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Sessions 2 & 3: DEMAND ANALYSIS II

1. 1.1 Pre-Work Introduction The theoretical or generalized demand function, discussed earlier, has identified three important demand factors under the assumption of unchanging tastes & preferences. These are: Own Price (Px), Income (I), and Prices of related products (Py). It was also discussed that the

significance of these factors in determining the demand for a product would differ depending on the nature of the product and type of demand. These dimensions of demand analysis serve as a benchmark for the identification of the demand factors at the firm level.

In assessing what consumers want and to respond appropriately to changes in demand factors, business decision makers need to assess the market impact of the changes in the demand factors. Estimating the

market demand function has been one of the approaches for identifying important long run demand factors at the firm level. However, short run responses to changes in demand factors is also possible by using elasticities the responsiveness of consumer demand to changes in demand factors. 1.2 Elasticity: Quantifying the Impact of Demand Factors Quantification of the impact of the demand factors on a product (X), is possible through a simple tool called Elasticity. By definition, Elasticity defines the responsiveness of a variable X due to changes in a variable Y. The elasticity measures of all the demand factors can be established by the above definition.


Price Elasticity of Demand p

p is % change in Qx due to 1 % change in Px

Q/Q P/P = Q . P P Q

Example Px 10 5 p = 10 . 5

Qx 15 25 10 = 1.33 15

When p = 1.33, it would imply that a 10% increase in price of X would lead to a 13 % fall in the quantity demanded. Alternatively, a 10% decrease in price would lead to a 13% increase in the quantity demanded. Hence product X is considered to be price elastic.

When p is < 1, the product is price inelastic. For example, if p = 0.50 it would imply that a 10% increase in Px will result in 5% fall in Qx or Or a 10% decrease in Px will result in 5% increase in Qx.


Measurement of p
For discrete data series, as in the earlier example, when Px decreases from 10 to 5, p = 1.33. However, if Px were to increase from 5 to 10, the
Is p same for all products? Depending on the underlying demand curve, the p would vary between products as also between markets. Why does the demand curve vary between products?

p = 0.4.

In other words, when price is

decreased, product X in price elastic but is inelastic when price is increased.

In order to avoid such discrepancies, Arc rice elasticity is calculated.

Arc p =

Q P1 P2 . P Q1 Q 2

For continuous data series, defined by Qx = a b Px, Point price elasticity is p = Q x . Px b. Px Qx Px Q x 2


Factors affecting p High or low p values are influenced by three factors. (a) More number of substitutes for a product will
entail high p and vice-versa. Why? When there are large number of substitutes available small changes in price will induce the consumer shift to other products. other words, a competitive market In is Is p constant demanded curve? along with

p =

Q x Px . Px Q x

Q x is the inverse of the slope of Px

the demand constant for However, curve, which is a straight line.

characterized by high value p.

Px would be different Qx

(b) The smaller the share of a product in

consumer budget, the lower will be the value of

for different values along the demand curve. Hence, the value of would vary along the demand curve


For example, consider the

demand for salt. Given its low price, it may account for less than 1 % of a consumers monthly budget. A change in price will not affect the demand for salt. Hence, the value of p for salt will be closer to zero. From this it is evident that low priced products or necessity goods the

p>1 p - 1 p<1

p will be low.

(c) In the short run, the p for a product will be low. This is because, the possibilities of developing substitutes for a product are virtually non - existent. However, in the long run, with R & D there are possibilities of developing substitutes, hence, value of p will be high.


Price & Revenue Relationships

p varies along the demand curve. Given this, how can business firms take
decisions whether to P or P?

Such decisions depend on how change in prices effect the revenue (TR) earned by the firm. In this context, we distinguish between three ranges of p. RELATIONSHIP BETWEEN EP, PRICE AND REVENUE The Case of 1. Elastic Demand EP> 1 2. Unitary Demand EP= 1 3. Inelastic Demand EP < 1 Implies % Q > % P % Q = % P % Q < % P Following a P Following a P Revenue Revenue Revenue Unchanged Revenue Revenue Unchanged Revenue

For example, when p >1, and if price is reduced, the % increase in quantity demanded is greater than the % decrease in price. Hence, the total revenue (TR) will increase. Similarly, if price is increased, % decrease in quantity is greater than % increase in price. Hence, TR will decrease if prices are increased. Similarly, if p < 1 and if price is reduced, the % increase in quantity demanded is lower than the % decrease in price. Hence, TR will decrease. Against this, if prices are increased, TR will increase. Thus, if a product is price elastic, TR rises if prices are reduced. And, if the product is price inelastic, TR rises if prices are increased.

The implications of a price change on revenue will required an understanding of what would be the additional (incremental) revenue

earned by the firm due to one unit increase in the quantity sold? Conceptually, this is defined as Marginal Revenue (MR). MR = TR Q

From the above definition, it is clear that as long as MR is positive, TR will increase. Hence, a price change that results in a positive MR would meet the objective of increasing TR. The relationship between demand curve, MR and TR is given below. P
Why is MR below the demand curve? By definition MR =

p > 1


p = 1 p < 1

Suppose P = a - b Q TR = P X Q = (a-bQ) Q = aQ-bQ2 MR = =

d TR dQ

TR Q When MR is positive, TR is increasing. When MR = D, TR is maximum. When MR turns negative, TR declines.


Income Elasticity of Demand (I)

I measures the responsiveness of quantity Demanded (Qx) to changes in

Income (I)

I =

Q x I . I Q

Arc I =

Qx I 2 I1 . I Qx2 Qx1

Based on the value of I, we distinguish between two categories of products. These are:

I > 0 : Normal or superior goods

I < 1 : Inferior goods

Thus the sign (whether + or -) indicates whether the goods is a normal or an inferior good. Among the normal goods, we further distinguish

between the following:

I > 1 : Luxury goods I ~ 0 : Necessity goods


Cross Price Elasticity of Demand (xy) The xy measures the responsiveness of the change in quantity demanded of Product X to price changes in Product Y.

xy =

Q x Py . Py Q x

Arc xy =

Q x Py 2 Py1 . Py Q x 2 Q x1

If the xy is positive then the two goods X and Y are substitutes. And if xy is negative, then X & Y are complementary goods. Similarly, if xy ~ 0, then X & Y are unrelated.