2-1

The Demand Function

• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

• Qxd = quantity demand of good X.

• Px = price of good X.
• PY = price of a related good Y.
• Substitute good.
• Complement good.
• M = income.
• Normal good.
• Inferior good.
• H = any other variable affecting demand.
 2-2

The Supply Function

• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

• QxS = quantity supplied of good X.

• Px = price of good X.
• PR = price of a production substitute.
• W = price of inputs (e.g., wages).
• H = other variable affecting supply.
 2-3

If price is too low…

Price
S

D
Shortage
12 - 6 = 6

6 12 Quantity
 2-4

Impact of a Price Floor

Price Surplus
S

PF

P*

Qd Q* QS Quantity
Impact of a Price Ceiling Price Ceilings
The maximum
legal price that
Price can be charged.
S
Examples:
Gasoline prices in
PF
the 1970s.
Housing in New
P* York City.
Proposed
restrictions on
ATM fees.
P Ceiling

Shortage D

Qs Qd Quantity
Q*
Impact of a Price Floor Price Floors The
minimum legal
price that can be
Price Surplus charged. Examples:
S
Minimum wage.
PF Current PA
minimum wage
$6.25 Increased
P*
from $5.15 January
1, 2007 Increase to
$7.15 by July, 1
2007 Agricultural
D price supports.

Qd Q* QS Quantity
Big Picture: Impact of lower PC prices on
the software market
Price S
of Software

P1
P0

D*

Q0 Q1 Quantity of
Software
Big Picture: Impact of decline in
component prices on PC market
Price S
of
PCs S*

P0
P*

Quantity of PC’s
Q0 Q*
 3-9

Own Price Elasticity of Demand

%QX
d
EQX , PX 
%PX
• Negative according to the “law of demand.”

Elastic: EQ X , PX  1
Inelastic: EQ X , PX  1
Unitary: EQ X , PX  1
 3-10

Elasticity, Total Revenue and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
 3-11

Demand, Marginal Revenue (MR) and Elasticity

P • For a linear inverse

100
Elastic
demand function,
80 Unit elastic MR(Q) = a + 2bQ,
60
where b < 0.
Income Elasticity Inelastic • When
40
• MR > 0, demand is
20 elastic;
• MR = 0, demand is unit
elastic;
0 10 20 40 50 Q • MR < 0, demand is
inelastic.
MR
 3-12

Cross Price Elasticity of Demand d

%QX
EQX , PY 
%PY
If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

Income Elasticity
If EQX,M > 0, then X is a normal

%QX
d good

EQX , M 
%M If EQX,M < 0, then X is a inferior
good.
 3-13

Interpreting Demand Functions

• Mathematical representations of demand curves.
• Example:

QX  10  2 PX  3PY  2M
d

• Law of demand holds (coefficient of PX is negative).

• X and Y are substitutes (coefficient of PY is positive).
• X is an inferior good (coefficient of M is negative).
 4-14
Consumer Preference Ordering
Properties

• Completeness for any two bundles, say A and B,

either A > B, B > A, A – B.
• More is Better:
• Diminishing Marginal Rate of Substitution: As a
consumer obtains more of good X, the rate at
which he or she is willing to substitute good X for
good Y decreases.
• Transitivity
 4-15

Consistent Bundle Orderings

• Transitivity Property
• For the three bundles A, B, and C, Good Y
the transitivity property implies III.
that if C  B and B  A, then C  A.
• Transitive preferences along with II.
the more-is-better property imply I.
that
100 A
• indifference curves will not C
intersect. 75
B
• the consumer will not get 50
caught in a perpetual cycle of
indecision.

1 2 5 7 Good X
 4-16

The Budget Constraint

• Opportunity Set The Opportunity Set
Y
• The set of consumption bundles
that are affordable.
Budget Line
• PxX + PyY  M.
M/PY
Y = M/PY – (PX/PY)X
• Budget Line
• The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution
• The slope of the budget line M/PX
• -Px / Py X
 4-17

Decomposing the Income and

Substitution Effects
Initially, bundle A is consumed. Y
A decrease in the price of good
X expands the consumer’s
opportunity set.
The substitution effect (SE) C
causes the consumer to move
from bundle A to B. A II
A higher “real income” allows B
the consumer to achieve a
higher indifference curve. I
The movement from bundle B to
C represents the income effect IE X
0
(IE). The new equilibrium is SE
achieved at point C.
 4-18

A Classic Marketing Application

Other
goods
(Y)

A
A buy-one, get-
one free pizza C E
deal.
D II
I

0 0.5 1 2 B F Pizza
(X)
 5-20

Production Analysis
• Production Function
• Q = F(K,L)
• Q is quantity of output produced.
• K is capital input.
• L is labor input.
• F is a functional form relating the inputs to output.
• The maximum amount of output that can be produced with K units of capital
and L units of labor.
• Short-Run vs. Long-Run Decisions
• Fixed vs. Variable Inputs
5-21
 5-22
Productivity Measures: Marginal Product
of an Input
• Marginal Product on an Input: change in total
output attributable to the last unit of an input.
• Marginal Product of Labor: MPL = Q/L
• Measures the output produced by the last worker.
• Slope of the short-run production function (with respect to
labor).
• Marginal Product of Capital: MPK = Q/K
• Measures the output produced by the last unit of capital.
• When capital is allowed to vary in the short run, MPK is the
slope of the production function (with respect to capital).
 5-23
Increasing, Diminishing and
Negative Marginal Returns

Q Increasing Diminishing Negative

Marginal Marginal Marginal
Returns Returns Returns

Q=F(K,L)

AP
L
MP
 5-24

Guiding the Production Process

• Producing on the production function
• Aligning incentives to induce maximum worker effort.
• Employing the right level of inputs
• When labor or capital vary in the short run, to maximize profit a manager will
hire
• labor until the value of marginal product of labor equals the wage: VMPL = w, where
VMPL = P x MPL.
• capital until the value of marginal product of capital equals the rental rate: VMPK = r,
where VMPK = P x MPK .
 5-25

Marginal Rate of Technical Substitution

(MRTS)

• The rate at which two inputs are substituted while

maintaining the same output level.

MPL
MRTS KL 
MPK
 5-27
Isocost
• The combinations of inputs that K New Isocost Line
produce a given level of output associated with higher
at the same cost: C1/r costs (C0 < C1).
wL + rK = C C0/r
• Rearranging,
C0 C1
K= (1/r)C - (w/r)L L
C0/w C1/w
• For given input prices, isocosts K
farther from the origin are New Isocost Line for
associated with higher costs. C/r a decrease in the
wage (price of labor:
• Changes in input prices change w0 > w1).
the slope of the isocost line.

L
C/w0 C/w1
 5-28

Cost Minimization
• Marginal product per dollar spent should be equal for all inputs:
MPL MPK MPL w w
   MRTS KL 
w r MPK r r
• But, this is just
Profit-Maximizing Input Usage
To maximize profits, a manager should use inputs at
levels at which the marginal benefit
equals the marginal cost. More specifically, when the cost
of each additional unit of labor
is w, the manager should continue to employ labor up to
the point where VMPL w in the
range of diminishing marginal product.
Formula: Marginal Product for a Linear Production Function

MPK=a MPL=b

Formula: Marginal Product for a Cobb-Douglas Production Function.

 5-30

Some Definitions
Average Total Cost
ATC = AVC + AFC $
ATC = C(Q)/Q MC ATC
AVC
Average Variable Cost
AVC = VC(Q)/Q

Average Fixed Cost

AFC = FC/Q MR
Marginal Cost
MC = C/Q

AFC

Q
Optimal Input Substitution
To minimize the cost of producing a given level of
output, the firm should use less of an input and more
of other inputs when that input’s price rises.
 linear regression log-linear regression

Multiple R 0,73972 Multiple R 0,63356

R Square 55% R Square 40%

Adjusted R Adjusted R
54% 39%
Square Square

Standard Error 1,06324 Standard Error 0,58688

Observations 100 Observations 100

ANOVA
ANOVA
df SS MS F Significance F
df SS MS F Significance F

Regression 2 132,512 66,25604 58,609 2,05053E-17

Regression 2 22,403 11,2013611 32,522 1,5532E-11

Residual 97 109,656 1,13047076

Residual 97 33,409 0,34442352
Total 99 242,168 Total 99 55,812

Standard Upper Standard Upper

Coefficients t Stat P-value Lower 95% Coefficients t Stat P-value Lower 95%
Error 95% Error 95%

Intercept 6,52 0,8231 7,92117 3,945E-12 4,886 8,1534 Intercept -1,99 2,2433 -0,88650 3,775E-01 -6,441 2,4637

Price -1,614 0,1515 -10,65769 5,127E-18 -1,915 -1,314 lnP -2,170 0,2761 -7,85795 5,370E-12 -2,717 -1,6215

Ads 0,0047 0,0016 2,96151 3,849E-03 0,002 0,0078 lnA 0,9107 0,3703 2,45896 1,571E-02 0,176 1,6457
b. Table 3-11 contains the output from the linear regression model. That model indicates that R2 = .55, or that
55 percent of the variability in the quantity demanded is explained by price and advertising. In contrast, in
Table 3-12 the R2 for the log-linear model is .40, indicating that only 40 percent of the variability in the
natural log of quantity is explained by variation in the natural log of price and the natural log of advertising.
Therefore, the linear regression model appears to do a better job explaining variation in the dependent
variable. This conclusion is further supported by comparing the adjusted R2s and the F-statistics in the two
models. In the linear regression model the adjusted R2 is greater than in the log-linear model: .54 compared
to .39, respectively. The F-statistic in the linear regression model is 58.61, which is larger than the F-statistic
of 32.52 in the log-linear regression model. Taken together these three measures suggest that the linear
regression model fits the data better than the log-linear model. Each of the three variables in the linear
regression model is statistically significant; in absolute value the t-statistics are greater than two. In contrast,
only two of the three variables are statistically significant in the log-linear model; the intercept is not
statistically significant since the t-statistic is less than two in absolute value.