Managerial Economics

Demand Analysis
and Optimal Pricing
 DETERMINANTS OF DEMAND
Case: The management of a leading regional airline
wants to analyze the state of travel demand for a
nonstop route between Houston, Texas and Florida. The
airline flies one daily departure from each city to the
other (two flights in all) and faces a single competitor
that offers two daily flights from each city. Reviewing
the past experience, the management realizes the main
determinants of airline’s traffic as “it’s own price” , the
“price of it’s competitor”, and “income in the region”.
This follows the demand function:
Q = f(P, P°, Y).
 DETERMINANTS OF DEMAND
Q = f(P, P°, Y).
Suppose the economic forecasting unit of the airline has
supplied the following equation, which best describes
demand:
Q = 25 +3Y + P° - 2P
What does the equation say about the present state of
demand?
If this airline and it’s competitor are charging the same one-
way fare, $240. The current level of income in the region is
105.
Putting these values into Equation, we get
Q = 25 + 3(105) + 1(240) - 2(240) = 100 seats.
 DETERMINANTS OF DEMAND
Q = 25 + 3(105) + 1(240) - 2(240) = 100 seats.
Q = 25 +3Y + P° - 2P
From the Equation, we see that
1. For each point increase in the income index, 3 additional seats
will be sold.
2. For each $10 increase in the airline’s fare, 20 fewer seats will
be sold.
3. For each $10 increase in the competitor’s fare, 10 additional
seats will be sold.
In fact, the total change in demand caused by simultaneous
changes in the explanatory variables can be expressed as
∆Q =3∆Y +1∆ P° - 2∆P
 The Demand Curve and Shifting Demand
Suppose the regional income is expected to remain at 105 and the
competitor’s fare will stay at $240. However, the airline’s own fare
is not set in stone, and management is interested in testing the
effect of different possible coach prices. Substituting the values of
Y and P° into Equation , we find the demand function as:
Q = 25 + 3(105) + 1(240) – 2P
Q = 580 - 2P
It is important to remember that, in the background, all other
factors affecting demand are held constant (at the values
Y=105 and P°=240).
As usual, the demand curve is downward sloping
 The Demand Curve and Shifting Demand
The demand curve shows a higher price means lower sales.
But what happens if there is a change in one of the other factors that
affect demand? Suppose that a year from now P° is expected to be
unchanged but Y is forecast to grow to 119. What will the demand
curve look like a year hence?
To answer this question, substitute the new value, Y= 119
Then, Q = 25 + 3(119) + 1(240) – 2P = 622 – 2P
As we now show, such a change causes a shift in the demand curve.
 General Determinants of Demand
• Obviously, the good’s own price is a key determinant of demand.
• Level of income of the potential purchasers of the good or service.
(Normal goods v/s inferior goods).
• Prices of substitute and complementary goods.
(A substitute good competes with and can substitute for the good in question. A pair of
goods is complementary if an increase in demand for one causes an increase in demand
for the other. For instance, an increase in the sales of new automobiles will have a
positive effect on the sales of new tires.)
• Normal population growth of prime groups that consume the good
or service will increase demand.
• Changes in preferences and tastes are another important factor.
The demand function shows, in equation form, the
relationship between the unit sales of a good or service and
one or more economic variables.
(i) The demand curve depicts the relationship between quantity and
price. A change in price is represented by a movement along the
demand curve. A change in any other economic variable shifts
the demand curve.
(ii) A pair of goods are substitutes if an increase in demand for one
causes a fall in demand for the other. In particular, a price cut
for one good reduces sales of the other.
(iii) A pair of goods are complements if an increase in demand for
one causes an increase in demand for the other. In particular, a
price cut for one good increases sales of the other.
(iv) A good is normal if its sales increase with increases in income.
ELASTICITY OF DEMAND
Most managers agree that the toughest decision they face is the
decision to raise or lower the price of their firms’ products.

When Walt Disney Company decided to raise ticket prices at its theme parks
in California, and Orlando, Florida, the price hike. The price increase was a
success, however, because it boosted Disney’s revenue: the price of a ticket
multiplied by the number of tickets sold.

Price increases do not always increase a firm’s revenue.

Suppose just one gasoline producer, ExxonMobil, were to increase the price
of its brand of gasoline while rival gasoline producers left their gasoline
prices unchanged. ExxonMobil would likely experience falling revenue,
even though it increased its price, because many ExxonMobil customers
would switch to one of the many other brands of gasoline. In this situation,
the reduced amount of gasoline sold would more than offset the higher price
of gasoline, and ExxonMobil would find its revenue falling.
ELASTICITY OF DEMAND
Managers recognize that quantity demanded and price are
inversely related.

It is more important for managers to know by how much sales

will change for a given change in price.

A 10 percent decrease in price that leads to a 2 percent increase

in quantity demanded differs greatly in effect from a 10 percent
decrease in price that causes a 50 percent increase in quantity
demanded.
There is a substantial difference in the effect on total revenue
between these two responses to a change in price. Certainly,
when making pricing decisions, managers should have a good
idea about how responsive consumers will be to any price
changes and whether revenues will rise or fall.
ELASTICITY OF DEMAND

Price Elasticity

Price elasticity measures the responsiveness of a good’s quantity

demanded to a change in price along a demand curve and an
indicator of the effect of a price change on total consumer expenditure
on a product.

This concept is important for two reasons:

– First, knowledge of a good’s price elasticity allows firms to predict the impact of price
changes on unit sales.
– Second, price elasticity guides the firm’s profit-maximizing pricing decisions.

The concept of price elasticity provides managers, economists, and

policymakers with a framework for understanding why consumers in
some markets are extremely responsive to changes in price while
consumers in other markets are not. This understanding is useful in
many types of managerial decisions.
ELASTICITY OF DEMAND

Price Elasticity
The price elasticity of demand is the ratio of the percentage change in quantity and the
percentage change in the good’s price, all other factors held constant.

For example, consider the airline’s demand curve as described in Equation 3.4. At
the current $240 fare, 100 coach seats are sold. If the airline cut its price to $235,
110 seats would be demanded. Therefore, we find

In this example, price was cut by 2.1 percent (the denominator), with the result that quantity
increased by 10 percent (the numerator). Therefore, the price elasticity (the ratio of these
two effects) is 4.8.
ELASTICITY OF DEMAND

Price Elasticity
ELASTICITY OF DEMAND

Price Elasticity
Elasticity measures the sensitivity of demand with respect to price. Elasticity
measures the sensitivity of demand with respect to price.
In describing elasticities, it is useful to start with a basic benchmark.
First, demand is said to be unitary elastic if E(P) = -1. In this case, the percentage
change in price is exactly matched by the resulting percentage change in quantity,
but in the opposite direction.

Second, demand is inelastic if . The term inelastic suggests that

demand is relatively unresponsive to price: The percentage change in quantity is
less than the percentage change in price.

Finally, demand is elastic if EP < -1 . In this case, an initial change in price causes a
larger percentage change in quantity.
• In short, elastic demand is highly responsive, or sensitive, to changes in price.
ELASTICITY OF DEMAND

Price Elasticity

• Here sales are constant (at Q 100) no matter how high the price charged. Thus,
for any price change, the quantity change is zero, and therefore the demand is
said to be perfectly inelastic.
ELASTICITY OF DEMAND

Price Elasticity

• This figure shows the opposite extreme: a horizontal demand curve where
demand is perfectly elastic, The horizontal curve indicates that the
firm can sell as much output as it likes at the given price; whether it sells a large
or small output quantity will have no effect on its price.
• In this case, we say that the market determines the firm’s price. (Note also that
the firm can sell nothing at a higher-than-market price.) Demand is called
perfectly elastic because sales are infinitely sensitive to price.
 FOUR IMPORTANT FACTORS AFFECTING PRICE
ELASTICITY
Here are four important factors.

1. The degree to which the good is a necessity.

– If a good or service is not considered essential, the purchaser can easily
do without it—if and when the price becomes too high—even if there are
no close substitutes. In that case, demand is elastic.
– If the good is a necessary component of consumption, it is more difficult
to do without it in the face of a price increase. Thus, demand tends to be
price inelastic.

2. Availability of substitutes

With many substitutes, consumers easily can shift to other alternatives if the
price of one good becomes too high; demand is elastic. Without close
substitutes, switching becomes more difficult; demand is more inelastic.
 FOUR IMPORTANT FACTORS AFFECTING PRICE
ELASTICITY
3. The proportion of income a consumer spends on the good
• The issue here is the cost of searching for suitable alternatives to the good. It takes time
and money to compare substitute products. If an individual spends a significant portion
of income on a good, he or she will find it worthwhile to search for and compare the
prices of other goods. Thus, the consumer is price sensitive. If spending on the good
represents only a small portion of total income, however, the search for substitutes will
not be worth the time, effort, and expense
4. Time of adjustment
• When the price of gasoline dramatically increased in the last five years, consumers
initially had little recourse but to pay higher prices at the pump. Much of the population
continued to drive to work in large, gas-guzzling cars. As time passed, however,
consumers began to make adjustments. Some commuters have now switched from
automobiles to buses or other means of public transit. Gas guzzlers have been replaced
by smaller, more fuel-efficient cars including hybrids. Some workers have moved closer
to their jobs, and when jobs turn over, workers have found new jobs closer to their
homes. Thus, in the short run, the demand for gasoline is relatively inelastic. But in the
long run, demand appears to be much more elastic as people are able to cut back
consumption by a surprising amount. Thus, the time of adjustment is crucial.
Rule: demand is more elastic in the long run than in the short run.
Question: The point elasticity of demand at certain price P i.e.
ED(P) = - 0.84. Determine the effect on demand at this
price level when the price is reduced by 12%.

Question: Let demand (Q) is related to the price (p) by the equation:
Q =f(p)= 1000(40 – p).
Calculate Point elasticity of demand at price P i.e. 𝐸𝐷 (𝑝) .
Discuss the impact on demand at price level of $ 8, if price
are increased by 10%.
Question: A retail store faces a demand equation for
Roller Blades given by:
Q = 180 - 1.5P
where Q is the number of pairs sold per month and P is the
price per pair in dollars.
a. The store currently charges P = $80 per pair. At this
price, determine the number of pairs sold.
b. If management were to raise the price to $100, what
would be the impact on pairs sold? On the store’s
revenue from Roller Blades?
c. Compute the point elasticity of demand first at P $80,
then at P $100. At which price is demand more price
sensitive?