Topic 7: Demand and Elasticity Market vs. firms demand 1 2 - PowerPoint PPT Presentation

Topic 7: Demand and Elasticity ➥ Market vs. firm’s demand 1 2 Elasticity and revenue 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 • Demand and Elasticity Slide 1 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

“firms are price-takers” vs. Perfect vs. imperfect competition “firms have market power” Firms are price-takers Firms have market power (Perfect competition) (Imperfect competition) (Sessions 5–7) (Sessions 8–15) Session 7 • Demand and Elasticity Slide 2 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

From the individual firm’s viewpoint Imperfect competition = firm has market power P i Demand curve for i ’s output 5 = firm sees a trade-off 4 between price and volume 3 2 1 Q i 1 2 3 4 5 6 7 Perfect competition = firm is a price-taker P i ’s volume–price trade-off 5 = firm believes it can sell any 4 amount at the market price 3 (e.g., market price is 3) 2 1 Q i 1 2 3 4 5 6 7 Session 7 • Demand and Elasticity Slide 3 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market power: where it comes from P i d i ( P i ) Q i Two cases: 1. Differentiated products: the firm’s branded product is differentiated from other products. 2. Homogeneous goods: Though products are not differentiated, the firm is a big player: increased output pushes down the market price. Next let’s compare market demand vs. a firm’s demand … Session 7 • Demand and Elasticity Slide 4 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market vs. firm’s demand Case 2: Homogeneous goods …starting with no market power MARKET DEMAND FIRM’S DEMAND “El Guadal” finca cafetera P P i 270 270 …when total output of other farms is 7.5M metric tons 240 240 US Cents per Pound US Cents per Pound 210 210 180 180 150 150 120 120 90 90 60 60 30 30 2 4 6 8 10 12 1 2 3 4 5 6 7 8 Q Q i Metric tons Millions of metric tons Session 7 • Demand and Elasticity Slide 5 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market demand vs. Market power: Our simulation firm’s demand MARKET DEMAND FIRM’S DEMAND When Q − i = 3173 Q = 6000 − 100 P P P i 60 60 50 50 40 40 30 30 20 20 10 10 1 2 3 4 5 6 20 40 60 80 100 120 Q Q i Thousands Session 7 • Demand and Elasticity Slide 6 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Corning and glass substrate Corning has over 50% market share of glass substrate. There are different grades (“5G, 6G, …”), but for a particular grade the products of different suppliers are viewed as close substitutes. News item from December 2005 (for example): The aggressive capacity added by both Corning of the U.S., the world’s No. 1 substrate supplier, and AGC, the No. 2, will lead to price drops for glass substrates and will especially benefit TV panel makers … Session 7 • Demand and Elasticity Slide 7 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market demand curve vs. Corning’s demand curve MARKET DEMAND FIRM’S DEMAND When Q − i = 1500 Q = 6000 − 100 P P P 60 60 50 50 40 40 30 30 20 20 10 10 1 2 3 4 5 6 1 2 3 4 5 6 Q Q i Thousands Thousands Session 7 • Demand and Elasticity Slide 8 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Market demand vs. Case 1: Differentiated products a firm’s demand Example: Airbus and Boeing Individual demand functions: Q A = 60 − 3 P A + 2 P B Q B = 60 − 3 P B + 2 P A Market demand: Choose measure of aggregate output, say Q = Q A + Q B . Choose price index, say P = ( P A + P B ) / 2 . Q = 120 − 2 P (See workbook-style “Exercise on Demand and Elasticity” for details and review.) Session 7 • Demand and Elasticity Slide 9 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Topic 7: Demand and Elasticity ✓ Market vs. firm’s demand 1 Elasticity and revenue ➥ 2 3 Numerical examples: Elasticity for linear and log-linear demand 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 • Demand and Elasticity Slide 10 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Labor markets: minimum wage €/hour 13 12 11 10 9 8 7 6 5 4 3 d ( P ) 2 1 1 2 3 4 5 6 7 8 9 Q (millions) Session 7 • Demand and Elasticity Slide 11 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Key point: % changes matter An increase in minimum wage has two effects on total wage bill: by % ∆ P P ↑ : Each worker is more expensive : wage bill ↑ by % ∆ Q Q ↓ : Firms employ fewer workers : wage bill ↓ Session 7 • Demand and Elasticity Slide 12 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Key point: % changes matter An increase in minimum wage has two effects on total wage bill: by % ∆ P P ↑ : Each worker is more expensive : wage bill ↑ by % ∆ Q Q ↓ : Firms employ fewer workers : wage bill ↓ Net effect depends on which is greater: % ∆ P or % ∆ Q Session 7 • Demand and Elasticity Slide 12 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Example: linear demand €/hour 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 1 2 3 4 5 6 7 8 Q (millions) Session 7 • Demand and Elasticity Slide 13 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Key point: own-price elasticity of demand Useful measure of price-sensitivity of demand: Elasticity E = − % change in Q % change in P . then a price increase causes and we say If … revenue (expenditure) to … demand is … E < 1 E = 1 E > 1 Session 7 • Demand and Elasticity Slide 14 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Other elasticities We can measure elasticities between any two related variables (e.g., demand and income, supply and price, etc.) Elasticity = sensitivity in terms of % changes (rather than slope). Some elasticities of demand: • Own-price elasticity: − % ∆ Q % ∆ P % ∆ Q • Cross-price elasticity: % ∆ P s % ∆ Q • Income elasticity: % ∆ I Remember: • This course: 97% on own-price elasticity; 3% on other elasticities. • “Elasticity of demand” (no qualifier) means “own-price elasticity. • Own-price elasticity is only one we use the minus sign for. Session 7 • Demand and Elasticity Slide 15 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Topic 7: Demand and Elasticity ✓ Market vs. firm’s demand 1 Elasticity and revenue ✓ 2 Numerical examples: Elasticity for linear and log-linear demand ➥ 3 4 Determinants of elasticity 5 Demand estimation exercise. Session 7 • Demand and Elasticity Slide 16 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Point elasticity Loosely: E = − % change in Q % change in P . Point elasticity: If d ( P ) is smooth then elasticity at point ( P , Q ) is E = − dQ P Q . dP Session 7 • Demand and Elasticity Slide 17 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Elasticity of linear demand: Q = A − BP Choke price: price at which demand is zero = ¯ P = P Point elasticity: . ¯ P − P Price ($1000s) 30 25 20 15 10 5 2 4 6 8 10 12 14 16 Demand for minivans (100,000s) Session 7 • Demand and Elasticity Slide 18 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Elasticity of log-linear demand: Q = AP − B “Taking logs” yields: log Q = log A − B log P Price d 1 ( P ) = 6 P − 3 d 2 ( P ) = 1.7 P − 1.5 d 1 ( P ) d 2 ( P ) Quantity Session 7 • Demand and Elasticity Slide 19 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Topic 7: Demand and Elasticity ✓ Market vs. firm’s demand 1 Elasticity and revenue ✓ 2 Numerical examples: Elasticity for linear and log-linear demand ✓ 3 ➥ Determinants of elasticity 4 5 Demand estimation exercise. Session 7 • Demand and Elasticity Slide 20 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Determinants of elasticity 1. The more close substitutes a good has, the elastic is demand. 2. ⇒ Demand for a particular brand (Samsung) or type ( 17 ′′ flat panel) is elastic than demand for the entire category (computer displays). 3. ⇒ The more differentiated the brand, the elastic is demand. 4. ⇒ Advertising usually both increases demand and makes it elastic. 5. When a product’s close substitutes become more expensive, demand for the product becomes elastic. 6. Demand is typically elastic for people with lower income. Session 7 • Demand and Elasticity Slide 21 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Elasticity of demand for some cars in USA (1980s data) Model Elasticity Mazda 323 6.3 Honda Accord 4.8 Nissan Maxima 4.8 Nissan Sentra 6.5 Ford Taurus 4.2 Ford Escort 6.0 Lexus LS400 3.0 Chevrolet Cavalier 6.4 Cadillac Seville 3.9 BMW 735i 3.5 But for entire category: 0.8 Session 7 • Demand and Elasticity Slide 22 P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets