Demand Theory

Introduction
M anagers spend enorm ous am ounts of tim e, energy, and m oney analyzing
the dem and for their p r o d u c t s - a n d it is not a sim ple task. C onsider Peter
D avidson, head of El Diario, New York's Spanish-Language daily new s
paper Trying to build revenues, h e raised the p ap er's price from 35 to 5
cents. A lthough h e expected only a 3 to 5 percent drop in circulation, the ac
tual decline exceeded 30 percent. In this and the follow ing chapters, we
focus attention on the theory of dem and, w hich sheds light on problem s
like Mr. D avidson's. In C hapter 5, w e will look m uch m ore closely at som e
of the techniques used to estim ate the dem and for a product.

The Market Demand Curve

T he m a r k e t d e m a n d s c h e d u le for a good is a table that show s the total
quantity of the good that w ould be purchased at each price. For exam ple,
suppose that the m arket dem and schedule for personal com puters is as
show n in Table 3 .I .1 A ccording to this table, 1.5 m illion personal com puters
w ill be dem anded per year if the price is $2,000 per com puter, 800,000 w ill

1 These num bers are hypothetical, but adequate for present purposes. In subsequent
chapters, w e shall provide data describing the actual relationship betw een the p n c e and
quantity d em anded of various goods. At this point, the em phasis is on th e concept o
m arket dem and schedule, n ot on the detailed accu racy of these num bers.

The M arket Demand Curve

Ch. 3 / Demand Theory

TABLE 3.1

M a rk e t D e m a n d S chedule fo r P ersonal C o m p u te rs, 1996

Price p e r com puter
(dollars)

Quantity dem anded per year

(thousands)

3,000
2,750
2,500
2,250
2,000

800
975
1,150
1,325
1,500

be dem anded if the price is $3,000, and so on. A nother w ay of presenting

the data in Table 3.1 is b y a m a r k e t d e m a n d c u rv e , w hich is a plot of the
m arket dem and schedule on a graph. T he vertical axis of the graph m ea
sures the price per unit of the good, and the horizontal axis m easures the
quantity of the good dem anded per unit of time. Figure 3.1 show s the m ar
ket dem and curve for personal com puters, based on the figures in Table 3.1.

Price of
computer 3 00O
(dollars)

2,500

2,000

800

1,200

1,600
Quantity demanded
(thousands of units)

FIGURE 3.1 Demand Curve for Personal Computers

graphical representation of the figures in Table 3.1.

This demand curve is a

In C hapter 1, w e provided an introductory look at the m arket dem and

curve. N ow we m ust study this topic in m ore detail. Three things should be
noted concerning Figure 3.1. First, the m arket dem and curve show s the total
quantity of personal com puters dem anded at each price, not the quantity
dem anded from a particular firm . We w ill discuss the dem and for a particu
lar firm 's product in the n ext section of this chapter. Second, the m arket de
m and curve for personal com puters slopes dow nw ard to the right. In other
w ords, the quantity of personal com puters dem anded increases as the price
falls. As w e pointed out in C hapter 1, this is true of the dem and curve for
m ost goods; they alm ost alw ays slope dow nw ard to the right. Third, the
m arket dem and curve in Figure 3.1 pertains to a particular period of time:
1996. A s you will recall from C hapter 1, any dem and curve pertains to som e
period of tim e, and its shape and position depend on the length and other
characteristics of this period. For exam ple, if w e w ere to estim ate the m ar
ket dem and curve for personal com puters for the first w eek in 1996, it
w ould be a different curve from the one in Figure 3.1, w hich pertains to the
w hole year. T he difference arises partly because consum ers can adapt their
purchases m ore fully to changes in the price of personal com puters in a
year than in a week.
Besides the length of tim e period, w hat other factors determ ine the posi
tion and shape of the m arket dem and curve for a good? A s indicated in
C hapter 1, one im portant factor is the tastes o f c o n s u m e rs . If consum ers
show an increasing preference for a product, the dem and curve w ill shift to
the right; that is, at each price, consum ers w ill desire to buy more than they
did previously. On the other hand, if consum ers show a decreasing prefer
ence for a product, the dem and curve w ill shift to the left, since, at each
price, consum ers w ill desire to buy less than previously. For exam ple, if
people find that personal com puters are m ore h elp fu l than they thought,
and if they begin to use them more and give them in larger num bers to
their children and others, the dem and curve for personal com puters m ay
shift to the right, as show n in Figure 3.2. T h e greater the shift in prefer
ences, the farther the dem and curve w ill shift.
A nother factor that influences the position and shape of a good's m arket
dem and curve is the le v e l o f c o n s u m e r in c o m e s . For som e types of prod
ucts, the dem and curve shifts to the right if per capita incom e increases,
w hereas for other types of com m odities, the dem and curve shifts to the left
if per capita incom e rises. In the case of personal com puters, one w ould ex
pect that an increase in per capita incom e w ould shift the dem and curve to
the right, as show n in Figure 3.3. Still another factor that influences the po
sition and shape of a good 's m arket dem and curve is the le v e l o f o th e r
p ric e s . For exam ple, one w ould expect that the quantity of personal com
puters dem anded w ould increase if the price of softw are for such com put
ers fell drastically.
Finally, the position and shape of a good's m arket dem and curve is also
affected by the size of the population in the relevant m arket. Thus, if the

Ch. 3 / Demand Theory

Industry and Firm Dem and Functions

population
equal, the
course, the
tle effect in

Price of
computer

increases, one w ould expect that, if all other factors w ere held
quantity of personal com puters dem anded w ould go up. O f
population generally changes slowly, so this factor often has lit
the very short run.

Industry and Firm Demand Functions

Demand
curve

Quantity demanded

FIG U RE 3.2 Effect of Increased Preference for Personal Computers on M arket

Demand Curve The demand curve for personal computers shifts to the right.

Building on the results of the previous section, w e can define the m a rk e t

d e m a n d fu n c tio n for a product, w hich is the relationship betw een the
quantity dem anded of the product and the various factors that influence
this quantity. Put generally, this m arket dem and function can be w ritten as
Q uantity dem anded
of good X
~ Q ~ /(price of X , incom es of consum ers, tastes
of consum ers, prices of other goods, pop
ulation, advertising expenditures, and so
forth).
To be useful for analytical and forecasting purposes, this equation m ust be
m ade m ore specific. For exam ple, if good X is personal com puters, the m ar
ket dem and function m ight be as follows:
Q = b,P + b2I + b3S + b4A ,

Price of
computer

Demand
curve

w here Q equals the num ber o f personal com puters dem anded in a particu
lar year, P is the average price of personal com puters in that year, I is per
capita disposable incom e during that year, S is the average price of softw are
during that year, and A is the am ount spent on advertising by producers of
personal com puters in that year. T he assum ption in equation (3.1) is, of
course, that the relationship is linear. (Also, w e assum e for sim plicity that
the population in the relevant m arket is essentially constant.)
G oing a step further, it generally is necessary for m anagers and analysts
to obtain num erical estim ates of the b's in equation (3.1). Em ploying the sta
tistical techniques described in Chapter 5, one usually can estim ate these socalled p a ra m e te rs of the dem and function. To illustrate the sorts of results
that m ight be obtained, w e m ight find that
Q = - 7 0 0 P + 2001 - 500S + 0.01 A.

Quantity demanded

FIG U RE 3.3 Effect of Increase in Per Capita Income on M arket Demand

Curve for Personal Computers The demand curve shifts to the right.

(3.1)

(3.2)

A ccording to equation (3.2), a $1 increase in the price of a personal com

puter results in a decrease in the quantity dem anded of 700 units per year; a
$1 increase in per capita disposable incom e results in a 200-unit increase in
the quantity dem anded; a $1 increase in the price of softw are reduces the
quantity dem anded by 500 units per year; and a $1 increase in advertising
raises the quantity dem anded by 0.01 units per year.

Ch. 3 / Dem and Theory

The Price Elasticity o f Demand

It is im portant to understand the relationship betw een the m arket de

m and function and the dem and curve. T h e m arket dem and curve show s
the relationship betw een Q and P w hen all other relevant variables are held
constant. For exam ple, suppose that w e w ant to know w hat the relation
ship betw een quantity dem anded and price w ould be if per capita dis
posable incom e is $13,000, if the average price of softw are is $400, and if
advertising expenditure is $50 m illion. Since 1 = 13,000, S = 400, and
A = 50,000,000, equation (3.2) becom es

Price of
computer
(dollars)

3,000

2,500

Q = - 7 0 0 P + 200(13,000) - 500(400)
+ .01(50,000,000),

(3 3 )

Q = 2,900,000 - 700P.

(3.4)

or

2,000

Solving this equation for P, w e obtain

P = 4,143 - .001429Q,
w hich is graphed in Figure 3.1. This is the dem and curve for personal com
puters, given that I, S, and A are held constant at the stipulated levels.
G iven the m arket dem and function, m anagers and analysts can readily
quantify the shifts in the dem and curve that w ill result from changes in the
variables oth er than the product's price. For exam ple, how m uch of a shift
w ill occur in the dem and curve if the price of softw are falls from $400 to
$200? Inserting 200 (rather than 400) for S in equation (3.3), w e find that
Q = 3,000,000 - 700P.

800

1,200

1,600
Quantity demanded
(thousands of units)

for Personal Computers If the price of software

5400 to $200' the demand curve shifts to the right by 100,000 units.

(3.5)

Solving this equation for P, w e obtain

P = 4,286 -.0 0 1 4 2 9 Q .

The Price Elasticity o f Demand

(3.6)

w hich is graphed (together with the dem and curve based on S = 400) in
Figure 3.4. Clearly, the dem and curve has shifted to the right, the quantity
dem anded bein g 100,000 m ore than w hen S = 400 (if P is held constant).
M arket dem and functions can be form ulated for individual firm s as well
as for entire industries. That is, one can form ulate an equation like equation
(3.2) to predict the sales of an individual producer of personal com puters.
In such an equation, the quantity dem anded of the firm 's good w ould be
inversely related to its price bu t directly related to the prices charged b y its
com petitors; and it w ould be directly related to its advertising expenditures
but inversely related to the advertising expenditures of its com petitors. It is
im portant to distinguish betw een industry and firm dem and functions,
since they are quite different. Both are im portant to m anagers, because
firm s often are interested in the effects of variables like disposable incom e
and advertising on industry sales, as well as on the sales of their own
firm w hich obviously is of prim ary significance.

maandeddtomnarnd T
es vmy with regard * the sensitivity of quan y ded ^ e f a T l f SOm! ?dS' a Sma11 chanSe in P * e results in a big
,n 8 n V
^ demanded' for oth goods, a big change in price results
demandae d t atnnSehm
dem anded' To
how sensitive quantity
i
f
i J
g6S m p n ce ' econm ists use a m easure called the price

n i l

mand- The P 6 elaSticity of demand * detoed to be the verdenWnded

dQ

P_

dP ' Q
i T ^ e n t fa c r e a s e fa t
L
the P t o ela S
Of H
t h a t L give m e d a s l l r a 3

2 ^ c e n t change in price.

(3-7)

^
PdCe f C tton shirts
* a
dem anded
* e U nited States. If so,
^ COtt n ?hirts is
C onvention dictates

price is negative and the h

^
that *h e ChanS e
g Ve and the chan8 e m quantity dem anded is positive The

Point and A rc Elasticities

Ch. 3 / Dem and Theory

( c o n c e p ts
Price
(dollars)

Demand curve,
price elasticity = 0

in

c o n t e x t

Tennis Anyone?

Demand curve,
price elasticity = co

Quantity

FIGURE 3.5 Demand Curves with Zero and Infin ite Price Elasticities of
Demand The demand curve is a vertical line if the price elasticity is zero and a
horizontal line if it is infinite.

price elasticity of dem and generally w ill vary from one point to another on
a dem and curve. For instance, the price elasticity of dem and m ay be higher
w hen the price of cotton shirts is high than w hen it is low. Similarly, the
price elasticity of dem and w ill vary from m arket to m arket. For exam ple,
India m ay have a different price elasticity of dem and for cotton shirts from
that of the U nited States.
T he price elasticity of dem and for a product m ust lie betw een zero and
infinity. If the price elasticity is zero, the dem and curve is a vertical line;
that is, the quantity dem anded is unaffected by price. If the price elasticity
is infinite, the dem and curve is a horizontal line; that is, an unlim ited
am ount can be sold at a particular price ($15 in Figure 3.5), bu t nothing can
be sold if the price is raised even slightly. Figure 3.5 show s these tw o limiting cases.

Point and Arc Elasticities

If w e have a m arket dem and schedule show ing the quantity of a com m od
ity dem anded in the m arket at various prices, how can we estim ate the
price elasticity of m arket dem and? L et AP be a change in the price of the

In 1994, the producers and sellers of

tennis racquets w ere com plaining bit
terly. W eve been in a free fall for the
past 18 to 24 m onths, said Jerry
M atthews of H erm ans W orld of
Sporting Goods, a New Je rse y-b a se d
chain of 39 stores. The Tennis In
dustry Association reported that U.S.
racquet sales fell from $158 m illion in
1992 to $123 m illion in 1993. Prince
Sports Group, th e second largest rac
quet producer, laid off em ployees and
cut its num ber of racquet models.
According to C harles Pfeiffer, P rinces
president, W eve resized . . . to m eet
the realities of the m arketplace.
According to close observers, the
basic problem w as th a t the dem and
curve fo r tennis racquets had shifted
to the le ft and this w as not a new
developm ent. Industry figures indicate
that w hereas abou t 35 m illion people
played tennis in 1978, only about 22.5
million did so in 1994. According to
Jim Baugh, vice president at W ilson
Sporting G oods Com pany, the biggest
racquet producer, The sport isnt m ar
keted properly. W hen you th ink of ac
tivities you can do fo r exercise, you
cant pick one better than tennis. But
no one is telling the story. It com es
down to leadership and not being in
touch with consum ers.
Bob Carr, publisher of an industry
newsletter, goes further. T he sport
has no pizazz. Its so dam ned elitist.
The business peaked in the 1970s
and died. Then m oney didnt go into
building courts. Its a sport that re
quires facilities and som eone near
your skill level to play w ith. Also,

P ete S am pras

m odern m etal racquets often do not

have to be replaced as frequently as
older w ooden m odels, and, according
to experts, there has not been any
m ajor im provem ent in racquet design
that w ould prom pt players to purchase
new models.
To reverse the leftward shift of the
dem and curve, tennis equipm ent m ak
ers have begun to devote m ore atten
tion to prom otion and advertising.
Prince signed Jim m y C onnors to test
and endorse a new design being d e
veloped. W ilson has Steffi Graf, Jim
Courier, Pete S am pras, and Todd
M artin under contract. The future fi
nancial health of these com panies d e
pends on how skillful they are in
influencing the position of the dem and
curve.*

For further discussion, see New York Times, May 30, 1994.

Using the Demand Function to Calculate the Price Elasticity o f Demand

Ch. 3 / Dem and Theory

is used, the answ er w ill be

TABLE 3.2

Quantity Demanded at Various Prices (Small Increm ents in Price)

Price
(cents p e r unit of commodity)

Quantity demanded per unit o f time

(units o f commodity)

99.95

20,002

100.00

20,000

100.05

19,998

= -

-AP
jr.

4 -5
=

3 - 40
V=

61.67

5 -4

40~ *

The difference betw een these two results is very large. To avoid this diffi
culty, it is advisable to com pute the arc ela sticity o f dem and, w hich uses
the average value of P and Q:

good and AQ be the resulting change in its quantity dem anded. If AP is

very sm all, w e can com pute the p o in t elasticity o f dem and:
V -

40 - 3
_
,

V=

AQ

AP

(Qi + Q2)/2

(P1 + P2) / 2

AP(Q! + Q2Y

n
(3m
.8 )

where P1 and Q 1 are the first values of price and quantity dem anded, and P,
and Q 2 are the second set. Thus, in Table 3.3,
For instance, consider Table 3.2, w here data are given for very sm all incre
m ents in the price of a commodity. If w e w ant to estim ate the price elastic
ity of dem and w hen the price is betw een 99.95 cents and $1, w e obtain the
follow ing result:
_ 20,002 - 20,000 ^ 99.95 - 100 = 2
V

20,000

'

Quantity Demanded at Various Prices (Large Increm ents in Price)

Price
(dollars p e r unit o f commodity)

Quantity dem anded p e r unit o f time

(units o f commodity)______

3
4

50
40

40 - 3

4 -5

(40 + 3)/2

(4 + 5)/2

------------------------------------------------- = 7 .7 4

Using the Demand Function to Calculate the

Price Elasticity of Demand

100

N ote that w e used $1 as P and 20,000 as Q. We could have used 99.95 cents
as P and 20,002 as Q, but it w ould h ave m ade no real difference to the answer.
But if w e have data concerning only large changes in price (that is, if AP
and AQ are large), the answ er m ay vary considerably depending on w hich
value of P and Q is used in equation (3.8). Consider the exam ple in Table
3.3. Suppose that w e w ant to estim ate the price elasticity of dem and in the
price range betw een $4 and $5. T hen , depending on w hich value of P and Q

TABLE 3.3

v .

As we saw in a previous section, estim ates frequently are m ade of the de

mand function for particular products. In equation (3.2), we provided the
following hypothetical dem and function for personal com puters:
Q = 7OOP + 2007 - 500S + 0.01 A
Given such a dem and function, how can you calculate the price elasticity of
demand?
The first step is to specify the point on the dem and curve at w hich this
price elasticity is to be m easured. A ssum ing that per capita disposable in
come (I) is $13,000, the average price of softw are (S) is $400, and advertislng expenditure (>4) is $50 m illion, w e know from equation (3.4) that the
relationship betw een quantity dem anded and price is
Q = 2,900,000 - 700P.

(3.10)

Suppose that w e w ant to m easure the price elasticity of dem and w hen price
equals $3,000. At this point on the dem and curve (point A in Figure 3.1),
Q = 2,900,000 - 700(3,000)
= 800,000.

Price Elasticity and Total M oney Expenditure

Ch. 3 / Demand Theory

N ext, w e m ust evaluate the partial derivative of Q w ith respect to P.

A pplying C hapter 2 's rules for finding a derivative to equation (3.10), we
find that the desired derivative equals
dQ
#
= -*
A ccording to equation (3.7), to obtain the price elasticity of dem and, we
m ust m ultiply d Q / d P b y - P / Q . Perform ing this m ultiplication, w e get
/ - 3 ,0 0 0 \

M w m = 2 -6 2 '
w hich m eans that the price elasticity of dem and equals 2.62.
As a further illustration, let's calculate the price elasticity of demand
w hen price equals $2,000 rather than $3,000. A t this point on the demand
curve (point B in Figure 3.1),
Q = 2,900,000 - 700(2,000)
Quantity
demanded (Q )

= 1,500,000.
Since d Q / d P = - 7 0 0 ,

FIGURE 3.6 Values of the Price Elasticity of Demand at Various Points along
a Linear Demand Curve The price elasticity increases as price rises, approach
ing infinity as quantity approaches zero.

g
. = 700) ( 2' - I = 0.93.
/
BP
Q
K
\1,500,000
Thus, the price elasticity of dem and equals 0.93.
A n im portant thing to note is that the price elasticity of dem and can vary
greatly from point to point on a particular dem and curve. A s w e have just
seen, on the dem and curve in Figure 3.1, the price elasticity of dem and is
2.62 at point A, bu t only 0.93 at point B. For any linear dem and curve, the
price elasticity of dem and w ill vary from zero to infinity, as show n in Figure
3.6. If
P = a-bQ ,
w here a is the intercept of the dem and curve on the price axis, and b is the
slope (in absolute term s) of the dem and curve, it follow s that

e - il*

Thus, the price elasticity of dem and is

8Q

M anagers are interested in questions like: W ill an increase in price result in

an increase in the total am ount spent b y consum ers on their product? Or
wi an m crease in price result in a decrease in the total am ount spent by
consum ers on their product? T he answ ers depend on the price elasticity of
em and, as w e show in this section.
Suppose that the dem and for the product is price ela stic, that is, the
P ice elasticity of dem and exceeds 1. T he total am ount of m oney spent by
D

P _ _ 1_ a ~ bQ

dP ' Q ~

Price Elasticity and Total Money

Expenditure

b'

Clearly, if the dem and curve is linear, the price elasticity approaches zero as
P ( = a - bQ) gets very sm all, and approaches infinity as Q gets very small.

SUmers [ L. the P roduct equals the quantity dem anded tim es the price
7*
s situation/if the price is reduced, the percentage increase in
hi f u dem anded is greater than the percentage reduction in price (since

folln
T S fr m the definition of the P rice elasticity of dem and). It then
s
ws that a price reduction m ust lead to an increase in the total am ount
pent by consum ers on the com m odity. Sim ilarly, if the dem and is price

Price Elasticity and Total M oney Expenditure

Ch. 3 / Demand Theory

elastic, a price increase leads to a reduction in the am ount of m oney spent

on the commodity.
if the dem and for the product is p ric e in e la s tic (w hich m eans that the
price elasticity of dem and is less than 1), a price decrease leads to a reduc
tion in the total am ount spent on the com m odity, and a price increase leads
to an increase in the am ount spent on the com m odity. If the dem and is of
u n itary elasticity (w hich m eans that the price elasticity of dem and equals
1), an increase or decrease in price has no effect on the am ount spent on the
commodity.
A s an illustration, consider the case show n m Figure 3.7. ih e demand
curve show n there is a rectangular hyperbola, w hich m eans that
Q = J ,

(3-lD

a n a ly z in g m a n a g e r ia l d e c is io n s

The Demand for Newsprint

In early 1995, there w as a sharp in
crease in the price of new sprint, the
paper used by new spapers. Since
newsprint is the second-largest ex
pense fo r Am erican new spapers (after
salaries), publishers w ere concerned
about the price hike. S uppose that the
dem and fo r new sprint can be repre
sented as follows:
Q> = 17.3 - .0 09 2 P + 0.0067/,

w here Q is the quantity dem anded of the good, P is its price, and m is some
constant. This kind of dem and curve is of unitary elasticity at all points.
Thus, changes in price have no effect on the total am ount spent on the
product. It is evident from equation (3.11) that, regardless of the price, the
total am ount spent on the product will be m ($10 m illion in Figure 3.7).

Price
(dollars)

where Q: equals the quantity de

manded (in kilogram s per capita), P is
the price of new sprint (in dollars per
metric ton), and I is incom e per capita
(in dollars).
(a) If there are 1 m illion people in
the market, and if per capita incom e
equals $ 10,000, w hat is the dem and
curve for new sprint? (b) U nder these
circum stances, w hat is the price elas
ticity of dem and if the price of new s
print equals $400 per m etric ton? (c)
According to a 1984 study,* the de
mand curve for new sprint in the north
eastern United States is
Q2 = 2672 - 0.51 P,
where Q2 is the num ber of m etric tons
of newsprint dem anded (in th o u
sands). W hat is the price elasticity of
demand for new sprint in the north
eastern United States if price equals
00 per m etric ton? (d) Based on this
study, will the 1995 price increase re
sult in an increase or decrease in the
am ount spent on new sprint in the
northeastern U nited States? W hy?

Demand
curve

10
Quantity (millions)

FIGURE 3.7 D e m a n d Curve with Unitary Elasticity at All Points The demand
curve is a rectangular hyperbola if the price elasticity of demand is always 1.

lion people in the m arket, and since

Q 1 equals p e r capita quantity de
m anded,
the
quantity
dem anded
equals 1 m illion tim es Q r Letting Qj
be the quantity dem anded (in m illions
of kilogram s),
Q; = 17.3 - .0092P
+ .0067(10,000)
= 84.3 - .0 0 9 2 P.
(b) Since d Q \l d P = -.0 0 9 2 , the price
elasticity of dem and equals .0092 P/Q'r
Because P = 400 and I = 10,000, O '
m ust equal 17.3 - .0092(400) +
.0067(10,000) = 80.62 m illion kilo
gram s. Thus, the price elasticity of d e
m and equals .0092(400/80.62) = .05.
(c) Since dQ2/d P = - 0 .5 1 , and since
P = 500, the price elasticity of de
mand equals 0.51(500) -f- [2,672 .51(500)] = .11. (d) It will result in an
increase in the am ount spent on
new sprint because the dem and for
new sprint is price inelastic.

S o lu tio n , (a) Since there are 1 milI n d u s t ^ / n t o l i B/uo0n9i0rn

Interregional Analysis of the North American Newsprint
Iry> Interfaces (Septem ber-O ctober 1984 ), pp. 8 5 - 9 5 .

Ch. 3 / Demand Theory

Tota! Revenue, Marginal Revenue, and Price Elasticity

Total Revenue, Marginal Revenue, and Price

Elasticity

Price
(dollars)

To its producers, the total am ount of m oney spent on a product equals their
total revenue. Thus, to the Ford M otor Com pany, the total am ount spent on
its cars (and oth er products) is its total revenue. Suppose that the demand
curve for a firm 's product is linear; that is,
P = a-bQ ,

Demand is
price elastic

(3.12)

w here a is the intercept on the price axis, and b is the slope (in absolute
term s), as show n in panel A of Figure 3.8. Thus, the firm 's total revenue
equals
Marginal
revenue
= a-2bQ

TR = P Q
= (a - bQ )Q
= a Q - bQ 2.

(3.13)

An im portant concept is m a r g in a l re v e n u e , w hich, as w e know fro m

C hapter 2, is defined as d T R /d Q . In subsequent chapters, w e w ill use this
concept repeatedly. In the present case,
,
m r

Demand is
price inelastic

a/ 2b

Quantity
demanded (Q)

Dollars

dTR
= ^

_ d(aQ - bQ 2)
dQ
= a - 2bQ ,

(3-14)
Total revenue
= aQ - b Q 2

w hich is also show n in panel A of Figure 3.8. C om paring the m arginal rev
enue curve w ith the dem and curve, w e see that both have the sam e inter
cept on the vertical axis (this intercept bein g a), but that the m arginal
revenue curve has a slope that (in absolute term s) is tw ice that of the de
m and curve.
A ccording to the definition in equation (3.7), the price elasticity of de
m and, rj, equals - ( d Q / d P ) (P / Q ). Thus, since d Q / d P = - 1 / b and P =
a - bQ, it follow s that in this case,

1
V

a-bQ
Q

(3.15)

Thus, w heth er t \ is greater than, equal to, or less than 1 depends on

w hether Q is less than, equal to, or greater than a / 2 b . As show n in Figure
3.8, dem and is price elastic if Q < a / 2 b ; it is of unitary elasticity if Q = a / 2 b ;
and it is price inelastic if Q > a / 2b.
Panel b in Figure 3.8 plots the firm 's total revenue against the quantity
dem anded of its product. A s w ould be expected, at quantities w here m a r-

0
B

Quantity
demanded (Q)

Tou V rpI ! ; ! Re>? onshif >***** Price Elasticity, M arginal Revenue, and
in

If demand is price elastic, marginal revenue is positive, and

mami m qUantlty result in
total revenue. If demand is price inelastic,
enu
revenue is negative, and increases in quantity result in lower total rev-

Determinants o f the Price Elasticity of Demand

Ch. 3 / Demand Theory

eirtal revenue is positive, increases in quantity result in higher total rev

enue- at quantities w here m arginal revenue is negative, increases m quantitv result in low er total revenue. W hy w ould this be expected. Because, as
pointed out above, m arginal revenue is the derivative of total revenue w ith
respect to quantity. Thus, if m arginal revenue is positive (negative), in
creases in quantity m ust increase (decrease) total revenue.
A nother thing to note about Figu re 3.8 is that at qu an tities w here d e
m and is p rice elastic, m arginal revenue is p o sitiv e; at qu an tities w h ere it
is of u n itary elasticity, m arginal revenue is zero; and at qu an tities w here
it is price in elastic, m arginal revenue is n egative. T his is no accident. In
gen eral, w h eth er or n o t the dem and cu rve is linear, this w ill be th e case.
To see why, recall that by definition,
dTR
m r

= Hq -

Since total revenue equals price tim es quantity, it follow s that

A/n?

d(P Q)

dQ

MR =

U sing the rule for differentiating a product (given in Chapter 2),

Determinants of the Price Elasticity of

Demand
Table 3.4 show s the price elasticity of dem and for selected products in the
United States. W hat determ ines w hether the dem and for a product is price
elastic or price inelastic? W hy does the price elasticity of dem and for restau
rant meals equal 1.63 and the price elasticity of dem and for gasoline and oil
equal 0.14?
1.
The price elasticity of dem and for a product depends heavily on the
num ber and closeness of the substitutes that are available. If a product has
lots of close substitutes, its dem and is likely to be price elastic. If the prod
uct's price is increased, a large proportion of its buyers will turn to the close
substitutes that are available; if its price is reduced, a great m any buyers of
substitutes w ill sw itch to this product. T he extent to w hich a product has
close substitutes depends on how narrow ly it is defined. A s the definition
of the product becom es narrow er and m ore specific, the product w ould be
expected to have m ore close substitutes, and its dem and w ould be expected
to becom e m ore price elastic. H ence, the dem and for a particular brand of
gasoline is likely to b e m ore price elastic than the overall dem and for gaso
line, and the dem and for gasoline is likely to be m ore price elastic than the
demand for all fuels taken as a whole.

dQ
dP
M R = P - % + Q - ttzdQ
dQ
Because d Q / d Q = 1,

TABLE 3.4

MR = P + Q

= P I +

dP

Commodity

dQ
Q
p

Price Elasticity of Demand, Selected Products, United States

dP
dQy

A nd since the definition of the price elasticity of dem and im plies that

Q / P d P / d Q = - l / v ,
MR = P |1

Equation (3.16) is a fam ous result, w hich show s that if r\

,
g
revenue m u st b e positive, if t| < 1, m arginal revenue m ust be
,
if = 1 m arginal revenue m ust be zero. (This is w hat w e set out to prove
In later chapters, w e w ill use equation (3.16) repeatedly. Y o u sh o u ld study i
carefully, and understand it. To illustrate its m eaning, w hat is the value ot
m arginal revenue if price is $10 and the price elasticity of dem and is 2 .
Based on equation (3.16), it equals 10(1 -

k)

*>

Tomatoes (fresh)
Restaurant meals
Glassware
Taxi service
Radios, TV service
Furniture
Housing
Alcohol
Movies
Air travel (foreign)
Shoes
Legal services
Auto repair
Medical insurance
Gasoline and oil

Price elasticity o f demand

4.60
1.63
1.34
1.24
1.19
1.01
1.00
0.92
0.87
0.77
0.70
0.61
0.36
0.31
0.14

s urce. H. Houthakker and L. Taylor, Consumer Demand in the United States, 2d ed.

Ch. 3

Uses of the Price Elasticity o f Demand

/Demand Theory

2 T he price elasticity of dem and fo r a p rod u ct m ay depend on the

im portance of the product in consum ers' budgets. It is som etim es claim ed
th it the dem and for products like thim bles, rubber bands, and salt m ay be
nuite inelastic, since the typical consum er spends only a very sm all traction
of his or her incom e on such goods. In contrast, for products that bulk
larger in the typical co n su m er's budget, like m ajor appliances, the elasticity
of dem and m ay tend to be higher, since consum ers m ay be more conscious
of and influenced by, price changes in the case of goods that require larger
outlays. However, although a tendency of this sort is som etim es hypothe
sized there is no guarantee that you can count on its being true.
3 The price elasticity of dem and for a product is likely to depend on the
length of the period to w hich the dem and curve pertains. (As pointed out
above, every m arket dem and curve pertains to a certain time interval.)
Dem and is likely to be m ore elastic, or less inelastic, over a long period of
tim e than over a short period of tim e because the longer the period of tim e,
the easier it is for consum ers and firm s to substitute one good for another.
If for instance, the price of oil should decline relative to other fuels, the
consum ption of oil in the day after the price decline w ould probably in
crease very little. But over a period of several years, people w ould have an
opportunity to take account of the price decline in choosing the type of fuel
to be used in new houses and renovated old houses. In the longer period of
several years, the price decline w ould have a greater effect on the consum p
tion of oil than in the shorter period of one day.2

Uses of the Price Elasticity of Demand

M anagers display an avid interest, and for good reason, in the p r i c e elastic
ity of dem and for their products. C onsider Table 3.5, w hich provides esti
m ates of the price elasticity of dem and for first-class, regular economy, and
excursion air tickets betw een the U nited States and Europe. T he price elas
ticity of dem and for first-class air tickets is m uch low er than for regul
econom y or excursion tickets, ow ing in part to the fact that t e peop e v
go first class often business travelers and relatively w ealthy people
unlikely to change their travel plans if m oderate increases or d e c e a s e s
occur in the price of an air ticket. A irline executives have studied th * s
carefully, w ith an eye tow ard the pricing of various kinds of tickets.

TABLE 3.5
Europe

E la s tic itie s o f D e m a n d fo r A ir T icke ts b e tw e e n U n ite d States and

Price
elasticity

Income
elasticity

First class
Regular economy

0.45
1.30

Excursion

1.83

1.50
1.38
2.37

Type o f ticket

Source: J. Cigliano, Price and Income Elasticities for Airline Travel: The North Atlantic
Market, Business Economics (September 1980).

the price elasticity of dem and for first-class air tickets is relatively low, they
have nudged up the prices for such tickets.
It is im portant to recognize that no m anager interested in m axim izing
profit will set price at a point w here the dem and for his or h er product is
price inelastic. To see w hy this is a m istake, recall from equation (3.16) that
marginal revenue m ust be negative if dem and is price inelastic (that is, if
r| < 1). If m arginal revenue is negative, a firm can increase its profit by rais
ing its price and low ering its output. W hy? Because its total revenue w ill in
crease if it sells less. (This, after all, is w hat it m eans to say that m arginal
revenue is negative.) Since the firm 's total cost will not rise if less is sold, its
profits will go up if it sells less.
M arket researchers are continually engaged in studies to estim ate the
price elasticity of dem and for particular products. T he results enable firm s
to answer questions like: H ow m uch of an increase in sales can w e expect if
we reduce our price by 5 percent? To increase the am ount we sell by 10 per
cent, how m uch m ust w e reduce price? These are fundam ental questions of
the sort that firm s confront repeatedly.
For exam ple, take the soft drink industry. T he price elasticity of dem and
or Koyal Crow n Cola has been estim ated to be about 2.4, w hich m eans that
e am ount sold is very sensitive to price. A 1 percent reduction in the price
in a
Wn C ola (holding * e prices of its com petitors constant) results
a 2.4 percent increase in the quantity sold. C oke is even m ore price elasPricpZ Pr v f u f f 7 b d n g ab Ut 5 -5 Thus' a 1 Percent reduction in the
Perronf 6 ^
the Pn ces of its com petitors constant) results in a 5.5
Crown
^ ^
^uantity sold -3 Clearly, the m anagers of Royal
and

n
inform ation to function effectively and they
^ 'n such f o r m a t i o n mberS ^

m anded will tend to increase.

aCr SS ^

for Es

COUntry sPend Plenty to ob~

s Consumer Demand- " ,m 1 f

Ch. 3 / Demand Theory

The Income Elasticity o f Demand

Price Elasticity and Pricing Policy

The Income Elasticity o f Demand

To see m ore specifically how m anagers use inform ation concerning the
price elasticity of dem and for their products, let's consider in m ore detail
the im portant topic of pricing. A ccording to equation (3.16),
MR = P (l - i j .
From C hapter 2, w e know that m arginal revenue equals m arginal cost if a
firm is m axim izing profit, w hich m eans that
MC = p ( l -

(3.17)

w here M C equals m arginal cost. [To obtain equation (3.17), w e substitute

M C for M R on the left-hand side of equation (3.16).] Solving equation (3.17)
for P, w e obtain

m c (

(3 i8 )

W hile equation (3.18) looks rather innocuous, it is in fact a very powerful

and useful result. W hat it says is that the optim al price of a product de
pends on its m arginal cost and its price elasticity of dem and. Suppose that
the m arginal cost of a particular type of shirt is $10 and that its price elastic
ity of dem and equals 2. A ccording to equation (3.18), its optim al price is
P = io /

1/2

20 dollars.
For present purposes, the central point to note is that the optim al price
depends heavily on the price elasticity of dem and. H olding constant the
value of m arginal cost, a product's optim al price is inversely related to its
price elasticity of dem and. Thus, if the sh irt's price elasticity of demand
w ere 5 rather than 2, its optim al price w ould be
P = 10

As was stressed in previous sections, price is not the only factor that influ
ences the quantity dem anded of a product. A nother im portant factor is the
level of m oney incom e am ong the consum ers in the m arket If shoppers
have plenty of m oney to spend, the quantity dem anded of m en 's suits is
likely to be greater than it w ould b e if they w ere poverty-stricken Or if in
comes in a particular city are high, the quantity dem anded of cognac is
likely to be greater than it w ould be if incom es w ere low.
The in c o m e e la s tic ity o f d e m a n d for a particular good is defined to be
the percentage change in quantity dem anded resulting fro m a 1 percent change in
consumers' income. M ore precisely, it equals
_ dQ
I
SI " q

where Q is quantity dem anded, and I is consum ers' incom e. F o r som e prod
ucts, the incom e elasticity o f dem and is positive, indicating that increases in
consum ers m oney incom e result in increases in the am ount of the good
consumed. For exam ple, one w ould generally expect luxury item s like
gourm et foods to have positive incom e elasticities. O ther goods have nega
tive incom e elasticities, indicating that increases in m oney incom e result in
ira d e s T f m

g d consum ed- For exam ple, inferior

l i c l l c u l w th
'
g ght h aW neS ative incom e elasticities.
corf an
all ccom
o r nmeodities
d V 6 mCT
^ constant.
tlCity f d6m and' * is assum ed that the P ^ e s
are held

lo w f h L t

eeIaStidty f d6mand for a firm's Product is Wgh or

Firms m aking n

u the flrm S P P ortunities and problem s.

tiv d y Z i d i r r
gh inC m e elaStidtieS are likeIy to grow relam lfn
P
m6S nSe m an expanding economy, w hereas firm s
m aking products w ith low incom e elasticities are likely to experience m Z
m odest expansion. O n the other hand, if the econom y i s j o lte d b y a s e Z

c o ~ t i c m t r T r / i 1sharpiy-firms mak- g ^
those m aking products

e S t S i^

m ajor pro'ducte
1 - 1/5

According to stu d ies b v P

Daniel Suits am on e r t L T

f
T ^ r
S

^
*

qUantity l a n d e d for m any

f d"
iS f ^
to p
7
g ry C h W and M ichigan State's

ss

= 12l/i dollars
G iven the im portance of the price elasticity of dem and in determ ining the
optim al price of a product, it is not hard to see w hy m anagers are so intent
on obtaining at least rough estim ates of its value. (In Chapters 11 to 13, we
will say m uch m ore about optim al pricing policies.)

(3-19)

m a n d f e lir s ^
a 1.50 percent increase m the quantity dem anded of such tickets.

Ch. 3

Using the Demand Function to Calculate the Income Elasticity o f Demand

/Demand Theory

CONSULTANTS CORNER

TABLE 3.6

Income Elasticity of Demand, Selected Commodities, United

States

___________ _
In c o m e e la s tic ity o f d e m a n d

C o m m o d ity

1.54
1.49
1.48
1.42
1.40

Alcohol
Housing, owner-occupied
Furniture
Dental services
Restaurant meals
Shoes
Medical insurance
Gasoline and oil
Butter
Coffee
Margarine
Flour

1.10

0.92
0.48
0.42

0
0.20
-0 .3 6

Source: H. Houthakker and L. Taylor, Consumer Dem and in the United States.

Table 3 6 show s the incom e elasticity of dem and for other com m odities. In
m e a s u r i n g incom e elasticities, incom e can b e defined as the aggregate mcom e of consum ers (as in Table 3.6) or as p er capita m com e (as m the nex
section), depending on the circum stances.

Using the Demand Function to Calculate the

Income Elasticity of Demand
In a previous section, w e learned how to calculate the
m and, based on a product's dem and function. H ere v.
function
elasticity of dem and can be calculated. Suppose that the dem and tun
for good X is
q

Estimating the Quantity Demanded of Fresh

Premium Salmon"

= 1,000 - 0 .2 Px + 0 .5Py + -04i,

w here Q is the quantity dem anded of

th e price of good Y, and 1 is per capita disposable m com e.
ticity of dem and is
dQ

$ $

A leading producer of consum er

goods, interested in entering the busi
ness of supplying salm on, carried out
a study to estim ate the quantity that
would be dem anded of fresh prem ium

salm on (A tlantic and Pacific) four

years hence. The consum ption of
fresh prem ium salm on at the tim e
of the study w as estim ated to be as
follows:

Country

Thousands o f tons
consum ed p e r ye a r

United States
Canada
Japan
France
United Kingdom
Germany
Other European countries
Total

90
14
110
35
16
8
22
295

Using a statistical analysis, the

firm s analysts and m anagers esti
mated the incom e elasticity of d e
mand for salm on to be about 4
(except in Japan, w here it w as esti
mated to be about 2). During the next
tour years, incom e w as expected to
r'se by about 10 percent in all c o u n
tie s . The firm s m anagers w anted to

estim ate the total consum p tion of

fresh prem ium salm on in these co u n
tries fo u r years hence, assum ing that
price and other nonincom e variables
rem ained the sam e as at the tim e of
the study.
How w ould you m ake such an esti
mate?

nhfh' t Section is based on an actual case, alth

p"fied somewhat.

gh the numbers and situation have been sim-

Ch. 3 / Demand Theory

The Advertising Elasticity o f Demand

If I = 10,000 and Q = 1,700,

=

711

10/000
I 1,700

m i

TABLE 3.7 Cross E la s tic ity o f D e m a n d , Selected Pairs o f C o m m o d itie s ,

U n ite d States

= .24.

Thus, the incom e elasticity of dem and equals .24, w hich m eans that a 1 per
cent increase in per capita disposable incom e is associated w ith a .24 per
cent increase in the quantity dem anded of good X.

G oodX
E le ctricity
C a lifo rn ia o ra n g e s
B utter
Pork

Besides price and incom e, still another factor influencing the quantity de
m anded of a product is the price of other com m odities. H olding constant
the product's ow n price (as w ell as the level of m oney incom es) and allow
ing the price of another product to vary m ay result in im portant effects on
the quantity dem anded of the product in question. By observing these ef
fects, w e can classify pairs of com m odities as s u b s titu te s or c o m p le m e n ts ,
and w e can m easure how close the relationship (either substitute or com
plem entary) is. C onsider two com m odities, good X and good Y. If good Y's
price goes up, w hat is the effect on Qx, the quantity of good X that is de
m anded? T h e cross e la s tic ity o f d e m a n d is defined as the percentage change
in the quantity dem anded o f good X resulting fro m a 1 percent change in the price
o f good Y. Expressed in term s of derivatives,

/ v i/

. Jx _
Q

(3.20)

G oods X and Y are classified as substitutes if the cross elasticity of de

m and is positive. For instance, an increase in the price of w heat, w hen the
price of corn rem ains constant, w ill tend to increase the quantity of corn de
m anded; thus, T|ri; is positive, and w h eat and corn are classified as substi
tutes. O n the other hand, if the cross elasticity of dem and is negative, goods
X and Y are classified as com plem ents. Thus, an increase in the price of soft
ware m ay tend to decrease the purchase of personal com puters, w hen the
price of personal com puters rem ains constant; thus, rixy is negative, and
softw are and personal com puters are classified as com plem ents.
^
To illustrate the calculation of cross elasticities, suppose once again tha
the dem and function for good X is
Q v = 1,000 - 0.2 Px + 0.5PV + .04/,
w here Q . is the quantity dem anded of good X , Px is the price of good X , Pyis
the price of good Y, and I is per capita disposable incom e. T he cross elastic
ity of dem and betw een goods X and Y is
BQr

py

Cross elasticity o f demand

Natural gas
Florida interior oranges
Margarine
Beef

+ 0.20
+0.14
+0.67
+0.14

Source: R. Halvorsen, Energy Substitution in U.S. Manufacturing," Review o f Economics and

Statistics (November 1977); and others.

Cross Elasticities of Demand

=
'xa
dp

G ood Y

= 0.5 Py
Q
Although the value of the cross elasticity w ill depend on the values of P
and Qx, the goods w ill alw ays be substitutes, since T} m ust be positive, re
gardless o f the values of Py and Qx. If Py = 500 and Q x = 1,500,
/ 500 ,

^ = a5( W = -1 7 The cross elasticity of dem and is of fundam ental im portance to firm s be
cause they continually m ust do their best to anticipate w hat w ill happen to
their ow n sales if their rivals change their prices. To do so, they need infor
mation concerning the cross elasticities of dem and. Table 3.7 show s the
cross elasticities of dem and for selected pairs of com m odities. In C hapter 5,
we will take up som e of the statistical techniques used to estim ate them.

The Advertising Elasticity o f Demand

Although the price elasticity, incom e elasticity, and cross elasticities of de
mand are the m ost frequently used elasticity m easures, they are not the
on y ones. For exam ple, firm s som etim es find it useful to calculate the ade r tis in g e la s tic ity o f d e m a n d . Suppose that the dem and function for a
Particular firm 's product is
Q = 500 - 0.5P + 0.01/ + .82A ,
^ h ere Q is the quantity dem anded of the product, P is its price, I is per
capita disposable incom e, and A is the firm 's advertising expenditure. The
a vertising elasticity is defined as the percentage change in the quantity de-

The Constant-Elasticity o f Demand

Ch. 3 / Demand Theory

m anded o f the product resulting from a 1 percent change in advertising expendi

ture. M ore precisely, it equals
= iQ . . A
VA
dA Q '

(3.21)

VA = -8 2 q a /Q

a n a ly z in g m a n a g e r ia l d e c is io n s

Price Cutting at the London Times

The London Times, ow ned by Rupert
Murdoch, is one of the leading new s
papers in the w orld. In S eptem ber
1993, the London Tim es low ered its
price from 45 pence to 30 pence,

Thus, in this case, since d Q / d A = .82,

If

103

w hile the prices o f its rivals rem ained

unchanged. The num bers of new spa
pers sold by the London Tim es and its
rivals in A u g u st 1993 and M ay 1994
were as follow s:

the am ount of advertising per unit of the product dem anded is

$2,
nA = .82 (2) = 1.64.
This elasticity is useful because it tells the firm 's m anagers that a 1 percent
increase in advertising expenditure results in a 1.64 percent increase in the
quantity dem anded. In later chapters, w e shall see how inform ation of this
sort can be used to help guide m ajor m anagerial decisions.

The Constant-Elasticity Demand Function

In previous sections of this chapter, w e generally have assum ed that the de
m and function is linear. T hat is, the quantity dem anded of a product has
been assum ed to be a linear function of its price, the prices of other goods
consum er incom e, and other variables. A nother m athem atical form that is
frequently used is the co n stan t-elasticity dem and fu n ction . If the quant y
dem anded (Q) depends only on the p rod u ct's price (P) and consum er in

M ay 1994

355.000
1.024.000
325.000
392.000

518.000
993.000
277.000
402.000

London Times
Daily Telegraph
Independent
Guardian
(a) Based on these figures, what
was the price elasticity of dem and for
the London Tim es? (b) W as the cross
electricity of dem and betw een the
D a ily Telegraph and the London
Tim es positive o r negative? W ould
you expect it to be positive or nega
tive? W hy? (c) Did this price reduction
increase o r decrease the London
Tim ess total revenue from new spaper
sales? (d) Based on new spaper sales
=

alone, w as this price reduction prof

itable? (e) Peter S tothard, editor of the
London Times, pointed out that the
increase in circulation . . . m ade the
p ape r a m ore attractive vehicle for ad
vertisers. * If so, could this price re
duction be profitable?
S o lu tio n , (a) Based on these figures,
the arc elasticity was

518,000 - 355,000
~~355,000 + 5 1 8 ,0 0 0 \

com e (I), this m athem atical form is

q = aP~blI b2-

August 1993

(3 22)

Thus, if a 200, b 1 = .3, and b2 = 2,

Q = 200P~3I 2.
A n im portant property of this dem and function is th a tth e price elasticity
of dem and equals bv regardless of the value of P or I. (Thisaccoun
<Jif_
being called the constant-elasticity dem and function.) To see t h i ,
ferentiate Q w ith respect to price, the result being

P to B lten. lb s B a n s te y
la b ile
nos
N e w Y orkpf vi/W iB . p is

vvav***tofTwo
in :ha i w e vailoy
T o ca y'3 tofcert. p a g i 3 a

30 - 45
: 45 + 30 = .93.

Summary
Ch. 3 / Demand Theory
T his assum es th a t the dem and curve
did not shift betw een A ugust 1993 and
M ay 1994. (b) Positive, since a cut in
the price of the London Tim es re
duced the quantity sold of the D aily
Telegraph. It w ould be expected to be
positive since the London Tim es and
the D aily Telegraph are substitutes, (c)
Total revenue from new spaper sales
fell from 355,000 X 45 pence =
15,975,000 pence to 518,000 X 30

pence = 15,540,000 pence, (d) No.

Since total revenue fell and total cost
did not fall (because the output of pa
pers increased), profits w ent down, (e)
If the increase in advertising revenue
due to the new spa pers higher circula
tion w ere large enough, it could offset
the decline in profit from new spaper
sales. O nly tim e w ill tell w hether this
occurs.1

aUantity depends on the level of price. T he m ultiplicative relationship in

equation (3 .22) is often m ore realistic than the additive relationship in equa
tion (3-1)- Second, like the linear dem and function, the constant-elasticity
demand function is relatively easy to estim ate. If w e take logarithm s4 of
both sides of equation (3.22),
log Q = log a - bx log P + b2 log I.

(3.25)

Since this equation is linear in the logarithm s, the param eters a, bv and
j __Can readily be estim ated by regression analysis. In C hapter 5, w e will
learn how such estim ates can b e made.

*New York Times, June 13, 1994, p. D7.

tpor further discussion, see ibid.

Summary

Thus,
- * B ..L =b
dP
Q
1

(3.23)

Since the left-hand side of equation (3.23) is defined to be the p r i c e elasticity

of dem and, it follow s that the price elasticity of dem and equals bv a con
stant w hose value does not depend on P or I.
Sim ilarly, the incom e elasticity of dem and equals bv regardless of the
value of P or I. To prove this, let's differentiate Q w ith respect to incom e, the
result being
dQ = b,aP ~ b'Ib2- l
dl
2
= ^ (aP~h I k )

= Q.
I w
Thus,
S Q .l = b
dl
Q
r

(3.24)

Since the left-hand side of equation (3.24) is defined to be the income^elas

ticity of dem and, it follow s that the incom e elasticity of dem and equ
2
another constant w hose value does not depend on P or L
d
T he constant-elasticity dem and function is often used b y m an g
m anagerial econom ists, for several reasons. First, in contrast to the lmear
dem and function, this m athem atical form r e c o d e s that the effect of price
on quantity depends on the level of incom e, and that the effect of incom e on

1. The m arket dem and curve for a product show s how m uch of the prod
uct will be dem anded at each price. T he m arket dem and curve shifts in
response to changes in tastes, incom es, the prices of oth er products, and
the size of the population.
2. The m arket dem and function for a product is an equation show ing how
the quantity dem anded depends on the product's price, the incom es of
consum ers, the prices of other products, advertising expenditure, and
additional factors. H olding all factors other than the prod u ct's price con
stant, one can derive the m arket dem and curve for the product from the
m arket dem and function. M arket dem and functions can b e form ulated
for individual firm s as w ell as for entire industries.
3. The price elasticity of dem and is the percentage change in quantity de
m anded resulting from a 1 percent change in price; m ore precisely, it
equals ( d Q/ d P) (P/Q). W hether a price increase (or decrease) results in
an increase in the total am ount spent by consum ers on a product de
pends on the price elasticity of demand.
4. M arginal revenue is the change in total revenue resulting from a 1-unit
increase in quantity; that is, it equals the derivative of total revenue w ith
respect to quantity. M arginal revenue equals P (1 1 /17), w here P is
price and 77 is the price elasticity of demand.
3- The price elasticity of dem and for a product tends to b e high if the prod
uct has a large num ber of close substitutes. A lso, it often tends to be
higher in the long run than in the short run. It is som etim es asserted that
the dem and for a product is relatively price inelastic if the product ac-

review of som e basic points regarding logarithm s m ay be of use. To begin w ith, X

9 Uia s
logarithm of Y (i.e., log Y ) if 10x = Y. Thus, the logarithm of the p rod u ct of
1 rv riables (say ^1 anc* Y2) equals the sum of the logarithm s of these variables; that is,
i ^ ) = log Y, + log Yr A lso, the logarithm of Y c equals C log Y.