Assignment 1: Demand Estimation
Demand and Supply Estimation
Based on the given information, we will calculate the elasticities of different variables.
For the first demand function, QD = - 5200 - 42P + 20PX + 5.2I + 0.20A + 0.25M
Price of the microwave oven, P = 500,
Price of leading competitor’s product, PX = 600
Per capita income, I = 5,500
Monthly advertising expenditure, A = 10,000
Substituting the values of P, M, PX, I and A in the above equation, we will get the value of quantity demanded as,
QD= - 5200 – 42(500) + 20(600) + 5.2(5500) + 0.20(10000) + 0.25(5000) = 17,650 units
Price Elasticity (Ep) = (P/Q) (∆Q/∆P)
When we take the first derivative of the given demand function with respect to P, we get
∆Q/∆P = -42.
Hence, the price elasticity (Ep) = (P/Q) (-42) = (500/17650) x -42 = -1.19,
In the similar fashion,
Cross- price elasticity ( Ec) = 20(600/17560) = 0.68
Elasticity of microwave oven sales (EM) = (P/Q) (0.25) = 0.25 x (5000/17650) = 0.07
Advertisement-elasticity (EA) = (P/Q) (0.20) (10000/17650) = 0.11
Income-elasticity (EI) = (P/Q) (5.2) = (5500/17650) x 5.2 = 1.62
The measure of the elasticity can have several implications to the management. The information about the elasticity is very important for the managers to make various decisions like pricing the product. Based on the above calculated elasticities for the demand of the low calorie microwave oven, following implications can be derived.
Price Elasticity: From the above calculation of the price elasticity, we have found out the value to be -1.19. This proves the validity of the demand law i.e. the price and the quantity demanded has an inverse relation. The meaning of -1.19 means the for every 1% increase in the price of the product, the quantity demanded falls by 1.19%. This reflects the elastic nature of the quantity demanded. i.e. there occurs the change in the quantity demanded when the price changes. So, the company must be very careful in determining its price because the large change in price can lead to large fall in the demand for the product.
Cross –Price Elasticity: The calculations suggest the cross price elasticity to be 0.68. The interrelationship of one product to that of its competitor is shown by cross price elasticity. As the price of competitor's product rises by 1%, the overall demand for the given product would increase by 0.68%. So, it is inelastic in nature since the change in the price of competitors did not bring much change in the quantity demanded of the given product. There is no need to worry about the competitor's product due to no impact on the sales of the competitors (Sadd, 2005).
Income Elasticity: The calculation shows the income elasticity to be 1.62. This means that the increase in purchasing power among the consumer will lead to greater level of consumption pattern or increase in quantity demanded of the product. It will increase by 1.62% if the income increases by 1%. The product is highly elastic in nature. So, the company can use the strategy to increase the price level when the income of the consumers increases.
Microwave Oven Elasticity: The relationship of quantity demanded to the microwave oven among household in the area is determined by the microwave oven elasticity. The elasticity is 0.07. This suggests that the increase in a number of microwave ovens in the area will increase the demand by only 0.07%. This is only a slight increase in demand with the increase in a number of the oven. So, it is inelastic in nature.
Advertisement Elasticity: The calculations suggest the advertisement elasticity to be 0.11. If there is 1% increase in the advertising expenses made by the company, the overall impact on the demand will only be 0.11%. So, the nature of elasticity is inelastic. This can reduce the number of consumers demand if the company spends more on advertising expenses leading to increasing in prices. Thus, the increase in the price level will reduce the demand. The product will not benefit from more advertising.
Total revenue = P * Q
Differentiating the above equation with respect to P,
dTR/ dP = Q (dP/dP) + P (dQ/dP)
(1/Q) (dTR/dP)= (dP/dP) + (P/Q) (dQ/dP) = 1 + E
Therefore, dTR/dP >0 and E is elastic, then the reduction in price will lead to higher revenue and increase in quantity demanded.
According to the price elasticity of the product, it is highly elastic i.e. the demand increases by 1.19% when the price falls by 1%. So, if the price of the product is reduced, it will increase the overall market demand and that will ultimately lead to higher market share. The revenue can also be maximized when the elasticity becomes 1. As the price cut will lead to greater demand in the market, there is a higher net gain from the product sales as it moves towards unity.
Thus, the company will benefit from reducing the price of the product which will enhance the market share and create greater revenue.
Apart from every thing, we now analyse the change in quantities demanded by changing the price of the product. This will help us to understand the change in the quantities demanded for the change in the price. Keeping all the other factors constant, the demand equation will take the form as:
Q = -5200 - 42(P) + 20(600) +5.2(5500) +0.2(10,000) +0.25(5000)
Q = 38,650 – 42P
Similarly we will be plotting the supply curve to see the interaction of the demand and supply curve. The supply function is Q = 5200 + 45P . So, with the change in the price, we wil derive the quantities supplied and plot it in the graph.
Q = 5200 + 45P
Thus, by solving the two equations of demand and supply, we get:
38,650 - 42P = 5200 + 45P
87P = 33,450
Price = $384.48
Substituting price in order to get equilibrium quantity,
Q = 5200 + 45(384.48)
Q = 22,501.6 units
After the interaction of the demand and supply curve, we discovered equilibrium quantity of the product i.e. 22,501 units and the equilibrium price is 384 cents. The equilibrium is the point where both the curves of demand and supply meet.
There are several factors that can bring a change in demand. Some of them are changes in the price of correlated goods, competitor's price, income level, tastes, and preference, consumer awareness, seasonal factors, speculation of future price changes, governmental policies, persuasive advertising, population size, etc.
Similarly, in the case of the supply curve, there will be a change in supply in case of changes in the labor market, raw materials, production technologies, number of suppliers, the price of other commodities, the price of factors of production, time period, tax and subsidies, etc. These factors will bring changes in the production cost and then the supply of the product.
The main factor bringing changes in demand and supply is the price of the product itself. The increase in price will reduce the demand while it will increase the supply of the product.
The shift in demand curve to the left suggests a reduction of demand while to the right suggests an increase in demand. When the price of complementary goods reduces, increase in preference of consumers towards low-calorie food, the rise in population, etc., the demand curve will shift to the right. When the income decreases, preference changes, the price of complementary goods increases, etc., the demand will shift towards the left (McGuigan, Moyer, & Harris, 2014).
Similarly, for supply, improvement in technology, availability of factors of productions, decrease in government regulations and taxes, etc. leads to shifting in supply to the right. But, in the case of unavailability of raw materials, a decrease in subsidies, an increase in taxes, etc. will lead the supply curve to shift to the left.
References
Daniels, B. J., & Hyde, W. F. (1985). Estimation of supply and demand for North Carolina's timber. Research Triangle Park, N.C: Southeastern Center for Forest Economics Research.
Sadd, M. H. (2005). Elasticity: Theory, applications, and numerics. Amsterdam: Elsevier Butterworth Heinemann.
McGuigan, J. R., Moyer, R. C., & Harris, F. H. (2014). Managerial economics: Applications, strategy, and tactics.
