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 microeconomic 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.
OUTLINE 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
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 microeconomic 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.
OUTLINE 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
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 microeconomic 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.
OUTLINE 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
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 microeconomic 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.
OUTLINE 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
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 amount 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 microeconomics and macroeconomics. Use the case of analysis at the
(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 amount 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 microeconomics and macroeconomics. Use the case of analysis at the
Chapter 1: Managers and Economics 3
start of the chapter to ask them which 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 prices 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. Markets: The mechanisms used for the buying and selling of products.
There are four markets 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.
start of the chapter to ask them which 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 prices 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. Markets: The mechanisms used for the buying and selling of products.
There are four markets 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.
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 Competition: Market structures of monopoly, oligopoly and
monopolistic 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. The 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.
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 Competition: Market structures of monopoly, oligopoly and
monopolistic 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. The 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.
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 fiscal 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).
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 fiscal 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).
Loading page 6...
Chapter 2: Demand, Supply and Equilibrium Prices 6
CHAPTER 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, all other
factors held constant. The discussion uses graphical and algebraic methods. The chapter begins
with a case of analysis (Demand and Supply in The Copper Industry) which demonstrates how
demand and supply factors influenced the copper supply and demand and how changes in these
functions impact the market price of copper.
OUTLINE 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. Managers 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
CHAPTER 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, all other
factors held constant. The discussion uses graphical and algebraic methods. The chapter begins
with a case of analysis (Demand and Supply in The Copper Industry) which demonstrates how
demand and supply factors influenced the copper supply and demand and how changes in these
functions impact the market price of copper.
OUTLINE 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. Managers 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
Loading page 7...
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 changes. 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 quantity 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 quantity 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.
of the case is to illustrate how the non-price factors can cause demand and/or supply
to changes. 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 quantity 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 quantity 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,
after 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 and 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 can 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 goods 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
Teaching Tip: The text has concrete examples of tastes and preferences. For instance,
after 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 and 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 can 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 goods 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
Loading page 9...
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 Function: Function represented by QXD= f (PX, T, I, PY, PZ, EXC, NC, ...)
where:
QXD= quantity demanded of X
PX= price of X
T= variables representing an individual’s tastes and preferences
I= income
PY, PZ= 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. Demand 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.
(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 Function: Function represented by QXD= f (PX, T, I, PY, PZ, EXC, NC, ...)
where:
QXD= quantity demanded of X
PX= price of X
T= variables representing an individual’s tastes and preferences
I= income
PY, PZ= 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. Demand 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 Demanded: 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 Demand: 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 the 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 Summation: For every price, add the quantity that each
individual in a market demands.
2. A simple example is when there are two individuals in a market. This is
illustrated in Figure 2.3.
4. Price and quantity demanded have a negative relationship.
E. Change in Quantity Demanded and Change in Demand
1. Change in Quantity Demanded: 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 Demand: 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 the 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 Summation: For every price, add the quantity that each
individual in a market demands.
2. A simple example is when there are two individuals 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 Function: 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: QD=3-2PC+0.2I+1.6TC+0.4E
where:
QD= quantity demanded of copper (millions of pounds)
PC= 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 price
over the following six months
2. The negative coefficient on PC shows an inverse relationship between price
and quantity demanded for copper.
3. The positive coefficient on I shows that copper is a normal good.
4. The positive 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 but a decreased demand for
copper for the current period.
G. Linear Demand Function and Curves
1. Linear Demand Function: 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: QD=3-2PC+0.2I+1.6TC+0.4E
where:
QD= quantity demanded of copper (millions of pounds)
PC= 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 price
over the following six months
2. The negative coefficient on PC shows an inverse relationship between price
and quantity demanded for copper.
3. The positive coefficient on I shows that copper is a normal good.
4. The positive 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 but 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: QD=15-2PC 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 market.
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.
6. Equation 2.3: QD=15-2PC 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 market.
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 QXS= f (PX, TX, PI, PA, PB, EXP, NP, ...)
where:
QXS= quantity supplied of X
PX= price of X
TX=state of technology
PI= prices of inputs of production
PA, PB= 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 influencing 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
(b) Changes in laws or regulations including trade barriers (quotas and
tariffs) can also achieve the same result.
C. Supply Function: Function represented by QXS= f (PX, TX, PI, PA, PB, EXP, NP, ...)
where:
QXS= quantity supplied of X
PX= price of X
TX=state of technology
PI= prices of inputs of production
PA, PB= 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 influencing 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 entire 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: QS= -5+8PC-0.5W+0.4T+0.5N
where:
QS= quantity supplied of copper (millions of pounds)
PC= 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 positive coefficient on PC shows a positive relationship between price
and quantity supplied of copper.
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 entire 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: QS= -5+8PC-0.5W+0.4T+0.5N
where:
QS= quantity supplied of copper (millions of pounds)
PC= 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 positive coefficient on PC 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 negative coefficient on W shows that as the input price increases,
supply decreases due to costly production.
4. The positive coefficient on T shows that an increase in technology
increases the supply of copper.
5. The positive coefficient on N shows that an increase in the number of
active mines increases the supply of copper.
6. Equation 2.6: QS= -25+8PC 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.
3. The negative coefficient on W shows that as the input price increases,
supply decreases due to costly production.
4. The positive coefficient on T shows that an increase in technology
increases the supply of copper.
5. The positive coefficient on N shows that an increase in the number of
active mines increases the supply of copper.
6. Equation 2.6: QS= -25+8PC 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 (PE): 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 (QE): 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 prices 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: QD= 15-2PC
2. Equation 2.6: QS= -25+8PC
3. In equilibrium, there is only one quantity where QD=QS. 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
1. Equilibrium Price (PE): 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 (QE): 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 prices 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: QD= 15-2PC
2. Equation 2.6: QS= -25+8PC
3. In equilibrium, there is only one quantity where QD=QS. 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 (D0 to D1) raises the equilibrium price and
raises the equilibrium quantity. This is illustrated in Figure 2.9.
(b) A decrease in demand (D0 to D2) 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 (S0 to S1) lowers the equilibrium price and
raises the equilibrium quantity. This is illustrated in Figure 2.10.
(b) A decrease in supply (S0 to S2) raises the equilibrium price and
lowers the equilibrium quantity. This is illustrated in Figure 2.10.
3. The effects of changes 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.
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 (D0 to D1) raises the equilibrium price and
raises the equilibrium quantity. This is illustrated in Figure 2.9.
(b) A decrease in demand (D0 to D2) 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 (S0 to S1) lowers the equilibrium price and
raises the equilibrium quantity. This is illustrated in Figure 2.10.
(b) A decrease in supply (S0 to S2) raises the equilibrium price and
lowers the equilibrium quantity. This is illustrated in Figure 2.10.
3. The effects of changes 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 increase in supply raise the equilibrium
quantity but the effect on the equilibrium price is indeterminate. This is
illustrated in Figures 2.13 and 2.14.
5. An increase in demand and an increase in supply raise the equilibrium
quantity but the effect 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 the
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 the
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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.
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
CHAPTER 3: DEMAND ELASTICITIES
OVERVIEW
This chapter introduces students to the concept of elasticity of demand. 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.
OUTLINE 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
CHAPTER 3: DEMAND ELASTICITIES
OVERVIEW
This chapter introduces students to the concept of elasticity of demand. 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.
OUTLINE 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 lowered 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.
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 lowered 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 (eP): 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: eP= %∆QX / %∆PX
where:
eP= price elasticity of demand
∆= the absolute change in the variable: (Q2-Q1) or (P2-P1)
1. Price elasticity of demand is illustrated by the change in quantity
demanded from Q1 to Q2 as the price changes from P1 to P2.
2. This is shown as the movement along the demand curve from A to B in
Figure 3.1.
B. The price elasticity of demand affects managerial decisions on pricing strategies
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. Price 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.
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 (eP): 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: eP= %∆QX / %∆PX
where:
eP= price elasticity of demand
∆= the absolute change in the variable: (Q2-Q1) or (P2-P1)
1. Price elasticity of demand is illustrated by the change in quantity
demanded from Q1 to Q2 as the price changes from P1 to P2.
2. This is shown as the movement along the demand curve from A to B in
Figure 3.1.
B. The price elasticity of demand affects managerial decisions on pricing strategies
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. Price 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: |eP|=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: |eP|>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: |eP|<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.
1. Unitary Elasticity: |eP|=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: |eP|>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: |eP|<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 period 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 Q1 and Q2
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 period 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 Q1 and Q2
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Chapter 3: Demand Elasticities 26
(c) To remedy these problems, the following equation is used.
(d) Equation 3.3: eP= (Q2-Q1)/ [(Q1+Q2)/2]
(P2-P1)/ [(P1+P2)/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 specific demand function, appropriate derivatives can be
computed.
(b) Equation 3.4: eP= dQX PX
dPx QX
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 Arc 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 elasticity coefficients vary.
(c) To remedy these problems, the following equation is used.
(d) Equation 3.3: eP= (Q2-Q1)/ [(Q1+Q2)/2]
(P2-P1)/ [(P1+P2)/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 specific demand function, appropriate derivatives can be
computed.
(b) Equation 3.4: eP= dQX PX
dPx QX
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 Arc 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 elasticity coefficients vary.
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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.
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.
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 demand 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 analysis 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 econometric studies of
selective demand from 1961 to 1985.
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 demand 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 analysis 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 econometric 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 different 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.
(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 different 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.
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Subject
Economics