Demand and Supply Estimation
Imagine that you work for the maker of a leading brand of low-calorie, frozen microwavable food that estimates the following demand equation for their product using data from 26 supermarkets around the country for the month of April.
Option 1:
Note: The following is a regression equation. Standard errors are in parenthesis for the demand of widgets.
QD= - 5200 - 42P + 20Px + 5.2I + 0.20A + 0.25M
(2.002) (17.5) (6.2) (2.5) (0.09) (0.21)
R2= 0.55, N = 26 F= 4.88
Your supervisor has asked you to compute the elasticity for each independent variable. Assume the following values for the independent variables:
Q D = Quantity demanded
P (in cents) per case = Price of the product = 500 cents
PX (in cents) = Price of leading competitor’s product = 600 cents
I (in dollars) = Per capita income of the standard metropolitan statistical area (SMSA) where the supermarkets are located = 5500
A (in dollars) = Monthly advertising expenditures = $10,000
1. Compute the elasticity for each independent variable. Note: Write down all of your calculations.
When P= 500, C=600, I=5,500, A=10,000, and M=5000, using the regression equation,
QD= - 5200 – 42(500) + 20(600) + 5.2(5500) + 0.20(10000) + 0.25(5000)= 17,650
Price Elasticity = (P/Q) (∆Q/∆P)
From the regression equation, ∆Q/∆P = -42.
So, Price Elasticity (Ep) = (P/Q) (-42) (500/17650) = -1.19, Likewise,
Ec = 20(600/17560) = 0.68
EA= (P/Q) (0.20) (10000/17650) = 0.11
EI = (P/Q) (5.2) (5500/17650) = 1.62
EM = (P/Q) (0.25) (5000/17650) = 0.07
2. Determine the implications for each of the computed elasticity for the business in terms of short-term and long-term pricing strategies. Provide a rationale in which you cite your results.
Price Elasticity is – 1.19. That is a 1% increase in price of the product will make quantity demanded to drop by 1.19%. Thus, the demand for this product is somewhat elastic. Consequently, increase in income may drive consumers away.
Cross- price elasticity is 0.68 that is if the price of the competitor’s product goes up by 1%, then quantity demanded of this product with increase by 0.68%. This product is fairly inelastic to a competitor’s price and there exists no need to be concerned about the competitor since their pricing won’t affect sales.
Income-elasticity is 1.62. This indicates that a 1% rise in the average area income will boost the quantity demanded by 1.62%. In this aspect, the product is elastic and the company can make the decision to raise the price if the average income rises.
Advertisement-elasticity is 0.11, which means that A 1% increase in advertising expense will raise the quantity demanded by 0.11%. Therefore, demand is rather inelastic to advertising. For that reason, more advertisement doesn’t automatically means a company can raise the price because that still could drive consumers away.
With respect to microwave ovens in the area, elasticity is 0.07, which shows an elevation of 1% in the number of ovens in the area increasing the quantity demanded by a mere 0.07%. Therefore, in this aspect, demand is inelastic and the pricing strategy can simply skip this element.
3. Recommend whether you believe that this firm should or should not cut its price to increase its market share. Provide support for your recommendation.
Since the price elasticity is greater than one in absolute value, a decrease in price will lead to an even greater increase in quantity demanded (in % terms), leading to an increase in market shares. Yes, cutting the price will lead to an increase in the company share as the PED is bigger than (1.19).
4. Assume that all the factors affecting demand in this model remain the same, but that the price has changed. Further assume that the price changes are 100, 200, 300, 400, 500, 600 cents.
i) Plot the demand curve for the firm.
ii) Plot the corresponding supply curve on the same graph using the supply function Q = 5200 + 45P (Q= -7909.89+79.0989P) with the same prices.
iii) Determine the equilibrium price and quantity
iv) Outline the significant factors that could cause changes in supply and demand for the product. Determine the primary manner in which both the short-term and the long-term changes in market conditions could impact the demand for, and the supply, of the product.
Solutions:
With all others factors remaining constants, the demand equation is as follows:
Q = -5200 - 42(P) + 20(600) +5.2(5500) +0.2(10,000) +0.25(5000)
Q = 38,650 – 42P
P = 38,650/42-Q/42
Q = 5200 =45P
P = - 5200/45 + Q/45
Thus, solving the demand and supply curves concurrently,
38,650 - 42P = 5200 + 45P
87P = 33,450
P = 384.48 AND
Q = 5200 + 45(384.48)
Q = 22,501.6
Therefore, the equilibrium price is 384 cents and the equilibrium quantity is 22,501 units. Additionally, the equilibrium price and the quantity can be seen on the graph indicated at the point where the supply and demand meet or intercept.
As is pointed out in the demand equation, demand of the low-calorie food can change if there is a change in consumer income, the pricing of a competitor product, and the price of correlating goods (microwave ovens). This change can also happen as the result of change in consumer preference (e.g. consciousness towards low-calorie food). Supply of the product can change if there is a change in the number of product suppliers, production technological advances in additional to the other elements like labor and raw materials availability change, which directly affect production costs.
5. Indicate the crucial factors that could cause rightward shifts and leftward shifts of the demand and supply curves.
An increase in consumer income, a price cut in the price of complementary product (e.g. microwave ovens) could cause a right ward shift of demand curve for the product; as well
as a population increase or increased preference for the product (e.g. awareness towards low-calorie food). A decrease in consumer income or a recession (like the U.S have been experiencing) can cause a left ward shift of the demand curve; additionally, an increase in a price of a complementary product (microwave ovens etc) could cause a leftward shift of the demand curve.
Technology advances in food processing, increased availability of cheap labor and raw materials, increased tax-cuts and government subsidies (among other things) can cause a right-ward shift of supply curve. A leftward shift can be caused by a decrease in availability or an increase in price of labor and raw materials, increased taxes, etc.
Sunday 15 June 2014
Tuesday 10 June 2014
FACTORS AFFECTING DEMAND
Factors Affecting Demand
Even though the focus in economics is on the relationship between the price of a product and how much consumers are willing and able to buy, it is important to examine all of the factors that affect the demand for a good or service.
These factors include:
Price of the Product
There is an inverse (negative) relationship between the price of a product and the amount of that product consumers are willing and able to buy. Consumers want to buy more of a product at a low price and less of a product at a high price. This inverse relationship between price and the amount consumers are willing and able to buy is often referred to as The Law of Demand.
The Consumer's Income
The effect that income has on the amount of a product that consumers are willing and able to buy depends on the type of good we're talking about. For most goods, there is a positive (direct) relationship between a consumer's income and the amount of the good that one is willing and able to buy. In other words, for these goods when income rises the demand for the product will increase; when income falls, the demand for the product will decrease. We call these types of goods normal goods.
However, for some goods the effect of a change in income is the reverse. For example, think about a low-quality (high fat-content) ground beef. You might buy this while you are a student, because it is inexpensive relative to other types of meat. But if your income increases enough, you might decide to stop buying this type of meat and instead buy leaner cuts of ground beef, or even give up ground beef entirely in favor of beef tenderloin. If this were the case (that as your income went up, you were willing to buy less high-fat ground beef), there would be an inverse relationship between your income and your demand for this type of meat. We call this type of good an inferior good. There are two important things to keep in mind about inferior goods. They are not necessarily low-quality goods. The term inferior (as we use it in economics) just means that there is an inverse relationship between one's income and the demand for that good. Also, whether a good is normal or inferior may be different from person to person. A product may be a normal good for you, but an inferior good for another person.
The Price of Related Goods
As with income, the effect that this has on the amount that one is willing and able to buy depends on the type of good we're talking about. Think about two goods that are typically consumed together. For example, bagels and cream cheese. We call these types of goods compliments. If the price of a bagel goes up, the Law of Demand tells us that we will be willing/able to buy fewer bagels. But if we want fewer bagels, we will also want to use less cream cheese (since we typically use them together). Therefore, an increase in the price of bagels means we want to purchase less cream cheese. We can summarize this by saying that when two goods are complements, there is an inverse relationship between the price of one good and the demand for the other good.
On the other hand, some goods are considered to be substitutes for one another: you don't consume both of them together, but instead choose to consume one or the other. For example, for some people Coke and Pepsi are substitutes (as with inferior goods, what is a substitute good for one person may not be a substitute for another person). If the price of Coke increases, this may make Pepsi relatively more attractive. The Law of Demand tells us that fewer people will buy Coke; some of these people may decide to switch to Pepsi instead, therefore increasing the amount of Pepsi that people are willing and able to buy. We summarize this by saying that when two goods are substitutes, there is a positive relationship between the price of one good and the demand for the other good.
The Tastes and Preferences of Consumers
This is a less tangible item that still can have a big impact on demand. There are all kinds of things that can change one's tastes or preferences that cause people to want to buy more or less of a product. For example, if a celebrity endorses a new product, this may increase the demand for a product. On the other hand, if a new health study comes out saying something is bad for your health, this may decrease the demand for the product. Another example is that a person may have a higher demand for an umbrella on a rainy day than on a sunny day.
The Consumer's Expectations
It doesn't just matter what is currently going on - one's expectations for the future can also affect how much of a product one is willing and able to buy. For example, if you hear that Apple will soon introduce a new iPod that has more memory and longer battery life, you (and other consumers) may decide to wait to buy an iPod until the new product comes out. When people decide to wait, they are decreasing the current demand for iPods because of what they expect to happen in the future. Similarly, if you expect the price of gasoline to go up tomorrow, you may fill up your car with gas now. So your demand for gas today increased because of what you expect to happen tomorrow. This is similar to what happened after Huricane Katrina hit in the fall of 2005. Rumors started that gas stations would run out of gas. As a result, many consumers decided to fill up their cars (and gas cans), leading to long lines and a big increase in the demand for gas. This was all based on the expectation of what would happen.
The Number of Consumers in the Market
As more or fewer consumers enter the market this has a direct effect on the amount of a product that consumers (in general) are willing and able to buy. For example, a pizza shop located near a University will have more demand and thus higher sales during the fall and spring semesters. In the summers, when less students are taking classes, the demand for their product will decrease because the number of consumers in the area has significantly decreased.
Even though the focus in economics is on the relationship between the price of a product and how much consumers are willing and able to buy, it is important to examine all of the factors that affect the demand for a good or service.
These factors include:
Price of the Product
There is an inverse (negative) relationship between the price of a product and the amount of that product consumers are willing and able to buy. Consumers want to buy more of a product at a low price and less of a product at a high price. This inverse relationship between price and the amount consumers are willing and able to buy is often referred to as The Law of Demand.
The Consumer's Income
The effect that income has on the amount of a product that consumers are willing and able to buy depends on the type of good we're talking about. For most goods, there is a positive (direct) relationship between a consumer's income and the amount of the good that one is willing and able to buy. In other words, for these goods when income rises the demand for the product will increase; when income falls, the demand for the product will decrease. We call these types of goods normal goods.
However, for some goods the effect of a change in income is the reverse. For example, think about a low-quality (high fat-content) ground beef. You might buy this while you are a student, because it is inexpensive relative to other types of meat. But if your income increases enough, you might decide to stop buying this type of meat and instead buy leaner cuts of ground beef, or even give up ground beef entirely in favor of beef tenderloin. If this were the case (that as your income went up, you were willing to buy less high-fat ground beef), there would be an inverse relationship between your income and your demand for this type of meat. We call this type of good an inferior good. There are two important things to keep in mind about inferior goods. They are not necessarily low-quality goods. The term inferior (as we use it in economics) just means that there is an inverse relationship between one's income and the demand for that good. Also, whether a good is normal or inferior may be different from person to person. A product may be a normal good for you, but an inferior good for another person.
The Price of Related Goods
As with income, the effect that this has on the amount that one is willing and able to buy depends on the type of good we're talking about. Think about two goods that are typically consumed together. For example, bagels and cream cheese. We call these types of goods compliments. If the price of a bagel goes up, the Law of Demand tells us that we will be willing/able to buy fewer bagels. But if we want fewer bagels, we will also want to use less cream cheese (since we typically use them together). Therefore, an increase in the price of bagels means we want to purchase less cream cheese. We can summarize this by saying that when two goods are complements, there is an inverse relationship between the price of one good and the demand for the other good.
On the other hand, some goods are considered to be substitutes for one another: you don't consume both of them together, but instead choose to consume one or the other. For example, for some people Coke and Pepsi are substitutes (as with inferior goods, what is a substitute good for one person may not be a substitute for another person). If the price of Coke increases, this may make Pepsi relatively more attractive. The Law of Demand tells us that fewer people will buy Coke; some of these people may decide to switch to Pepsi instead, therefore increasing the amount of Pepsi that people are willing and able to buy. We summarize this by saying that when two goods are substitutes, there is a positive relationship between the price of one good and the demand for the other good.
The Tastes and Preferences of Consumers
This is a less tangible item that still can have a big impact on demand. There are all kinds of things that can change one's tastes or preferences that cause people to want to buy more or less of a product. For example, if a celebrity endorses a new product, this may increase the demand for a product. On the other hand, if a new health study comes out saying something is bad for your health, this may decrease the demand for the product. Another example is that a person may have a higher demand for an umbrella on a rainy day than on a sunny day.
The Consumer's Expectations
It doesn't just matter what is currently going on - one's expectations for the future can also affect how much of a product one is willing and able to buy. For example, if you hear that Apple will soon introduce a new iPod that has more memory and longer battery life, you (and other consumers) may decide to wait to buy an iPod until the new product comes out. When people decide to wait, they are decreasing the current demand for iPods because of what they expect to happen in the future. Similarly, if you expect the price of gasoline to go up tomorrow, you may fill up your car with gas now. So your demand for gas today increased because of what you expect to happen tomorrow. This is similar to what happened after Huricane Katrina hit in the fall of 2005. Rumors started that gas stations would run out of gas. As a result, many consumers decided to fill up their cars (and gas cans), leading to long lines and a big increase in the demand for gas. This was all based on the expectation of what would happen.
The Number of Consumers in the Market
As more or fewer consumers enter the market this has a direct effect on the amount of a product that consumers (in general) are willing and able to buy. For example, a pizza shop located near a University will have more demand and thus higher sales during the fall and spring semesters. In the summers, when less students are taking classes, the demand for their product will decrease because the number of consumers in the area has significantly decreased.
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