September 21-22, 2023

Demand Analysis

Managerial Economics

András Olivér Németh

nemeth.andras@uni-corvinus.hu

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 September 21-22, 2023

The effect of changes in income and prices

The optimal decision of the consumer depends on his disposable income and the prices of the products
(besides the preferences of the consumer).
If either the disposable income or one of the prices changes, it affects the optimal consumption bundle.

What happens if disposable income changes?

- Income–consumption curve
- Engel curve
What happens if a price changes?
- Price–consumption curve
- Demand curve
Elasticities of demand
- Income elasticity
- Price elasticity
- Cross-price elasticity
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 September 21-22, 2023

A change in the disposable income

Income–consumption Income elasticity: the ratio of the percentage
curve: optimal change in quantity demanded and the percentage
∗ ∗ 𝜕𝑥1∗ 𝑚
1 Τ𝑥1
consumption bundles change in income: 𝐸𝑚 = 𝑑𝑥
𝑑𝑚Τ𝑚
= ∙
𝜕𝑚 𝑥 ∗
1
for different levels of
income (while prices - 𝐸𝑚 > 0 – Normal goods: quantity demanded
are held constant) increases if income increases.
- 𝐸𝑚 < 0 – Inferior goods: quantity demanded
decreases if income increases.
Engel curve: quantity - 𝐸𝑚 > 1 – Luxury goods: the rate of increase in
demanded of a good as quantity demanded is higher than the rate of
a function of the income increase in income.
of the consumer - 0 < 𝐸𝑚 < 1 – Necessity goods: the rate of
increase in quantity demanded is lower than
the rate of increase in income. 3

A change in one of the prices
Price–consumption
curve: optimal
consumption bundles
for different prices of a
good (while income and
the other price are held
constant)
Demand curve: quantity
demanded of a good as a
function of the price of the
good
September 21-22, 2023
Price elasticity: the ratio of the percentage
change in quantity demanded and the percentage
𝑑𝑥1∗ Τ𝑥1∗ 𝜕𝑥1∗ 𝑝1
change in the price of the good: 𝐸11 = 𝑑𝑝 Τ𝑝
=
𝜕𝑝
∙ ∗
𝑥
1 1 1 1
- 𝐸11 < 0 – Law of demand: quantity demanded
decreases if price increases.
- 𝐸11 > 0 – Giffen goods: quantity demanded
increases if price increases.
- 𝐸11 < −1 – Elastic demand: the rate of change
in quantity demanded is higher than the rate
of change in price.
- −1 < 𝐸11 < 0 – Inelastic demand: the rate of
change in quantity demanded is lower than
the rate of change in price. 4

Substitution and income effects
The sign of the substitution effect is certainly
opposite to the sign of the price change:
- A price decrease means the decrease of
the relative price of the product that leads
to higher quantity demanded.
The sign of the income effect depends on
whether the good is normal or inferior:
- A price decrease means that real income
increases; in the case of normal goods this
increases quantity demanded, while in the
case of inferior goods it decreases it.
September 21-22, 2023
One of the factors influencing the (price) elasticity
of demand is whether the product is a luxury or
necessity good.
This is due to the income effect:
- In the case of luxury goods, income effect
is stronger (a change in real income leads
to a larger change in quantity demanded),
therefore the price elasticity of demand is
also higher in the case of luxury goods than
in the case of necessities.
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 September 21-22, 2023

Substitute and complementary goods

What happens with the quantity demanded of a good if the price of the other good changes?

Cross-price elasticity: the ratio of the percentage change in quantity demanded and the percentage
𝑑𝑥1∗ Τ𝑥1∗ 𝜕𝑥1∗ 𝑝2
change in the price of the other good: 𝐸12 = 𝑑𝑝 Τ𝑝 = 𝜕𝑝 ∙ 𝑥 ∗
2 2 2 1

- 𝐸12 > 0 – Substitute goods - 𝐸12 < 0 – Complementary goods

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 September 21-22, 2023

Individual and market demand

Individual demand: the quantity a consumer
buys of a good as a function of its price.

Market demand: the total quantity consumers

buy of a good as a function of its price.

Market demand is the (horizontal) sum of

individual demands.

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Estimating demand – data sources 1

Consumer surveys
- Ask the consumers directly about their preferences or how they would react to different changes
- Sample bias (respondents may misrepresent the consumers)
- Response bias (intentional distortion in answers)
- Limited response accuracy
- Costly

Controlled consumer experiments

- Respondents face simulated purchasing decisions, while different aspects are changed
- Similar problems as in the case of consumer surveys (response bias, limited response accuracy)
- Even costlier, which means smaller samples (stronger sample bias)

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Estimating demand – data sources 2

Controlled market studies
- Intentional variation in key determinants of demand (price, advertisements, etc.)
- Cross-sectional or time-series approach
- Not always easy to find comparable markets
- Costly (not only the technical costs, but it means giving up profits)

Uncontrolled market data

- Many factors change at the same time
- Not all of these factors can be controlled (potentially misleading conclusions)
- Possible identification problem

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Estimating demand – regression analysis

Univariate linear regression
- Assumed demand curve: 𝑞𝑖 = 𝑎 + 𝑏 ∙ 𝑝𝑖 + 𝑒𝑖
- The task is to find those parameters 𝑎 and 𝑏, for which the sum of squared errors between observed
𝑞𝑖 and estimated 𝑞ො𝑖 = 𝑎 + 𝑏 ∙ 𝑝𝑖 values is minimal.

Linear regression can be used to estimate non-linear demand curves as well.

- Quadratic demand curve: 𝑞𝑖 = 𝑎 + 𝑏1 ∙ 𝑝𝑖 + 𝑏2 ∙ 𝑝𝑖2 + 𝑒𝑖
- Log-linear demand curve: 𝑞𝑖 = 𝑎 ∙ 𝑝𝑖𝑏 ∙ 𝑒𝑖

Multivariate extension (inclusion of other explanatory variables)

- Prices of other goods
- Disposable income of consumers

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Forecasting demand
Forecasting demand has a key importance from the perspective of investment decisions.
- Not only current demand matters, but future demand as well.
- How permanent are the changes in demand?

Real-life market data can be used to forecast future demand.

Time-series analysis: a time-series of data can be broken up to…

- Trends (linear or exponential)
- Cyclicality (business cycles)
- Seasonal variations
- Random fluctuations

Barometric forecasting models: the use of leading indicators

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Thank you
for your attention!