Assignment 2: Operations Decision

Assignment 1: Demand Estimation

October 17th 2016

Demand Estimation

Introduction

The demand for low-calorie microwavable food is hypothesized to depend on various variables in addition to its price. According to a study the demand was estimated as:

(2.002) (17.5) (6.2) (2.5) (0.09) (0.21) R2 = 0.55 n = 26 F = 4.88

Where QD is the quantity demanded (the only dependent variable); the rest are exogenous variables.

P and PX are the company’s food price and substitute’s prices respectively. :

I : per-capita income

A : advertising expenses

M : number of microwaves sold (compliment)

Therefore the elasticity’s of demand in respect to the independent variables are:

Price Elasticity of demand

Using the estimated function

= 17650 3-pack units

= -1.19

Cross Elasticity of demand (due to PX)

Cross Elasticity of demand (due to M)

Income Elasticity of demand

Advertising Elasticity of demand

Elasticities of demand explanation

The price elasticity of demand is larger than 1(= -1.19), hence a unit change in price results to a more than proportionate change in quantity demanded, in the reverse direction(nte the negative sign). Therefore, reducing price creates a more than proportionate increase quantity and hence increase revenue.In the short run, when costs are fixed, this would increase total profits. However, the company ought to consider production cost changes in the long run before altering price to ensure no losses. The reverse action is irrational, as the loss in revenue due reduction in quantity exceeds the gain due to price rise.

Demand is relatively inelastic to the price of the substitute; PX. However, since the value is more than 0.5 (XED = 0.68), the competitor still poses a significant threat to the company, and thus the long-term pricing sector needs to consider the competitors price moves. Note that the competitor can steal market share by reducing prices in the future.

The value is not statistically different from zero (XED = 0.07 ≈ 0); therefore the company needs not consider the availability of microwaves in pricing, both in short-term and long term pricing. However, encouraging individual to acquire microwaves slightly increases the demand for microwavable food.

In the short run, income is assumed to be constant and thus does not influence the pricing strategy. However, if income is expected to rise, the company can set a low price that attracts customers and increase markets share. Since a unit increase in income causes a more than proportional increase in demand, then the proposed rise in income would shift the demand curve and return price to the required level in the long run. The short run increase in market share will ensure long run profitability.

Demand is relatively irresponsive to advertising. A unit cost incurred in advertising raises demand insignificantly and hence reducing advertising expenditure is a rational decision to cut out unnecessary costs

Price Cut Effects on Market Share

Demand is relatively elastic responsive to price (PED = -1.19 ˃ 1 in absolute terms), hence a reduction in price increases demand more than proportionately. Additionally, the cross elasticity is less than one (XED (PX) ˂ 1), implying that the company’s competitors reduction in price reaps less than proportionate share of the market. Combining these two effects, it can be precisely seen that a simultaneous reduction in price by the two companies (price war) is advantageous to our company, since the fall in quantity demanded due to reduction in PX is offset by the more than unitary increase in quantity resulting from the firm’s price reduction. Therefore, reducing price is advantageous even in existence of price wars. However, price can only be reduced if and only it exceeds Marginal cost. Any price below Marginal costs constitutes a negative economic profit.

DEMAND / SUPPLY SCHEDULE

The adjusted demand function (when all other factors are held constant)

QD = 38650 – 42P and QS = -7909.89 + 79.0989P

Demand and Supply Curves

The equilibrium point E (23, 385), occurs at the place where demand equals supply.

P* ≈ 385 cents

Q* ≈ 23000 3-pack units

Factors influencing supply and demand

From the model, its observed that the demand of the product is affected by, the price of the product, price of competing products (PX), Per-capita income, advertising and supply of Microwaves( complimentary good). Supply on the other hand is mainly determined by price of the commodity, number of producers, and cost of production among others. .

An increase in price would increase supply while reducing demand, and vice versa. Notably, the effect of price change would only result to a movement along the demand and supply curves hence causing excess supply (for an increase in price), without shifting the equilibrium point. Market forces would restore the equilibrium price and quantity.

An increase in price of substitute (PX), per-capita income or effective advertising expenditure shifts the demand curve to the right. Change in per-capita income causes a permanent shift while the rest have a short run effect on demand. As matter of fact, the competitor may either reduce its price PX, to restore its market share or a different company may strategically reap a certain proportion our products demand in the long run. Advertising is short –lived given that other companies might also invest in product promotion hence reducing its effectiveness. Note the reduction in these factors shifts the demand curve to the left.

In the short-run, supply curve can be shifted by changes in production costs mostly due to wage rate and advertising fluctuations (note that capital is fixed in the short run). An increase in production costs shifts the supply curve to the right. In the long run, supply curve can be shifted to the right by an increase in number of producing firms, increase in production costs, and advancement in technology which increases productivity. A reverse change in these factors would cause a leftward shift in supply curve.

References

Christ, S. (2011). Operationalizing Dynamic Pricing Models: Bayesian Demand Forecasting and Customer Choice Modeling for Low Cost Carriers. Wiesbaden: Gabler

Conlon, C. T., Mortimer, J. H., & National Bureau of Economic Research. (2008). Demand estimation under incomplete product availability. Cambridge, MA: National Bureau of Economic Research.

Hirschey, M., & Hirschey, M. (2006). Managerial economics. Mason, OH: Thomson/South Western.

Winter-Ebmer, R. (2012). Managerial Economics : Unit 1; Demand Theory. Retrieved from http://www.econ.jku.at/members/WinterEbmer/files/Teaching/managerial/ws2012/Unit1/ME_Unit1_DemandTheory.pdf

supply curve 0 7.9098899999999999 15.81978 23.729669999999999 31.639559999999999 39.54945 100 200 300 400 500 600 demand curve 34.450000000000003 30.25 26.05 21.85 17.649999999999999 13.45 100 200 300 400 500 600

quantity in '000 3 pack units

price