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Chapter 3 Demand Theory

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INTRODUCTION manager of a firm.

DEMAND THEORY

You would have done demand theory in your diploma course. Your lecturer would have discussed the theoretical aspect of demand. Now you will be applying this theory to make decisions in a firm. In managerial economics you have to assume that you are a

For your firm to survive or to be established it needs sufficient demand. It cannot survive if there is no demand even though it has the most efficient production method. As a manager you have to understand and analyse the forces that determine the demand for your product. For example how will customers react to an increase in the price of haircut during festive season and off-festive seasons? How does the recession affect the demand for your product? Therefore it can be seen that the demand theory is important for the creation, survival and profitability of your firm. This chapter will begin by explaining the basic differences between demand function and demand curve function, followed by market demand curve. Then attention will be given to different revenue functions. Finally the concept of elasticity and its importance in decision making will be discuss .The mechanics of demand will also be analyses using algebraic equation and graph.

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Chapter 3 Demand Theory

Key terms for review: Determinants of demand Multiplicative demand function Total revenue Average revenue price elasticity of demand Cross elasticity Complements Luxury goods Inferior goods Demand function Linear demand function Demand curve Marginal revenue Elasticity Price elasticity Income elasticity Substitutes Basic necessities Normal goods

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Chapter 3 Demand Theory

CHAPTER OVERVIEW

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Chapter 3 Demand Theory

Learning Objectives After reading this chapter, the students should be able to: 1. 2. 3. 4. 5. Explain a demand function. Derive a demand curve function from the demand function Derive the total, marginal and average revenue function and describe the relationship between them. Calculate and interpret price, income and cross elasticity. Analyse the importance of elasticity in decision making.

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Chapter 3 Demand Theory

3.1

THE DEMAND FUNCTION

A textbook definition of effective demand is - demand that is backed by the purchasing power. This definition can further be analysed as the desire, willingness and ability to buy a product at a specific price at given point of time. Demand function refers to the relationship that exists between the quantity demanded and the determinants of demand. The determinants of demand are the factors that influence demand. For example, the demand for shoes (Qs) is influenced by price of shoes (Ps), advertising expenditure (A), income (I) and (T). The demand function can be written in a functional form as: Qs = f (Ps, A, I, T ) Eqn 3a

FORMS OF DEMAND FUNCTIONS There are various forms of demand functions. The specific form of the demand function is determined empirically. At this stage we shall analyse two forms of demand function. They are:

a)

Linear Demand Function The determinants of demand for product X in a linear form can be written as : Qx = - 0 Px + 1 Py + 2 I + 3 T Eqn 3b

where Px is price of product X, Py is the price of related product y. I is income and T is taste, 0 to 3 = constant and includes all the other variables not mentioned in the demand function. = coefficients of the demand function.
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Chapter 3 Demand Theory

The coefficients indicate the marginal impact of each independent variable on the quantity demanded. For example if the price of X change by one unit the quantity demanded will change by 0 units. The sign (+/-) before the coefficient shows the (positive or negative) relationship between the independent and dependent variable.

b)

Multiplicative Demand Function Q = Px 0 Py 1 I 2 T 3 Where 0 to 3 = = constant measures the percentage change in the Eqn 3c

dependent variable relative to the percentage change in the respective independent variable. The coefficients are replaced by their numerical equivalent after they are estimated using regression analysis.

Example 1 Suppose the demand function for product X has been estimated and is as follow: Qx = 1.0 - 2.0Px + 1.5I + 0.8Py + 2.0T and coefficients are replaced by their numerical equivalents, the positive or

negative signs before the respective coefficient indicates the direction of the relationship that variable has on Qx. For example, coefficient -2.0 Px , explains that when the price of X increase by one unit the quantity demanded of X will decrease by 2.0 units. If we assume Px = 2, I = 4, Py = 2.5 , and T = 2 , The quantity demanded will be: (Substitute these values into the equation) Qx = 1.0 - 2.0(2) + 1.5(4) + 0.8(2.5) + 2.0(2) = 9 Units
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Chapter 3 Demand Theory

Based on the equation we can predict that, at the current values of the independent variables, quantity demanded of product X will be 9 units, ceteris paribus.

3.2

The Demand Curve

The Law of demand seeks to explain the relationship between quantity demanded and price, that is quantity and price are inversely related (price increases, quantity demanded decrease and vice versa). The Law of demand can be depicted in a functional form by a demand curve function. A demand curve function shows the relationship between quantity demanded and the price of the product assuming all the other factors influencing its demand to remain constant (Ceteris Paribus). The demand curve function is a special sub-case of the demand function. In other word it is derived from the demand function. In functional form a demand curve function is written as: Qx = f (Px) ceteris paribus. In a linear form it will be: Qx = A - 0Px A is derived Eqn 3e Eqn 3d

by compressing (adding) all the factors that determine demand except for

price of the product, based on equation Eqn 3b, A is: A = + 1Py + 2I + 3T Note: Since traditionally price is being placed on the y-axis and quantity on the x-axis, the above equation can be rewritten to make Px the subject. But one has to bear in mind that quantity (Qx) is the dependent variable and price (Px) is the independent variable. Rewritten in the conventional way (making P the subject):
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Chapter 3 Demand Theory

Px=

A 0

_ 1Q 0 is a and 1/ is b. Therefore the

For easy reference we shall assume that A/ demand curve function will be as follows: Px = a b Qx

Eqn 3f

The demand curve function can be represented graphically in diagram 3.1.

Diagram 3.1 Demand Curve

Example 2 This example will show you how to derive a demand curve function from demand function. Based on the estimated demand function from Example 1 where: Qx = 1.0 - 2.0Px + 1.5I + 0.8Py + 2.0T

Given Px = 2, I = 4, Py = 2.5 , T = 2 Get the value of A:


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Chapter 3 Demand Theory

= 1.0 + 1.5 (4) + 0.8 (2.5) + 2.0 (2) = 13

and then by substituting it into the demand curve function: Qx = In the conventional form: Px = 6.5 0.5Qx 13 - 2.0Px

DEMAND CURVE FUNCTION Diagram 3.2 shows the demand curve:

Diagram 3.2 Demand curve

NOTES The price is expressed as a linear function of quantity demanded, 6.5 is the intercept on the vertical axis (a) and 0.5 is the slope term (b). The negative sign before the slope term or coefficient shows an inverse relationship between price and quantity. The intercept on the horizontal axis is 13 (the value of A)

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Chapter 3 Demand Theory

3.3

THE MARKET DEMAND CURVE

Market demand of a product or service is the sum of individual demand. It shows the total quantity demanded in the market at various prices. To get the market demand function we add the individual demand functions horizontally, that is:

Qm = Qa +Qb +Qc +. + Qn When P1 = P2 = P3 = = Pn

Eqn 3g

Example 3 Given individual demand functions as : Individual 1 Individual 2 Individual 3 Q1 = 10 - 4p Q2 = 6 - 3p Q3 = 15 - 0.9p

The market demand curve function is QM QM QM = Q1 + Q2 + Q3

= (10 - 4p) + (6 - 3p) + (15 - 0.9p) = 31 - 7.9p or PM = 3.92 - 0.126 QP

The market demand curve can also be determined graphically by adding the quantity demanded at a given price. For simplicity we assume that there are two individuals with the following demand curves.
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Diagram 3.3 The market demand curve Referring to the diagram 3.3 when the price is RM10, Individual 1 buys 3 units and individual II buys 2 units. The market demand at this price will be 5 units (2+3). At price RM5 the market demand is (5+6) 11 units.

3.4

TOTAL, MARGINAL AND AVERAGE REVENUE FUNCTIONS

TOTAL REVENUE FUNCTION The total revenue shows the total dollar sales of a firm at a certain period of time. Managers are interested in the relationship between price and quantity since it influences total revenue. When the price changes the total revenue will change. To get the total revenue function, total quantity demanded (sold) is multiplied by the price of the product (P x Q). That is : Total revenue is: Px = a b Qx TR = P x Q

By substituting P x into the total revenue function we get :

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Chapter 3 Demand Theory

TR x = (a b Qx) Qx Therefore the total revenue function is

TRx = a Qx bQx2

Eqn 3h

Example 4 Based on Example 2 : Px = 6.5 - 0.5Qx the TR function is equal to TR = Q (6.5 - 0.5Qx) = 6.5Q - 0.5Q2 The total revenue function can be represented graphically by plotting quantity against the total revenue. For example, if the quantity is 2 the total revenue will be: 6.5(2) - 0.5 (2)2 = 9 and at quantity 6.5 and 7 the total revenue is 21.125 and 14 respectively. Using these values the total revenue curve can be plotted as show in diagram 3.4.

Diagram 3.4 The Total Revenue Curve


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To find the total revenue maximising quantity, differentiate the equation, set it equal to zero and solve for Q The process is shown below. TR = 6.5Q - 0.5Q2 TR = 6.5 - Q = 0 Q Q = 6.5 We studied optimization in chapter 2. Make a point to revise the chapter if you find difficulties

At quantity 6.5 units the total revenue is 6.5 (6.5) - 0.5 (6.5) 2 which is 21.125.

THE MARGINAL REVENUE FUNCTION The marginal revenue is defined as the change in the total revenue that results from one unit change in the quantity demanded. It can be express as a first derivative of total revenue with respect to Qx That is: TRx MRx = a Qx bQx2 = TR = a 2bQx Qx Diagram 3.5 shows a graphical representation of marginal revenue function. Eqn 3i

Example 5 Based on Example 4: TR = 6.5Q - 0.5Q2 The marginal revenue function is MR = TR = 6.5 - Q Q
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The marginal revenue slope downwards and the intercept is at 6.5. marginal curve is shown in Diagram 3.5 MR/p 6.5 P = 6.5 -0.5Q

The

MR = 6.5 Q or a 2bQx

6.5

Qtty

Diagram 3.5 The Marginal Revenue Curve The marginal revenue is zero at quantity 6.5. MR = 6.5 - Q = 0 Q = 6.5

THE AVERAGE REVENUE FUNCTION Average revenue is the revenue earned per unit of output sold. It is calculated by dividing total revenue by the quantity. TRx = a Qx bQx2

AR x

= TR Qx

= a bQx

Eqn 3j

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NOTES The average revenue function is also the demand curve function.

Example 6 The average revenue function can be computed from the above total revenue function. Given: TR AR = 6.5Q - 0.5Q2 = TR = 6.5 - 0.5Q Qx The average revenue function is similar to the demand curve function P = 6.5 - 0.5Q.

The relationship between demand curve, marginal revenue and the total revenue curves. The relationship between demand curve, marginal revenue and the total revenue curve functions can be analyse diagrammatically.

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Again, section 2.2 previously explained this relationship

Diagram 3.5 The relationship between Total Revenue and Marginal Revenue Curve. Based on diagram 3.5 first we begin by comparing the similarities and differences between the average /demand curve and marginal revenue functions. a. b. AR and MR has the same intercept, this indicates that both curves must begin from the same point on Y axis. The slope of marginal revenue curve is twice (2 b Qx) of the demand curve (b Qx ) Next we shall look at the relationship between marginal revenue and total revenue. a. b. c. When marginal revenue is zero the total revenue is at its maximum. (refer to quantity Q*) When marginal revenue is positive the total revenue is increasing (refer to quantity O- Q*) When marginal revenue is negative the total revenue is decreasing (refer to quantity after Q*)

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QUESTIONS

1.

Given the demand curve function for caps as: Q = 3200 - 12P Q - Quantity demand for caps P - Price of caps. a) b) c) Rewrite the demand curve function in the conventional way. How many caps will be sold at RM10 each? At what price would sales equal zero?

2.

There are three individuals with different demand curve function wanting to buy badges (the quantity is in hundreds). individual is as follows. Individual I Individual II Individual III a) b) PI PII PIII = 5 - 5 Q1 = 4 - 3.5Q = 8 - 1.5Q Their demand curve function for each

What is the market demand curve function? How many badges will be bought in the market at price RM2 and how will this be distributed among the individuals?

3.

Suppose the demand function for special Sukom files is Qd = 2500 - 6P a) b) c) Derive the total revenue function? At what output is the total revenue maximum? Derive the marginal revenue function?
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Chapter 3 Demand Theory

d) e) 4.

At what output is marginal revenue zero? What can you conclude from the answers in (b) and (d)

A firm selling hot-dogs estimates the demand function for hot-dogs as Qh = 150.3 + 10.2 A + 9.6 Py - 15.4 Ph. Where Qh is the quantity of hot dogs, A is advertising expenditure, Py is the price of hot dog competitor and Ph is the price of hot dog Given A is RM100; Py is RM2; and Ph is RM18.00. a) b) Determine the demand curve function and plot the demand curve using any three price-quantity combinations. Derive the marginal revenue function.

SUGGESTED SOLUTIONS

1.

a)

Q P P

= 3200 - 12P = 3200 - Q 12 = 266.67 - 0.083 Q = 10 = 3200 - 12 (10) = 3080 units

b)

When P Q

c)

When Q P P

=0 = 266.67 - 0.083 (0) = 266.67

2.

a)

Market demand is equal QI + QII + QIII


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(make Q the subject) PI Q1 Q1 PII Q11 QII PIII QIII QIII QM QM PM b) When P QM = 5 - 5 Q1 = 5 = 1.0 - 0.20P = 4 - 3.5Q = 4P 3.5 = 1.14 - 0.29P = 8 - 1.5Q = 8-P 1.5 = 5.33 - 0.67P = QI + QII + QIII = 7.47 - 1.16P = 6.44 - 0.86Q =2 = 7.47 - 1.16 (2) = 5.15 Each Individual will buy: QI QII QIII 3. a) P TR TR b) = = = = 1-0.2(2) = 1.14 - 0.29(2) = 5.33 - 0.67(2) 416.67 - 0.17Q PQ 416.67Q - 0.17Q2 = 0.6 = 0.56 = 3.99 5- P

TR maximising quantity.
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TR Q

= 416.67 - 0.34Q

Q = 1225.5 c) MR = TR = 416.67 - 0.334Q Q d) MR 416.67 - 0.34 Q Q = 0 =0 = 1225.5

e) 4. a)

When marginal revenue is zero the total revenue is maximum. Qh A = A - 15.4 Ph = 150.3 + 9.6 (2) + 10.2 (100) = 150.3 + 19.2 + 1020 = 1189.5

The demand curve function is: Qh = 1189.5 - 15.4 Ph Written in the convention form: Ph = 77.24 - 0.065 Qh To plot the demand curve we can take any three values of Q.

Price RM 77.24 70.84 61.24

Quantity 0 100 250

Points A B C

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Price 77.24 70.84 A Demand curve. B

61.24 100 b) TR MR = 77.24 Q - 0.065 Q2 = TR Q = 77.24 - 0.13 Q 250

C D Quantity

3.5

ELASTICITY

Elasticity is a measure of responsiveness of the quantity demanded when there is a change in its determinants You would have learnt about concept of elasticity and how to calculate it in the economics course at diploma level. You would have used a standard formula to calculate elasticity. For example, the price elasticity is calculated by using following formula: (basic formula) EP = percentage change in quantity demanded percentage change in price or EP = OD - ND X OP OP-NP OQ

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Where OD is original demand, ND is new demand, OP is original price and NP is new price. This method of measuring elasticity is quite sensitive to which value is chosen as old and which is chosen as the new. However, in this course you are introduced to two other approaches to compute elasticity. They are arc price elasticity (where the basic formula is the same) and point price elasticity. Arc elasticity measures the elasticity over a range of price and takes into consideration averages. The point elasticity is used to measure a very small or infinitesimally small change in the price.

PRICE ELASTICITY OF DEMAND (Ex) Price elasticity of demand measures the responsiveness of quantity demanded when there is a change in its price. Basically elasticity can be divided into three broad categories and two extreme cases. Price elasticity of demand is seen a positive integer (Note: When elasticity is interpreted the negative sign can be ignored for normal goods) a) b) c) Elastic (E > 1). Consumers are responsive to the change in price. Inelastic (E < 1). Consumers are not very responsive to the change in price. Unitary elasticity (E = 1) Consumer are proportionately responsive to the change in price. There are two extreme cases. a) Perfectly elastic (E = ) consumers are very responsive to the change in price. When there is a slight increase in price, the quantity demanded will fall to zero. The demand curve is a horizontal straight line. When there is a slight decrease in the price, the consumers will buy up all that available in the market i.e. price elasticity is infinity.

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b) Perfectly inelastic (E = 0) consumers are not responsive to change in price. The demand curve is a vertical straight line. Quantity demanded remain unchanged when the price changes.

MEASUREMENT OF PRICE ELASTICITY The price elasticity is measured by dividing the percentage change in quantity demanded by the percentage change in price. Arc Price Elasticity: As mention earlier the basic formula is the same, however, the method of calculating the percentage differs. It takes into consideration the average of the old quantity and the new quantity on the denominator and the average of old price and new price on the numerator The formula is:

Q2 - Q1 P2 - P1

P2 + P1 Q2 + Q1

Where: Q1 Q2 P1 P2

is original quantity demanded, is new quantity demanded, is original price and is new price

Point Elasticity: Point elasticity calculates elasticity for an infinitesimally small change in the independent variable (price). The formula is:

Ep =

Qx P x

Px Qx

eqn 3k

The first term is the partial derivative of the demand function in terms of Px. Px and Qx is the price and the quantity demanded of the product X respectively. Based on Eqn 3.1 the demand function is

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Qx = - 0 Px + 1 Py + 2 I + 3 T The point price elasticity based on the above formula will be;

Ex = - 0

Px /Qx

Example 7 Based on Example 1 where : Qx = 1.0 - 2.0Px + 1.5I + 0.8Py + 2.0T Given Px = RM2 Py = RM2.5 I = 4 and T = 2

Qx = 9 units The point elasticity can be calculated by differentiating the equation in terms of Px and then multiplying by the ratio of Px to Qx. Qx = - 2.0 Px The point price elasticity is Ex = - 2.0 x 2/9 = - 0.44 (inelastic) When the price changes by one percent the quantity demanded will change by 0.44 percent. Qx = 9 Px = 2

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ELASTICITY ALONG A DEMAND CURVE In a linear demand curve function the elasticity along the demand curve varies from zero to infinity. This is because QX / PX is constant but Px / Qx will increase as price increase. (You may want to check it out yourselves. The elasticity at different points along the demand curve can be determined by calculating the quantity demanded at different price level and then substituting it into the elasticity formula). Diagram 3.6 shows elasticity along a demand curve at different points. Price E= E>1 E = 1 (Mid - point) E<1 E = 0 Quantity Diagram 3.6 Elasticity along the Demand Curve

THE IMPORTANCE OF PRICE ELASTICITY The concept of elasticity is useful in decision-making. It helps managers to understand the relationship between elasticity, total revenue and marginal revenue. It assist the manager in terms of pricing decision that is, whether to change or maintain the price of the product when the objective is to maximise revenue. The relationship between price, marginal revenue and total revenue can be summarized in a single number known as price elasticity of demand. That is: TR MR = PQ = dTR dQ = P + Q P Q
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P P

1 + Q Q P

Given the elasticity formula as E = Q - P P and next: MR = P 11 E For normal good the price elasticity is negative, the positive sign in the above equation becomes negative when multiplied by a negative. Q

1 = Q - Q E P P

MR

1+1 E eqn 3l

Bases on the above equation the following relationship can be develop: a. b. When price elasticity is greater than one the marginal revenue is positive (Ex > 1, MR > 0) When price elasticity is less than one the marginal revenue is negative (E x < 1, MR < 0) c. When price elasticity is equal to one the marginal revenue is zero (E x = 1, MR = 0)

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The relationship can be diagrammatically represented as in diagram 3.7 Price E>1 TR DD MR = 0 Quantity MR Diagram 3.7. Elasticity, Total Revenue and Marginal Revenue A producer will not sell his output in the region where elasticity is less than one. This is because the total revenue is decreasing and the marginal revenue is negative as more units are sold. By reducing the output the producer will be able to increase his profits: as total revenue will increases and total cost decreases. E=1 E<1

DETERMINANTS OF DEMAND ELASTICITY

a)

Availability of substitutes Substitutes play an important role in determining the elasticity of the product. Products with substitute have a higher price elasticity compared to products with poor or no substitutes. For example if the price of coca-cola increases, the Thus, the demand for coca-cola is demand for its substitutes will increase. The demand for coca-cola will decrease rapidly with a slight increase in price. relatively elastic.

b)

Proportion of income spent on the product. The demand for the product is said to be elastic if the expenditure on the product forms a large proportion of the total expenditure For example, students who are
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staying outside campus and are renting rooms, if the rent increases, these students will find alternative accommodation as a large proportion of their income is spent on rental. The demand for rented rooms can be considered elastic. On the other hand, demand is inelastic for products that account for a small proportion of total expenditure e.g. salt.

c)

Length of the period In the long run demand is more elastic than in the short runs as consumers are able to adjust to new prices. For example, demand for electricity. In the short run, when the price of electricity increases, consumers will not reduce their consumption of electricity. Consumers may still use their electrical appliances. But given some time (long run), consumers are able to find other energy sources, i.e. replace electrical appliances with non electrical appliances or to use them less frequently, reducing the consumption of electricity in the long run. Consumers are more responsive to the changes in price in the long run.

INCOME ELASTICITY (EI) Income elasticity measures the responsiveness of demand to the change in income.

MEASUREMENT OF INCOME ELASTICITY Income elasticity is measured by dividing the percentage change in quantity demanded by the percentage change in income. Arc Income Elasticity: The formula is very much like the arc price elasticity. For arc

income elasticity the variable price is changed to income. The formula is: EI = Where: Q1 Q2 I1 I2 Q2- Q1 I2 - I1 X I2 + I1 Q2+ Q1

is old quantity demanded, is new quantity demanded, is original income and is new income
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Point Income Elasticity: Where the change in income is infinitesimally small. The formula is:

Ei

Qx x I

I Qx eqn 3m

Based on demand function in equation 3.1: Qx = - 0 Px + 1 Py + 2 I + 3 T The income elasticity is: EI = 2 X I / Qx

Example 8 Based on Example the income elasticity for product X is: Qx Given Px Qx = 1.0 - 2.0Px + 1.5I + 0.8Py + 2.0T = RM2 Py = RM2.5 = 9 Qx = 1.5; Qx = 9, I = 4 I EI EiI = = 1.5 x 4/9 0.67
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I = 4 and T = 2

Chapter 3 Demand Theory

When income increase by one percent the quantity demanded will increase by 0.67 percent. This product can be classified as a basic necessity. level (economic growth). It is also recession proof product since the impact on quantity demand is smaller compare to the fall in the income

IMPORTANCE OF INCOME ELASTICITY As a decision maker income elasticity is important. It shows how the consumers react towards the quantity demand when there is a change in the income. Income elasticity is useful to:

a)

Determine the type of good. Positive income elasticity is

Income elasticity can either be positive or negative.

associated with normal goods, i.e. when income increases the quantity demanded for these goods increase. Normal goods can further be divided into basic necessities and luxury goods. For basic necessities the income elasticity is less than one or close to zero, whereas for luxury good the income elasticity is greater than one. On the other hand, negative income elasticity is associated with inferior goods. That is, when income increases, the spending power increases the demand for an inferior good will decrease. Consumers will buy better quality goods and reduce their purchase of inferior quality goods. .

b)

Forecasting the future demand

A producer will need to forecast the future demand and be prepared to supply the amount of quantity demanded. One-way to forecast the demand the product is to determine the phase of business cycle in the economy, that is in which phase (recession, expanding, peak and contraction) is the economy. If the economy is expanding or during economic prosperity, consumers are willing to spent more on luxury goods and the demand for luxury goods will increase. The rate of increase in demand for these good is greater than the rate of income (economic growth). The reverse is true during recession;
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the demand for luxury goods is weak. During this time producers should concentrate on basic necessities. Basic necessities are said to be recession proof as the percentage decrease in demand is much smaller compare to the percentage decrease in income The consumers spending on these goods is consistent or the impact of decreasing income is very small.

c)

Promotional strategies Luxury products

Income elasticity is also useful in promoting or marketing a product.

that are consumed by higher income-group are advertised in media that reaches them. Their promotional strategies would differ in terms of service and are given personal touch. These products are also be displayed in an exclusive manner Whereas normal products can be promoted in daily media and be displayed to reach the general public .

CROSS ELASTICITY (Exy) Cross elasticity measures the responsiveness of the demand of one product (X) when the price of another changes (Y).

MEASUREMENT OF CROSS ELASTICITY The cross elasticity is measured by dividing the percentage change in quantity demanded of one product (X) by the percentage change in the price of another product (Y). Arc Cross Elasticity:: The formula is : Exy = Qx, 2 - Qx,1 Py, 2 - Py,1 X Py,2 + Py,1 Qx,2 + Qx,1

Where: Qx,1 Qx, 2 Py, 1 Py, 2

is old quantity demanded, is new quantity demanded, is original price of product y and is new price of product y
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Point Cross price Elasticity: Measure the change in the quantity demand of a product when there is an infinitesimally small change in price of another product. The formula is :

Exy

Qx Py

Py Qx eqn 3 n

Based on equation 3a demand function: Qx = - 0 Px + 1 Py + 2 I + 3 T The elasticity is: Ex = 1 X Py /Qx

IMPORTANCE OF CROSS ELASTICITY The cross elasticity is used to it determine the relationship between the two goods. That is If the cross elasticity is positive the two goods are substitutes, for example Pepsi and Coke. The higher the value of the cross elasticity the better the substitutes. If the cross elasticity is negative the two goods are complementary, for example pen and ink. If the cross elasticity is zero, it shows that the two products are not related.

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Example 9 From Example 1 above, the cross elasticity for product X is Qx = 1.0 - 2.0Px + 1.5I + 0.8Py + 2.0T Given Px = RM2 Py = RM2.5 Qx = 9 The cross elasticity is Qx = 0.8, Py Exy = = 0.8 x 2.5 / 9 0.22 Qx = 9, Py = 2.5 I = 4 and T = 2

When the price of X changes by one percent the quantity demanded for X will change by 0.22 percent. The two products are said to be poor substitutes

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QUESTIONS

1.

The demand function for Rainbow Lemonade has been estimated as QL = 26 - 20PL + 28 Pc - 17Ac + 20AL + 5I Where QL is the quantity of Rainbow Lemonade (in cases) PL is the price of Rainbow Lemonade in RM PC is the price of competitor in RM AL is the advertising expenditure of Rainbow lemonade. AC is the advertising expenditure of competitor. I is the income per capita in RM The current values of the independent value are AL = RM10, a) b) c) d) PL = RM 1.50, PC = RM 1.8, I = RM12, AC = RM 15

Derive the demand curve function and the total revenue function. At what output is the total revenue maximum? Calculate the price at this output? If the income decrease by 10% what is the impact on Rainbow Lemonade. (Calculate income elasticity)? What is the price and cross elasticity? Interpret the elasticity

2.

Given the following demand function Qx = 7 - 2PX + 5Py + 8I Where Qx and Px is the quantity and price of X respectively PY is the price of another product; and I is per capita income. Given Px = RM5, Py = 5.50 and I = 4.

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a) b) c)

Calculate the price elasticity. Interpret the elasticity. Calculate the income elasticity. What can you say about the product? Calculate the cross elasticity. What is the relationship between this two product?

3.

A firm XYZ has written childrens comic books. The estimated total revenue function for the sales is TR = 150Q - 20Q2 a) b) c) Over what range is demand elastic? Derive the demand curve function. Given the current price is RM50, should the firm maximise its total revenue? change the price to

4.

A consultant estimates the price-quantity relationship for Alice Pizza to be P = 75 - 25 Q a) b) c) At what output is demand unitary elastic? At what output is marginal revenue zero? At price RM7, what is the price elasticity?

5.

The price elasticity for fish is estimated to be -0.6 and income elasticity is 0.7. At a price of RM8.00 per kg and a per capita income of RM30, 000, the demand for fish is 25,000 kg. a) b) c) Is fish a basic or Luxury good? Explain. If the per capita increase to RM30, 500, what will the quantity demanded? If the price of fish increases to RM9.00 when per capita is RM30, 000, how much should the per capita income change for the quantity demanded to remain at 25,000 kg?

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SUGGESTED SOLUTIONS

1.a)

QL QL PL TR

= 26 - 20PL + 28 (1.8) - 17 (15) + 20 (10) +5(12) = 81.4 - 20PL = 4.07 - 0.05 QL = 4.07Q - 0.05QL2 Total Revenue function Demand curve function

b)

TR maximising output is TR = 4.07 - 0.1Q Q Q P = 40.7 = 4.07 - 0.05 (40.7) = 2.035 = Q Marginal Revenue function

Total revenue maximising quantity is 40.7 cases and the priceRM2.035. c) Income elasticity: QL QL EI = 26 20(1.5) + 28 (1.8) - 17 (15) + 20 (10) +5(12) = 51.4 = QL I EI = 5 x 51.4
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I QL

12

= 1.17

Chapter 3 Demand Theory

When income falls by 10% quantity demanded will decrease by 1.17 x 10 = 11.7 %. d) Price elasticity Ep = QL PL QL QL Ep x PL QL

= 26 20(1.5) + 28 (1.8) - 17 (15) + 20 (10) +5(12) = 51.4 = -20 X 1.5 51.4 = - 0.58

When price increase by 1% the quantity demanded decreases by 0.58%. Cross elasticity ELC = QL x PC ELC = 28 x PC QL 1.8 = 0.98 51.4 When the price of competitor increases by 1% the quantity demanded for Rainbow Lemonade will increase by 0.98%. 2.a) The quantity demanded is Qx = 7 - 2 (5) + 5 (5.50) + 8 (4) Qx = 56.5
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Chapter 3 Demand Theory

Price elasticity Ep = Qx P x Ep = -2 x 5 56.5 When the price increases by 1% the quantity demanded decrease by 0.18%. b) Income elasticity EI = Qx I EI = 8x 4 56.5 When income increases by 1% the quantity demanded increases by 0.57%. The product is a basic necessity. c) Cross elasticity Exy = Qx Py Exy = 5 x 56.5 = 0.49 x Py Qx 5.5 x I Qx = 0.57 x Px Qx = -0.18

When the price of Y increases by 1% the quantity demanded for X will increase by 0.49%. The two products are substitutes.
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Chapter 3 Demand Theory

3.a)

TR maximizing quantity is: TR TR Q Q = 3.75 = 150Q - 20Q2 = 150 - 40Q =0

When the total revenue is at the maximum, elasticity is unitary. Therefore the demand curve is elastic just before the total revenue maximizing quantity is achieved. In this case it will be before 3.75 units. The elastic range will be 0 to3.75 units b) Demand curve function is: P = TR = 150 - 20 Q Q c) To find the total revenue maximising price substitute the total revenue quantity calculated in (a) into the demand curve function: TR P P = 150 Q - 20 Q2 = 150 - 20 (3.75) = RM 75 Demand curve function

The firm should increase the price to maximise to RM75 to increase total revenue. 4.a) Unitary elasticity (calculate the quantity that maximise total revenue). TR = 75 Q - 25 Q2
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Chapter 3 Demand Theory

TR Q

= 75 - 50 Q Q

= 0 = 1.5

When total revenue is maximum when elasticity is unitary at Q = 1.5. c) MR MR =0 = 75 - 25 Q Q c) TR P = 75 Q - 25 Q2 = TR Q Given P = 7 , substitute into the demand curve function 7 Q = 75 - 25Q = 2.72 =75 -25Q Demand curve function = 0 = 1.5

Price elasticity Ep = Qx P x 1 25 x 7 2.72 x Px Qx

= 0.103 - demand price elasticity.

When the price increases by 1% quantity demanded will decrease by 0.103%.

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Chapter 3 Demand Theory

5. a)

Fish is an Basic good because the income elasticity is less than one (EI.= 0.7)

b)

The percentage change is income is 30500 - 30000 X 100 = 1.67% 30000 When the income changes by 1% quantity demanded will change by 0.7%.If income changes by 1.67 quantity demanded will change by : 1.67 x 0.7 = 1.17%, that is The change in quantity is: 1.17 x 25000 = 292.5 units 100 The quantity demanded will be (25000 + 292.5) = 25292.5.5

c)

At price RM9.00 the quantity demanded will be. Percentage change in price of fish 9 - 8 x 100 = 12.5% 8 The percentage change in quantity demanded is: 12.5 x 0.6 = 7.5% The total quantity is 7.5% x 25000 = 1875. The percentage change income to offset the decrease in quantity demanded will be.
123

Chapter 3 Demand Theory

7.5% = 10.7 % 0.7% The income will increases by 10.7% x 30,000 = 3214.28

SUMMARY

This chapter explained how to derive the demand curve, total marginal and average revenue curve function from a demand function.

It showed how the above three functions are interrelated. You will also notice how elasticity is calculated. Here emphasis was given on point elasticity and it looked at price, income and cross elasticity.

As a manager you will be made aware of the importance of elasticity in decisionmaking.

PRACTISE QUESTIONS

Q1.

The demand function for TV set is given as follow Qx = 350 3.7Px + 0.2Y + 4.2 Pz Where Qx is quantity of TV set demanded per month Px is the price of TV set Y is the per capita income Pz is the price of a competitive brand a. What is the demand curve function if Px = RM1200 Y = RM5500 Pz = RM1500.

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Chapter 3 Demand Theory

b. If the firm wishes to increase its total revenue, should the price be increased or decreased? c. At what price and output would total revenue maximize? Q2. The market demand for good X is Q = 70 3.5P 0.6M + 4Pz Where Q is the number of units of good X demanded P is the price of good X M is income of buyers Pz is the price of related good. a) Assuming P = 10, M= 20, and Pz = 6, calculate Q. hence, compute the price, income and cross elasticity of demand of good X. b) Is X a normal or inferior good? Explain. c) Are X and Z substitute or complements? Explain. d) Is demand for X elastic or inelastic? Why do you say so? e) Suppose the producer of X wishes to increase total revenue by changing price, should he increase or decrease price? State your reason. Q3. Zaids Frozen Pizza has enjoyed rapid growth in West Malaysia. From the analysis it was found that the demand curve follows this pattern. Q = 1000 3000P + 10A Where Q = quantity demanded P = product price (in RM) A = advertising expenditure (in RM) a) Assume that P = 3 and A = 2000 Suppose the firm reduces price. Would this increases total revenue? Explain. b) Assume that P =4 and A = 2100 Suppose the firm reduces price. Would this increase total revenue? Explain. Q4. Hardwood cutters offers seasoned, split fireplace logs to consumers in Kampung Parit, Perak. The company is the low-cost provider of firewood in this market with

125

Chapter 3 Demand Theory

fixed costs of RM10 000 per year, plus variable costs of RM25 for each unit of firewood. Annual demand for the company is: P= 225 0.125 Q Where p is the price of firewood per unit and Q is the number of units of firewood. a) Determine the marginal revenue and the marginal cost function. b) Calculate the profit maximizing quantity, price and profit. c) Calculate the price elasticity at the profit maximizing price. Q5. Syarikat Alpha-Beta has estimated the demand curve for its product as follows: Q = 8000 - 5P

where Q is quantity sold per week and P is the price per unit. a) on the estimated demand curve, write the equation for: i. ii. iii. Based total revenue Average revenue Marginal revenue

b) What is the maximum total revenue per week that Syarikat Alpha-Beta can obtain from sales of its product? c) Calculate the arc price elasticity of demand for Syarikat Alpha-Betas product between Q = 3,000 and Q = 3,200. Q6. The marketing department for a firm that manufactures vehicles has determined the following demand function for their vehicles: QV = 5000 0.6PV + 0.2PC + 0.04Y + 0.02A Where: QV PV PC Y A = the number of the firms vehicles sold weekly = the price of the firms vehicle = the price of a close competitors vehicle = average household income, and = weekly advertising dollars spent

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Chapter 3 Demand Theory

a) If PV = RM10, 000, PC = RM8000, Y = RM12,000 and A = RM4000, find the price elasticity of demand. b) Is demand elastic, unitary elastic, or inelastic? Why? If the firm decreases price, what will happen to total revenue? c) Assuming values of the variable is as given in part (a) above, determine the income elasticity. Interpret your answer. d) Calculate the cross price elasticity of demand and interpret your answer. Q7. The following functions describe the demand of 3 small firms: A, B and C that sell hand phone accessories to the customers. Firm A : P = 500 0.5QA Firm B : P = 300 0.25QB Firm C : P = 200 0.125QC Where Q is the quantity demanded and P is the price. a) Calculate the market demand function. b) Using the market demand function, determine the total revenue maximizing price and quantity. c) The industry supply equation is given by QS = -1000 + 10P. Determine the market equilibrium price and quantity Q8. The research department of White Pigeon wished to estimate the demand function for its new product, Cage XP. A demand function had been estimated on 120 respondents using regression analysis. The demand function is as follows: Q = 12,000 8P Where Q = Quantity demanded for Cage XP cages P = Price of Cage XP cages (RM70) A = Advertising expense, in thousands (RM54)
127

+ 1300A + 5Pc + 2I

Chapter 3 Demand Theory

Pc = Price of competitor's product (RM80) I = Average monthly income (RM400) a) Derive an expression for the firms conventional demand curve for the new product, Cage XP cages If the firms objective is to maximize total revenue from the sales of Cage XP cages, at what price should the firm charge? b) Should White Pigeon Company consider reducing its price in order to increase its total revenue? Explain. c) Calculate income elasticity of demand. Is the Cage XP cages a luxury, inferior or necessity good? d) Calculate the cross elasticity of demand. Are Cage XP cages and interpret it.

STUDY NOTES

128