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Utilizing the attached PDF, answer the following questions that are included in the PDF:Work the following problems in Chapter 3 (page 38-39 in PDF, page 113-114 in book): Technical questions 1, 2, 3, 4, 5, and 6.Work the following problems in Chapter 4 (page 67 in PDF, page 142 in book): Technical questions 1 and 2.Work the following questions in Chapter 3 (page 39-40 in PDF, page 114-115 in book): Application questions 1, 2 and 3.Work the following questions in Chapter 4 (page 68 in PDF, page 143 in book): Application questions 1, 2 and 3.
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3
Demand Elasticities
I
n this chapter, we explore the concept of demand in more detail. We
focus on the downward sloping demand curve, which shows an inverse
relationship between the price of the good and the quantity demanded
by consumers, all else held constant. This demand curve applies to the
entire market or industry in a perfectly competitive market structure, even
though individual firms in this market are price-takers who cannot influence
the product price.
All firms in the other market structures—monopolistic competition, oligopoly, and monopoly—face downward sloping demand curves because they
have varying degrees of market power. These firms must lower the price at
which they are willing to sell their product if they want to sell more units. If
the product price is higher, consumers will buy fewer units. Thus, product
price is a strategic variable that managers in all real-world firms must choose.
Managers must also develop strategies regarding the other variables influencing demand, including tastes and preferences, consumer income, the price of
related goods, and future expectations. This chapter focuses on the quantitative measure—demand elasticity—that shows how consumers respond to
changes in the different variables influencing demand.
We begin this chapter with a case that discusses Procter & Gamble Co.’s
pricing strategies and consumer responsiveness to the demand for its products as the company navigated the economic downturn from 2009 to 2011. We
then formally present the concept of price elasticity of demand and develop
a relationship among changes in prices, changes in revenues that a firm
receives, and price elasticity. Next we illustrate all elasticities with examples
drawn from both the economics and the marketing literature.
The chapter appendix presents the formal economic model of consumer
behavior, which shows how both consumer tastes and preferences and the
constraints of income and product prices combine to influence the consumer’s
choice of different products.
76
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Case for Analysis
Demand Elasticity and Procter & Gamble’s Pricing Strategies
Like many other companies, Procter & Gamble Co. (P&G) had
to constantly alter its pricing strategies as it faced declining
and shifting consumer demand for many of its products from
2009 to 2011. Although the recession that began in December
2007 officially ended in June 2009, P&G managers continued
to face consumer cutbacks even on basic household staples.
Rather than purchase P&G premium-priced brands, such as
Tide detergent and Pampers diapers, consumers chose lessexpensive brands, including Gain detergent and Luvs diapers.
The P&G chief executive noted at the time that consumers were
trying more private-label and retailer brands than they would in
more normal economic times.1
Because the company also faced higher commodity prices
and global currency swings, P&G officials raised prices in the
first quarter of 2009, developed new products, and increased
advertising to emphasize why their brands offered more value
than the competition. Officials reported that the higher prices
hurt sales volume but increased total sales revenues by 7 percent. However, industry analysts wondered if the deceased
sales volume would eventually cause the company to lower
prices and increase promotions.2
By spring 2010, P&G had reversed course and was engaged
in a market-share war by cutting prices, increasing product
launches and spending more on advertising. The company’s
goal was to win back market share lost during the recession to
lower-priced rivals even at the expense of profitability. P&G
lowered prices on almost all of its product categories during
early 2010.3
This strategy continued into the summer of 2010,
although there were concerns at that point that the company had missed industry analyst profit estimates even
though it had increased market share. Although the company
announced that it intended to raise prices in the first half
of 2011, officials debated whether consumers had become
1
Ellen Byron, “P&G, Colgate Hit by Consumer Thrift—
Household Products Makers See Sales Weakening, Raise Prices
to Keep Quarterly Profits from Plunging,” Wall Street Journal
(Online), May 1, 2009.
2
Byron, “P&G, Colgate Hit by Consumer Thrift—Household
Products Makers See Sales Weakening, Raise Prices to Keep
Quarterly Profits from Plunging.”
3
Ellen Byron, “P&G Puts Up Its Dukes Over Pricing—ConsumerProducts Makers Risk Margins to Grab Market Share from
Rivals and Cheap Store Brands,” Wall Street Journal (Online),
April 30, 2010.
accustomed to the lower prices. Industry analysts argued
that the company needed to sell more products in the lowerpriced categories.4
The ongoing discounting reduced P&G’s profits, which
decreased 12 percent in the second quarter of 2010, because
sales revenue rose less than P&G expected. To offset the negative effects of the lower prices, P&G introduced new products
including Gillette razors that promised a less irritating shave,
Crest toothpaste with a “sensitive shield,” and Downy fabric
softener that advertised keeping sheets smelling fresh for a
week. The company also began moving into emerging markets such as Brazil, where its research showed that Brazillians
took more showers, used more hair conditioner, and brushed
their teeth more often than residents of any other country. The
company planned to enter the Brazillian market in several new
product categories at once, such as Oral B toothpaste and Olay
skin cream.5
Given continued lower-than-expected revenue and slow
sales in early 2011, P&G announced that it would cut costs
but would also try to raise prices on goods to offset the
higher costs. P&G announced initiatives to eliminate some
manufacturing lines and sell off smaller brands. However,
private-label brands continued to post larger sales gains than
brand names.6
In April 2011, the company announced a 7 percent
increase in prices for its Pampers diapers and a 3 percent
increase in the price of wipes. Surveys indicated that customers were less likely to switch to a cheaper baby product
than for items such as bleach, bottled water, and liquid soap.
The company hoped that parents would be willing to pay
higher prices for diapers, even if they cut back elsewhere,
in the belief that the higher-priced products were better for
their baby’s comfort or development. P&G also raised the
price of its Charmin toilet paper and Bounty paper towels.
One industry analyst concluded that brands that had the
highest market share, were purchased infrequently (such as
sunscreen or light bulbs), were necessities, had few competitors, or where it would be difficult to reduce consumption
4
John Jannarone, “The Hefty Price of Procter’s Gambet,” Wall
Street Journal (Online), August 12, 2010.
5
Ellen Byron, “P&G Chief Wages Offensive Against Rivals, Risks
Profits,” Wall Street Journal (Online), August 19, 2010.
6
Ellen Byron, “Earnings: P&G Feels the Pinch of Rising Costs,”
Wall Street Journal (Online), January 28, 2011.
77
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78
PART 1 Microeconomic Analysis
(toilet paper) were most likely to be the products whose
prices could be increased. P&G, with its distinctive items,
including beauty products, pet food, and toothpaste, was
likely to be better able to raise prices than Kimberly-Clark
and Clorox that operated in highly competitive product categories with large commodity cost pressures.7
By fall 2011, P&G reported solid sales growth and that it
had successfully raised prices even though some of its competitors held back on their price increases. P&G had more ability to raise prices on its premium products because company
officials observed that higher-end consumer spending had held
up better than that of lower-income shoppers, who were still
affected by continuing unemployment. P&G lost some market share in North America and Western Europe because its
competitors did not immediately follow its price increases.
However, company officials expected that the competitors
would soon follow P&G on its higher prices.8
7
Ellen Byron and Paul Ziobro, “Whoa Baby, Prices Are Jumping
for Diapers, Other Family Basics,” Wall Street Journal (Online),
April 25, 2011.
8
Paul Ziobro, “P&G Says Costs Will Curb Current Quarter,” Wall
Street Journal (Online), October 28, 2011.
This case illustrates how a company’s pricing policies
depend on how consumers respond to price changes. In the first
quarter of 2009, P&G raised prices and then reported declining sales volume but increased sales revenues. In subsequent
years, the company lowered prices, which increased sales volume, but did not increase revenue as much as expected so that
there was a negative effect on profits. Because the company
was concerned about consumer adjustment to lower prices over
time, it also adopted other strategies to increase profitability,
such as developing new products and entering new markets.
Thus, it appears from the above case that consumer responsiveness to a company’s price changes is related to
1. Tastes and preferences for various quality characteristics of
a product as compared to the impact of price
2. Consumer income and the amount spent on a product in
relation to that income
3. The availability of substitute goods and perceptions about
what is an adequate substitute
4. The amount of time needed to adjust to change in prices
To examine these issues in more detail, we first define demand
elasticity, and we relate this discussion to the variables influencing demand.
Demand Elasticity
Demand elasticity
A quantitative measurement
(coefficient) 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.
A demand elasticity is a quantitative measurement (coefficient) 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. Thus, an elasticity can be calculated with regard to product
price, consumer income, the prices of other goods and services, advertising budgets, education levels, or any of the variables included in a demand function. 9
The important point is that an elasticity measures this responsiveness in terms
of percentage changes in both variables. Thus, an elasticity is a number, called
a coefficient, that represents the ratio of two percentage changes: the percentage change in quantity demanded relative to the percentage change in the other
variable.
Percentage changes are used so that managers and analysts can make comparisons among elasticities for different variables and products. If absolute
changes were used instead of percentage changes and the quantities of products were measured in different units, elasticities could vary by choice of the
unit of measurement. For example, using absolute values of quantities, managers would find it difficult to compare consumer responsiveness to demand
variables if the quantity of one product is measured in pounds and another is
measured in tons, because they would be comparing changes in pounds with
changes in tons.
9
Although we can also calculate supply elasticities from a product supply function in a comparable manner,
we will postpone our discussion of this issue until we present the model of perfect competition (Chapter 7).
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CHAPTER 3 Demand Elasticities
79
Price Elasticity of Demand
The price elasticity of demand (ep) is defined as the percentage change in
the quantity demanded of a given good, X, relative to a percentage change in its
price, all other factors assumed constant, as shown in Equation 3.1.10 A percentage
change in a variable is the ratio of the absolute change (Q2 – Q1 or ∆Q; P2 – P1 or
∆P) in that variable to a base value of the variable, as shown in Equation 3.2.
Price elasticity of demand
(eP)
The percentage change in the
quantity demanded of a given
good, X, relative to a percentage
change in its own price, all other
factors assumed constant.
%∆QX
%∆PX
3.1
eP =
3.2
∆QX
Q2 − Q1
QX
QX
eP =
=
∆ PX
P2 − P1
PX
PX
where
e P = price elasticity of demand
∆ = the absolute change in the variable: (Q2 − Q1 ) or (P2 − P1 )
QX = the quantity demanded of good X
PX = the price of good X
Price elasticity of demand is illustrated by the change in quantity demanded
from Q1 to Q2 as the price changes from P1 to P2, or the movement along the
demand curve from point A to point B in Figure 3.1. Because we are moving along
a demand curve, all other factors affecting demand are assumed to be constant,
and we are examining only the effect of price on quantity demanded. All demand
elasticities are defined with the other factors influencing demand assumed
constant so that the effect of the given variable on demand can be measured
independently.
FIGURE 3.1
P
Price Elasticity and the
Movement Along a Demand
Curve
Price elasticity is measured as a
movement along a demand curve
from point A to point B.
A
P1
∆P
B
P2
0
Demand
∆Q
Q1
Q2
Q
10
Price elasticity is sometimes called the “own price elasticity of demand” because it shows the ratio of the
percentage change in the quantity demanded of a product to the percentage change in its own price.
M03_FARN0095_03_GE_C03.INDD 79
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80
PART 1 Microeconomic Analysis
The Influence of Price Elasticity on Managerial
Decision Making
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.
Price elasticity of demand is an extremely important concept for a firm because it
tells managers what will happen to revenues if the price of a product changes. It
can also help firms develop a pricing strategy that will maximize their profits.
The demand for airline travel changed substantially between 1999 and 2006 due
to the following factors. Although business travelers have always been less price
sensitive than tourists because they have less ability to postpone a trip or search
for alternatives, they have become more price sensitive due to improvements in
electronic communications and increased restrictions on travel reimbursement.
Tightened security restrictions at airports have resulted in travelers having an
increased preference for direct flights. The option of purchasing tickets on the
Internet has reduced customer search costs and increased their knowledge
about alternative fares. It has been estimated that the price elasticity of demand
for tourists increased in absolute value from 0.78 to 1.05 and for business travelers from 0.07 to 0.10 over the period 1999 to 2006. The price elasticity was
31 percent larger for tourists and 43 percent larger for business travelers. The
connection semi-elasticity, or the percentage reduction in quantity demanded if
a direct flight became a connecting flight, increased in absolute value from 0.55
to 0.75 for business travelers and from 0.75 to 0.80 for tourists. Thus, both business travelers and tourists exhibited a stronger preference for direct flights in
2006.11 The airlines use knowledge about these different elasticities to develop
a complex schedule of prices for different groups of travelers and varying types
of flights.
Information on the price elasticity of demand for gasoline affects managerial
decisions in the automobile industry. In response to a price increase, consumers
may travel less by car, either switching to alternative modes of transport or by traveling less in general. Consumers may also sell their cars, buy more efficient models,
or change the usage of various household models. Thus, changes in gasoline prices
affect the quantity demanded of gasoline though fuel efficiency, mileage per car,
and car ownership. Consumers will typically drive less in the short run and then
consider ownership changes in the long run.12
In an analysis based on data from 43 other studies, researchers estimated a shortrun price elasticity of gasoline demand of –0.34 and a long-run elasticity of –0.84.
Consumers have more options to adjust to changes in gasoline prices in the long
run than in the short run. The long-run elasticity estimate can be decomposed into
estimates of the price elasticities of fuel efficiency (0.31), mileage per car (–0.29),
and car ownership (–0.24). Thus, in the long run the response to changes in gasoline prices is driven by a similar size of response in terms of fuel efficiency, mileage per car, and car ownership. These relatively small price elasticities in both the
short run and the long run indicate that the use of gasoline taxes to decrease the
demand for gasoline may not be a very effective policy.13
Elasticities are also important for management in the public sector. For example,
a manager at a public transit agency needs to know how much decrease in ridership
will result if the agency raises transit fares and the impact of this fare increase on
the total revenue the agency receives from its passengers (the amount of money
received by a producer for the sale of its product, calculated as the price per unit
times the quantity sold).
11
Steven Berry and Panle Jia, “Tracing the Woes: An Empirical Analysis of the Airline Industry,” American
Economic Journal: Microeconomics 2 (August 2010): 1–43.
12
Martijn Brons, Peter Nijkamp, Eric Pels, and Piet Rietveld, “A Meta-Analysis of the Price Elasticity of
Gasoline Demand: A SUR Approach,” Energy Economics 30 (2008): 2105–22.
13
Brons et al., “A Meta-Analysis of the Price Elasticity of Gasoline Demand: A SUR Approach.”
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CHAPTER 3 Demand Elasticities
Price Elasticity Values
81
Elastic demand
The calculated value of all price elasticities for downward sloping demand curves
is a negative number, given the inverse relationship between price and quantity demanded. If price increases, quantity demanded decreases and vice versa.
Therefore, it is easier to drop the negative sign and examine the absolute value
(|eP|) of the number to determine the size of the price elasticity. This procedure
leads to the definitions shown in Table 3.1.
As shown in Table 3.1, demand is elastic if the coefficient’s absolute value is
greater than 1 and inelastic if the coefficient’s absolute value is less than 1. For
elastic demand, the percentage change in quantity demanded by consumers is
greater than the percentage change in price. This implies a larger consumer responsiveness to changes in prices than does inelastic demand, in which the percentage change in quantity demanded by consumers is less than the percentage change
in price. In the case of unitary elasticity, where 0 e P 0 = 1, the percentage change in
quantity demanded is exactly equal to the percentage change in price.
Elasticity and Total Revenue
The percentage change in quantity
demanded by consumers is greater
than the percentage change in
price and 0 e P 0 7 1.
Inelastic demand
The percentage change in quantity
demanded by consumers is less
than the percentage change in
price and 0 e P 0 6 1.
Unitary elasticity (or unit
elastic)
The percentage change in quantity
demanded is exactly equal to the
percentage change in price and
0 e P 0 = 1.
The fourth column of Table 3.1 shows the relationship among price elasticity,
changes in prices, and total revenue received by the firm, which, as noted above, is
defined as price times quantity [(P)(Q)]. If demand is elastic, higher prices result in
lower total revenue, while lower prices result in higher total revenue. This outcome
arises because the percentage change in quantity is greater than the percentage
change in price. If the price increases, enough fewer units are sold at the hig …
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