economic for managers (pricing and output decision)

7/22/2019 Economic for managers (Pricing and output decision)

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Dr. M. Nusrate AzizGraduate School of ManagementMultimedia University

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Law of Demand and Supply

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Determinants of market demand include - Price of own of the commodity or service

Income

Consumer Preference / Taste

Price of substitute and complementary goods and soon.

The functional form can be given as follows

where, Qd is quantity demanded, P is own price, Y isincome of consumer, T is taste/preference and Pr isprice of other related commodities/services.

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Assume that all the determinants except own price of the

considered commodity/service are unchanged. Then, wefind an inverse relationship between price and demand ofthe commodity/service, which is known as law of demand.

The following equation represents the law of demand

where Q is quantity demanded and P is the price of theconsidered goods or service.

If you plot the above equation, you will find a downwardsloping demand curve.

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Lets talk about price and demand of a novel.

The lineD1 shows howEmmas purchases of

novels depend on theprice of novels whenher income is heldconstant. Because theprice and the quantity

demanded arenegatively related, thedemand curve slopesdownward.


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The location of Emmas

demand curve for novelsdepends on how muchincome she earns. Themore she earns, the morenovels she will purchase atany given price, and thefarther to the right herdemand curve will lie.CurveD1representsEmmas original demandcurve when her income is$30,000 per year. If herincome rises to $40,000

per year, her demand curveshifts toD2. If her incomefalls to $20,000 per year,her demand curve shifts toD3.


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Supply

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Production cost: Since most private companies goal is profitmaximization. Higher production cost will lower profit, thus hindersupply. Factors affecting production cost are: input prices, wagerate, government regulation and taxes, etc.

Technology: Technological improvements help reduce productioncost and increase profit, thus stimulate higher supply.

Number of sellers: More sellers in the market increase the marketsupply.

Expectation for future prices: If producers expect future price to behigher, they will try to hold on to their inventories and offer theproducts to the buyers in the future, thus they can capture the

higher price.

A specific supply function can be written as follows -


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A supply curve can be shown as follows -

This supply curve, whichgraphs the supply schedule,

shows how the quantitysupplied of the good changes asits price varies. Because ahigher price increases thequantity supplied, the supplycurve slopes upward.


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Market Equilibrium

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General form of demand and supply curve -

We notice a negative relationship between price and demand;while a positive relationship between prices and supply ofcommodity.

Equilibrium Price and Quantity:

When market demand is equal to market supply we then findmarket equilibrium (i.e., Qd= Qs). This gives us market price andequilibrium quantity -


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Can you decide about price of your product as a manager? Market Price -


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Market Demand

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The market demand curve

Determinants of market demand (similar to simple demand)

Consumer Preference Income

Price of own

Price of other substitute and complementary goods

D1 D2

DM

1510

4 5

P PP

Qd Qd Qd2 8 6 13

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Suppose Raihan, a graduating senior, has accumulated impressive casestudies during his university career which have market value. Now he needsto sell them to obtain money for his impending marriage. Three of hiswealthy friends express interest in buying some of them. Their individualdemand functions can be expressed as follows:

where the quantity subscripts denote each of the three friends and price ismeasured in dollar per test

(a) What is the market demand equation for Raihanscase studies?

(b) How many more case studies can he sell for each one dollar decrease inprice?

(c) If he has a file of 60 case studies what price should he charge to sell hisentire collection?

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Governments Role

Suppose, the market demand and market supply equations are

Qd = 90 3P ---- (3)

Qs = -10 + 2P ---- (4)

Suppose, government impose a price restriction on supplier that

supplier cannot charge more that RM15 per unit of commodity.(i) What will then be market demand and supply?

(ii) Is there any excess supply or demand? If yes, how much?

(iii) What will be the market price , if government does notintervene?

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Elasticity of Demand

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There are two approached of elasticity computation: (i) Point elasticity(which we usually derive from demand/supply equations) and (ii) Arc

Elasticity (which includes discrete values of price and demand/supply).

Arc Elasticity:The percentage change in price is the change in price dividedby price. Similarly, the percentage change in quantity demanded is the

change in quantity divided by quantity. Thus the price elasticity can beexpressed as:

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P Q5 61 10

Where, Ep

= price elasticity of demand,P = P2 P1 (change in price)Q = Q2 Q1 (change in demand)Q = Q1 (initial quantity)P = P1 (initial price)

Suppose,

Elasticity, Ep= -0.83


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The higher price do not always result in greater revenue. A change inprice can either increase or decrease or keep the total revenue

constant depending on the nature of demand function (i.e., elasticity

of demand).

Price Elasticity of Demand: it is measured by percentage change inquantity demanded divided by percentage change in price.

Implication of elastic inelastic and unitary elastic demand:Supposethat a firm increases the price of its product by 2 percent and quantity

demanded subsequently decreases by 3 percent, the price elasticity

would be -

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Implication of price elasticity:

Consider the following demand function. Find price elasticity ofdemand of this function. Also find the inverse demand function of it.

Elastic

Unitary elastic

Inelastic

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Price elasticity is important for decision making.

In case of inelastic demand we can earn more revenue byincreasing price.

When there is elastic market demand, if we increase price

total revenue will fall. If we reduce price total revenue will beincreased.

When there is unitary elastic demand for a particularcommodity, increase or decrease of price does not increasetotal revenue.

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Let us derive the relationship between price, revenue and elasticity.

We know,

Now, suppose the elasticity is greater than one or less than one orexactly unity. What are the impact of price changes on total revenue?

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In case of unitary elastic demand, marginal revenue is zero. A changein price would have no real effect on total revenue. (Check it!)

In case of elastic demand, a reduction in price would increase totalrevenue. (Check!)

In case of inelastic demand, increase in price would increase totalrevenue. (Check!)

Read the Case Study [How much tuition for college students?] at

page 85 of Managerial Economics, (4th

Edition), by Petersen, Lewisand Jain.

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How the change in income may affect the demand?

Income Elasticity: ratio of percentage change in quantity demanded andpercentage change in income.

where, y = income; q = quantity demanded; dy = change in income

Find income elasticity from the following equation when initial income was Tk.

10,500.

Is the changes are positive or negative?: Income elasticity can be positive ornegative. It can be less or greater than unity.

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Inferior Goods:If an increase in income is associated with a fall in demand for anyparticular commodity, we say that the good (or service) is inferior in nature.

For example, when income increases consumers buy quality rice by paying more.Hence, the demand for the earlier type of rice falls. The earlier type of rice is called

inferior good.

Normal Goods: Income elasticity of demand for Normal Goods or services arepositive. For example, for a poor family, the demand for bread is increased with the

increase in its income. But it increase less than proportionate. Luxurious Goods: Demand elasticity of luxurious goods and services are more

than unity. For example, if you become more wealthier, you buy better branded car,

right? Thus, spend more and more in luxuries.

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You know, whether you are a manger in a normal goods (or services), inferior orluxurious commodity producing firm. Think about the recession which has been

affecting economies from the late-2007 till now. What do you think about the

demand of your commodity? Suppose, the commodity is luxurious or normal or

inferior.

You are a manager in a remote area of the country. You have both high quality andless quality products. Of course, production cost differs for producing the products.

Do you decide to sell the high or low quality products to sale there?

Suppose, you are going to start a business in Kuala Lumpur. Do you introduce aquality but expensive business or just a normal grocery (less quality and cheaper

business).

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Demand of a commodity is also influenced by the price of othercommodities. The responsiveness of quantity demanded to the change in

price of other goods is measured by cross-elasticity of demand.

Suppose, demand of x in terms of y can be given as follows:

How to find the cross-elasticity of demand of x for y.

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Decisions rules for cross-elasticity of demand:1. If, the value of cross-elasticity EC = 0, commodity (or service) x and y are

uncorrelated.

2. If the value of EC> 0 (is positive), xand yare substitute goods.

3. If the value of EC< 0 (is negative), xand yare complementary goods.

Practice:Suppose, there are demand for tea and price of coffee are interrelated. The

relationship can be expressed as follows:

Suppose, initial price of coffee was Tk. 20 per cup. Find the cross-elasticity

of demand of tea for coffee.

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Practice 1

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Market Equilibrium

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Practice 2

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Market Equilibrium

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Practice 3

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Elasticity

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Practice 4

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Elasticity

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Practice 5

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Elasticity

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What is Next?

Output Decision

From Market Demand Function

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economic for managers (pricing and output decision)

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