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 etween change in Demand and Change in !uantity Demanded -"rom indi#idual to mar$et demand -

Outline of the lecture

-%rice elasticity of Demand &%oint and 'rc( -Income )lasticity of Demand &%oint and 'rc( -Cross-%rice elasticity of demand - )-commerce

Demand Theory
In this chapter* we egin our analysis of consumer demand+ Demand is one of the most important aspects of managerial economics* since a firm would not e esta lished or sur#i#e if a sufficient demand for its product did not e,ist or could not e created+

 The fundamental o -ecti#e of demand theory is to identify and analy.e the asic determinants of consumer needs and wants+ Therefore* an understanding of the forces ehind demand is a powerful tools for managers+ /uch $nowledge pro#ides the ac$ground needed to ma$e pricing decisions* forecast sales* and formulate mar$eting strategies+

 Demand analysis was introduced as a tool for managerial economics+ "or e,ample* a $nowledge of price and cross elasticities can assist managers in pricing and that income elasticities pro#ide useful insights into how demand for a product will respond to different macroeconomic conditions+

Determinants of Demand
0e egin this section y e,amining the determinants of indi#idual1s demand of a commodity+ In managerial economics* we are primarily interested in the demand for a commodity faced y the firm+

Determinants of Demand
In determining what to purchase* indi#idual consumers face a constrained optimi.ation pro lem+ That is* gi#en their income &the constraint(* they select that com ination of goods and ser#ices that ma,imi.es their personal satisfaction+

Determinants of Demand
The consumer demand theory postulates that the 2uantity demanded of a commodity is a function of* or depends on: - the price of the commodity -the consumer1s income -the price of related commodities &complements and su stitutes( -tastes of the consumer

3raph of the demand function

4owe#er* when we graph the relationship etween the price and the demand* we assume other #aria les& income* tastes and preferences( are constant* meaning their #alues do not change+

D)M'>D /C4)D=L) for mil$

%@IC) 8+<8 7+88 7+78 7+:8 7+38 7+58 7+68

!='>TIT? ;6 ;8 96 98 66 68 56

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 D r i $1.50 c 1.40 e

A B C E F G H

1.30 1.20

$%i&'

1.10 1.00 .90

0 45 50 55 60

D
65 70 75

Quan i ! "# milk

Copyright :888 y 4arcourt* Inc+ 'll rights reser#ed+

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
!d,A "& %,* I* %y* T( 0here !d,A 2uantity demanded of commodity B %,A %rice per unit of commodity B IA consumer1s income %yA %rice of related commodities TA tastes of the consumer

Difference etween change in 2uantity demanded and change in demand

!A" &%,* I* %r* T*C( To study the relationship etween the price and 2uantity demanded* we assume that income* price of related goods and tastes are constant+

MOVEMEN( A)ON* A DEMAND CURVE VER+U+ +,-F( "# .' /'man/ &u%0'
D1 D0
$1.30
C

$%i&'

1.10

D1 D0 Quan i ! D'man/'/
Copyright :888 y 4arcourt* Inc+ 'll rights reser#ed+

Change in Quantity

Demand vs. Quantity Demanded

Demanded = movement along the demand curve Change in Demand = movement of the entire

"rom indi#idual to mar$et demand

The mar$et demand cur#e is simply the hori.ontal summation of the demand cur#es of all the consumers in the mar$et+ &include the 3 graphs on page <:(

The andwagon effect

0hen people sometimes demand commodity ecause others are purchasing it and in order to e fashiona le

The /no effect

Occurs when many consumers who see$ to e different and e,clusi#e y demanding less of a commodity as more people consume it

Dura le goods
3oods that pro#ide ser#ices not only during the year when they are purchased ut also in su se2uent years+ ),ample: washing machines* automo iles

%rice )lasticity of Demand

' price change can either increase or decrease total re#enue* depending on the nature of the demand function+ The uncertainty in#ol#ed could e reduced if managers had a method of measuring the pro a le effect of price changes on total re#enue+

%rice )lasticity of Demand

One such measure is the price elasticity of demand* which is defined as the percentage change in 2uantity demanded di#ided y the percentage change in price+ Measure the responsi#eness of the consumer to a change in price+

0hy is the concept of elasticity of demand to the firmD

"rom a decision-ma$ing perspecti#e* the firm needs to $now the effect of changes in any of the independent #aria les in the demand function on the 2uantity demanded+ /ome of these #aria les are under the control of management* such as price* ad#ertising* product 2uality* and customer ser#ice+ Ey affecting sales* the pricing policies of the firm also affect its production costs* and thus its profita ility+

4ow to find the percentage changeD

),ample 7: %7A F788 %:A F768 ),ample :: !7A<<8 !:A7688 ),ample: %7AF6 %:AF3

%oint Gersus 'rc )lasticity

There are two approaches to computing price elasticities: &:( The point price elasticity &3( The arc price elasticity The choice etween the two depends on the a#aila le data and the intended use+

'rc elasticity
They are appropriate for analy.ing the effect of discrete changes in price+ "or e,ample* a price increase from F7 to F: could e e#aluated y computing the arc elasticity+ In actual practice* most elasticity computations in#ol#e the arc method+

%oint )lasticity
This approach can e used to e#aluate the effect of a #ery small price changes or to compute the price elasticity at a particular price+ %oint elasticities are important in theoretical economics+

%rice )lasticity of Demand

Eecause of the in#erse relationship etween % and !* )p is negati#e+ 4owe#er* for simplicity* we use the a solute #alue of )p or I)pI to interpret the result

Q Q Q P Ep = = P P Q P

 If I)pIH7

The demand is elastic

Meaning: If the price of the product increases y 7I* the consumers respond y decreasing their demand of the product y more than 7I+

 If I)pIJ7 the demand is inelastic Meaning: if the price of the product increases y 7I* the consumers respond y decreasing their demand of the product y less than 7I ),ample: a necessary good gas* electricity* water

 If I)pIA7 the demand is unit elastic Meaning: if the price of the product increases y 7I* the consumer responds y decreasing its demand of the product y e,actly the same percent+

/'man/ &u%0'
K 9 5 : 8 8 :88 588 988 K88 Quan i ! /'man/'/

$%i&'

 't E

Q = 100 0 = 100 P = 5 6 = 1 P=5 Q = 100 IEpI = 5 > 1 The demand is elastic

 %oint elasticities can also e computed from a demand e2uation+ /uppose that the demand e2uation is as follows: !dA 788 L 5% %AF78 )pA -8+9; %AF:8 )pA -5+8

'rc %rice )lasticity of Demand

Measures the price elasticity of demand etween two prices

Q ( P1 + P2 ) / 2 Ep = P (Q1 + Q2 ) / 2

),ample
=sing the point elasticity of demand* let1s compute )p: C to D )pA-: D to C )pA-7 To a#oid this* we use the a#erage of the two prices and the a#erage of the two 2uantities

Eetween C and D
%7M%:A5M3A ; !7M!:A:88M388A688 )pA-7+5

),ample
Consider the >E' corporation* which had monthly as$et all shoe sales of 78*888 pairs &at F788 per pair( efore a price cut y its ma-or competitor+ 'fter this competitor1s price reduction* >E'1s sales declined to K*888 pairs a month+ "rom the past e,perience >E' has estimated the price elasticity of demand to e a out -:+8 in this price-2uantity range+ If the >E' wishes to restore its sales to 78*888 pairs a month* determine the price that must e charged+

/olution
Letting !:A78*888 !7AK*888 %7AF788 and )DA-:+8* the re2uired price* %:* may e computed:

10,000 8,000 10,000 + 8,000 2.0 = P2 $100 P2 + $100 P2 = $89.50

%rice )lasticity* Total @e#enue and Marginal @e#enue

T@A%+! M@ANT@ON! If % increases I)pIJ7 T@ increases ),ample: 3as &necessary good( there is no close su stitute for gas+ It can e an answer to many who wonder why oil companies are ma$ing huge profits when gas prices are increasing+

%rice )lasticity* Total @e#enue and Marginal @e#enue

If % increases I)pIH7 T@ falls '#aila ility of close su stitutes led the consumer to su stitute the product with the closest su stitute M@A%& 7 M 7O)p( Discuss this formula in detail

"actors affecting the price elasticity of demand

The price elasticity of demand depends primarily on: - the e,istence of close su stitutes for the commodity -the length of time o#er which the 2uantity response to the price change is measured

 The price elasticity of demand is larger the closer and the greater is the num er of a#aila le su stitutes for the commodity Intuiti#ely* the price elasticity of sugar is higher than the price elasticity of salt ),ample: /ugar has more su stitutes than salt /u stitutes 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+ 's time goes y* consumers learn a out the e,istence of su stitutes and ad-ust their purchases to the price change

),ample
During the period following the sharp increase in gasoline price in 7<;5* the price elasticity was #ery low+ se#eral years later* howe#er* the reduction in the 2uantity demanded of gasoline was much greater than in the short-run as consumers changed their uying ha its y purchasing fuel-efficient* compact carsP switched to pu lic transportation and too$ other steps to reduce gasoline consumption+

%rice elasticity and Decision Ma$ing

Information a out price elasticities can e e,tremely 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 re#enue+ 'lternati#ely* reducing the price of a product with elastic demand would cause re#enue to increase+

%rice elasticity and Decision Ma$ing

The relationship etween elasticity and total re#enue can e shown using simple calculus+ M@A%&7M7O)p( If )pA-7 M@A8 Q interpretation: if the demand is unitary elastic* prices will not change total re#enues+

%rice elasticity and Decision Ma$ing

If )pJ-7 Q the demand is elastic QM@H8 Q ' price reduction would increase the 2uantity demanded+ Therefore* total re#enue would increase+ If )pH-7 Q the demand is inelastic QM@J8 Q ' price reduction would decrease total re#enue+

Income )lasticity of Demand

Measures the responsi#eness of the demand for a commodity to a change in consumer1s income

0hy the income elasticity of demand is important to the firmD

-Income is one of the determinant of demand+ "or instance* consumers tend to change their uying ha it during a recession or e,pansion+ Therefore* the firm needs to ta$e that factor into consideration while choosing the amount of output to produce

%oint Income elasticity of Demand

Q Q I Q EI = = I I Q I

'rc Income )lasticity of Demand

Q ( I1 + I 2 ) / 2 EI = I (Q1 + Q2 ) / 2 Q I1 + I 2 EI = I Q1 + Q2

Definitions
' >ormal good: a good whose 2uantity demanded rises as the income of the consumer increases+ ),amples: automo iles* education* tra#el* mo#ies* housing

 Inferior good: ' good whose 2uantity demanded increases as the income of the consumer falls+ ),ample: Elac$ and 0hite TG* hot dogs ham urgers

 If )IH8 If )IJ8

>ormal goods Inferior goods

),ample of normal goods: lu,ury item such as #acations in the Cari ean* which will increase when the economy is ooming

>ormal goods
"ood* clothing and housing )IH8 ut low necessities 4ealthcare and education )IH7

Inferior goods
)IJ8 Elac$ and 0hite TG "lour

Cross-price elasticity of demand

The demand of a commodity also depends on the price of related &i+e+ su stitutes and complements( commodities+ ),ample: If the price of tea rises* the demand for coffee increases Consumers su stitute 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 responsi#eness in the demand for commodity B to a change in the price of commodity ?+

Qx Qx Qx Py E XY = = Py Py Qx Py

 If ),yH8 commodities B and ? are su stitutes ),amples: coffee and tea utter and margarine

 If ),yJ8 commodities B and ? are complements ),amples: sugar and coffee cars and gasoline

 If )B?A8 B and ? are independent commodities ),amples: oo$s and eer cars and candy pencils and potatoes

 The cross-price elasticity of demand is a #ery important concept in managerial decision-ma$ing+ "irms 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+

),ample
3eneral motors corporation can use the cross-price elasticity of demand to measure the effects of changing the price of Che#rolets on the demand for %ontiacs+ Che#rolets and %ontiacs are su stitutes+ Therefore* lowering the price of Che#rolets will reduce the demand for %ontiacs

)-Commerce
It refers to the production* ad#ertising* sale* and distri ution of products and ser#ices from usiness to usiness and from usiness to consumers through the internet+ In e-commerce* there is no tra#eling to a traditional store* no salesperson* and no cashregister+ The e-commerce has tremendously change the way in which uyers and sellers interact in the mar$etplace+

'd#antages of )-commerce
- reduction of time and distance arriers etween uyers and sellers+

/u stitution effect
0hen the price of a good L such as stea$ L declines* it ecomes less e,pensi#e in relation to other goods L for e,ample* chic$en+ 's a result of the price decline* the rational consumer may e a le to increase his or her satisfaction &or utility( y purchasing more of the good whose price has declined and less of the other goods+ This is $nown as the su stitution effect+

),ample
/uppose that the prices of stea$ and chic$en are F6 and F: per pound* respecti#ely+ 'ssume that an indi#idual purchases two pounds of stea$ and two pounds of chic$en per wee$ for total e,penditure of F75+ /uppose that the price of stea$ declines to F5 per pound+ 's a result of this price decrease* an indi#idual who has a preference for stea$ may decide to increase his or her consumption of stea$ to three pounds per wee$- which re2uires the same total e,penditure of F75 per wee$+ Thus we see that a decrease in the price of stea$& relati#e to chic$en( has led to an increase in the demand for stea$+

Income effect
0hen the price of a good L for e,ample* stea$ L declines* the effect of this decline is that the real income of the consumer has increased+ This is $nown as the income effect+ If an indi#idual normally purchases two pounds of stea$ per wee$ at F6 per pound* a price decline to F5 per pound would ena le the consumer to purchase the same amount of stea$ for F: less per wee$ This sa#ings of F: represents an increase in real income of F:* which may e used to purchase greater 2uantities of stea$ &as well as other goods( each wee$

%ro lems
In class pro lems %ro lem R7 page 7:K %ro lem R: page 7:K 0ritten assignment %ro lem R3 page 7:K