Summary of Demand Theory & Elasticity

The Demand for a Commodity

The demand for a commodity faced by a firm depends on the market or industry demand for the commodity,
which, in turn is the sum of the demands for the commodity of the individual consumers in the market.

The demand for the commodity that a firm faces depends on the:

a. Price of the commodity.

b. The size of number of consumers in the market.
c. Consumer income.
d. The price of related commodities.
e. Tastes.
f. Price expectations.
g. The promotional efforts of the firm.
h. Competitors pricing, and
i. Promotional policies.

An Individual’s Demand for a commodity

The demand for a commodity arises from the consumer’s willingness and ability to purchase the commodity.
Consumer demand theory postulates that the quantity demanded of a commodities is a function of, or
depends on:

a. The price of commodity

b. The consumer’s income

c. The price of related commodities, and

d. Taste of consumer

Which in functional form, can be expressed as:

Increases the price of commodity will make sales generally decline, while lowering the price will makes
more sales. But when a consumer’s income rises, they usually purchases more of most commodities which
is called Normal goods ( Shoes, steaks, movies, travel, education, automobiles, housing and others primary
needs) and there is Inferior goods which referring to many goods and services but the consumer purchases
less as their income rises such as; potato, hot dogs, burgers, because now they can afford steaks, fine dining,
and other higher-quality foods.

The quantity demanded of a commodity by an individual also depends on the price of related commodities.
For example, people will buy more coffee if the price of tea increases or if the price of sugar falls.

• From Individual to Market Demand

The market demand curve for a commodity is simply the horizontal summation of the demand curves of all
the consumers in the market.

• The Demand Faced by a Firm

Monopoly is rare in the real world, and when it does occur, it is usually the result of a government franchise,
which is accompanied by government regulation. Examples of this are public transportation and some other
public utility companies. Meanwhile at the opposite extreme is the form of market organization called
Perfect Competition. For example, there are a large number of firms producing a homogeneous product,
each firm is to small to affect the price of commodity. In such a case, each firm is a price taker and faces a
horizontal demand curve for the commodity (firm can sell any amount of the commodity without affecting
the price). This form of market organization is very rare, the closest example in the US is when millions of
small farmers raised wheat of the same type.
The vast majority of the firms operating in the US and other industrial countries today fall between the
extremes of monopoly and perfect competition, which called Oligopoly. In oligopoly, there are only a few
firms in the industry, producing either a homogeneous or standardized product (cement, steel, and
chemicals) or a heterogenous (automobiles, cigarettes, and soft drinks). The most striking characteristic of
oligopoly is the interdependence that exists among the firms in the industry.
The other common form is call Monopolistic Competition. As the name implies, monopolistic competition
has elements of both competition and monopoly. The competitive element arises from the fact that there
are many firms in the industry and the monopoly element arises because each firm’s product is somewhat
different from the product of the other firms. Thus, the firm has some degree of control over the price it
charges. However, because of the products of the many other firms in the industry are very similar, the
degree of control that a firm has over the price of the product is very limited. The easiest example for this
are gas stations and barbershops (similar products but not identical, and different services).
The demand for a firm’s product also depends on type of product that the firm sells, if the firm sells durable
goods (automobiles, washing machines, etc) the firm will generally face a more volatile or unstable demand
that a firm selling nondurable goods. The reason is consumers can run their own cars, washing machines a
little longer by increasing their expenditures on maintenance and repairs so they can postpone to buy a
new one until their economy capability improves.
In general, the quantity response by a firm to a change in the price of the commodity will be some fraction
of the total market response. The demand for durable goods is generally less stable than the demand for
nondurable goods. The firm’s demand for inputs for resources (producer’s goods) is derived from the
demand for the final commodities produced with the inputs.
Price Elasticity of Demand

• Point Price Elasticity of Demand

The responsiveness in the quantity demanded of a commodity to a change in its price could be measured
by the inverse of the slope of the demand curve. The disadvantage is that the inverse of the slope is
expressed in terms of units of measurement.
The price elasticity of demand (Ep) is given by the percentage change in the quantity demanded of the
commodity divided by percentage change in its price, holding constants all other variables in the demand
function. That is:

• Arc Price Elasticity of Demand

More frequently than point price elasticity of demand, we measure arc price elasticity of demand, or the
price elasticity of demand between two points on the demand curve, in the real world. While we have been
examining the price elasticity of the market demand curve for a commodity, the concept applies equally
well to individuals' and firms' demand curves. In general, the price elasticity of the demand curve that a
firm faces (i.e., the absolute value of E) is larger than the price elasticity of the corresponding market
demand curve because the firm faces competition from similar commodities from rival firms, while there
are few, if any, close substitutes for the industry's product from other industries.

• Price Elasticity, Total Revenue, and Marginal Revenue

There is an important relationship between the price elasticity of demand and the firm's total revenue and
marginal revenue. Total revenue (TR) is equal to price (P) times quantity (O), while Marginal revenue (MR)
is the change in total revenue per unit change in output or sales (quantity demanded). That is,

With a decline in price, total revenue increases if demand is elastic (i.e., if |Ep| > 1; TR remains unchanged
if demand is unitary elastic, and TR declines if demand is inelastic. The reason for this is that if demand is
elastic, a price decline leads to a proportionately larger increase in quantity demanded, and so total revenue
increases. When demand is unitary-elastic, a decline in price leads to an equal proportionate increase in
quantity demanded, and so total revenue remains unchanged. Finally, if demand is inelastic, a decline in
price leads to a smaller proportionate increase in quantity demanded, and so the total revenue of the firm
declines. Since a linear demand curve is elastic above the midpoint, unitary elasticity at the midpoint, and
inelastic below the midpoint, a reduction in price leads to an increase in TR down to the midpoint of the
demand curve (where total revenue is maximum) and to a decline thereafter. MR is positive as long as TR
increases, MR is zero when TR is maximum, and MR is negative when TR declines.
• Factors Affecting the Price Elasticity of Demand
The price elasticity of demand for a commodity depends primarily on the availability of substitutes for the
commodity but also on the length of time over which the quantity response to the price change is measured.
The size of the price elasticity of demand is larger the closer and the greater is the number of available
substitutes for the commodity. For example, the demand for sugar is more price elastic than the demand
for table salt because sugar has better and more substitutes (honey and saccharine) than salt.

The price elasticity of demand (Ep) measures the percentage change in the quantity demanded of a
commodity divided by the percentage change in its price, while holding constant all other variables in the
demand function. We can measure point or arc price elasticity of demand.

- A linear demand curve is price elastic (i.e., |Ep|>1) above its geometric midpoint, is unitary elastic (i.e.,
|Ep|=1) as its midpoint, and is inelastic (i.e., |Ep|<1) below the midpoint.

- For a decline price, total revenue (TR) increases if demand is elastic, remains unchanged if demand is
unitary elastic, and declines if demand is inelastic.

The elasticity of demand is greater when the substitutes available are better for the commodity and the
greater is the length of time allowed for the quantity response by consumers to the price change.

Income Elasticity of Demand

The income elasticity of demand (E1) measures the percentage change in the demand for a commodity
divided by the percentage change in consumer income, while holding constant all the other variables in the
demand function, including price.

- We can measure point or arc income elasticity of demand. For normal goods (E1>0), for inferior goods E1<0.
Those normal goods for which E1>1, are called luxuries, while normal goods for which E, is between 0 and
1 are necessities.

Cross-Price Elasticity of Demand

The cross-price elasticity of demand for commodity X to commodity Y (Exy):

- Measures the percentage change in the demand for commodity X divided by the percentage change in
the price of commodity Y, while holding constant all other variables in the demand function, including
income and the price of commodity X. We can measure point or arc cross-price elasticity. Commodities X
and Y are substitute if Exy is positive, complementary if Exy is negative, and independent if Exy is close to 0.

The use of cross-price elasticity of demand is to estimate the effect of reducing the price of a commodity
on the demand of other related commodities than the firm sells. A high cross-price elasticity of demand is
also used to define an industry.

For the analysis of demand, the firm should first identify all the important variables that affect the demand
for the product it sells. By using regression analysis, the firm could obtain reliable estimates of the effect of
a change in each of these variables on demand for the product.
Using Elasticities in Managerial Decision Making
The analysis of the forces or variables that affect demand and reliable estimates of their quantitative
effect on sales are essential for the firm to make the best operating decisions and to plan its growth. Some
of the forces that affect demand are under the control of the firm, while others are not. A firm can usually
set the price of the commodity it sells and decide on the level of its expenditures on advertising, product
quality, and customer service, but it has no control over the level and growth of consumer’s incomes,
consumer’s prices expectations, competitor’s pricing decisions, and competitor’s expenditures on
advertising, product quality, and customer service.

International Convergence of Tastes

There is an increasing trend of converging tastes around the world. Tastes in the US affect tastes around
the world and tastes abroad strongly influence tastes in the US. While some national differences will surely
remain, the information revolution and cross-fertilization of cultures can be expected to accelerate the
global convergence of tastes. This has very important implications for all firms.

Electronic Commerce
Since the mid-1990s, the Internet has given rise to e-commerce, which is revolutionizing traditional business
relationships. E-commerce refers to production, advertising, sale, and distribution of products and services
from B2B and from B2C through the Internet.

The biggest lures of e-commerce for consumers are the convenience of having around the-clock access to
the virtual store and the ability to engage in comparative shopping at minimal cost and effort. Through e-
commerce, sellers can sharply reduce:

a. Cost of executing sales and procuring inputs.

b. Reformulate supply chains and logistics, and

c. Redefine customers relationship management.