (such as plastic and aluminum) C. Changes in q uantity supplied – a producer’s response to a change in the price. The case demonstrates (page 18, first full paragraph) that higher copper prices encourage suppliers of copper to mine lower grade copper. D. Demand for copper factors discussed in the case include (changes in demand): 1. The impact of the macroeconomic conditions in China 2. The impact of a global economic slowdown 3. The impact of the expectations about the future (a) Changes in initial unemployment claims in the US (b) Expectations of stabilization policy in the EU E. Supply for copper factors discussed in the case include (changes in supply) 1. Labor issues and labor strikes at important mining facilities 2. Natural disasters affecting production centers (a massive earthquake hitting Chile in 2010). F. Copper is widely used in manufacturing and construction. As a result, the copper market is an indicator of the state of the global economy (a coincident indicator) . III. Demand A. Demand : Functional relationship between the price and quantity demanded of goods and services by consumers in a given period of time, all else held constant . B. Non - price factors influence demand, causing either an increase or a decrease in demand. These factors are the following. 1. Tastes and Preferences (a) A favorable change in the taste for good X increases its demand.

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    Chapter 2: Demand, Supply and Equilibrium Prices 8 Teaching Tip: The text has concrete examples of tastes and preferences. For instance, af ter September 11, 2001, airlines have used different marketing strategies to encourage more people to fly. The advertising message shifted to safety of flying because it was the safety concern that was responsible for the decline in the demand. 2. Income (a) Normal Good : A product whose demand will increase with an increase in income. (b) Inferior Good : A product whose demand will decrease with an increase in income. Teaching Tip: Make sure the students understand the difference between normal and inferior goods. Normal and inferior goods are differently impacted by recessions. Use examples like new cars versus fast food as illustrations. The textbook examples include jewelry, gourmet pet food, dollar general stores. Ask the students to come up with other examples of inferior goods as they have better a nd interesting examples . Ask them how revenues of inferior goods producers are expected to be affected by economic recessions and expansions. 3. Prices of Related Goods (a) Substitute Goods : Products that c an be used in place of one another. An increase in the price of a substitute good, Y, causes an increase in the demand for good X. (b) Complementary Goods : Products that are used together. A decrease in the price of a complementary good, Y, causes an increase in the demand for good X. Teaching Tip: Make sure the students understand the difference between substitute goods and complementary goods. The examples used in the text are iPods and laptops that serve as substitutes for wristwatches, palladium as a cheap substitute for platinum and personal computers being complementary to printers and printer cartridges. Ask the students to come up with other examples of substitute good s and complementary goods. 4. Future Expectations (a) An expected increase in the future price of good X will increase its current demand. (b) This was demonstrated in the world grain prices in 2007 and in steel prices in 2011 . 5. Number of Consumers

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    Chapter 2: Demand, Supply and Equilibrium Prices 9 (a) An increase in the number of buyers of good X will increase the market demand for X . The illustration provided is that of the US timber industry during 2007 - 2011. During this time the entry by Chinese buyers of timber into the US market helped the US timber industry compensate for the decline in the domestic demand (due to a drop in housing construction). C. Demand F unction : Function represented by Q XD = f (P X , T, I, P Y , P Z , EXC, NC , ... ) where: Q XD = quantity demanded of X P X = price of X T= variables representing an individual’s tastes and preferences I= income P Y , P Z = prices of goods Y and Z, which are related in consumption to good X EXC= consumer expectations about future prices NC= number of consumers 1. Individual Demand Function : Function that shows the variables that affect an individual consumer’s quantity demanded of a particular product. 2. Market Demand Function : Function that shows the variables that affect all consumers’ quantity demanded of a particular product in the market. D. D eman d Curve : The graphical relationship between the price of a good (P) and the quantity demanded by consumers (Q), with all other factors influencing demand held constant. 1. Demand Shifters : The variables in a demand function that are held constant when defining a given demand curve. If their values change, the demand curve would shift. 2. Price is on the vertical axis and quantity demanded is on the horizontal axis. 3. Demand curves are generally downward sloping.

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    Chapter 2: Demand, Supply and Equilibrium Prices 10 4. Price and quantity demanded have a negative relationship. E. Change in Quantity Demanded and Change in Demand 1. Change in Quantity D emanded : Movement along a demand curve when consumers react to a change in the price of the product, all other factors held constant. This is illustrated in Figure 2.1. 2. Change in D emand : Movement of the entire demand curve when consumers react to a change in factors other than the price of the product changing. This is illustrated in Figure 2.2. Teaching Tip: Make sure the students understand t he distinction between a change in quantity demanded versus a change in demand . Although the difference in the wording seems trivial, these two concepts are quite different. The price of the product itself is the only determinant of a change in quantity demanded. All other factors are determinants of a change in demand. F. The market demand curve can be derived by horizontal summation of the individual demand curves. 1. Horizontal S ummation : For every price, add the quantity that each individual in a market demands. 2. A simple example is when there are two in dividuals in a market. This is illustrated in Figure 2.3.

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    Chapter 2: Demand, Supply and Equilibrium Prices 11 G. Linear Demand Function and Curves 1. Linear Demand F unction : Mathematical relationship in which all terms are added or subtracted. 2. The graph of a linear demand curve is a straight line. H. Math Example of a Demand Function (for copper at the beginning of 2010) 1. Equation 2.2 : Q D = 3 - 2 P C +0.2I+1.6 T C+0.4 E where: Q D = quantity demanded of copper (millions of pounds) P C = price of copper ($ per pound) I= consumer income index TC= telecom index showing uses or tastes for copper in the telecommunications industry E=expectation index representing purchaser’s expectations of a lower pric e over the following six months 2. The n egative coefficient on P C shows an inverse relationship betwee n price and quantity demanded for copper. 3. The p ositive coefficient on I shows that copper is a normal good. 4. The p ositive coefficient on TC shows that improved technology and greater demand for telecom services lead to higher demand. 5. The negative coefficient on E shows that expectations of lower price leads to an increased demand for copper in the future b ut a decreased demand for copper for the current period.

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    Chapter 2: Demand, Supply and Equilibrium Prices 12 6. Equation 2.3 : Q D =15 - 2 P C is the alternative demand equation that is derived after substituting values for I, TC and E. It illustrates the meaning of the expression, “all else equal.” IV. Supply A. Supply : Functional relationship between the price and quantity supplied of goods and services by producers in a given period of time, all else equal. B. Non - price factors influence the cost of production , causing either an increase or a decrease in supply. These factors are the following. 1. State of Technology (a) Better technology allows for a more efficient use of resources, increasing supply. 2. Input Prices (a) Lower prices of inputs (labor, capital, land and raw materials) lead to a reduction in the production cost and an increase in supply. 3. Prices of Goods Related in Production (a) Substitute Goods : The same inputs can be used to produce one good over another . An increase in the price of a substitute good, Y, causes an increase in the production of good X. (b) Complementary Goods : Products that are produced together. A decrease in the price of a complementary good, Y, causes an increase in the production of good X. Teaching Tip: Students sometimes get confused between prices of related goods that affect demand and the prices of goods related in production that affect supply . Make sure that they understand the distinctions that come from the demand or supply side of the marke t. 4. Future Expectations (a) An expected decrease in the future price of good X will increase its current supply. 5. Number of Producers (a) An increase in the number of sellers of good X will increase its supply.

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    Chapter 2: Demand, Supply and Equilibrium Prices 13 (b) Changes in laws or regulations including trade barriers (quotas and tariffs) can also achieve the same result. C. Supply Function : Function represented by Q XS = f (P X , TX, P I , P A , P B , EXP, NP, ...) where: Q XS = quantity supplied of X P X = price of X TX=state of technology P I = prices of inputs of production P A , P B = prices of goods A and B, which are related in production of good X EXP= producer expectations about future prices NP= number of producers D. Supply Curve : The graphical relationship between the price of a good (P) and the quantity supplied by producers (Q), with all other factors influenci ng supply held constant. 1. Supply Shifters : The variables in a supply function that are held constant when defining a given supply curve. If their values change, the supply curve would shift. 2. Price is on the vertical axis and quantity supplied is on the horizontal axis. 3. Supply curves are generally upward sloping. 4. Price and quantity supplied have a positive relationship. E. Change in Quantity Supplied and Change in Supply

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    Chapter 2: Demand, Supply and Equilibrium Prices 14 1. Change in Quantity Supplied : Movement along a supply curve when producers react to a change in the price of the product, all other factors held constant. This is illustrated in Figure 2.4. 2. Change in Supply : Movement of the ent ire supply curve when producers react to a change in factors other than the price of the product changing. This is illustrated in Figure 2.5. Factors capable of shifting a supply curve (changes in supply) include technological changes that increase input productivity, changes in input costs, changes in the prices of related in production goods, changes in producer’s expectations. F. Math Example of a Supply Function 1. Equation 2.5 : Q S = - 5+8 P C - 0.5W+0.4T+0.5 N where: Q S = quantity supplied of copper (millions of pounds) P C = price of copper ($ per pound) W= an index of wage rates in the copper industry T= technology index N = number of active mines in the copper industry. 2. The p ositive coefficient on P C shows a positive relationship between price and quantity supplied of copper.

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    Chapter 2: Demand, Supply and Equilibrium Prices 15 3. The n egative coefficient on W shows that as the input price increases, supply decreases due to costly production. 4. The p ositive coefficient on T shows that an increase in technology increases the supply of copper. 5. The p ositive coefficient on N shows that an increase in the number of active mines increas es the supply of copper . 6. Equation 2.6 : Q S = - 25+8 P C is the alternative supply equation that is derived after substituting values for W, T and N. It illustrates the meaning of the expression, “all else equal.” G. Summary of Demand and Supply Factors 1. Table 2.1 provides a summary of the discussion V. Demand, Supply and Equilibrium A. When the market is in equilibrium, there is an equilibrium price and quantity. This is illustrated in Figure 2.6.

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    Chapter 2: Demand, Supply and Equilibrium Prices 16 1. Equilibrium Price (P E ) : The price that actually exists in the market (or toward which the market is moving) where the quantity demanded by consumers equals the quantity supplied by producers. 2. Equilibrium Quantity (Q E ) : The quantity of a good, determined by the equilibrium price, where the amount of output that consumers demand is equal to the amount that producers want to supply. B. Lower - than - equilibrium p rices would result in a shortage of the good, as the quantity demanded exceeds the quantity supplied. This is illustrated in Figure 2.7. C. Higher - than - equilibrium prices would result in a surplus of the good, as the quantity supplied exceeds the quantity demanded. This is illustrated in Figure 2.8. D. Math Example of Equilibrium 1. Equation 2.3 : Q D = 15 - 2 P C 2. Equation 2.6 : Q S = - 25+8 P C 3. In equilibrium, there is only one quantity where Q D =Q S . Equating the two equations lead to an equilibrium price of $ 4.00 and an equilibrium quantity of 7 million pounds . E. Changes in Equilibrium Prices and Quantities

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    Chapter 2: Demand, Supply and Equilibrium Prices 17 1. A change in demand results from a change in tastes and preferences, income, prices of related goods, expectations or the number of consumers. This alters the market equilibrium in the following ways. (a) An increase in demand (D 0 to D 1 ) raises the equilibrium price and raises the equilibrium quantity. This is illustrated in Figure 2.9. (b) A decrease in demand (D 0 to D 2 ) lowers the equilibrium price and lowers the equilibrium quantity. This is illustrated in Figure 2.9. 2. A change in supply results from a change in technology, input prices, prices of goods related in production, expectations, or the number of suppliers. This alters the market equilibrium in the following ways. (a) An increase in supply (S 0 to S 1 ) lowers the equilibrium price and raises the equilibrium quantity. This is illustrated in Figure 2.10. (b) A decrease in supply (S 0 to S 2 ) raises the equilibrium price and lowers the equilibrium quantity. This is illustrated in Figure 2.10. 3. The effects of c hanges in both sides of the market on the equilibrium price and quantity depend on the sizes of the shifts of the demand and supply curves. 4. An increase in demand and a decrease in supply raise the equilibrium price but the effect on the equilibrium quantity is indeterminate. This is illustrated in Figures 2.11 and 2.12.

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    Chapter 2: Demand, Supply and Equilibrium Prices 18 5. An increase in demand and an in crease in su pply raise the equilibrium quantity but the ef fect on the equilibrium price is indeterminate. This is illustrated in Figures 2.13 and 2.14.

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    Chapter 2: Demand, Supply and Equilibrium Prices 19 F. Math Example of an Equilibrium Change (continuation of the prior setup of the copper market in 2010 1. Start with an initial equilibrium price of $ 4.00 and an initial equilibrium quantity of 7 million pounds at the beginning of 2010 . 2. Assume that the US and European economic weaknesses cause cancellation of copper orders during 2010 - 2011 . Assume that a decrease in the demand for copper that resulted from the weaknesses in the US and Europe was not offset by an increase in the demand for copper from China. This causes several of the relevant to the market demand factors to change: the income index (I) to decrease from 20 to 14, the telecom index (TC) decreases from 2.5 to 1.875, the expectations index (E) decreases from 100 to 80. 3. Supply side factors are also allowed to change . Assume that the wage index (W) decreases from 100 to 98, the technology index increases from 50 to 55, NP increases from 20 to 28 (due to a release of copper stockpile in China). 4. Substituting for new values of for the above listed factors into the demand and supply equations results in the new equilibrium price is $3.00 and th e

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    Chapter 2: Demand, Supply and Equilibrium Prices 20 new equilibrium quantity is 6 million pounds. This is also illustrated graphically in Figure 2.15.

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    Chapter 3: Demand Elasticities 21 C HAPTER 3: DEMAND ELASTICITIES OVERVIEW This chapter introduces students to the concept of elasticity of de mand. A demand elasticity measures how consumer demand responds to changes in a variable in the demand function. The price elasticity of demand is the key elasticity measure discussed in this chapter. It measures the sensitivity of the consumer’s behavior to changes in the price of the product by dividing the percentage change in the quantity demanded by the percentage change in the price that induced the change in the quantity demanded. The case for analysis demonstrates on the example of Procter and Gamble Co. how a company’s pricing policies depend on how consumers respond to price changes. The other elasticity measures introduced in this chapter are the income and cross - price elasticities of demand. In addition, the appendix presents the standard economic model of consumer choice. O UTLINE OF TEXT MATERIAL I. Introduction A. With the exception of perfectly competitive price - taking firms, all firms with market power face downward sloping demand curves. These firms must lower prices to sell more units of the product. B. For firms that have varying degrees of market power, product price is a strategic variable that managers must understand and manipulate. C. Demand (Price) Elasticity : Quantitative measure that shows how responsive consumers are to changes in price. D. The chapter also discusses the relationship between price elasticity and revenue, and its relevance to the decisions of managers. E. In addition to price elasticity of demand, income and cross - price elasticities of demand are introduced. II. Case for Analysis : Demand Elasticity and Procter & Gamble’s Pricing Strategies

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    Chapter 3: Demand Elasticities 22 A. The Case for Analysis provides a discussion of how a company’s pricing strategy depends on consumers’ price sensitivity. The case focuses on P&G and their responses to weaknesses in consumer spending between 2009 – 2011. 1. Post 2007 - 09 recession consumers remained careful with their spending which lead to substitution to private - label and retailer brands. This caused the demand for P&G products to decrease. 2. In 2009, P&G attempted to address the weakening demand by increasing advertising and introducing new products. In light of rising costs of production, the company decided to raise prices. This increase in prices leads to lower sales but higher overall total revenues (inelastic or inflexible response of the consumer). 3. In spring of 2010, the company reversed its strategy and lower ed its prices. This was in part done to recapture the lost during the recession market share to private - label brands. Although this stimulated the volume of sales, it also lead to reduced profits. 4. In the beginning of 2011, P&G once again adjusted its pricing strategy and increased the prices on products for babies. This strategy was supported by the idea that consumers would be less willing to switch from brand names when it comes to products for their babies (a market with less flexible consumers and therefore a smaller response to price increases). In addition, the company observed that the demand for products designed for higher income consumers remained strong, allowing the company to prices on those products. 5. During that time the company also explored the possibility of expanding into other markets (Brazil) where the consumer demand was expected to be higher due to consumer tastes. B. The case shows several important for discussion points: 1. Pricing strategy depends on consumer response. The consumer response to a price change effects the firm’s total revenues and profits 2. A recession (which is characterized by declining incomes) negatively impacted the demand for P&G products and induced substitution towards non - brand names. 3. High income consumers appeared to be less price sensitive, suggesting that the amount spent on a product in relation to income matters 4. It takes time to adjust to changes in prices 5. A price increase can increase or decrease total revenue III. Demand Elasticity : Quantitative measurement showing the percentage change in the quantity demanded of a particular product relative to the percentage change in any one of the variables included in the demand function for that product.

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    Chapter 3: Demand Elasticities 23 A. Elasticity measures the responsiveness of consumers in terms of percentage changes in both variables. Teaching Tip: Students find that elasticity is a very difficult concept to grasp. Although some students master the actual calculation of the elasticity coefficient, they have a difficult time understanding what the numbers mean. Make sure they understand how to analyze these numbers, in addition to the calculations. IV. Price Elasticity of Demand (e P ) : Percentage change in the quantity demanded of a given good, X, relative to a percentage change in its price, all other factors constant. A. Equation 3.1 : e P = %∆ Q X / %∆P X wher e: e P = price elasticity of demand ∆= the absolute change in the variable: (Q 2 - Q 1 ) or (P 2 - P 1 ) 1. Price elasticity of demand is illustrated by the change in quantity demanded from Q 1 to Q 2 as the price changes from P 1 to P 2 . 2. This is shown as the moveme nt along the demand curve from A to B in Figure 3.1 . B. The p rice elasticity of demand affects managerial decisions on pricing strategi es through the total revenue . 1. Total Revenue : The amount of money received by a producer for the sale of its product calculated as the price per unit times the quantity sold. C. P rice elasticities for downward sloping demand curves are negative because of the inverse relationship between price and quantity demanded . However, to determine the size of the price elasticity, absolute values are taken for the coefficients.

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    Chapter 3: Demand Elasticities 24 1. Unitary Elasticity : |e P |=1, when the magnitude of the percentage change in quantity demanded is equal to the magnitude of the percentage change in price. 2. Elastic Demand : |e P |>1, when the magnitude of the percentage change in quantity demanded is greater than the magnitude of the percentage change in price. 3. Inelastic Demand : |e P |<1, when the magnitude of the percentage change in quantity demanded is less than the magnitude of the percentage change in price. D. Price elasticity of demand and total revenue are related in the following ways. 1. When demand is elastic, a higher price will decrease total revenue while a lower price will increase total revenue. This is illustrated in Figure 3.2. 2. When demand is inelastic, a higher price will increase total revue while a lower price will decrease total revenue. This is illustrated in Figure 3.3. 3. When demand is unit elastic, there is no change in the total revenue.

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    Chapter 3: Demand Elasticities 25 E. Managerial rule of thumb: elasticity can be estimated as Px/(P1 - P2). We can either use the average price (midpoint formula) or the starting value for Px. The textbook uses the starting value of P1. 1. The rule is derived from the elasticity equation 3.2 on page 49. Since we assume that the quantity demanded changes from Q1 to zero, the change in quantity demanded equals Q1, thereby simplifying the equation 3.2 to the managerial rule stated above. V. Determinants of Price Elasticity of Demand A. Number of Substitute Goods 1. Demand is more inelastic when there are fewer substitutes available, all else constant. 2. An example of inelastic demand is airline travel by business passengers due to the lack of available substitute modes of transportation. B. Percent of Consumer’s Income Spent on the Product 1. Demand is more inelastic when a smaller fraction of a consumer’s income is spent on the product, all else constant. 2. An example of inelastic demand is the local newspaper since it makes up a very tiny fraction of a consumer’s income. C. Time Period 1. Demand is more inelastic when the time peri od under consideration is short, all else constant. 2. It takes time for substitute products to be made available. VI. Numerical Example of Elasticity, Prices and Revenues A. Calculating Price Elasticities 1. Arc Price Elasticity of Demand : A measurement of the price elasticity of demand where the base quantity or price is calculated as the average value of the starting and ending quantities or prices. (a) If Q 1 and Q 2 are very different from each other, a different value for the percentage change in quantity demanded may result. (b) If P 1 and P 2 are very different from each other, a different value for the percentage change in price may result.

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    Chapter 3: Demand Elasticities 26 (c) To remedy these problems, the following equation is used. (d) Equation 3.3 : e P = (Q 2 - Q 1 )/ [(Q 1 +Q 2 )/2 ] (P 2 - P 1 )/ [(P 1 +P 2 )/2] 2. Point Price Elasticity of Demand : A measurement of the price elasticity of demand calculated as a point on the demand curve using infinitesimal changes in prices and quantities. (a) For a specif ic demand function, appropriate derivatives can be computed. (b) Equation 3.4: eP= dQ X P X dP x Q X B. A numerical example of demand, total revenue, average revenue and marginal revenue functions is shown in Table 3.2. The functions related to demand are the following. 1. Total Revenue Function : The functional relationship that shows the total revenue (price times quantity ) received by a producer as a function of the level of output. 2. Average Revenue Function : The functional relationship that shows the revenue per unit of output received by the producer at different levels of output. 3. Marginal Revenue Function : The functional relationship that shows the additional revenue a producer receives by selling an additional unit of output at different levels of output. C. Table 3.3 presents a numerical example of total revenue and marginal revenue computation. Table 3.4 extends the computational analysis to A rc and point price elasticities . D. Price elasticity is not the same as the slope. Even though the demand curve is linear and has a single slope, the price elastici ty coefficients vary . Teaching Tip : Make sure the students understand the distinction between the slope and price elasticity of a linear demand curve. 1. The price elasticity coefficient is larger (smaller) at higher (lower) prices for a linear demand function. 2. In the elastic (inelastic) portion of the linear demand curve, a decrease (increase) in price results in an increase (decrease) in total revenue.

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    Chapter 3: Demand Elasticities 27 3. In the elastic (inelastic) portion of the linear demand curve, marginal revenue is positive (negative) and decreasing in value. E. Demand Elasticity, Marginal Revenue, and Total Revenue 1. Figure 3.4 illustrates the relationship between demand and marginal revenue. Figure 3.4 and Table 3.5 connect elasticity to total revenue and marginal revenue. VII. Vertical and Horizontal Demand Curves A. Two polar cases of demand curves, vertical and horizontal demand curves are important. B. Perfectly Inelastic Demand : Zero elasticity of demand, illustrated by a vertical demand curve, where there is no change in quantity demanded for any change in price. 1. An example is the demand for insulin by a diabetic, who is completely unresponsive to changes in price. C. Perfectly Elastic Demand : Infinite elasticity of demand, illustrated by a horizontal demand curve, where there the quantity demanded would vary tremendously if there were any changes in price.

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    Chapter 3: Demand Elasticities 28 1. There is no exact application of a perfectly elastic demand in reality. Examples that illustrate this idea are the demand for common fruits and vegetables. VIII. Income and Cross - Price Elasticity of Demand A. Income Elasticity of Demand : The percentage change in the quantity demanded of a given good, X, relative to a percentage change in consumer income, all other factors constant. 1. Normal Good: A product whose demand will increase with an increase in income. This good has a positive income elasticity of demand. 2. Inferior Good : A product whose demand will decrease with an increase in income. This good has a negative income elasticity of demand. B. For goods with positive income elasticities , a distinction between necessities and luxuries is made. 1. Necessity : A good with income elasticity between 0 and 1 where the expenditure on the good increases less proportionately with changes in income. 2. Luxury : A good with an income elasticity great than 1 where the expenditure on the good increases more proportionately with changes in income. C. Cross - Price Elasticity of Demand : The percentage change in the quantity demanded of a given good, X, relative to the percentage change in the price of good Y, all other factors constant. 1. Substitute Goods : Products that can be used in place of one another. These goods have a positive cross - price elasticity of demand.

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    Chapter 3: Demand Elasticities 29 2. Complementary Goods : Products that are used together. These goods have a negative cross - price elasticity of demand. IX. Elasticity Estimates: Economics Literature A. Table 3.7 shows estimates of elasticity of demand coefficients derived in the economics literature. 1. The demand for many agricultural products is price inelastic. They are generally necessities with income elasticity less than 1. 2. The price elasticity coefficient for beer as a commodity is less than 1. However, the estimates for the individual packages are quite elastic due to the substitutability of brands. 3. The price elasticity of demand for cigarettes for adults is inelastic. For teenagers and college students, it is more elastic because they spend a larger fraction of their income than adults. 4. The d emand for health care is price inelastic. It is also income inelastic, indicating that health care is a necessity for consumers. 5. The demand for higher education tends to be price inelastic. However, the demand for higher education from a particular university tends to be elastic as there are many substitutes to a given university. X. Elasticity Issues: Marketing Literature A. Marketing extends the economic analysi s of price elasticity in detail. 1. These studies examine the demand for specific brands of products and the demand at the level of individual stores. 2. 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, all other factors constant. 3. Marketing Study I: Tellis (1988) (a) This study is from a meta - analysis of other econometri c studies of selective demand from 1961 to 1985.

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    Chapter 3: Demand Elasticities 30 (b) Tellis find a mean price elasticity of - 1.76 , using 367 elasticities from 220 brands . 4. Marketing Study II: Sethuraman and Tellis (1991) (a) This study is derived from a meta - analysis of 16 studies conducted from 1960 to 1988. (b) The authors find a mean price elasticity of - 1.609 and a mean short - term advertising elasticity of +0.109 , using 262 elasticities from 130 brands . 5. Marketing Study III: Hoch et al. (1995) (a) This study estimates store - level price elasticities from Dominick’s Finer Foods. (b) The authors find that elasticities differ based on opportunity cost to the consumer (more educated individuals tend to be less price sensitive given that they have higher incomes), family size (this relates to the share of household’s income allocated to food). XI. Appendix 3A: Economic Model of Consumer Choice A. Consumer tastes and preferences are measured with utility, how much satisfaction is derived from the consumption of dif ferent amounts of two goods , X and Y . The following are assumptions about consumer preferences. 1. Preference orderings are complete. 2. More of the goods are preferred to less of the goods. 3. Consumers are selfish. 4. The goods are continuously divisible so that consumers can always purchase one more or one less unit of the goods. B. An indifference curve shows alternative combinations of the goods that provide the same level of utility.

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