American Public University
1. Compute the elasticities for each independent variable. Note: Write down all of your calculations.
The demand estimation as follows: QD = -3,500 - 150P + 30A + 75PX + 10Y. When P=300, A=750, PX=200, and Y=10,000. Placing these numbers into equation: QD=-3,500-150(300)+30(750)+75(200)+10(10,000)=QD=-3,500-45,000+22,500+15,000+100,000=89,000. Under given these numbers, we have 89,000 products demanded.
Price elasticity of demand is [d(QD)/d(P)]/[QD/P]. Therefore, we take a derivative of the function subject to price, and we assume other variables do not change (Hubbard & O'Brien, 2008). Subsequently, all other variables disappears after taking derivative. d(QD)/d(P)=-150. When P=300, we found that QD=89,000. Therefore, the price elasticity of demand is (-150)/(89,000/300)=-0.506.
Similarly, advertising expenditure elasticity of demand is [d(QD)/d(A)]/[QD/A] (Hubbard & O'Brien, 2008). d(QD)/d(P)=30 and QD/A=89,000/750=118.67. The Advertising elasticity is 30/118.67=0.253.
Leading competitors’ products elasticity is [d(QD)/d(PX)]/[QD/PX] (Hubbard & O'Brien, 2008). d(QD)/d(PX)=75 and QD/PX=89,000/200=445. The leading competitors’ products price elasticity is 75/445=0.168.
Income elasticity is [d(QD)/d(Y)]/[QD/Y] (Hubbard & O'Brien, 2008). d(QD)/d(Y)=10 and QD/Y=89,000/10,000=8.9. The income elasticity is 10/8.9=1.123.
2. Determine the implications for each of the computed elasticities for the business in terms of short-term and long-term pricing strategies. Provide a rationale in which you cite your results.
The price elasticity is -0.506. It is less than “1”; thus, the estimated demand has an inelastic reaction to the changes in price. That means when the price increase 1%, the demand for this product decreases by 0.506%. According to these results, the customers are not so sensitive to the changes in price. In the short-run, the company can easily increase the price because the customers cannot find an alternative to this product, and the low price elasticity would allow the company to get a relatively higher profit. However, in the long-run, when the customers face a high price, they might start looking for substitute products and they will have enough time to do this. Subsequently, we might expect that the price elasticity might rise in the future. Therefore, increasing prices in the long-run might decrease the profit because of increasing price elasticity in the long-run. Consequently, in the long-run, consumers can find solutions for not paying high prices to some products (Huang, Jones, Hahn, & Leone, 2010).
The advertising expenditure elasticity of demand is 0.253 and it is less than “1.” That means the demand is inelastic. Increasing advertising expenditure by 1% increases the demand by 0.253%. That exhibits that advertising does not work efficiently for this product. The company should stop the current advertising in the short-run. In the long-run, the company should develop a new promotion and advertising campaign depending on the market surveys. The advertising expenditure elasticity should be equal to 1 or more than 1 at least. Therefore, by spending on advertisements might contribute to the sales of the products (Lancaster, 1984).
Leading competitors’ products price elasticity or cross-price elasticity is 0.168. The sign is positive and that means when the rival products’ prices increase, the demand for the company’s product increases. Therefore, these products are substitute products. The elasticity is very low; thus, we can claim that the relation between the products is weak. That is a good sign and it means there are no close substitutes or consumers believe that the company’s product is different from the others. If the company increases the price in the short-run, it does not cause a loss of a big market share to the other companies. However, in the long-run, the consumers’ belief might change, and the company might not be able to increase the price freely.
The income elasticity is 1.123 and that means the demand is elastic as bigger than 1. That means demand is sensitive to the changes in income. The sign of the income elasticity is positive and it means the product is a normal good. When the income increases by 1%, the demand increases by 1.123% and vice versa. Therefore, developing a marketing strategy for different income groups might increase the profit of the company. The company might implement a relatively higher price and vice versa. Price differentiation can create a bigger profit. Also, the company should monitor the income changes in the future in order to develop a proper marketing strategy (Gallet, 2010).
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.
The company can increase the price in the short-run because the price elasticity is lower than 1. When the demand is inelastic and increasing the price might increase the profit of the company. The competing leader companies’ products elasticity is very close to 0, and that means there is not strong substitution relation between the products in the market. Advertising expenditure does not have a strong influence on the demand. Consequently, it seems like that the company could manage to get a prestige in the market. Therefore, the company can make a price differentiation for increasing its profit while extending its market share. Considering that the company has a low price elasticity of demand, increasing the price in the short-run would not cause a big loss of customers.
While increasing the price, the company might lose some customers in the short-run and the long-run, the customers’ sensitivity would increase because the increasing prices push the customers to look for alternatives to the product. Therefore, the company needs to produce a strategy, and the function indicates us that the company can use the advertising for improving its position in the market in the long-run. However, the company needs to change its advertising style because the current advertising strategy cannot create efficient results. For creating a relatively more efficient advertising, the company can make some innovations in the product, and develop a supportive advertising campaign. Creating a belief among the consumers that the company’s products are superior to the other rival products in the market can make an enormous contribution to the market share of the company in the long-run (Sternthal & Rucker, 2011).
After implementing a properly developed advertising strategy, the company can differentiate its product and implement a price differentiation. By implementing different prices for different income groups might increase the profit of the company without losing its market share (Sternthal & Rucker, 2011).
4. Assume that all the factors affecting demand in this model (A, PX, and Y) remain the same. Plot the demand curve for the firm using these prices: 100, 200, 300, 400, 500, 600, 700, and 800 cents. The equation for the firm’s supply curve is: Qs = -7909.79 + 79.0989 P, where Qs is quantity supplied and P is price. Plot the supply curve, Qs, using the same prices 100, 200, 300, 400, 500, 600, 700, and 800 cents.
The schedule of demand and supply and the plots of the demand and the supply are as shown below.
Diagram 1: Demand vs. Price
Diagram 2: Supply vs. Price
As known from the law of demand, the demand is negatively slopped, and the law of supply indicates that the supply is positively slopped (Pindyck & Rubinfeld, 2005).
5. Determine the equilibrium price and quantity. (Show this graphically and/or calculate using algebra.)
Diagram 3: Demand and Supply
For calculating the equilibrium, we equalize the demand function to the supply equation (Pindyck & Rubinfeld, 2005).
(1) QD = -3,500 - 150P + 30A + 75PX + 10Y=-7,909.79 + 79.0989 P=Qs.
We know the values of A, PX, and Y.
(2) QD = -3,500 - 150P + 30(750) + 75(200)+ 10(10,000)=-7,909.79 + 79.0989 P=Qs
(3) QD=134,000-150P=-7,909.79+79.0989P=Qs
(4) 141,909.79=229.0989P
(5) P=619.43 USD and Q=-7.909.79+79.0989(619.43) and Q=41086.44.
Finally the equilibrium is P=619.43 USD and Q=41086.44.
6. What short-term and long-term changes in market conditions could shift the demand and supply curves for this product?
In the short-term, the economics theory assumes that the only determinant is price and this assumption is named as “Ceteris Paribus.” Therefore, we might assume that other products’ prices, advertisement expenditure, and income do not change in the short-run. Subsequently, the demand and the supply are determined by the price in the short-run. The price changes causes a move on the demand and the supply lines.
In the long-run, some other factors influencing the demand are given in the question while the supply is only determined by price. The changes in these external forces shift the demand line to right or left. Increasing advertisement expenditures shifts the demand line to the right and vice versa. Income and other products’ price have the same influence on the demand.
On the other side, this question ignores the external forces for the supply. However, we know that the supply is derived from the costs of production. The external influences other than price cause increases in the costs of production, this shifts the supply to the left and vice versa.
References
Gallet, C. (2010). The income elasticity of meat: a meta-analysis. Australian Journal Of Agricultural And Resource Economics, 54(4), 477-490. http://dx.doi.org/10.1111/j.1467-8489.2010.00505.x
Huang, M., Jones, E., Hahn, D., & Leone, R. (2010). Assessing price elasticity for private labels and national brands by store locations. Journal Of Revenue And Pricing Management, 11(2), 175-190. http://dx.doi.org/10.1057/rpm.2010.32
Hubbard, R. & O'Brien, A. (2008). Microeconomics (1st ed.). Upper Saddle River, N.J.: Pearson Prentice Hall.
Lancaster, K. (1984). Brand Advertising Competition and Industry Demand. Journal Of Advertising, 13(4), 19-30. http://dx.doi.org/10.1080/00913367.1984.10672913
Pindyck, R. & Rubinfeld, D. (2005). Microeconomics (1st ed.). Upper Saddle River, N.J.: Pearson Prentice Hall.
Sternthal, B. & Rucker, D. (2011). Advertising strategy (1st ed.). Acton, MA: XanEdu Publishing, Inc.
