The Concept of Demand and Its Role in Managerial Economics - Assignment Example

A Paper on the Concept of Demand THE CONCEPT OF DEMAND AND ITS ROLE IN MANAGERIAL ECONOMICS Introduction The concept of demand is a very basic one in economics. For decisions makers in the corporate world, its importance lies in its role in revenue analysis. The law of demand states that “All other factors held constant, the higher the unit price of a good, the fewer the number of units demanded by consumers, and, consequently, sold by firms (Samuelson and Marks, 1995). Described in another way, it posits that s lower price generally increases the amount of a commodity that people in the market are willing to buy (Baumol, 1997). The demand curves, which is downward sloping, expresses the relationship between price and quantity demanded by the market. The horizontal axis indicates the amount of goods demanded by consumers and sold by a firm during a specific span of time. The vertical axis lists the price per unit or per lot of the product. The demand curve in a model shows the firms theoretical sales level at various prices along the line. The demand schedule is a list of prices and the corresponding quantities derived from the intersection of straight lines starting from the axes, on specific points on the demand curve itself. The downward curve is explained by the fact that as price falls there is a corresponding increase in the sales volume. The downward slope means that the elasticity coefficient drawn from the line is a negative number. However, economists have done away with the negative sign of that elasticity and have expressed it as an absolute number. Another point to remember is that the straight-line demand curve does not have a uniform elasticity of 1 (also termed unit elasticity) at all points of the line; rather, the curve is elastic above the mid-point and inelastic below that midpoint. Fig. 1 The demand curve in green shows a straight line with varying elasticities at different points (D2), while internal curved line in red shows a demand curve with uniform price elasticity of 1 (D1). A firms economist draws the demand curve to explain to management what the profit consequences would be for each price alternative, as for example, when an airline considers giving Fig. 2. Graph showing the demand curve and the area of total revenue derived from the product of price and quantity. selective fare discounts to travelers, or when analyzing the impact of fuel oil increases on the companys pricing policies. The firm would use the demand curve in discussing the consequences of alternative output and pricing policies on the revenue targets over a certain future period. Since revenue is simply the product of price and output (see Fig. 1), management would explore the various price and output alternatives en route to decision making by its marketing and production departments to achieve revenue targets. Demand Elasticities Price elasticity (Ep) of demand is the ratio of the percentage change in quantity and the percentage change in a goods price, all other things remaining unchanged. Algebraically, this is expressed in the following simple equation: Ep = %∆Q / %∆P where P and Q are the price and quantity, respectively. This formula assumes point elasticity for the sake of simplicity, although an arc price elasticity, which uses average figures for each variable, may also be used. For this paper, the use of point elasticity would enable sufficient understanding of the elasticity concept. Price elasticity measures how responsive the sales would be in relation to changes in price. Products and services inherently have different price elasticities, so that managerial decisions on expansion or reduction of output would depend to a crucial degree on the accurate determination of such elasticities. Elasticity measures the sensitivity of demand vis-a-vis price. For a start, we may consider the benchmark of elasticity = 1, which indicates that a percentage change in price is just matched by the same percentage change in quantity demanded. Where demand is somewhat unresponsive to changes in price, we can say that demand is relatively inelastic, that is to say, a percentage increase in price triggers a lower percentage change in quantity demanded. Demand is relatively elastic when a change in price brings about a larger percentage change in quantity. A vertical demand curve denotes perfectly inelastic demand with an Ep of 0, whereas a perfectly elastic demand would be a horizontal demand curve with an Ep of infinity ∞. What determines price elasticity? An important criterion is whether a good is a necessity - as opposed to a luxury - in which case the demand is relatively inelastic. If a good is not essential to the buyer, that is, when the buyer can do without it when the price is high, then its demand is elastic. The same thing is true with a product which has a substitute. Another factor is whether the price of a commodity is a significant proportion of a person’s income. For example, a 50% increase in the price of a packet of salt would not carry much weight in the choice of the consumer whether to buy it or not, whereas a 50% increase of a motorcycle would be prohibitive in relative terms. Additionally, the definition of the market is a factor: The more narrowly defined the product, the more elastic it is likely to be. Food in general, for example, would be considered inelastic in terms of price, but a cone of vanilla ice cream would be considered elastic because close substitutes can be found for it. Finally, the period of adjustment is considered important in determining elasticity, particularly when a necessary good is involved. Often cited by economic writers is the experience of the oil shocks in the early 1970s, when oil importers had to take whatever price was offered by the OPEC cartel. This was followed by an adjustment period when alternatives to fuel oil were found and the price of oil had to go down, with inelastic demand metamorphosing over time into one described as elastic. It is too early to say whether the same adjustment capability exists among oil importers and consumers in relation to the present phenomenon of the current oil crisis with price skyrocketing to $135 per barrel. Demand and Other Elasticities The primary determinants of demand are consumer incomes, prices of related goods and services (substitutes and complements), consumer tastes, and number of consumers or buyers in the market (Mankiw, 2004). Other writers such as Baumol (1997) have added the following determinants to the list: expectations about the future prices and income, credit terms on loans, and advertising. At this juncture one encounters the concept of cross-price elasticity of demand, which is a measured by the ratio of the percentage change in quantity demanded to the percentage change in price of a related product. Complements are products characterized by a direct relationship in the changes in their demand, such as CDs and CD players, automobile and tires, and hamburger and fries. An increase/decrease in the price of CD players means also an increase/decrease in the demand for CDs. Substitutes are products where the decrease in the price of one would mean a decrease in the quantity demanded of the other as buyers switch their preference to the competing product whose price has fallen. Goods can be considered normal goods when the quantity demanded varies directly with the change in income and decreases when income falls. A category of normal goods is superior goods, those whose quantity demanded increases more than proportionately to the percentage increase in income. These are also called cyclical normal goods because the demand varies thus during the business cycle (Truett and Truett, 2004). If there is an inverse relationship, the good is an inferior good. For example when income increases, there is less demand for inferior goods such as canned sardines and second-hand clothes in favor of chicken or steak and fashionably tailored clothes. According to Parkin (2000), the determinants of demand are: 1) the price of the good, 2) the price of related goods, 3) expected future prices, 4) income, 5) population, and 6) consumer preferences. The first item corresponds to a change in the quantity demanded, whereas the rest have to do with the shift in demand over time. As mentioned above, the change in quantity demanded is caused by a change in the price alone. When other causative factors trigger a change in demand, there is a change in demand instead of a change in quantity demanded, and this means that the demand curve shifts either to the right, when demand increases, or to the left, when demand falls (Fig. 3). Fig. 3. A change in demand, as distinguished from a change in the quantity demanded, is shown in the above graph. The new demand is towards the left. The price of related goods can cause consumers to switch to another good although the price of the good in question has remained constant. Also, when prices are expected to increase, there will be an increase in current purchases; and when prices are predicted to fall, consumers will hold to their cash in the expectation that they will be able to buy the good at a lower price in the near future. The rise and fall of income is of course well-recognized determinant of demand, and shifts the demand curve to the right. When population increases in a certain area or region, such as the development of a retirement community that attracts retirees, demand for goods in that area is going to increase. And, of course, people change their tastes and preferences, and market researchers should be able to anticipate the change early enough so as not to be left behind by competitors. Equilibrium of Demand and Supply The law of supply and demand states that in a free market, the forces of supply and demand generally push the price toward the level at which quantity supplied and quantity demanded are equal (Baumol, 1997). Economists call that point of intersection the point of equilibrium (Fig. 4). Below the intersection point there is a shortage of supply against demand as indicated by the gap measured horizontally between the two curves. This would motivate sellers to sell more. Above the equilibrium point there is a surplus area, and because demand is less than supply, sellers would be forced to reduce their price and supply so that supply would just be enough to meet demand, and the market is in a state of equilibrium. Fig. 4. The intersection of supply and demand at $3 and 70 units in the graph. Conclusion The understanding of the concept of demand is very important for decision makers who must make sense of the markets and make decisions in pursuit of the profitability goals of the firm. One very important aspect of the concept which no decision maker should be naïve about is that of elasticity. A very common error made by executives is the belief that reducing the price of the company’s goods and services would mean a reduction in revenues/sales and consequently earnings. One who understands demand elasticity would be able to find out that it is always a good decision, all other things being equal, to reduce the price of its products when the their demand is inelastic, because here the increase in sales volume would more than offset the drop in price. Also, increasing one’s price is not necessarily the best solution to the problem of stagnant or declining sales. If the elasticity of demand is less than 1 (demand is relatively inelastic), then it is often a good decision to increase the price. Further, when the government imposes an excise tax on goods, the amount that can be shifted to the consumer as an addition to the current price would also depend on the product’s elasticity. Finally, cross-price elasticities are important particularly in determining product substitutability, for competing products, or complementarity, for products whose sales are directly related. REFERENCES Baumol, W. J. & Blinder, A. S. (1997). Microeconomics, 7th ed. Orlando, FL: The Dryden Press Mankiw, N. G. (1998). Principles of Economics. Orlando, FL: The Dryden Press _________ (2004). Principles of Macroeconomics, 3rd ed. Mason, OH: South-Western Publishing Parkin, M. (2000). Macroeconomics, 5th ed. Don Mills, Ontario, CA: Addison-Wesley Publishing. Samuelson, W. F. & Marks, S.G. (1995). Managerial Economics, 2nd ed. Orlando, FL: The Dryden Press. Schenck, R. Supply and Demand. Cybereconomics. Retrieved June 2, 2008, from http://ingrimayne.com/econ/DemandSupply/OverviewSD.html Truett, L. J. & Truett, D. B. (2004). Managerial Economics: Analysis, Problems, Cases, 8th ed. Hoboken, NJ: John Wiley & Sons Read More