Market

Demand
Chapter 5

Slides by Pamela L. Hall

Western Washington University
©2005, Southwestern
 Introduction
 Demand for a commodity is differentiated from a
want
 In terms of society’s willingness and ability to pay for
satisfying the want
 This chapter determines total amount demanded
for a commodity by all households
• Called market demand or aggregate demand
 Sum of individual household demands
 Assuming individual household demands are independent of
each other
 Will explore network externalities
 Independence assumption does not hold

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 Introduction
 Major determinants of market demand for a commodity are
 Its own price
 Price of related commodities
 Households’ incomes
 Elasticity of demand is a measure of influence each parameter has on
market demand
 We investigate own-price elasticity of demand
 Classify market demand as elastic, unitary, or inelastic
• Depending on its degree of responsiveness to a price change
 Relating own-price elasticity to households’ total expenditures for a
commodity
 Demonstrate how this determines whether total expenditures for a
commodity will increase, remain unchanged, or decline, given a price
change

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 Introduction
 Define income elasticity of demand and elasticity of demand
for the price of related commodities
 Called cross-price elasticity
 Applied economists are active in estimating elasticities for
all determinants (parameters) of market demand
 Knowledge of the influence these determinants provides
information for firms’ decisions
 Government policymakers also use estimates of elasticities
 With reliable estimates of elasticities based on economic
models
 Economists can explain, predict, and control agents’ market behavior

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 Market Demand
 One arm of Marshallian cross
 Conveys individual household preferences for a commodity
given a budget constraint
 Sum of all individual households’ demands for a single
commodity
 Consider only two households—Robinson, R, and Friday,
F—and two commodities

• xR1 and xF1 are household Robinson’s and household Friday’s demand for
commodity x1, respectively
 Both households face same per-unit prices for the two commodities
• Each household is a price taker
 Both households are bound by budget constraints
• IR and IF represents income for Robinson and Friday, respectively
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 Market Demand
 Market demand, Q1, is sum of amounts demanded by the
two households

 Holding p2, IR, and IF constant, we obtain market demand curve for x1
in Figure 5.1
 For a private good, market demand curve is horizontal summation of
individual household demand curves

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Figure 5.1 Market demand for
commodity Q1 …

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 Market Demand
 At p*1 Robinson demands 5 units of Q1 and Friday demands 3
 For a total market demand of 8 units
 Varying price will result in other associated levels of market demand
• Will trace out market demand curve for Q1
 Will have a negative slope
 For market demand to have a positive slope, a large portion of households would
have to consider x1 a Giffen good
 Assume market demand for a commodity is inversely related to its own
price
 Shifts in market demand will occur if there is a change in household
preferences, income, price of another commodity, or population
 As illustrated in Figure 5.2, market demand curve will shift outward for
an increase in
 Income
 Population
 Price of substitute commodities, or
 A decrease in prices of complement commodities 8
Figure 5.2 Shift in market
demand

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 Network Externalities
 Horizontal summation of households’ demand functions
assumes individual demands are independent of each other
 For some commodities, one household’s demand does
depends on other households’ demands
 Example of network externalities
• Exist when a household’s demand is affected by other households’
consumption of the commodity
 Positive network externalities result when
 Value one household places on a commodity increases as other
households purchase the item
 Negative network externalities exist if household’s
demand decreases as a result of other households’ actions

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 Bandwagon Effect
 Specific type of positive network externality
 Individual demand is influenced by number of other
households consuming a commodity
 The greater the number of households consuming a
commodity
 More desirable commodity becomes for an individual household
 Key to marketing most toys and clothing is to create a
bandwagon effect
 Results in market demand curve shifting outward
 Individual household demand increases in response to increased
demand by numerous other households

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 Market Effect
 If positive network externalities exist, summation of individual
household demands does not take into account households’
increase in demand when other households increase their
demand for the commodity
 Will underestimate true market demand
• Shown in Figure 5.3
 Individual household demand curves are positively influenced
by other households’ level of demand for commodity
 Results in a further outward shift of individual household demand
curves, and market demand curve
 Instead of market demand being sum of 5 plus 3 units at p*1
 Positive network externalities result in a market demand of 7 plus 6
units

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Figure 5.3 Market demand for
commodity Q1 …

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 Market Effect
 If negative network externalities exist
 Summation of individual household demands will
overestimate true market demand
• Shown in Figure 5.4
 Results in inward shift of individual household demand
curves
 With a corresponding inward shift in market demand
curve

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Figure 5.4 Market demand for
commodity Q1 …

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 Elasticity
 Market demand function provides a relationship between
price and quantity demanded
 Quantity demanded is inversely related to price
 Of greater interest to firms and government policymakers is
how responsive quantity demanded is to a change in price
 Downward-sloping demand curve indicates
 If a firm increases its price, quantity demanded will decline
• Does not show magnitude of decline
 To measure magnitude of responsiveness use derivative or
slope of curve
 The larger the partial derivative, the more responsive is y

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 Units Of Measurement
 One problem in using derivative is units of measure
 By changing units of measure—say from dollars to
cents or pounds to kilograms
 Cause magnitude of change or value of derivative to vary
• For example, if y is measured in pounds, x in dollars, and ∂y/∂x =
2
 Measurement is 2 pounds per dollar
 For each $1 increase in x, y will increase by 2 units
 However, if change scale used to measure y to ounces, then ∂y/∂x =
32
 For each $1 increase in x, y will increase by 32 units
 Just changing scale makes it appear that y is more responsive to a
given change in x

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 Unit-free Measure Of
Responsiveness
 Prior failure to convert from English to metric system of
measurement caused loss of Mars Climate Orbiter
 To avoid making such errors in comparing responsiveness
across different factors with different units of measurement
in economics
 Use a standardized derivative, elasticity
• Removes scale effect
 Derivative is standardized (converted into an elasticity)
 By weighting it with levels of variables under consideration
• Results in percentage change in y given a percentage change in x
 Provides a unit-free measure of the responsiveness
• Partial derivative is not as useful as elasticity measurement

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 Logarithmic Representation
 As a percentage change measure, elasticity
can be expressed in logarithmic form

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 Price Elasticity Of Demand
 For market quantity, Q is defined as
 Q,p(∂Q/∂p)(p/Q) = ∂ ln Q/∂ ln p
 Elasticity of demand indicates how Q
changes (in percentage terms) in response
to a percentage change in p
 Ordinary good: ∂Q/∂p < 0
• Implies Q,p < 0 given that p and Q are positive
 Examples of demand elasticities are provided in Table 5.1

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Table 5.1 Estimates of price
elasticities of demand

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 Perfectly Inelastic Demand
 A change in price results in no change in
quantity demanded
 Q,p = 0
 Represented in Figure 5.5
• Results in a vertical demand curve
 At every price level quantity demanded is the same
 Examples are difficult to find due to the lack of
households with monomania preferences
 For example, alcoholics and drug addicts would have
highly inelastic demands over a broad range of quantity

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Figure 5.5 Perfectly inelastic
demand curve

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 Perfectly Elastic Demand
 Smallest possible value of Q,p is for it to approach
negative infinity
 If Q,p = - demand is perfectly elastic
 Very slight change in price corresponds to an infinitely
large change in quantity demanded
• Illustrated in Figure 5.6
 Many examples of perfectly elastic demand curves
 Whenever a firm takes its output price as given it is
facing a perfectly elastic demand curve
• For example, agriculture

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Figure 5.6 Perfectly elastic
demand curve

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 Classification of Elasticity
 Between elasticity limits from - to 0, elasticity may
be classified in terms of its responsiveness
 Q,p < -1, elastic, |∂Q/Q| > |∂p/p|
• Absolute percentage change in quantity is greater than absolute
percentage change in price
 Quantity is relatively responsive to a price change
 Q,p = -1, unitary, |∂Q/Q| = |∂p/p|
• Absolute percentage change in quantity is equal to absolute
percentage change in price
 Q,p > -1, inelastic, |∂Q/Q| < |∂p/p|
• Absolute percentage change in quantity is less than absolute
percentage change in price
 Quantity is relatively unresponsive to a price change

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 Linear Demand
 Linear demand curve will exhibit all three elasticity
classifications
 Consider linear demand function for commodity x1
 x1 = 120 – 2p1
• Plotted in Figure 5.7
 Elasticity of demand represented as
• 11 = (∂x1/∂p1)(p1/x1)
 Size of elasticity coefficient increases in absolute value for
movements up this linear demand curve
• Because slope is remains constant while weight is increasing
 At point B
 11 = (∂x1/∂p1)p1/x1 = -2(45/30) = -3, elastic
 At D
 11 = (∂x1/∂p1)p1/x1 = -2(15/90) = -1/3, inelastic
 At point C (A) [E] elasticity of demand is unitary (-) [0]
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Figure 5.7 Linear demand curve
…

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 Linear Demand
 General functional form for a linear market
demand function
 Q1 = a + bp1, b<0
• Q1 denotes market demand for commodity 1
• p1 is associated price per unit
• Partial derivative is equal to constant b
 Elasticity of demand is not constant along a linear demand
curve
 As p1/Q1 increases, demand curve becomes more elastic

 In the limit, as Q1 approaches zero, elasticity of demand

approaches negative infinity, perfectly elastic
 p1 = 0 results in perfectly inelastic elasticity of demand

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 Linear Demand
 A straight-line
(linear) demand curve is
certainly the easiest to draw (Figure 5.8)
 However, such behavior is generally
unrealistic
• Because linear demand curve assumes
(∂Q1/∂p1) = constant
 Impliesthat a doubling of prices will have same
effect on Q1 as a 5% increase

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Figure 5.8 Linear demand curve

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 Proportionate Price Changes
 Assuming households respond to proportionate
rather than absolute changes in prices
 May be more realistic to consider the demand
function
 Q1 = apb1, a > 0, b > 0 or
 ln Q1 = ln a + b ln p1
• Elasticity of demand is
 11 = (∂Q1/∂p1)(p1/Q1) = bap1b-1(p1/Q1) = b or
 11 = (∂ ln Q1/∂ ln p1) = b
 Elasticity of this demand curve is constant along its entire
length
 Constant elasticity of demand curve, with b = -1 is illustrated in
Figure 5.9

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Figure 5.9 Constant unitary
elasticity of demand …

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 Price Elasticity and Total
Revenue
 Valuable use of elasticity of demand
 Predict what will happen to households’ total expenditures on a
commodity or to producers’ total revenue when price changes
 Total revenue (TR) and total expenditures are defined as
price times quantity (p1Q1)
 A change in price has two offsetting effects
 Reduction in price has direct effect
• Reduces total revenue for the commodity
• Results in an increase in quantity sold
 Increases total revenue
 Considering these two opposing effects, total revenue from a
commodity price change may rise, fall, or remain the same
• Effect depends on how responsive quantity is to a change in price
 Measured by elasticity of demand

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 Price Elasticity and Total
Revenue
 Relationship between total revenue and elasticity of demand
may be established by differentiating total revenue (p1Q1)
with respect to p1
 Using product rule of differentiation, dividing both sides by
Q1 and multiplying left-hand-side by p1/p1 yields total
revenue elasticity
 TR, p = 1 + 11
• Measures percentage change in total revenue for a percentage change
in price
• Sign depends on whether 11 is > or < -1
 If 11 > -1, demand is inelastic and TR,p > 0
 Price and total revenue move in same direction
 If 11 < -1, demand is elastic, and TR,p < 0
 An increase in p1 is associated with a decrease in total revenue
 If elasticity of demand is unitary, Q,p = -1, then TR,p = 0
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 Price Elasticity And Total
Revenue
 If elasticity of demand is elastic
 Quantity demanded will increase by a larger percentage than price
decreases
• Total revenue will increase with a price decline
 Opposite occurs when demand is inelastic
 A price decline results in total revenue declining
• Because quantity demanded increases by a smaller percentage than
price decreases
 In elastic portion of demand curve
 Price and total revenue move in opposite directions
 In inelastic portion
 Price and TR move in same direction

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Table 5.2 Response of total
revenue to a price change

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Figure 5.10 Elasticity of demand
and total revenue …

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 Price Elasticity and the Price
Consumption Curve
 Setting p2 as numeraire price, p2 = 1
 Then p1x1 + x2 = I
 Solving for total revenue (expenditures) for x1 yields
 p1x1 = I – x2
 On vertical axis in Figure 5.7, at p1 = $45,
• Income I is initially allocated between total expenditures for x2,
x2, and total expenditure on x1, I - x2
 Decreasing p1 from $45 to $30 results in a decline in total
expenditure for x2 and an increase in total expenditure for
x1
• Movement from B to C in indifference space results in a
negatively sloping price consumption curve

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 Price Elasticity and the Price
Consumption Curve
 Declining price consumption curve is associated with an
increase in total expenditures on x1
 Indicating elastic demand
 Negatively sloping portion of price consumption curve is
associated with elastic portion of demand curve
 Positively sloping price consumption curve is associated
with inelastic portion of demand curve
 Decreasing p1 from $30 to $15 results in total expenditures for x2
increasing and total expenditures for x1 declining
 Indicating inelastic demand
 If price consumption curve has a zero slope, unitary
elasticity exists

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 Price Elasticity and the Price
Consumption Curve
 Slope of price consumption curve is determined by
magnitude of income and substitution effects
 Total effect of a price change is sum of these two effects
 Closeness of substitutes for a commodity directly influences
substitution effect
• The more closely related substitutes are to the commodity, the larger will
be the substitution effect
• A relatively large substitution effect will decrease slope of price
consumption curve
 Will make demand curve more elastic
• If a commodity has a close substitute and if price of substitute remains
constant
 A rise in price of commodity will divert households’ expenditures away from
product toward substitute

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 Price Elasticity and the Price
Consumption Curve
 Other important determinants of slope of price
consumption curve
 Proportion of income allocated for a commodity
• And whether commodity is normal or inferior
 The smaller the proportion of income allocated for a
commodity, the larger the slope of price consumption
curve
• The more inelastic the demand
 Income effect is relatively small for a commodity
requiring a small fraction of income
 Results in a more inelastic demand

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 Price Elasticity and the Price
Consumption Curve
 An inferior commodity will tend to result in a
positively sloping price consumption curve
 Inelastic demand curve
 If inferior nature of a commodity results in a Giffen good,
result is
• Backward-bending price consumption curve
• Positively sloping demand curve
 A final major determinant of demand elasticity is
time allowed for adjusting to a price change
 Elasticities of demand tend to become more elastic as
time for adjustment lengthens
• The longer the time interval after a price change, the easier it
may become for households to substitute other commodities
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 Income Elasticity Of Demand
 Relationship between change in quantity demanded and
change in income may be represented by the slope of an
Engel curve
 Weighting this slope with income divided by quantity results
in income elasticity
 ηQ = (∂Q/∂I)(I/Q)
 Measures percentage change in quantity to a percentage change in
income
• Classified as follows

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Table 5.3 Estimated income
elasticities

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Cross-Price Elasticity of Demand
 Demand for a commodity such as an automobile will depend
on its own price and income and
 Prices of other related commodities
 Measure responsiveness of demand to a price change in a
related commodity by cross-price elasticity
 Cross-price elasticity of demand for commodities x1 and x2
 When Q1 is a gross substitute for Q2
• 12 = (∂Q1/∂p2)(p2/Q1) = ∂ ln Q1/∂ ln p2 > 0
 When Q1 is a gross complement for Q2
• 12 = (∂Q1/∂p2)(p2/Q1) = ∂ ln Q1/∂ ln p2 < 0
 Cross-price elasticity can be either positive or negative
• Depending on whether Q1 is a gross substitute or gross complement for
Q2

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Table 5.4 Estimated cross-price
elasticities of demand …

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 Slutsky Equation in Elasticities
 Slutsky equation from Chapter 4

 Substitution elasticity

• Indicates how demand for x1 responds to proportional compensated price

changes

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Slutsky Equation in Elasticities
 Slutsky equation in elasticity form

 Where α1 = p1x1/I is proportion of income spent on x1

• Indicates how price elasticity of demand can be disaggregated
into substitution and income components
 Relative size of income component depends on proportion of total
expenditures devoted to commodity in question
 Given a normal good, the larger the income elasticity and
proportion of income spent on the commodity, the more elastic
is demand
 Income effect will be reinforced by substitution effect
 Larger the substitution effect, the more elastic is demand

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