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Chapter 3
Demand Analysis and Optimal Pricing
a single monopolist dominates an industry or product line. Other things being equal, the monopolist’s demand is less elastic (since it is the sole producer) than the demand facing a particular firm in a multifirm industry. A third determinant of price elasticity is the proportion of income a consumer spends on the good in question. The issue here is the cost of searching for suitable alternatives to the good. It takes time and money to compare substitute products. If an individual spends a significant portion of income on a good, he or she will find it worthwhile to search for and compare the prices of other goods. Thus, the consumer is price sensitive. If spending on the good represents only a small portion of total income, however, the search for substitutes will not be worth the time, effort, and expense. Thus, other things being equal, the demand for small-ticket items tends to be relatively inelastic. Finally, time of adjustment is an important influence on elasticity. When the price of gasoline dramatically increased in the last five years, consumers initially had little recourse but to pay higher prices at the pump. Much of the population continued to drive to work in large, gas-guzzling cars. As time passed, however, consumers began to make adjustments. Some commuters have now switched from automobiles to buses or other means of public transit. Gas guzzlers have been replaced by smaller, more fuel-efficient cars including hybrids. Some workers have moved closer to their jobs, and when jobs turn over, workers have found new jobs closer to their homes. Thus, in the short run, the demand for gasoline is relatively inelastic. But in the long run, demand appears to be much more elastic as people are able to cut back consumption by a surprising amount. Thus, the time of adjustment is crucial. As a general rule, demand is more elastic in the long run than in the short run.
Other Elasticities The elasticity concept can be applied to any explanatory variable that affects sales. Many of these variables—income, the prices of substitutes and complements, and changes in population or preferences—have already been mentioned. (An additional important variable affecting sales is the firm’s spending on advertising and promotion.) To illustrate, consider the elasticity of demand with respect to income (Y). This is defined as EY
% change in Q % change in Y
¢Q/Q ¢Y/Y
in a manner exactly analogous to the earlier price elasticity definition.9 Income elasticity links percentage changes in sales to changes in income, all other If an infinitesimal change is considered, the corresponding elasticity expression is EY (dQ /Q)/(dY/Y). In addition, when multiple factors affect demand, the “partial derivative” notation emphasizes the separate effect of income changes on demand, all other factors held constant. In this case, we write EY ( Q /Q)/( Y/Y).
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