Lecture 4

BUSINESS and ECONOMICS DEPARTMENT

Demand Analyses

MUNKHBUREN

Ch 3: Demand Theory

© 2004, Managerial Economics, Dominick Salvatore © 2010/11, Sami Fethi, EMU, All Right Reserved.

Demand:

Demand is a buyer's willingness and ability to pay a price for a specific quantity of a good or service..

Et.c:

Needs=Demand+Dreams

Demand= NEEDS+MONEY-DREAMS

Ch 3: Demand Theory


© 2009 Pearson Addison-Wesley. All rights reserved. 2-3

Influencing factor for Demand:

: Price Essay Information Cross price

Substitutes and Complement Revenue of consumer Laws Elasticityother

Ch 3: Demand Theory


Demand analyses have two mission.

Efficient for Demand

Relation of demand and Revenue

Ch 3: Demand Theory


Influencing factor of Elasticity

Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon

Demand tends to be more elastic: the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.

Ch 3: Demand Theory


Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Ch 3: Demand Theory


Computing the Price Elasticity of Demand

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:

( )

( . . ).

1 0 81 0

1 0 0

2 2 0 2 0 02 0 0

1 0 0

2 0 %

1 0 %2

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Ch 3: Demand Theory


The Midpoint Method

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.

2 1 2 1

2 1 2 1

( ) /[( ) / 2]Price elasticity of demand =

( ) /[( ) / 2]

Q Q Q Q

P P P P

Ch 3: Demand Theory


The Midpoint Method: A Example

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:

(10 8)22%(10 8) / 2

2.32(2.20 2.00) 9.5%

(2.00 2.20) / 2

Ch 3: Demand Theory


The Variety of Demand Curves

Inelastic Demand Quantity demanded does not respond

strongly to price changes. Price elasticity of demand is less than

one. Elastic Demand

Quantity demanded responds strongly to changes in price.

Price elasticity of demand is greater than one.

Ch 3: Demand Theory



Perfectly Inelastic Quantity demanded does not respond

to price changes. Perfectly Elastic

Quantity demanded changes infinitely with any change in price.

Unit Elastic Quantity demanded changes by the

same percentage as the price.

Ch 3: Demand Theory


Computing the Price Elasticity of Demand

Demand is price elastic.

$5

4Demand

Quantity1000 50

3percent 22

percent 67

5.00)/2(4.005.00)(4.00

50)/2(10050)(100

ED

Price

Ch 3: Demand Theory



Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

But it is not the same thing as the slope!

Ch 3: Demand Theory


$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

Price

2. . . . leaves the quantity demanded unchanged.

(a) Perfectly Inelastic Demand: Elasticity Equals 0

The Price Elasticity of Demand

Ch 3: Demand Theory


(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100


Ch 3: Demand Theory


2. . . . leads to a 22% decrease in quantity demanded.

(c) Unit Elastic Demand: Elasticity Equals 1

Quantity

4

1000

Price

$5

80

1. A 22%increasein price . . .

Demand


Ch 3: Demand Theory


(d) Elastic Demand: Elasticity Is Greater Than 1

Demand

Quantity

4

1000

Price

$5

50

1. A 22%increasein price . . .

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


Ch 3: Demand Theory


(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.


Ch 3: Demand Theory


The Price Elasticity of Demand and Total Revenue

Total revenue is the amount paid by buyers and received by sellers of a good.

Computed as the price of the good times the quantity sold.

TR=P*Q

Ch 3: Demand Theory


Price Elasticity of Demand

In all cases, εP < 0 . Price Elasticity and Total Revenue

Price cut increases revenue if │εP│> 1.

Revenue constant if │εP│= 1.

Price cut decreases revenue if │εP│< 1.

Ch 3: Demand Theory


Demand

Quantity

Q

P

0

Price

P × Q = $400(revenue)

$4

100

When the price is $4, consumers will demand 100 units, and spend $400 on this good.

Ch 3: Demand Theory


With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

How Total Revenue Changes When Price Changes: Inelastic Demand

Demand

Quantity0

Price

Revenue = $100

Quantity0

Price

Revenue = $240

Demand$1

100

$3

80

An Increase in price from $1 to $3 …

… leads to an Increase in total revenue from $100 to $240

Ch 3: Demand Theory


How Total Revenue Changes When Price Changes: Elastic Demand

With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Demand

Quantity0

Price

Revenue = $200

$4

50

Demand

Quantity0

Price

Revenue = $100

$5

20

An Increase in price from $4 to $5 …

… leads to an decrease in total revenue from $200 to $100

Ch 3: Demand Theory


Price Elasticity and Optimal Pricing Policy

Optimal Price FormulaMR and εP are directly related.

MR = P/[1+(1/ εP)].

Optimal P* = MC/[1+(1/ εP)].

Ch 3: Demand Theory


Other Demand Elasticities

Income Elasticity of Demand Income elasticity of demand measures

how much the quantity demanded of a good responds to a change in consumers’ income.

It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Ch 3: Demand Theory


Income Elasticity of Demand

Computing Income Elasticity

Ch 3: Demand Theory



Income Elasticity Types of Goods

Normal Goods Inferior Goods

Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Ch 3: Demand Theory



Income Elasticity Goods consumers regard as necessities

tend to be income inelastic Examples include food, fuel, clothing,

utilities, and medical services. Goods consumers regard as luxuries

tend to be income elastic. Examples include sports cars, furs, and

expensive foods.

Ch 3: Demand Theory


Other Demand Elasticities

Cross-price elasticity of demand A measure of how much the quantity demanded of one

good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

Ch 3: Demand Theory


Cross-price Elasticity of Demand

Cross-price elasticity shows demand sensitivity to changes in other prices. εPX = ∂QY/QY ÷ ∂PX/PX.

Substitutes have εPX > 0. E.g., Coke demand and Pepsi prices.

Complements have εPX < 0. E.g., Coke demand and Fritos prices.

Independent goods have εPX = 0. E.g., Coke demand and car prices.

Ch 3: Demand Theory


MR and TR based on Elasticity- Example

-31,000-1/51,0001

-5001,2000

-11,600-1/28002

11,800-16003

31,600-24004

51,000-52005

-$ 0-indefinite0$ 6

(5)(4)(3)(2)(1)

MR=DTR/DQ

TR=P.QEpQP

Ch 3: Demand Theory


Graphically Showing Elasticities and MR-TR

MR>01PE 1PE

MR<0TR

1PE MR=0QX

600 12000

Ch 3: Demand Theory


Graphically Showing Elasticities and MR-TR

MRX

PX

1PE 1PE

1PE

QX600 12000

6

Ch 3: Demand Theory



/

/I

Q Q Q IE

I I I Q

Point Definition

Linear Function

3I

IE a

Q

Ch 3: Demand Theory



2 1 2 1

2 1 2 1I

Q Q I IE

I I Q Q

Arc Definition

Normal Good Inferior Good

0IE

Luxuries GoodNecessities Good

0IE

1IE 1I0 < E <

Ch 3: Demand Theory


Cross-Price Elasticity of Demand

/

/X X X Y

XYY Y Y X

Q Q Q PE

P P P Q

Point Definition

Linear Function 4Y

XYX

PE a

Q

Ch 3: Demand Theory


Cross-Price Elasticity of Demand

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PE

P P Q Q

0XYE

Arc Definition

Substitutes Complements

0XYE

Ch 3: Demand Theory


The End

Thanks

Lecture 4

Economy & Finance

Transcript of Lecture 4