Demand Analysis

PGDM RM 2010-12
 OVERVIEW
 Utility Theory
 Indifference Curves
 Budget Constraints
 Individual Demand
 Optimal Consumption
 Demand Sensitivity Analysis: Elasticity
 Price Elasticity of Demand
 Cross-price Elasticity of Demand
 Income Elasticity of Demand
 KEY CONCEPTS
 utility
 nonsatiation principle
 indifference
 ordinal utility
 cardinal utility
 utility function
 utils
 market baskets
 marginal utility
 law of diminishing marginal
utility
 indifference curves
 substitutes
 complements
 perfect substitutes
 perfect complements
 budget constraint
 income effect
 substitution effect
 price-consumption curve
 income-consumption curve
 Engle curve
 normal goods
 inferior goods
 Marginal rate of substitution
 Utility Theory
 Assumptions About Consumer Preferences
 More is better.
 Consumers rank-order desirability of products.
 Utility functions relate well-being to consumption.
 Marginal utility shows added benefit of a small
increase in consumption.
 Marginal utility is usually positive, MU>0.
 Law of Diminishing Marginal Utility
 Marginal utility eventually declines for everything.
 Indifference Curves
 Basic Characteristics
 Higher indifference curves are better.
 Indifference curves do not intersect.
 Indifference curves slope downward.
 Indifference curves are convex to origin.
 Perfect substitutes are products that satisfy
the same need, e.g., car models.
 Perfect complements are products consumed
together, e.g., cars and tires.
© 2009, 2006 South-Western, a
part of Cengage Learning
 Budget Constraints
 Basic Characteristics
 Show affordable combinations of X and Y.
 Slope of –PX/PY reflects relative prices.
 Effects of Changing Income and Prices
 Budget increase (decrease) causes parallel
outward (inward) shift.
 Relative price change alters budget slope.
 Income and Substitution Effects..
© 2009, 2006 South-Western, a
part of Cengage Learning
 Price Consumption Curve
 Price-consumption curve(PCC) shows
consumption impact of price changes.
 PCC depicts various market baskets that
maximizes the utility
 PCC explains how Optimal consumption of both
goods and services are affected by change in
Price of goods or services
 Demand curve illustrates how quantity demanded
changes with a change in price
PCC Reflects movement along demand curve.
© 2009, 2006 South-Western, a
part of Cengage Learning
Income-consumption curve
shows consumption impact
of income changes.
Reflects shift from one
demand curve to another.
Engle curves plot income
and consumption.
Normal good consumption
rises with income.
Inferior good consumption
falls with income (rare).

©
 Optimal Consumption
 Marginal Rate of Substitution (MRS)
 MRSXY = -MUX/MUY and equals indifference
curve slope.
 MRSXY shows tradeoff between X and Y
consumption, holding utility constant.
 MRSXY diminishes as substitution of X for Y
increases.
 Utility maximization requires
 PX/PY = MUX/MUY,.
 Demand Sensitivity Analysis:
Elasticity
 Elasticitymeasures sensitivity.
 Point elasticity shows sensitivity of Y
to small changes in X.
 εX = ∂Y/Y ÷ ∂X/X.
 Arcelasticity shows sensitivity of Y to
big changes in X.
 EX = (Y2–Y1)/(Y2+Y1) ÷ (X2-X1)/(X2+X1).
Price Elasticity of Demand
 If Ep=0, demand is perfectly inelastic
 If Ep=1,demand is unit elastic
 If Ep=∞ demand is perfectly elastic
 If 0<Ep>1, demand is inelastic
 If 1<Ep> ∞, demand is elastic
 Shape of demand curve- perfectly
elastic- Horizontal: perfectly inelastic
right angle
 Price Elasticity - Determinants
 Elasticity Varies along Demand Curve
 As price rises, so too does │εP│.
 As price falls, so too does│εP│.
 (a)Availability of substitutes; (b)nature of
the goods( luxury or necessity); (c) Time
period(d) number of uses the
commodities is put to use
 Close substitute- more elastic
 Luxury- elastic
 Necessity- inelastic
 Demand is more elastic in the long run
 More possible uses greater elastic

© 2009, 2006 South-Western, a

part of Cengage Learning
©
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.
 Cross elasticity
 Higher the value of cross elasticity the
stronger the degree of substitutability
 The main determinant of cross elasticity is
the nature of goods/services relative to
their use
 If two commodities can satisfy equally well
the same need, the cross elasticity is high
and vice versa
 Income Elasticity of Demand
 Income elasticity shows demand
sensitivity to changes in income.

εI = ∂Q/Q ÷ ∂I/I.
 Normal goods have εI > 0.

Noncyclical normal goods have 0 < εI < 1,
e.g., candy.

Cyclical normal goods have εI > 1, e.g.,
housing.
 Inferior goods have εI < 0.
 Very rare.
Income elasticity- Determinants
 Luxury if income elasticity is greater than
one
 Necessity if income elasticity isless than
one
 Determinants-nature of the need that
commodity satisfies( Engle Law); initial
level of income: time period
 Consumption Pattern adjust with time lag
© 2009, 2006 South-Western, a