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Chapter 3: Demand Theory

Instructor: Maharouf Oyolola


Outline of the lecture
• - Determinants of Demand
• -graph of the demand function
• -Demand schedule
• -Law of Demand
• -Difference between change in Demand
and Change in Quantity Demanded
• -From individual to market demand
• -
Outline of the lecture
• -Price elasticity of Demand (Point and Arc)
• -Income Elasticity of Demand (Point and
Arc)
• -Cross-Price elasticity of demand
• - E-commerce
Demand Theory
• In this chapter, we begin our analysis of
consumer demand. Demand is one of the
most important aspects of managerial
economics, since a firm would not be
established or survive if a sufficient
demand for its product did not exist or
could not be created.
• The fundamental objective of demand theory is
to identify and analyze the basic determinants of
consumer needs and wants.
• Therefore, an understanding of the forces
behind demand is a powerful tools for managers.
Such knowledge provides the background
needed to make pricing decisions, forecast
sales, and formulate marketing strategies.
• Demand analysis was introduced as a tool
for managerial economics.
• For example, a knowledge of price and
cross elasticities can assist managers in
pricing and that income elasticities provide
useful insights into how demand for a
product will respond to different
macroeconomic conditions.
Determinants of Demand
We begin this section by examining the
determinants of individual’s demand of a
commodity.
In managerial economics, we are primarily
interested in the demand for a commodity
faced by the firm.
Determinants of Demand
• In determining what to purchase,
individual consumers face a constrained
optimization problem. That is, given their
income (the constraint), they select that
combination of goods and services that
maximizes their personal satisfaction.
Determinants of Demand
• The consumer demand theory postulates
that the quantity demanded of a
commodity is a function of, or depends on:
• - the price of the commodity
• -the consumer’s income
• -the price of related commodities
(complements and substitutes)
• -tastes of the consumer
Graph of the demand function
• However, when we graph the relationship
between the price and the demand, we
assume other variables( income, tastes
and preferences) are constant, meaning
their values do not change.
DEMAND SCHEDULE for milk

PRICE QUANTITY
0.90 75
1.00 70
1.10 65
1.20 60
1.30 55
1.40 50
1.50 45
The Demand Schedule
•Demand Schedule: a list showing
quantities of a good that
consumers would choose to
purchase at different prices, with
all other variables held constant.
DEMAND CURVE FOR milk
p
r D A
i $1.50
c B
1.40
e
C
1.30
E
1.20
F
1.10
Price

G
1.00
H
.90
D
0 45 50 55 60 65 70 75
Quantity of milk

Copyright  2000 by Harcourt, Inc. All rights reserved.


Law of Demand

•The law of demand states


that when the price of a
good rises and everything
else remains the same, the
quantity of the good
demanded will fall.
In functional form
• Qdx= F( Px, I, Py, T)
• Where
• Qdx= quantity demanded of commodity X
• Px= Price per unit of commodity X
• I= consumer’s income
• Py= Price of related commodities
• T= tastes of the consumer
Difference between change in quantity
demanded and change in demand
• Q=F (Px, I, Pr, T,…)
• To study the relationship between the
price and quantity demanded, we assume
that income, price of related goods and
tastes are constant.
MOVEMENT ALONG A DEMAND CURVE
VERSUS SHIFT of the demand curve
D1
D0

C
$1.30
Price

F
1.10

D1
D0
Quantity Demanded
Copyright  2000 by Harcourt, Inc. All rights reserved.
Demand vs. Quantity
Demanded
•Change in Quantity
Demanded = movement
along the demand curve
•Change in Demand =
movement of the entire
From individual to market demand
• The market demand curve is simply the
horizontal summation of the demand
curves of all the consumers in the market.
• (include the 3 graphs on page 92)
The bandwagon effect
• When people sometimes demand
commodity because others are purchasing
it and in order to be fashionable
The Snob effect
• Occurs when many consumers who seek
to be different and exclusive by
demanding less of a commodity as more
people consume it
Durable goods
• Goods that provide services not only
during the year when they are purchased
but also in subsequent years.
• Example: washing machines, automobiles
Price Elasticity of Demand
• A price change can either increase or
decrease total revenue, depending on the
nature of the demand function.
• The uncertainty involved could be reduced
if managers had a method of measuring
the probable effect of price changes on
total revenue.
Price Elasticity of Demand
• One such measure is the price elasticity of
demand, which is defined as the
percentage change in quantity demanded
divided by the percentage change in price.

• Measure the responsiveness of the


consumer to a change in price.
Why is the concept of elasticity of
demand to the firm?

• From a decision-making perspective, the firm


needs to know the effect of changes in any of
the independent variables in the demand
function on the quantity demanded. Some of
these variables are under the control of
management, such as price, advertising,
product quality, and customer service.
• By affecting sales, the pricing policies of the
firm also affect its production costs, and thus its
profitability.
How to find the percentage
change?
• Example 1: P1= $100 P2= $150
• Example 2: Q1=990 Q2=1500
• Example: P1=$5 P2=$3
Point Versus Arc Elasticity
• There are two approaches to computing
price elasticities:
(2) The point price elasticity
(3) The arc price elasticity

The choice between the two depends on the


available data and the intended use.
Arc elasticity
• They are appropriate for analyzing the
effect of discrete changes in price.
For example, a price increase from $1 to
$2 could be evaluated by computing the
arc elasticity.
• In actual practice, most elasticity
computations involve the arc method.
Point Elasticity
• This approach can be used to evaluate the
effect of a very small price changes or to
compute the price elasticity at a particular
price.
• Point elasticities are important in
theoretical economics.
Price Elasticity of Demand
• Because of the inverse relationship
between P and Q, Ep is negative.
However, for simplicity, we use the
absolute value of Ep or IEpI to interpret
the result
∆Q
Q ∆Q P
Ep = = •
∆P ∆P Q
P
• If IEpI>1 The demand is elastic

• Meaning: If the price of the product


increases by 1%, the consumers respond
by decreasing their demand of the product
by more than 1%.
• If IEpI<1 the demand is inelastic

• Meaning: if the price of the product


increases by 1%, the consumers respond
by decreasing their demand of the product
by less than 1%
• Example: a necessary good
• gas, electricity, water
• If IEpI=1 the demand is unit elastic

• Meaning: if the price of the product


increases by 1%, the consumer responds
by decreasing its demand of the product
by exactly the same percent.
demand curve

8
6
Price

4 Q
2
0
0 200 400 600 800
Quantity demanded
• At B

∆Q = 100 − 0 = 100
∆P = 5 − 6 = −1
P=5
Q = 100
IEpI = 5 > 1 ⇒ The demand is elastic
• Point elasticities can also be computed
from a demand equation.
• Suppose that the demand equation is as
follows: Qd= 100 – 4P
P=$10 Ep= -0.67
P=$20 Ep= -4.0
Arc Price Elasticity of Demand
• Measures the price elasticity of demand
between two prices

∆ Q ( P1 + P2 ) / 2
Ep = •
∆ P (Q1 + Q2 ) / 2
Example
• Using the point elasticity of demand, let’s
compute Ep:
• C to D Ep=-2
• D to C Ep=-1
• To avoid this, we use the average of the
two prices and the average of the two
quantities
Between C and D
• P1+P2=4+3= 7
• Q1+Q2=200+300=500
• Ep=-1.4
Example
• Consider the NBA corporation, which had
monthly basketball shoe sales of 10,000 pairs
(at $100 per pair) before a price cut by its major
competitor. After this competitor’s price
reduction, NBA’s sales declined to 8,000 pairs a
month. From the past experience NBA has
estimated the price elasticity of demand to be
about -2.0 in this price-quantity range. If the NBA
wishes to restore its sales to 10,000 pairs a
month, determine the price that must be
charged.
Solution
• Letting Q2=10,000 Q1=8,000 P1=$100 and
ED=-2.0, the required price, P2, may be
computed:
10,000 − 8,000
10,000 + 8,000
− 2.0 =
P2 − $100
P2 + $100
P2 = $89.50
Price Elasticity, Total Revenue and
Marginal Revenue
• TR=P.Q
• MR=ΔTR/ΔQ
• If P increases IEpI<1 TR increases
• Example: Gas (necessary good) there is no
close substitute for gas.
• It can be an answer to many who wonder why
oil companies are making huge profits when
gas prices are increasing.
Price Elasticity, Total Revenue and
Marginal Revenue
• If P increases IEpI>1 TR falls
• Availability of close substitutes led the
consumer to substitute the product with
the closest substitute

• MR=P( 1 + 1/Ep)
• Discuss this formula in detail
Factors affecting the price elasticity
of demand
• The price elasticity of demand depends
primarily on:
• - the existence of close substitutes for the
commodity
• -the length of time over which the quantity
response to the price change is measured
• The price elasticity of demand is larger the
closer and the greater is the number of
available substitutes for the commodity
• Intuitively, the price elasticity of sugar is
higher than the price elasticity of salt
• Example: Sugar has more substitutes than
salt
• Substitutes for sugar: honey, saccharine
• The price elasticity of demand is also
larger the longer is the time period allowed
for consumers to respond to the change in
the commodity price.
• As time goes by, consumers learn about
the existence of substitutes and adjust
their purchases to the price change
Example
• During the period following the sharp increase in
gasoline price in 1974, the price elasticity was
very low. several years later, however, the
reduction in the quantity demanded of gasoline
was much greater than in the short-run as
consumers changed their buying habits by
purchasing fuel-efficient, compact cars; switched
to public transportation and took other steps to
reduce gasoline consumption.
Price elasticity and Decision
Making
• Information about price elasticities can be
extremely useful to managers as they
contemplate price decisions.
• If demand is inelastic at the current price,
a price decrease will result in a decrease
in total revenue.
• Alternatively, reducing the price of a
product with elastic demand would cause
revenue to increase.
Price elasticity and Decision
Making
• The relationship between elasticity and
total revenue can be shown using simple
calculus.

• MR=P(1+1/Ep)
• If Ep=-1 MR=0 → interpretation: if the
demand is unitary elastic, prices will not
change total revenues.
Price elasticity and Decision
Making
• If Ep<-1 → the demand is elastic →MR>0
→ A price reduction would increase the
quantity demanded. Therefore, total
revenue would increase.

• If Ep>-1 → the demand is inelastic


→MR<0 → A price reduction would
decrease total revenue.
Income Elasticity of Demand
• Measures the responsiveness of the
demand for a commodity to a change in
consumer’s income
Why the income elasticity of
demand is important to the firm?
• -Income is one of the determinant of
demand.
• For instance, consumers tend to change
their buying habit during a recession or
expansion. Therefore, the firm needs to
take that factor into consideration while
choosing the amount of output to produce
Point Income elasticity of Demand

∆Q
Q ∆Q I
EI = = •
∆I ∆I Q
I
Arc Income Elasticity of Demand

∆Q ( I1 + I 2 ) / 2
EI = •
∆I (Q1 + Q2 ) / 2
∆Q I1 + I 2
EI = •
∆I Q1 + Q2
Definitions
• A Normal good: a good whose quantity
demanded rises as the income of the
consumer increases.
• Examples: automobiles, education, travel,
movies, housing
• Inferior good: A good whose quantity
demanded increases as the income of the
consumer falls.
• Example: Black and White TV, hot dogs
hamburgers
• If EI>0 Normal goods
• If EI<0 Inferior goods

• Example of normal goods: luxury item


such as vacations in the Caribbean, which
will increase when the economy is
booming
Normal goods
• Food, clothing and housing EI>0 but low
necessities
• Healthcare and education EI>1
Inferior goods
• EI<0
• Black and White TV
• Flour
Cross-price elasticity of demand
• The demand of a commodity also
depends on the price of related (i.e.
substitutes and complements)
commodities.
• Example: If the price of tea rises, the
demand for coffee increases Consumers
substitute coffee for tea in consumption
• On the other hand, if the price of sugar (a
complement of coffee) rises, the demand
for coffee declines
The point cross-price elasticity of
demand
• Measures the responsiveness in the
demand for commodity X to a change in
the price of commodity Y.

∆ Qx
Qx ∆ Qx Py
E XY = = •
∆ Py ∆ Py Qx
Py
• If Exy>0 commodities X and Y are
substitutes
• Examples: coffee and tea
• butter and margarine
• If Exy<0 commodities X and Y are
complements
• Examples: sugar and coffee
• cars and gasoline
• If EXY=0 X and Y are independent
commodities

• Examples: books and beer


• cars and candy
• pencils and potatoes
• The cross-price elasticity of demand is a
very important concept in managerial
decision-making.
• Firms often use this concept to measure
the effect of changing the price of a
product they sell on the demand of other
related products that the firms also sell.
Example
• General motors corporation can use the
cross-price elasticity of demand to
measure the effects of changing the price
of Chevrolets on the demand for Pontiacs.
• Chevrolets and Pontiacs are substitutes.
Therefore, lowering the price of Chevrolets
will reduce the demand for Pontiacs
E-Commerce
• It refers to the production, advertising, sale, and
distribution of products and services from
business to business and from business to
consumers through the internet.
• In e-commerce, there is no traveling to a
traditional store, no salesperson, and no cash-
register.
• The e-commerce has tremendously change the
way in which buyers and sellers interact in the
marketplace.
Advantages of E-commerce
• - reduction of time and distance barriers
between buyers and sellers.
Substitution effect
• When the price of a good – such as steak
– declines, it becomes less expensive in
relation to other goods – for example,
chicken. As a result of the price decline,
the rational consumer may be able to
increase his or her satisfaction (or utility)
by purchasing more of the good whose
price has declined and less of the other
goods. This is known as the substitution
effect.
Example
• Suppose that the prices of steak and chicken are $5 and
$2 per pound, respectively.
• Assume that an individual purchases two pounds of
steak and two pounds of chicken per week for total
expenditure of $14.
• Suppose that the price of steak declines to $4 per
pound. As a result of this price decrease, an individual
who has a preference for steak may decide to increase
his or her consumption of steak to three pounds per
week- which requires the same total expenditure of $14
per week.
• Thus we see that a decrease in the price of steak(
relative to chicken) has led to an increase in the demand
for steak.
Income effect
• When the price of a good – for example, steak –
declines, the effect of this decline is that the real income
of the consumer has increased. This is known as the
income effect.
• If an individual normally purchases two pounds of steak
per week at $5 per pound, a price decline to $4 per
pound would enable the consumer to purchase the same
amount of steak for $2 less per week
• This savings of $2 represents an increase in real income
of $2, which may be used to purchase greater quantities
of steak (as well as other goods) each week
Problems
• In class problems
• Problem #1 page 128
• Problem #2 page 128
• Written assignment
• Problem #3 page 128