20-Jul-10

1
SEEG 5013 Managerial Economics
Topic 2: Demand Analysis
Chapter 3: Demand Theory
Dr. Hj. Mohd Razani Hj. Mohd Jali
Economics Building - 0.55
College of Arts and Sciences
razani@uum.edu.my
04-928 3524
Lecture objectives
o To examine the demand theory.
o Individuals demand
o Market demand
o To understand the important concept of
elasticity.
o Price elasticity of demand
o Income elasticity of demand
o Cross-price elasticity of demand
o Using elasticities in managerial decision making
2
Demand theory
Demand essential for creation, survival &
profitability of a firm.
Firm cannot survive without demand.
Demand theory forces that determine the
demand for a firms product or service.
Elasticity measure responsiveness in
quantity demanded of a commodity to
changes in each of the forces that determine
demand.
3
Demand theory
Forces that determine demand -
Price of commodity, consumers income, price
of related commodities and consumers
tastes.
4
Law of Demand
Holding all other things constant (ceteris
paribus), there is an inverse relationship
between the price of a good and the quantity
of the good demanded per time period.
5
In managerial economics
We are interested in demand for commodity
faced by the firm.
This depends on size of total market, which is
the sum of the demand of the individual
consumers in the market.
6
20-Jul-10
2
Consumer demand theory
Quantity demanded of a commodity is a
function of, or depend on, the price of the
commodity, the consumers income, the price
of related (complementary and substitute)
commodities and the tastes of the consumer.
7
Components of Demand:
The Income Effect
The real value of income is inversely related
to the prices of goods.
A change in the real value of income:
will have a direct effect on quantity demanded
if a good is normal.
will have an inverse effect on quantity
demanded if a good is inferior.
The income effect is consistent with the law
of demand only if a good is normal.
8
Individual Consumers Demand
Qd
X
= f(P
X
, I, P
Y
, T)
quantity demanded of commodity X by an
individual per time period
price per unit of commodity X
consumers income
price of related (substitute or
complementary) commodity
tastes of the consumer
Qd
X
=
P
X
=
I =
P
Y
=
T =
9
As we have already known
There is an inverse relationship between
quantity demanded and its price.
P , Q purchased ; P , Q sold
10
Qd
X
= f(P
X
, I, P
Y
, T)
Qd
X
/P
X
< 0
Qd
X
/I > 0 if a good is normal
Qd
X
/I < 0 if a good is inferior
Qd
X
/P
Y
> 0 if X and Y are substitutes
Qd
X
/P
Y
< 0 if X and Y are complements
11
Consumer demand theory
When consumers income rises, he/she
purchases more of a commodity shoes,
steaks, movies, travel, education, autos,
housing, etc known as normal good.
Some goods consumer will purchase less as
income rises burger, hot dog cheap items
or inferior goods.
12
20-Jul-10
3
Consumer demand theory
Consumer purchases more of a commodity if
price of substitute increase or if price of
complementary falls
Substitute coffee and tea.
Complementary coffee and sugar.
13 14
15
Market Demand Curve
Horizontal summation of demand curves of
individual consumers
Exceptions to the summation rules
Bandwagon Effect
Snob (Veblen) Effect
16
17
Market Demand Curve
Market demand curve is simply the horizontal
summation of the individual demand curve
only if consumption decisions of individual
consumers are independent.
Exceptions 1: Bandwagon Effect
When people sometimes demand a commodity
because others are purchasing it and in order to be
fashionable. The bandwagon effect tend to make
the market demand curve flatter than indicated by
simple horizontal summation of individuals
demand curve.
18
20-Jul-10
4
Market Demand Curve
Exceptions 2: Snob (Veblen) Effect
The opposite occurs as many consumers seek
to be different and exclusive by demanding less
of a commodity as more people consume it.
The snob effect tends make demand curve
steeper.
19
Market Demand Function
QD
X
= f(P
X
, N, I, P
Y
, T)
quantity demanded of commodity X
price per unit of commodity X
number of consumers on the market
consumer income
price of related (substitute or
complementary) commodity
consumer tastes
QD
X
=
P
X
=
N =
I =
P
Y
=
T =
20
Demand Curve Faced by a Firm Depends on
Market Structure
Market demand curve
Imperfect competition
Firms demand curve has a negative slope
Monopoly - same as market demand
Oligopoly
Monopolistic Competition
Perfect Competition
Firm is a price taker
Firms demand curve is horizontal
21
Demand Curve Faced by a Firm Depends on
Market Structure
Monopoly
Sole producer of a commodity, no substitutes.
The firm represents the industry.
Very rare. It occurs as a result of government
franchise, accompanied by government
regulation.
Example: local telephone, electricity, public
transportation & other public utility companies.
22
Demand Curve Faced by a Firm Depends on
Market Structure
Perfect Competition
Large number of firms producing a
homogeneous (identical) products. Each firm is
too small to effect the price of a commodity on
its own.
Firm is a price taker
Firms demand curve is horizontal
23
Demand Curve Faced by a Firm Depends on
Market Structure
Oligopoly
Only a few firms in the industry producing either
homogeneous or standardize product (cement,
steel) or heterogenous or differentiated product
(automobiles, cigarettes, soft drinks).
Characterized by interdependence that exists
among the firms in the industry.
Pricing, advertising & promotional behavior affect
other firms in the industry & evoke imitation &
retaliation.
Efficiency requires large scale operation.
24
20-Jul-10
5
Demand Curve Faced by a Firm Depends on
Market Structure
Monopolistic Competition
Many firms selling heterogeneous or
differentiated product.
Have elements of competition
There are many firms in the industry.
25
Demand Curve Faced by a Firm Depends on
Market Structure
Monopolistic Competition
Have elements of monopoly
Each firms products is somewhat different
from product of other firms.
Have some degree of control over the
price it charges, but very limited.
Each firm faces demand curve that,
though negatively sloped, is fairly flat
any increase in price would lead to a very
large decline in sales.
26
Demand Curve Faced by a Firm Depends on the
Type of Product
Durable Goods
e.g.: automobiles, washing machines,
refregerators.
Provide a stream of services over time (few years).
Demand is volatile/ unstable.
Consumers can use their goods longer by
increasing expenditure on maintenance and
repairs.
Demand can increase if economy improves or
credit incentives are introduced.
27
Demand Curve Faced by a Firm Depends on the
Type of Product
Nondurable Goods and Services
Producers Goods
Used in the production of other goods.
Demand is derived from demand for final goods or
services.
Demand for these goods (capital equipment & raw
materials that can be stored) is also more volatile
and unstable than the firms demand for
perishable raw materials.
28
Price Elasticity of Demand
Measures of responsiveness (elasticity) in
the quantity demanded of the commodity
to a change in its price.
Can be measured at one point as well as
over a range (arc) of the demand curve.
29
Point Price Elasticity of Demand
The price elasticity of demand (E
P
) is given
by the percentage change in the quantity
demanded of the commodity divided by
the percentage change in its price, holding
constant all other variables in the demand
function.
30
20-Jul-10
6
Price Elasticity of Demand
/
/
P
Q Q Q P
E
P P P Q



Linear Function
Point Definition
1 P
P
E a
Q

The above equation gives the point price elasticity of
demand.
31 32
Example
/
/
P
Q Q Q P
E
P P P Q



If Q/P = -100/$1 at every point on D
X
(since D
X
is linear) , price elasticity at point B is:
E
P
= Q/P . P/Q = -100/$1 . $5/100
= -1(5/1) = -5
33
Example
This means that quantity demanded
declines by 5 percent for each 1 percent
increase in price. Using the above
equation we get at point C, E
P
= -2, at
point F, E
P
= -1, at point G, E
P
= -1/2 and at
point H, E
P
= -1/5.
Thus the price elasticity of demand is
usually different at different point on the
demand curve.
34
Arc Price Elasticity of Demand
Another measure, besides price elasticity
of demand is arc price elasticity of
demand, which is the price elasticity of
demand between two points on the
demand curve.
35
Arc Price Elasticity of Demand
If we used the formula
to measure arc elasticity of demand, we
would get different results depending on
whether the price rose or fell.
/
/
P
Q Q Q P
E
P P P Q



36
20-Jul-10
7
Arc Price Elasticity of Demand
Example using the formula to measure arc
price elasticity for movement from point C
to point F on figure 3.3, which is a price
decline) on demand curve D
x
we would
obtain:
E
P
= P/Q x P/Q = 100/-$1 x $4/200 = -2
37
Arc Price Elasticity of Demand
But to measure arc price elasticity from
point F to point C, we would get
E
P
= P/Q x P/Q = 100/-$1 x $3/300 = -1
We get two different answers/elasticities
for the two same points but for changes in
different directions.
38
Arc Price Elasticity of Demand
To avoid this, we use the average of the
two prices and the average of the
quantities.
39
Arc Price Elasticity of Demand
Thus, the formula for arc price elasticity of
demand
E
P
= (Q/P) x [(P2 + P1)/2] / [(Q2 + Q1)/2]
where the subscript 1 and 2 refer to the original
and to new values of price and quantity.
2 1 2 1
2 1 2 1
P
Q Q P P
E
P P Q Q



40
Arc Price Elasticity of Demand
Example, to measure arc price elasticity
for a movement from point C to point F:
E
P
= [300 200/$3 - $4] . [$3 + $4/300 + 200]
= 7/-5
= -1.4
2 1 2 1
2 1 2 1
P
Q Q P P
E
P P Q Q



41
Arc Price Elasticity of Demand
And we get the same result for the
reverse movement from F to C:
E
P
= [200 300/$4 - $3] . [$4 + $3/200 + 300]
= -7/5
= -1.4
2 1 2 1
2 1 2 1
P
Q Q P P
E
P P Q Q



42
20-Jul-10
8
Arc Price Elasticity of Demand
Meaning between points C and F on
demand curve D
x
, a 1 percent change in
price results, on the average, in a 1.4
percent opposite change in the quantity
demanded of commodity X.
43
Price Elasticity, Total Revenue and Marginal Revenue
There is important relationship between price
elasticity of demand and the firms total revenue
and marginal revenue.
Total Revenue (TR) is equal to Price (P) times
Quantity (Q). Marginal Revenue (MR) is the
change in total revenue per unit change in
output or sales (quantity demanded).
TR = P . Q
MR = TR/Q
44
Price Elasticity, Total Revenue and Marginal Revenue
With a decline in price:
TR increase if demand is elastic.
TR remains unchanged if demand is unitary
elastic.
TR declines if demand is inelastic.
45
Price Elasticity, Total Revenue and Marginal Revenue
Reason:
If demand is elastic a price decline leads to
a proportionately larger increase in quantity
demanded TR increase.
If demand is unitary elastic a price decline
leads to an equal proportionate increase in
quantity demanded.
If demand is inelastic a price declines leads
to a smaller proportionatel increase in
quantity demanded TR declines.
46
Price Elasticity, Total Revenue and Marginal Revenue
Thus:
Since linear demand curve is elastic above
the midpoint, unitary elastic at midpoint and
inelastic below the midpoint, a reduction in
price leads to an increase in TR down to
midpoint of demand curve and to a decline
thereafter.
MR is positive as long as TR increases.
MR is zero when TR is maximum.
MR is negative when TR declines.
47
Price Elasticity, Total Revenue and Marginal Revenue
48
20-Jul-10
9
49
What do all these means?
Managerial decision making.
Some forces that affect demand are under firms
control.
Setting price to the commodity it sells.
Decide on level of expenditures on
advertising, product quality and consumer
service.
50
What do these all means?
Some forces that firm cannot control.
Growth of consumers incomes.
Consumers price expectations.
Competitors pricing decisions and
expenditures on advertising.
Product quality.
Customer service.
51
Firm can estimate elasticity of demand with respect to
the forces that affect demand for the commodity
that it sells.
In respect to variables outside the firms control, the
firm needs to respond appropriately and effectively
to competitors policies.
If price elasticity of the demand for its product
with respect to price of competitors product is
very high, it will quickly respond to competitors
price reduction. If not, it will lose much of its
sales.
If income elasticity is very low for its product,
rising consumers income will not benefit them.
It should improve its product or change to
product that has more income-elastic demand.
52
The firm should:
Identify all important variables that affect the
demand for its product.
Obtain variables estimates of the marginal
effect of a change in each variable on
demand.
Estimate elasticity of demand for the product
based on each variable in the demand
function.
53
Example: Using Elasticities in Managerial
Decision Making
A firm with the demand function defined below
expects a 5% increase in income (M) during the coming
year. If the firm cannot change its rate of production,
what price should it charge?
Demand: Q = 3P + 100M
P = Current Real Price = 1,000
M = Current Income = 40
20-Jul-10
10
Solution
Elasticities
Q = Current rate of production = 1,000
P = Price = - 3(1,000/1,000) = - 3
I = Income = 100(40/1,000) = 4
Price
%Q = - 3%P + 4%I
0 = -3%P+ (4)(5) so %P = 20/3 = 6.67%
P = (1 + 0.0667)(1,000) = 1,066.67
Example: Using Elasticities in Managerial
Decision Making
Regression of the demand for coffee X as follows:
Q
X
= 1.5 3.0P
X
+ 0.8I + 2.0P
Y
0.6P
S
+ 1.2A
where:
Q
X
= sales of coffee X, in millions of pounds per year.
P
X
= price of coffee X, in dollars per pounds.
I = personel disposable income, in trillions of dollars per year.
P
Y
= price of competitive brand of coffee, in dollars per
pounds.
P
S
= price of sugar, in dollars per pounds.
A = advertising expenditures for coffee X, in hundreds of
thousands of dollars per year.
Example: Using Elasticities in Managerial
Decision Making
Supposed that, P
X
= $2, I = $2.5, P
Y
= $1.80, P
S
= $0.50
and A = $1
We get
Q
X
= 1.5 3.0(2) + 0.8(2.5) + 2.0(1.8) 0.6(0.50)
+ 1.2(1)
= 2
Thus, the firm would sell 2 million pounds of coffee X
From this info, the firm can find elasticity of
demand for coffee X with respect to its price,
income, price of competitive coffee Y, price of
sugar and advertising:
E
P
= -3(2/2)) = -3
E
I
= 0.8(2.5/2) = 1
E
XY
= 2(1.8/2) = 1.8
E
XS
= -0.6(0.50/2) = -0.15
E
A
= 1.2(1/2) = 0.6
58
To estimate/forecast demand for next year.
Suppose the firm:
increase price by 5%.
increase advertisement by 12%.
expect personal disposable income rise by 4%
P
Y
to rise by 7%.
P
S
to fall by 8%.
59
Using level of sales (Q
X
) for this year of 2 million
pounds, the firm can determine its sales for next
year:
Q
X
= Q
X
+ Q
X
(P
X
/P
X
)E
P
+ Q
X
(I/I)E
I
+ Q
X
(P
Y
/P
Y
)E
XY
+ Q
X
(P
S
/P
S
)E
XS
+ Q
X
(A/A)E
A
= 2 + 2(5%)(-3) + 2(4%)(1) + 2(7%)(1.8)
+ 2(-8%)(-0.15) + 2(12%)(0.6)
= 2.2 million pounds.
60
20-Jul-10
11
Other Factors Related to Demand Theory
International Convergence of Tastes
Globalization of Markets
Influence of International Preferences on Market
Demand
Growth of Electronic Commerce
Cost of Sales
Supply Chains and Logistics
Customer Relationship Management
Problem
Consider a firm that produces a best-selling
software program. The firm continues to spend a
great deal of money revising and improving its
software in an effort to maintain its market share
lead over its next two or three strongest
competitors. In fact, its last revision and update
cost much more than the company expected. In
light of these added development costs and any
other relevant factors, how should top
management determine its pricing policy for the
updated program?
Solution
The firms optimal pricing policy depends on how
sensitive demand is to price changes -- in other
words on the elasticity of demand. Because
development costs are fixed (indeed largely
sunk), they do not affect the pricing decision.
Since the marginal cost of producing an extra
copy of the software is trivial, the firms problem
is essentially pricing to maximize revenue. Thus,
the price and performance characteristics of
competing spreadsheet software are extremely
important factors affecting demand elasticity.
Questions or comments?
Reference:
Salvatore (2008), Ch. 3