Theory of demand

Contents

1. Theories of demand
2. Estimating demand

3. Forecasting demand

I. Theories of demand
1. Indifference preference budget theory
2. Revealed preference theory
3. Demand characteristic of good
4. Asymmetric information and abnormal
consumption

I. Theories of demand
1. Indifference preference budget theory

Consumers preferences
Basic assumptions:
1. Preferences are complete
Consumers can rank market baskets

2. Preferences are transitive

If prefer A to B, and B to C, must prefer A
to C

3. Consumers always prefer more of any good

to less
More is better

I. Theories of demand
1. Indifference preference budget theory
Consumers preferences
A (preferred
area)
A

C (less
preferred
area)
C

I. Theories of demand
1. Indifference preference budget theory

Consumers
preferences

Movie

Indifference curve:
shows the various
combinations of consumption
quantities that lead to the
same level of well-being or
happiness

Better
A

C
I2

B
I1

Food

I. Theories of demand
1. Indifference preference budget theory

Consumers preferences
Indifference curves characteristics

Downward sloping, the closer to the right hand-side,

the more preferred
Never intersect
X.MUx + Y . MUy = 0
-MUx / MUy = Y / X
-MUx / MUy : the slope of Indifference curve = The
marginal rate of substitution (MRS)

I. Theories of demand
1. Indifference preference budget theory

Consumers preferences
MRS:

Slope of indifference
curve measures how
person trades (is willing
to substitute) one good
for another

reduce gradually as
the quantity consumed
increases

Indifference curves
are convex

B
C
D

I. Theories of demand
1. Indifference preference budget theory

Preferences do not explain all consumer

behavior

Budget constraints limit individuals ability to

consume in light of prices for various goods
and services

I. Theories of demand
1. Indifference preference budget theory

Budget constraint
- Budget line (BL): shows the various combinations of

consumption that consumer can get from the available

income
Movie
I=PX.QX+PY.QY
(Y)
QY= I/PY (PX/PY).QX
C
A
PX/PY : the slope of budget
constraint or price line
B
Area C: can not afford
D
Area D: Inefficient
Food
(X)

I. Theories of demand
1. Indifference preference budget theory

Budget constraint
Y
-

I, PX= const, PY changes

BL2

PY decreases: BL1 BL2

PY increases: BL1 BL3

BL1

BL3

I. Theories of demand
1. Indifference preference budget theory

Budget constraint
Y

I, PY= const, PX changes

PX decreases: BL1 BL2
PX increases: BL1 BL3
BL2
BL3

BL1
X

I. Theories of demand
1. Indifference preference budget theory

Budget constraint
Y

PX, PY= const, I changes

I increases: BL1 BL2
I decreases: BL1 BL3

BL3

BL1

BL2
X

I. Theories of demand
1. Indifference preference budget theory

Maximizing market basket:

1. Must be located on budget line

Spend all their income more is better

2. Must give consumer most preferred combination

of goods and services

I. Theories of demand
1. Indifference preference budget theory
Optimal consumption combination
Y

C
D
I3

B
I2
I1
X

I. Theories of demand
1. Indifference preference budget theory
Utilizing choice
- At point C, the indifference curve slope is equal to
the budget lines slope

MUX
P
MUX MUY
= X
=
MUY
PY
PX
PY

In case of many goods and services:

MU X MUY
MU Z
=
= ..... =
PX
PY
PZ

I. Theories of demand
1. Indifference preference budget theory

Optimal consumption point is where marginal

benefits equal marginal costs


If MRS PX/PY, then individuals reallocate basket

to increase utility

If MRS > PX/PY

If MRS < PX/PY

I. Theories of demand
1. Indifference preference budget theory

18

I. Theories of demand
1. Indifference preference budget theory

Corner solution exists if consumer buys in

extremes, and buys all of one category of
good and none of another



MRS is not necessarily equal to price ratio

If MRS is significantly greater than price ratio,
then small decrease in price of one good may not
alter consumers market basket

19

I. Theories of demand
1. Indifference preference budget theory

20

I. Theories of demand
1. Indifference preference budget theory

The affects of INCOME changes to individual

demand

An increase in income, with the prices of all goods fixed,

causes consumers to alter their choices of market
basket

When income increases, budget line will shift outward,

then, optimal consumption choice changes
correspondingly

I. Theories of demand
1. Indifference preference budget theory

The affect of income changes to individual

demand:
A corresponds to E, B to G and C to H
With the same price level P* but produces different
quantity levels no functional relationship between E,
G, H
E,G,H must belong to different demand curves we
have D1, D2 and D3

Change in income lead to a shift in the demand curve

I. Theories of demand
1. Indifference preference budget theory

- Income-consumption curve: traces out the utilitymaximizing combination of X and Y associated with
every income level

- The upward-sloping income-consumption curve

implies that an increase in income causes a shift to
the right in the demand curve

I. Theories of demand
1. Indifference preference budget theory

Income changes:
- When income-consumption curve has positive slope:
+ Quantity demanded increases with income
+ Income elasticity of demand is positive
+ Good is a normal one

- When income-consumption curve has negative slope:

+ Quantity demanded decreases with income
+ Income elasticity of demand is negative
+ Good is an inferior one

I. Theories of demand
1. Indifference preference budget theory

Engel curve:
is built from the
slope of income
consumption
curve

I. Theories of demand
1. Indifference preference budget theory

Engel curve:
- Relate quantity of good
consumed to income
- If good is normal, Engel
curve is upward sloping
- If good is inferior, Engel
curve is downward sloping

I
I3

Inferior

I*
I2
Normal
I1
Q1

Q3

Q2

I. Theories of demand
1. Indifference preference budget theory

The affects of PRICE changes to individual

demand

A decrease in prices, with a fixed amount of income,

causes consumers to alter their choices of market
basket

When price decreases, budget line will rotate outward,

then, optimal consumption choice changes
correspondingly

I. Theories of demand
1. Indifference preference budget theory

The affect of PRICE changes to individual

demand:
A corresponds to E, B to G and C to H
With different price level P produces different
quantity levels exists functional relationship between E,
G, H
E,G,H must belong to one demand curve we have
curve D

Change in price lead to a movement in the demand curve

I. Theories of demand
1. Indifference preference budget theory

Price-consumption curve traces the utilitymaximizing combinations of 2 goods X and Y associated

with every possible price of food.
Both X and Y consumption can increase because the
decrease in the price of X has increased the consumers
ability to purchased both X and Y (X increases, Y can
either increase or decrease)

I. Theories of demand
1. Indifference preference budget theory
Income and substitution effects: Change in price
of a good has two effects:
Substitution Effect
*Relative price of good changes when price changes
*Consumers tend to buy more of good that has
become relatively cheaper, and less of good that is
relatively more expensive
*Substitution effect is the change in items consumption
associated with change in price of item, with level of
utility held constant
*When price declines, substitution effect leads to
increase in quantity demanded

I. Theories of demand
1. Indifference preference budget theory
Income Effect
*Consumers experience increase in real purchasing
power when price of one good falls
*Income effect is the change in items consumption
brought about by increase in purchasing power, with
price of item held constant
*When income increases, quantity demanded may
increase or decrease
*Even with inferior goods, income effect rarely outweighs
substitution effect

I. Theories of demand
1. Indifference preference budget theory
When Px decreases, SE is always greater than 0,
IE may either be smaller or greater than 0
- If SE>0 and IE>0 downward sloping and flat curve,
- If SE>0 and IE<0: two cases:
+ /SE/>/IE/ downward sloping and flat curve
+ /SE/</IE/ upward sloping

Exercise
A consumer has utility function U=X.Y. He
decided to spend 60$ on X and Y, in which,
Px is 2$/ unit and Py is 4$/ unit
a. Calculate MUx and MUy
b. Find optimum consumption point for this
individual
c. The price of Y now is 8$. Build demand
function for Y

Case study
In order to improve the living standard of consumer,
who is working in State sector, the government has
2 options:
-

Subsidize the price of food, so that the price of food will be

cheaper
Increase the basic income for consumer in this sector from
630.000VND to 750.000 VND, so that consumer can buy
more food
(Assume that in both options, consumer can buy the same
level of more food)

Which one bring consumer higher utility?

I. Theories of demand
1. Indifference preference budget theory
Build demand function through algebraic method
(Lagrange multiplier method):
-

Consumer optimize utility:

-

Max U (X,Y)

Subject to budget constraint

-

Px.Qx+Py.Qy=I

I. Theories of demand
1. Indifference preference budget theory
Lagrange function:

L=U(X,Y) + (PxQx+PyQy - I) max

:Lagrange multiplier

L
=0
X

L
=0
Y

L
=0

Example
Given utility function: U=X.Y
Build X and Y demand function by Lagrange
multiplier method

I. Theories of demand
1. Indifference preference budget theory

Disadvantages of Indifference preference

budget theory



Assume that utility is measurable

Assume that marginal utility of money is
constant
The principle of diminishing marginal utility is
just a phenomenon of psychology

I. Theories of demand
2. Revealed preferences
- Do not use indifference curve in analyzing consumers
behavior
- Focus on consumers behavior observable, but not
preference - unobservable
- When consumer chooses a combination of goods, he
reveals his preference to that combination of goods rather
than other combinations

I. Theories of demand
2. Revealed preferences

Assumption:

With nominal income and fixed price of goods, consumer

spend all of his income on the goods
With a certain price and income, consumer just choose one
combination of goods
There exist one and only one price level and income for
each chosen combination of goods
Consumers choice is consistent .

I. Theories of demand
2. Revealed preferences

I.

Theories of demand
3. Demand characteristic of good

I.

Theories of demand
4. Asymmetric information and
abnormal consumption

Asymmetric information : consume based on price

guidance

Abnormal consumption: higher price, higher utility

(luxury items)

II. Estimating demand

Demand estimating:

On arc elasticity

On empirical technique

On marketing methods

Demand estimating
Price elasticity of demand (EPD)
-

The percentage changed in quantity

demanded resulting from 1% change in price

E PD =

% Q
% P

Demand estimating
Income elasticity of demand (EID)
-

The percentage changed in quantity demanded

resulting from 1% change in income

EID =
-

%Q
I
= Q '( I ) .
%I
Q

EID <0: Inferior goods

EID >0: Normal goods
EID >1: Luxury goods

Demand estimating
Cross-elasticity of demand (EPyD)
-

The percentage changed in quantity demanded

resulting from 1% change in price of related goods
E PDY =

% Q
P
= Q 'PY . Y
%PY
Q

EPyD > 0 : Substitutes goods

EPyD < 0 : Complements goods

EPyD = 0 : Independent goods

II. Estimating demand

Demand estimating on arc elasticity
-

Depend on the sale volume before and after

price-change
Assume that the previous and current quantity
and price are in the same demand curve

II. Estimating demand

Demand estimating on arc elasticity

Advantage: Easy to calculate

Disadvantage:

Previous and current quantity and price may not
be in the same demand curve (both demand and
supply curve shift to the new position)

Exercise
T&M company has data about elasticity to their product as
follow:
EP = -1,5; EI = 1,2; EY = 1,2 (Y is substitutes to companys
product)
In the year after, company wants to increase the price by 6%,
consumers income is expected to increase by 6%, price of
competitors product is expected to decreases by 3%
a. If sales volume of the company in current year is 1 million
units, estimate the volume for the year after.
b. How does the price of companys product change if the
company wants to keep the sale volume constant from this year
to next year?

II. Estimating demand

Demand estimating on econometric

technique (empirical technique)

-

Using regression method with available data on quantity

demanded and determinants in demand function to
estimate demand functions coefficients.
General form of demand function:
-

Qd=f(Px, Py, I, T, N, E, C, A....)

II. Estimating demand

Demand estimating on econometric

technique (empirical technique)




Advantage: widely used, relatively accurate result

Disadvantage:




Depend on the availability of data

Depend on the perfect assumption (BLUES)
Demand function problem

II. Estimating demand

Demand estimating on marketing

methods

Survey and observation on consumers

Consumer clinics
Market trial

II. Estimating demand

Demand estimating on marketing

methods

Survey on consumers:

To get consumers feedback on changes in determinants in

demand function
Implemented by direct interview or questionnaires
Disadvantage: High cost with large sample, incorrect
answers...

II. Estimating demand

Demand estimating on marketing

methods

Consumer clinics:

Giving consumer a certain amount of money and observing

their behavior in a shop
Advantage: More credible in comparison with survey
Disadvantage: Not objective, small sample due to high
cost

II. Estimating demand

Demand estimating on marketing

methods

Market trial:

Trial on real market

Advantage: Objective, large sample
Disadvantage: competitors interference, abnormal events
(strike, bad weather...), losing market share due to change
in price

III. Forecasting demand

Extrapolation
Time-series analysis
Root mean square error technique
Smoothing technique
Barometric method

III. Forecasting demand

Extrapolation
Assume that future sale volume is the same with
the pasts one or trend in the future is alike the
trend in the past
Advantage: Easy to calculate
Disadvantage: Just regards to time, regardless to
determinant in demand function

S a l e v o l u me

a tio n
E s tim

Past

u re
r fu t
o
f
t
cas
F o re

Present

Future

Time

III. Forecasting demand

-

Time-series analysis:
Using 3 variables: Season (S), Trend (T),
Abnormal event (I), Circle movement (C)
-

Xt=Tt+Ct+St+It or
Xt=Tt.Ct.St.It

Using empirical technique to draw

regression function

III. Forecasting demand

Root mean square error technique

RMSE

(A

Ft ) 2

At: current value of time series at t

Ft: estimating value
- Smaller RMSE, better focasting

III. Forecasting demand

-

-

Smoothing technique:
Depend on the value of At and Ft to forecast the
value of Ft+1
Ft+1=wAt+(1-w)Ft
Barometric method:
Depend on availability of current data to
forecast future (depend on the new born baby
to forecast fresh pupils 6 years later)