Microeconomics Salvatore

Copyright 2007 by Oxford University Press, Inc. PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.
Slide 1
1
Copyright 2007 by Oxford University Press, Inc. PowerPoint Slides Prepared by Robert F. Brooker, Ph.D. Slide 2
2
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.
Substitution Effect
Income Effect
Components of Demand:
The Substitution Effect
Assuming that real income is constant:
If the relative price of a good rises, then
consumers will try to substitute away from
the good. Less will be purchased.
If the relative price of a good falls, then
consumers will try to substitute away from
other goods. More will be purchased.
The substitution effect is consistent with
the law of demand.
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.
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 =
Qd
X
= f(P
X
, I, P
Y
, T)
AQd
X
/AP
X
< 0
AQd
X
/AI > 0 if a good is normal
AQd
X
/AI < 0 if a good is inferior
AQd
X
/AP
Y
> 0 if X and Y are substitutes
AQd
X
/AP
Y
< 0 if X and Y are complements
Market Demand Curve
Horizontal summation of demand
curves of individual consumers
Exceptions to the summation rules
Bandwagon Effect
collective demand causes individual demand
Snob (Veblen) Effect
conspicuous consumption
a product that is expensive, elite, or in short
supply is more desirable
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 =
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
Demand Curve Faced by a Firm Depends
on the Type of Product
Durable Goods
Provide a stream of services over time
Demand is volatile
Nondurable Goods and Services
Producers Goods
Used in the production of other goods
Demand is derived from demand for final
goods or services
Linear Demand Function
Q
X
= a
0
+ a
1
P
X
+ a
2
N + a
3
I + a
4
P
Y
+ a
5
T
P
X
Q
X
Intercept:
a
0
+ a
2
N + a
3
I + a
4
P
Y
+ a
5
T
Slope:
AQ
X
/AP
X
= a
1
Example Part 1
Demand Function for Good X
Q
X
= 160 - 10P
X
+ 2N + 0.5I + 2P
Y
+ T
Demand Curve for Good X
Given N = 58, I = 36, P
Y
= 12, T = 112
Q = 430 - 10P

Example Part 2
Inverse Demand Curve
P = 43 0.1Q

Total and Marginal Revenue Functions
TR = 43Q 0.1Q
2
MR = 43 0.2Q

Price Elasticity of Demand
/
/
P
Q Q Q P
E
P P P Q
A A
= =
A A
Linear Function
Point Definition
1 P
P
E a
Q
=
Price Elasticity of Demand
Arc Definition
2 1 2 1
2 1 2 1
P
Q Q P P
E
P P Q Q
+
=
+
Marginal Revenue and Price
Elasticity of Demand
1
1
P
MR P
E
| |
= +
|
\ .
Marginal Revenue and Price
P
X
Q
X
MR
X
1
P
E >
1
P
E <
1
P
E =
Marginal Revenue, Total
Revenue, and Price Elasticity
TR

Q
X
1
P
E <
MR<0

MR>0

1
P
E >
1
P
E =
MR=0

Determinants of Price
The demand for a commodity will be
more price elastic if:
It has more close substitutes
It is more narrowly defined
More time is available for buyers to
adjust to a price change
Determinants of Price
The demand for a commodity will be
less price elastic if:
It has fewer substitutes
It is more broadly defined
Less time is available for buyers to
adjust to a price change
Income Elasticity of Demand
Linear Function
Point Definition
/
/
I
Q Q Q I
E
I I I Q
A A
= =
A A
3 I
I
E a
Q
=
Income Elasticity of Demand
Arc Definition
2 1 2 1
2 1 2 1
I
Q Q I I
E
I I Q Q
+
=
+
Normal Good Inferior Good
0
I
E > 0
I
E <
Cross-Price Elasticity of Demand
Linear Function
Point Definition
/
/
X X X Y
XY
Y Y Y X
Q Q Q P
E
P P P Q
A A
= =
A A
4
Y
XY
X
P
E a
Q
=
Cross-Price Elasticity of Demand
Arc Definition
Substitutes Complements
2 1 2 1
2 1 2 1
X X Y Y
XY
Y Y X X
Q Q P P
E
P P Q Q
+
=
+
0
XY
E >
0
XY
E <
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
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
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
Chapter 3 Appendix
Indifference Curves
Utility Function: U = U(Q
X
,Q
Y
)
Marginal Utility > 0
MU
X
= U/Q
X
and MU
Y
= U/Q
Y

Second Derivatives
MU
X
/Q
X
< 0 and MU
Y
/Q
Y
< 0
MU
X
/Q
Y
and MU
Y
/Q
X

Positive for complements
Negative for substitutes
Marginal Rate of Substitution
Rate at which one good can be
substituted for another while holding
utility constant
Slope of an indifference curve
dQ
Y
/dQ
X
= -MU
X
/MU
Y
Indifference Curves:
Complements and Substitutes
Q
Y
Q
X
Q
Y
Q
X
Perfect
Complements
Perfect
Substitutes
The Budget Line
Budget = M = P
X
Q
X
+ P
Y
Q
Y
Slope of the budget line
Q
Y
= M/P
Y
- (P
X
/P
Y
)Q
X
dQ
Y
/dQ
X
= - P
X
/P
Y
Budget Lines: Change in Price
GF: M = $6, P
X
= P
Y
= $1
GF: P
X
= $2
GF: P
X
= $0.67
Budget Lines: Change in Income
GF: M = $6, P
X
= P
Y
= $1
GF: M = $3, P
X
= P
Y
= $1
Consumer Equilibrium
Combination of goods that maximizes
utility for a given set of prices and a
given level of income
Represented graphically by the point of
tangency between an indifference curve
and the budget line
MU
X
/MU
Y
= P
X
/P
Y
MU
X
/P
X
= MU
Y
/P
Y
Mathematical Derivation
Maximize Utility: U = f(Q
X
, Q
Y
)
Subject to: M = P
X
Q
X
+ P
Y
Q
Y
Set up Lagrangian function
L = f(Q
X
, Q
Y
) + (M - P
X
Q
X
- P
Y
Q
Y
)
First-order conditions imply
= MU
X
/P
X
= MU
Y
/P
Y

Microeconomics Salvatore

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Microeconomics Salvatore

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Copyright 2007 by Oxford University Press, Inc. PowerPoint Slides Prepared by Robert F. Brooker, Ph.D.

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