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Managerial Economics

Part 3
Consumer Behavior and
Demand Analysis

Fall 2016

The Role of Demand Analysis

Demand analysis serves three major managerial
objectives.
1. It provides the insights necessary for marketing
teams to effectively manage demand.
2. It helps forecast unit sales to inform operations
decisions.
3. It projects the revenue portion of a firms cash
flow stream for financial planning.

Before makingdemand analysis, the theory of

consumer choice should be introduced.

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Outline
The Theory of Consumer Behavior

Demand Analysis: Elasticity and Demand

Elasticity in Economics: a numerical measure of the
responsiveness of QD to one of its determinants.
Price Elasticity of Demand
Income Elasticity of Demand
Cross-Price Elasticity of Demand

The Theory of Consumer Behavior

Recall one of the Seven Principles: People face tradeoffs.
Buying more of one good leaves less income to buy other
goods.
Working more hours means more income and more
consumption, but less leisure time.
Reducing saving allows more consumption today but reduces
future consumption.
This section explores how consumers make choices like
these.
What the Consumer Can Afford: The Budget Constraint
What the Consumer Wants: Preferences, Utilities and
Indifference Curves
What the Consumer Chooses: Utility Optimization

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The Budget Constraint:

What the Consumer Can Afford
Example:
Hurley divides his income between two goods:
fish and mangos.
A consumption bundle is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
Budget constraint: the limit on the consumption
bundles that a consumer can afford.

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Consumers Budget Line

Shows all possible commodity bundles that can be
purchased at given prices with a fixed money income.

M PX X PY Y
or
M PX
Y X
PY PY

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Exercise 1
The Budget Constraint
Hurleys income: $1200 per month
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can he
buy?
D. Plot each of the bundles from parts A C on a
graph that measures fish on the horizontal axis and
mangos on the vertical, connect the dots.
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The Slope of Budget Constraint

Quantity The slope of the
From C to D, of Mangos budget constraint
rise = equals the relative
200 mangos price of the good on
run = the X axis.
C
+50 fish
Slope = 4 D

Hurley must
give up
4 mangos
to get one fish.

Quantity
of Fish
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The Change of Budget Constraint

Show what happens to Hurleys budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

A fall in income shifts the budget constraint down.

An increase in the price of one good pivots the
budget constraint inward.

Preferences:
What the Consumer Wants
Utility
An abstract measure of the satisfaction or happiness that a
consumer receives from a bundle of goods.
Marginal Utility
The marginal utility of any good is the increase in utility
that the consumer gets from an additional unit of that good.
MU U X
Diminishing marginal utility: For most goods, the more
of the good the consumer already has, the lower the marginal
utility provided by an extra unit of that good.

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Preferences:
What the Consumer Wants
Indifference curve
Also called as equal-utility curve
It shows consumption bundles that give the
consumer the same level of satisfaction
Quantity
of Mangos

One of Hurleys
B indifference curves
A, B, and all other bundles
A on I1 make Hurley equally
happy: he is indifferent
I1
between them.

Quantity of Fish

Preferences: What the Consumer Wants

Properties of Consumer Preferences
Completeness
For every pair of consumption bundles, A and B, the
consumer can say one of the following:
A is preferred to B
B is preferred to A
The consumer is indifferent between A and B
Transitivity
If A is preferred to B, and B is preferred to C, then A must
be preferred to C
Nonsatiation
More of a good is always preferred to less

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Indifference Map
Higher indifference curves are preferred to lower ones.

Quantity of Y

IV

III

II

Quantity of X

Properties of Indifference Curves

1. Indifference curves are Quantity

of Mangos
downward-sloping.
- If the quantity of fish is reduced, A
the quantity of mangos must be increased
to keep Hurley equally happy. 6

1
B
2. Indifference curves are 2
bowed inward (convex). 1 I1

- Hurley is willing to give up more Quantity

mangos for a fish if he has few fish of Fish
(A) than if he has many (B).

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The Marginal Rate of Substitution

Marginal rate of substitution (MRS):
- the rate at which a consumer is willing to trade one good for
another while keeping utility constant.
- MRS falls as you move down along an indifference curve.

Quantity
MRS = Negative of of Mangos
the slope of A
indifference curve
MRS = 6

1
B
MRS = 2
1 I1
Quantity of Fish

MRS and Marginal Utility

MRS = Negative of the slope of indifference curve

From point A to point B:

Quantity U MU X X MUY Y0
of Mangos
A
Y MU X
MRS = 6 MRS
X MUY
1
B
MRS = 2
1 I1
Quantity of Fish

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Optimization:
What the Consumer Chooses
A is the optimum: The optimum
Quantity
the point on the budget of Mangos is the bundle Hurley
constraint that touches most prefers out of
the highest possible all the bundles he
1200
indifference curve. can afford.

- Hurley prefers B to A,
but he cannot afford B. B
600
A
- Hurley can afford C and D,
but A is on a higher C
indifference curve. D

150 300 Quantity

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. of Fish

Optimization:
What the Consumer Chooses
At the optimum, Consumer optimization is
slope of the indifference Quantity another example of
curve equals slope of the of Mangos thinking at the margin.
budget constraint: 1200

MRS = MUF/MUM = PF/PM

600 A
marginal
value of fish price of fish
(in terms of (in terms of
mangos) mangos)

150 300 Quantity

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
of Fish

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Optimization:
What the Consumer Chooses
At the optimum point A:
Quantity
of Y
MRS = MUX/MUY = PX/PY

MUX/PX = MUY/PY
A
At the optimum, the marginal
utility per dollar spent on good X
equals the marginal utility per dollar
spent on good Y
Quantity
of X

Exercise 2
Utility Maximization
A consumers budget constraint is $20 per day. The prices of
bread and Coke is $2.5 and $2 respectively. Given the
following utility table, What is the consumers best choice?
Number MU of bread MUB/PB MU of Coke MUC /PC
of goods
1 20 8 60 30
2 15 6 40 20
3 12.5 5 20 10
4 10 4 16 8
5 7.5 3 8 4
6 5 2 4 2
Answer: 4 breads, 5 Cokes

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Individual Consumer Demand

An individuals demand curve for a specific
commodity relates utility-maximizing
quantities purchased to market prices
Money income & prices held constant
Slope of demand curve illustrates law of
demandquantity demanded varies
inversely with price

Deriving Hurleys Demand Curve for Fish

A: When PF = $4, Hurley demands 150 fish.
B: When PF = $2, Hurley demands 350 fish.
Quantity Price of
of Mangos Fish

A
$4
A
B
B
$2
DFish

150 350 Quantity 150 350 Quantity

of Fish of Fish
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The Effects of a Price Change

Initially, Quantity
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2 new
optimum
budget constraint 600
rotates outward, 500
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Income and Substitution Effects

A fall in the price of fish has two effects on
Hurleys optimal consumption of both goods.
Substitution effect
A fall in PF makes mangos more expensive relative to fish,
causes Hurley to buy fewer mangos and more fish.
Income effect
A fall in PF boosts the purchasing power of Hurleys
income, allows him to buy more mangos and more fish.
Notice: The net effect on mangos is ambiguous.

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The Income and Substitution Effects

Initial Quantity In this example,
optimum at A. of Mangos
the net effect
PF falls. on mangos is
negative.
Substitution effect:
from A to B,
buy more fish and A
fewer mangos. C

Income effect: B
from B to C,
buy more of both
goods. Quantity
of Fish

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income Effects and Substitution Effects

A fall in the price of a good or service:
Income effect
The change in consumption that arises because a lower
price makes the consumer better off.
It is represented by a movement from a lower
indifference curve to a higher one.
Substitution effect
The change that arises because a price change encourages
greater consumption of the good that has become
relatively cheaper.
It is represented by a movement along an indifference
curve.

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Application: Wages and Labor Supply

Budget constraint
Shows a persons tradeoff between consumption and
leisure.
Depends on how much time she has to divide between
leisure and working.
The relative price of an hour of leisure is the amount of
consumption she could buy with an hours wages.

Indifference curve
Shows bundles of consumption and leisure
that give her the same level of satisfaction.

Application: Wages and Labor Supply

Carrie is awake for 100 hours per week and her wage per hour is $50. If
she works a normal 40-hour week, she enjoys 60 hours of leisure and
has weekly consumption of $2,000.
At the optimum,
the MRS between
leisure and consumption
equals the wage.

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Application: Wages and Labor Supply

An increase in the wage has two effects
on the optimal quantity of labor supplied.
Substitution effect (SE): A higher wage makes
leisure more expensive relative to consumption.
The person chooses less leisure,
i.e., increases quantity of labor supplied.
Income effect (IE): With a higher wage,
she can afford more of both goods.
She chooses more leisure,
i.e., reduces quantity of labor supplied.

Application: Wages and Labor Supply

For this person, So her labor supply
SE > IE increases with the wage

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Application: Wages and Labor Supply

For this person, So his labor supply falls
SE < IE when the wage rises

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Could This Happen in the Real World?

Cases where the income effect on labor supply is very strong:
Over last 100 years, technological progress has
increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
When a person wins the lottery or receives an
inheritance, his wage is unchangedhence no
substitution effect.
But such persons are more likely to work fewer hours,
indicating a strong income effect.

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3-2 Demand Analysis:

Elasticity and Demand
Elasticity in Economics
A numerical measure of the responsiveness of
QD to one of its determinants.
Different elasticities
Price Elasticity of Demand
Income Elasticity of Demand
Cross-Price Elasticity of Demand

Price Elasticity of Demand (ED)

Measures responsiveness or sensitivity of consumers
to changes in the price of a good

Slopes change with a

change in units of measure.

P & Q are inversely related by the law of demand

so ED is always negative.
The larger the absolute value of ED, the more
sensitive buyers are to a change in price.

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Calculating Percentage Changes

Problem: The standard method gives different
answers depending on where you start.

P From A to B,
P falls 60%, Q rises 300%,
A
$5 ED = 300/(-60) = - 5
B
$2 From B to A,
D P rises 150%, Q falls 75%,
Q ED = (-75)/150 = -0.5
5 20

Calculating Percentage Changes:

Arc Price Elasticity
So, we instead use the midpoint method to calculate ED
between two points: (Q1, P1) and (Q2, P2)
Arc price elasticity is a measure of the average elasticity over
a discrete demand range.

P
A
$5
B
$2
D In this example,
ED between point A and B = -1.4
Q
5 20

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Price Elasticity of Demand (ED)

Percentage change in quantity demanded can

be predicted for a given percentage change in
price as:
%QD = %P ED
Percentage change in price required for a given
change in quantity demanded can be predicted
as:
%P = %QD ED

Exercise 3
The price elasticity of demand for personal
computers is estimated to be 2.2. If the price of
personal computers declines by 20 percent, what
will be the expected percentage increase in the
quantity of computers sold?

= %Q/(20%) = 2.2

%Q = +44% in personal computers sold

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Calculating Percentage Changes:

Point Price Elasticity
The elasticity of demand at any price point:

P
A
$5
B In this example,
$2
ED at point A = - 5, ED at point B = - 0.5
D
The slope of a linear demand curve is
Q constant, but its elasticity is not.
5 20

- Demand curve is vertical

- Demand curve is horizontal

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Price Elasticity
(both point price and arc elasticity)
1. The slope of a linear demand
curve is constant, but its
elasticity is not.
2. Points with low price and
high quantity: Inelastic
demand
price
3. Points with high price and
elastic region low quantity: Elastic demand
unit elastic

inelastic region
quantity

Unit Elastic Demand

Nonlinear demand curve example: ED = 1
Price

Demand

$5
1. A 22% 4
increase
in price
2. leads to a 22%
decrease in quantity
demanded
0 80 100
Quantity

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Two Common Demand Curves

(Nonlinear demand curve example)
The flatter the demand curve, the greater the price elasticity of demand.

Elastic Demand: Inelastic Demand:

ED> 1 0 <ED< 1
Price Price
A 22%
1. A 22% 2. leads
increase
increase to an 11%
in price
in price decrease
in quantity
$5 demanded
$5
4 Demand
4

2. leads to a
67% decrease
Demand
in quantity
demanded

0 50 100 0 90 100
Quantity Quantity

What Determines Price Elasticity?

Compare two common goods in each example. Suppose the
prices of both goods rise by 20%. For which good does QD drop
the most? Why?
Breakfast Cereal vs. Sunscreen
More availability and the closeness of substitutes, more elastic.
Apartment housing vs. Childrens toys
Larger proportion of the budget, more elastic.
Insulin vs. Caribbean Cruises
Price elasticity is higher for luxuries (positioning as income
superior) than for necessities.

Gasoline in the Short Run vs. Gasoline in the Long Run

The longer the time period of adjustment, generally, more elastic.
*

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Empirical Price Elasticities

Apparel (whole market) -1.1 Furniture -3.04
Apparel (one firm) -4.1 Glassware & China -1.2
Beer -.84 Household appliances -.64
Wine -.55 Flights to Europe -1.25
Liquor -.50 Shoes -.73
Regular coffee -.16 Soybean meal -1.65
Instant coffee -.36 Telephones -.10
Adult visits to dentist Tires -.60
Men -.65 Tobacco products -.46
Women -.78 Tomatoes -2.22
Children -1.4 Wool -1.32

Price Elasticity of Demand & Revenue

Total revenue, TR
Amount paid by buyers and received by sellers
of a good
Price of the good times the quantity sold (PQ)
%TR = %P+ %Q

For a price increase

If demand is inelastic, TR increases
If demand is elastic, TR decreases

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How TR Changes When Price Increase

Inelastic demand: Elastic demand:

TR increases TR decreases
P P

Price $5 Price $5
Effect A Effect A
4 4 D
D
B
B Quantity
Quantity
Effect
Effect

0 90 100 Q 0 70 100 Q

Slide 47

Another Way
P Elastic
to Remember
Unit Elastic
Linear demand curve A
Inelastic
TR on other curve
Look at arrows to see B
Q
movement in TR
A. Increasing price in the
inelastic region raises
revenue TR

B. Increasing price in the

elastic region lowers
revenue Q

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Marginal Revenue

Marginal revenue (MR) is the change in

total revenue per unit change in output
Since MR measures the rate of change in
total revenue as quantity changes, MR is the
slope of the total revenue (TR) curve

TR
MR
Q

Demand & Marginal Revenue

Unit sales (Q) Price TR = P Q MR = TR/Q
0 $4.50 $ 0 --

1 4.00 $4.00 $4.00

2 3.50 $7.00 $3.00
3 3.10 $9.30 $2.30
4 2.80 $11.20 $1.90
5 2.40 $12.00 $0.80
6 2.00 $12.00 $0
7 1.50 $10.50 $-1.50

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Demand, MR, & TR

Panel A Panel B

Price Elasticity over

Demand Function

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MR, TR, & Price Elasticity

Marginal Price elasticity
Total revenue
revenue of demand
MR > 0 TR increases as
Elastic
Q increases
(ED> 1)
(P decreases)
MR = 0 TR is maximized Unit Elastic
(ED= 1)
MR < 0 TR decreases as Inelastic
Q increases (ED< 1)
(P decreases)

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Income Elasticity of Demand

Income elasticity of Percent change in QD
=
demand (Ey)
Percent change in income

Income elasticity of demand measures the response

of QD to a change in consumer income.
Point income elasticity vs. Arc income elasticity
Necessities: 0 < Ey <1
For normal goods, Ey > 0
Luxuries: Ey >1
For inferior goods, Ey < 0

Example: Point Income Elasticity Calculation

Suppose the demand function is:
Q = 10 - 2P + 3Y
find the income and price elasticities at a price of
P = 2, and income Y = 10
So: Q = 10 -2(2) + 3(10) = 36
EY = (Q/Y)( Y/Q) = 3( 10/ 36) = .833
ED = (Q/P)(P/Q) = -2(2/ 36) = -.111
Characterize this demand curve, which means
describe them using elasticity terms.

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Advertising Elasticity

EA = %Q/ %ADV = (Q/ADV)( ADV/Q)

If the Advertising elasticity is .60, then a 1%

increase in Advertising Expenditures increases
the quantity of goods sold by .60%.

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Cross Price Elasticities

Ecross = %QA / %PB = (QA/PB)(PB /QA)

Substitutes have positive cross price elasticities:

Pepsi and Coke
Complements have negative cross price elasticities:
gas cars and gas
When the cross price elasticity is zero or
insignificant, the products are not related

An Empirical Illustration of Price,

Income, and Cross Elasticities
A study by Chapman etc. examined the elasticity of energy use by
residential, commercial, and industrial users. They hypothesized that
the demand for electricity was determined by the price of electricity,
income levels, and the price of a substitute goodnatural gas.

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Price Elasticity of Supply

Price elasticity of Percent change in QS QS/QS QS P

= = =
supply (ES) Percent change in P P/P P QS

Price elasticity of supply measures how much QS

responds to a change in P.
Loosely speaking, it measures sellers price-sensitivity.
Arc price elasticity of supply vs. Point price elasticity
of supply

The Variety of Supply Curves

Inelastic Elastic
Supply Supply

Perfectly Unit Perfectly

Inelastic Supply elastic Elastic Supply
Supply

ES = 0 0 < ES < 1 ES = 1 ES > 1 ES =

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Determinant of Price Elasticity

of Supply
Time period of adjustment
Supply is more elastic in long run
The longer the time, the more easily sellers can
change the quantity they produce, the greater the
price elasticity of supply.

How the Price Elasticity of Supply

Can Vary
P
S Supply often becomes less elastic
as Q rises due to capacity limits.
$15 ES < 1 Points with low P and Q
Elastic supply
12 Capacity for production not
being used
Points with high P and Q
ES > 1 Inelastic supply
4

$3
Q
100 200
500 525

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Applications of Supply, Demand,

and Elasticity

1. Can good news for farming be bad news for

farmers? Consider the introduction of new
hybrid of wheat that increases the production
per acre.
2. Why did OPEC fail to keep the price of oil
high?

Application 1
- New hybrid of
wheat: increase
production per acre
20%
- Supply curve shifts to
the right
- Higher quantity and
lower price
- Demand is inelastic:
total revenue falls

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Application 2
Why did OPEC fail to keep the price of oil high?
- Analysis on the reduction in world market supply for oil

Homework
1. Five consumers have the following marginal utility of apples
and pears. The price of an apple is $1, and the price of a pear
is $2. Which, if any, of these consumers are optimizing over
their choice of fruit? For those who are not, how should they
change their spending?

Marginal Utility of Apples Marginal Utility of Pears

Claire 6 12
Phil 6 6
Haley 6 3
Alex 3 6
Luke 3 12

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Homework
2. Consider a couples decision about how many children to have.
Assume that over a lifetime a couple has 200,000 hours of time to
either work or raise children. The wage is $10 per hour. Raising a
child takes 20,000 hours of time.
a. Draw the budget constraint showing the trade-off between
lifetime consumption and the number of children. (Ignore the fact
that children come only in whole numbers!) Show indifference
curves and an optimum choice.
b. Suppose the wage increases to $12 per hour. Show how the
budget constraint shifts. Using income and substitution effects,
discuss the impact of the change on the number of children and
lifetime consumption.
c. We observe that, as societies get richer and wages rise, people
typically have fewer children. Is this fact consistent with this
model? Explain.

Homework
3. The demand function for bicycles in Holland has been
estimated to be
Q = 2,000 + 15Y 5.5P
where Y is income in thousands of euros, Q is the
quantity demanded in units, and P is the price per unit.
When P = 150 euros and Y = 15(000) euros, determine
the following:
a. Price elasticity of demand
b. Income elasticity of demand

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Homework
4. Two driversTom and Jerryeach drive up to a
gas station. Before looking at the price, each places
an order.
Tom says, Id like 10 gallons of gas.
Jerry says, Id like $10 worth of gas.
What is each drivers price elasticity of demand?

Homework
5. Does drug interdiction increase or decrease drug-related
crime? Explain your answers using supply-and-demand
diagrams.

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