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INTRODUCTION manager of a firm.

DEMAND THEORY

You would have done demand theory in your diploma course. Your lecturer would have discussed the theoretical aspect of demand. Now you will be applying this theory to make decisions in a firm. In managerial economics you have to assume that you are a

For your firm to survive or to be established it needs sufficient demand. It cannot survive if there is no demand even though it has the most efficient production method. As a manager you have to understand and analyse the forces that determine the demand for your product. For example how will customers react to an increase in the price of haircut during festive season and off-festive seasons? How does the recession affect the demand for your product? Therefore it can be seen that the demand theory is important for the creation, survival and profitability of your firm. This chapter will begin by explaining the basic differences between demand function and demand curve function, followed by market demand curve. Then attention will be given to different revenue functions. Finally the concept of elasticity and its importance in decision making will be discuss .The mechanics of demand will also be analyses using algebraic equation and graph.

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Chapter 3 Demand Theory

Key terms for review: Determinants of demand Multiplicative demand function Total revenue Average revenue price elasticity of demand Cross elasticity Complements Luxury goods Inferior goods Demand function Linear demand function Demand curve Marginal revenue Elasticity Price elasticity Income elasticity Substitutes Basic necessities Normal goods

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Chapter 3 Demand Theory

CHAPTER OVERVIEW

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Chapter 3 Demand Theory

Learning Objectives After reading this chapter, the students should be able to: 1. 2. 3. 4. 5. Explain a demand function. Derive a demand curve function from the demand function Derive the total, marginal and average revenue function and describe the relationship between them. Calculate and interpret price, income and cross elasticity. Analyse the importance of elasticity in decision making.

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A. income (I) and (T). The determinants of demand are the factors that influence demand. I is income and T is taste. Py is the price of related product y.Chapter 3 Demand Theory 3. At this stage we shall analyse two forms of demand function. This definition can further be analysed as the desire. I. For example. They are: a) Linear Demand Function The determinants of demand for product X in a linear form can be written as : Qx = α .demand that is backed by the purchasing power. α β 0 to β 3 = constant and includes all the other variables not mentioned in the demand function. The specific form of the demand function is determined empirically. T ) Eqn 3a FORMS OF DEMAND FUNCTIONS There are various forms of demand functions. willingness and ability to buy a product at a specific price at given point of time. = coefficients of the demand function. advertising expenditure (A). the demand for shoes (Qs) is influenced by price of shoes (Ps).1 THE DEMAND FUNCTION A textbook definition of effective demand is . Demand function refers to the relationship that exists between the quantity demanded and the determinants of demand. 87 . The demand function can be written in a functional form as: Qs = f (Ps.β 0 Px + β 1 Py + β 2 I + β 3 T Eqn 3b where Px is price of product X.

The coefficients are replaced by their numerical equivalent after they are estimated using regression analysis. If we assume Px = 2. The quantity demanded will be: (Substitute these values into the equation) Qx = 1.0 units.0Px + 1. Py = 2. For example if the price of X change by one unit the quantity demanded will change by β 0 units. the positive or negative signs before the respective coefficient indicates the direction of the relationship that variable has on Qx.0(2) + 1. explains that when the price of X increase by one unit the quantity demanded of X will decrease by 2. The sign (+/-) before the coefficient shows the (positive or negative) relationship between the independent and dependent variable. b) Multiplicative Demand Function Q = α Px β 0 Py β 1 I β 2 T β 3 Where α β 0 to β 3 = = constant measures the percentage change in the Eqn 3c dependent variable relative to the percentage change in the respective independent variable.2.8(2.5 . coefficient -2. I = 4. For example.5) + 2.Chapter 3 Demand Theory The coefficients indicate the marginal impact of each independent variable on the quantity demanded.2.5I + 0.0 Px .0 . Example 1 Suppose the demand function for product X has been estimated and is as follow: Qx = 1.0T α and β coefficients are replaced by their numerical equivalents.5(4) + 0. and T = 2 .0 .0(2) = 9 Units 88 .8Py + 2.

2 The Demand Curve The Law of demand seeks to explain the relationship between quantity demanded and price. The demand curve function is a special sub-case of the demand function. In other word it is derived from the demand function. A demand curve function shows the relationship between quantity demanded and the price of the product assuming all the other factors influencing its demand to remain constant (Ceteris Paribus). Rewritten in the conventional way (making P the subject): 89 . ceteris paribus. at the current values of the independent variables. The Law of demand can be depicted in a functional form by a demand curve function. based on equation Eqn 3b. In a linear form it will be: Qx = A . 3.β 0Px A is derived Eqn 3e Eqn 3d by compressing (adding) all the factors that determine demand except for price of the product. quantity demanded decrease and vice versa). A is: A = α + β 1Py + β 2I + β 3T Note: Since traditionally price is being placed on the y-axis and quantity on the x-axis. that is quantity and price are inversely related (price increases. In functional form a demand curve function is written as: Qx = f (Px) ceteris paribus.Chapter 3 Demand Theory Based on the equation we can predict that. But one has to bear in mind that quantity (Qx) is the dependent variable and price (Px) is the independent variable. the above equation can be rewritten to make Px the subject. quantity demanded of product X will be 9 units.

5I + 0.0Px + 1. T = 2 Get the value of ‘A’: 90 .5 . Therefore the For easy reference we shall assume that A/ β demand curve function will be as follows: Px = a – b Qx 0 0 Eqn 3f The demand curve function can be represented graphically in diagram 3.1.Chapter 3 Demand Theory Px= A β0 _ 1Q β0 is a and 1/ β is b.2. Based on the estimated demand function from Example 1 where: Qx = 1.8Py + 2. I = 4. Py = 2.0T Given Px = 2.0 . Diagram 3.1 Demand Curve Example 2 This example will show you how to derive a demand curve function from demand function.

5) + 2.0 (2) = 13 and then by substituting it into the demand curve function: Qx = In the conventional form: Px = 6.5 is the slope term (b).5 –0.Chapter 3 Demand Theory A = 1.0Px DEMAND CURVE FUNCTION Diagram 3. The negative sign before the slope term or coefficient shows an inverse relationship between price and quantity.2 shows the demand curve: Diagram 3.0 + 1.8 (2.2 Demand curve NOTES The price is expressed as a linear function of quantity demanded.5Qx 13 .5 (4) + 0.2. 6. The intercept on the horizontal axis is 13 (the value of A) 91 .5 is the intercept on the vertical axis (a) and 0.

To get the market demand function we add the individual demand functions horizontally.3p Q3 = 15 .7.4p) + (6 .9p) = 31 . that is: Qm = Qa +Qb +Qc +.0.3p) + (15 . ……+ Qn When P1 = P2 = P3 = ………= Pn Eqn 3g Example 3 Given individual demand functions as : Individual 1 Individual 2 Individual 3 Q1 = 10 .0. It shows the total quantity demanded in the market at various prices.Chapter 3 Demand Theory 3.4p Q2 = 6 .9p The market demand curve function is QM QM QM = Q1 + Q2 + Q3 = (10 . For simplicity we assume that there are two individuals with the following demand curves.92 . 92 .9p or PM = 3.3 THE MARKET DEMAND CURVE Market demand of a product or service is the sum of individual demand.126 QP The market demand curve can also be determined graphically by adding the quantity demanded at a given price.0.

Individual 1 buys 3 units and individual II buys 2 units. To get the total revenue function. The market demand at this price will be 5 units (2+3). At price RM5 the market demand is (5+6) 11 units.4 TOTAL.3 when the price is RM10. MARGINAL AND AVERAGE REVENUE FUNCTIONS TOTAL REVENUE FUNCTION The total revenue shows the total dollar sales of a firm at a certain period of time. 3. total quantity demanded (sold) is multiplied by the price of the product (P x Q). When the price changes the total revenue will change.Chapter 3 Demand Theory Diagram 3. Managers are interested in the relationship between price and quantity since it influences total revenue. That is : Total revenue is: Px = a – b Qx TR = P x Q By substituting P x into the total revenue function we get : 93 .3 The market demand curve Referring to the diagram 3.

5 (2)2 = 9 and at quantity 6. if the quantity is 2 the total revenue will be: 6. Using these values the total revenue curve can be plotted as show in diagram 3.5Q2 The total revenue function can be represented graphically by plotting quantity against the total revenue.5(2) .5Q .5Qx) = 6.4 The Total Revenue Curve 94 .5Qx the TR function is equal to TR = Q (6.5 .5 and 7 the total revenue is 21. For example.0.125 and 14 respectively.0.4.0. Diagram 3.5 .Chapter 3 Demand Theory TR x = (a – b Qx) Qx Therefore the total revenue function is TRx = a Qx – bQx2 Eqn 3h Example 4 Based on Example 2 : Px = 6.0.

Chapter 3 Demand Theory To find the total revenue maximising quantity. differentiate the equation. set it equal to zero and solve for Q The process is shown below.Q = 0 ∂Q Q = 6.125.5 . Make a point to revise the chapter if you find difficulties At quantity 6.0. Eqn 3i Example 5 Based on Example 4: TR = 6.Q ∂Q 95 .5Q .5 units the total revenue is 6.5 We studied optimization in chapter 2.5) 2 which is 21.0. TR = 6.5Q2 ∂TR = 6.0. It can be express as a first derivative of total revenue with respect to Qx That is: TRx MRx = a Qx – bQx2 = ∂TR = a– 2bQx ∂Qx Diagram 3.5 shows a graphical representation of marginal revenue function.5 .5 (6.5) .5 (6.5Q2 The marginal revenue function is MR = ∂TR = 6. THE MARGINAL REVENUE FUNCTION The marginal revenue is defined as the change in the total revenue that results from one unit change in the quantity demanded.5Q .

marginal curve is shown in Diagram 3.5Q The MR = 6. MR = 6.Q = 0 Q = 6.5.5. It is calculated by dividing total revenue by the quantity.5 P = 6.5 The Marginal Revenue Curve The marginal revenue is zero at quantity 6.5 Qtty Diagram 3. TRx = a Qx – bQx2 AR x = TR Qx = a – bQx Eqn 3j 96 .Chapter 3 Demand Theory The marginal revenue slope downwards and the intercept is at 6.5 – Q or a– 2bQx 0 6.5 .5 -0.5 THE AVERAGE REVENUE FUNCTION Average revenue is the revenue earned per unit of output sold.5 MR/p 6.

Chapter 3 Demand Theory NOTES The average revenue function is also the demand curve function.5Q2 = TR = 6. 97 .5 .0.0.0.5Q Qx The average revenue function is similar to the demand curve function P = 6. Example 6 The average revenue function can be computed from the above total revenue function.5Q .5Q. The relationship between demand curve. marginal revenue and the total revenue curves. marginal revenue and the total revenue curve functions can be analyse diagrammatically. Given: TR AR = 6.5 . The relationship between demand curve.

a. c.2 previously explained this relationship Diagram 3.Chapter 3 Demand Theory Again. (refer to quantity Q*) When marginal revenue is positive the total revenue is increasing (refer to quantity O. section 2. b. b. Based on diagram 3.Q*) When marginal revenue is negative the total revenue is decreasing (refer to quantity after Q*) 98 . a. The slope of marginal revenue curve is twice (2 b Qx) of the demand curve (b Qx ) Next we shall look at the relationship between marginal revenue and total revenue.5 The relationship between Total Revenue and Marginal Revenue Curve. AR and MR has the same intercept. When marginal revenue is zero the total revenue is at its maximum.5 first we begin by comparing the similarities and differences between the average /demand curve and marginal revenue functions. this indicates that both curves must begin from the same point on Y axis.

Suppose the demand function for special Sukom files is Qd = 2500 .12P Q . a) b) c) Rewrite the demand curve function in the conventional way.6P a) b) c) Derive the total revenue function? At what output is the total revenue maximum? Derive the marginal revenue function? 99 .5Q Their demand curve function for each What is the market demand curve function? How many badges will be bought in the market at price RM2 and how will this be distributed among the individuals? 3. Individual I Individual II Individual III a) b) PI PII PIII = 5 .1. individual is as follows.Quantity demand for caps P .5 Q1 = 4 . Given the demand curve function for caps as: Q = 3200 .3. How many caps will be sold at RM10 each? At what price would sales equal zero? 2. There are three individuals with different demand curve function wanting to buy badges (the quantity is in hundreds).5Q = 8 .Chapter 3 Demand Theory QUESTIONS 1.Price of caps.

Py is the price of hot dog competitor and Ph is the price of hot dog Given A is RM100.2 A + 9.00. Py is RM2.12P = 3200 .6 Py .15. a) Q P P = 3200 .083 Q = 10 = 3200 .4 Ph.3 + 10.12 (10) = 3080 units b) When P Q c) When Q P P =0 = 266.0.67 .67 2. a) b) Determine the demand curve function and plot the demand curve using any three price-quantity combinations. Where Qh is the quantity of hot dogs.Chapter 3 Demand Theory d) e) 4. SUGGESTED SOLUTIONS 1. Derive the marginal revenue function.67 . and Ph is RM18.083 (0) = 266. A is advertising expenditure. a) Market demand is equal QI + QII + QIII 100 . At what output is marginal revenue zero? What can you conclude from the answers in (b) and (d) A firm selling hot-dogs estimates the demand function for hot-dogs as Qh = 150.0.Q 12 = 266.

56 = 3.33 .86Q =2 = 7.5Q = 8-P 1. 101 .0.47 .0.67(2) 416.15 Each Individual will buy: QI QII QIII 3.1.17Q PQ 416.1.47 .67P = QI + QII + QIII = 7.67 .5Q = 4–P 3.16P = 6.2(2) = 1.5 Q1 = 5 = 1.20P = 4 .14 . a) P TR TR b) = = = = 1-0.44 .29P = 8 .1.3.67Q .Chapter 3 Demand Theory (make Q the subject) PI Q1 Q1 PII Q11 QII PIII QIII QIII QM QM PM b) When P QM = 5 .6 = 0.5 = 5.0.14 .16 (2) = 5.0.5 = 1.29(2) = 5.33 .0 .99 5.0.17Q2 = 0.0.P TR maximising quantity.0.0.

4 Ph = 150.6 (2) + 10.84 61.0.3 + 19.2 + 1020 = 1189.065 Qh To plot the demand curve we can take any three values of Q.24 Quantity 0 100 250 Points A B C 102 .3 + 9.5 The demand curve function is: Qh = 1189.67 . Price RM 77.24 70.5 e) 4.15. a) When marginal revenue is zero the total revenue is maximum.34 Q Q = 0 =0 = 1225.24 .0.5 .67 . Qh A = A .0.5 c) MR = ∂ TR = 416.34Q Q = 1225.4 Ph Written in the convention form: Ph = 77.2 (100) = 150.67 .0.Chapter 3 Demand Theory ∂ TR ∂Q = 416.334Q ∂Q d) MR 416.15.

You would have used a standard formula to calculate elasticity. the price elasticity is calculated by using following formula: (basic formula) EP = percentage change in quantity demanded percentage change in price or EP = OD .24 100 b) TR MR = 77. B 61.065 Q2 = ∂ TR ∂Q = 77. For example.ND X OP OP-NP OQ 103 .24 .0.24 70.84 A Demand curve.13 Q 250 C D Quantity 3.Chapter 3 Demand Theory Price 77.0.24 Q .5 ELASTICITY Elasticity is a measure of responsiveness of the quantity demanded when there is a change in its determinants You would have learnt about concept of elasticity and how to calculate it in the economics course at diploma level.

ND is new demand. However. Price elasticity of demand is seen a positive integer (Note: When elasticity is interpreted the negative sign can be ignored for normal goods) a) b) c) Elastic (E > 1). the consumers will buy up all that available in the market i. OP is original price and NP is new price. Basically elasticity can be divided into three broad categories and two extreme cases. Consumers are responsive to the change in price. Unitary elasticity (E = 1) Consumer are proportionately responsive to the change in price. Arc elasticity measures the elasticity over a range of price and takes into consideration averages. Inelastic (E < 1). When there is a slight increase in price. This method of measuring elasticity is quite sensitive to which value is chosen as old and which is chosen as the new. the quantity demanded will fall to zero. There are two extreme cases. in this course you are introduced to two other approaches to compute elasticity.e.Chapter 3 Demand Theory Where OD is original demand. They are arc price elasticity (where the basic formula is the same) and point price elasticity. The demand curve is a horizontal straight line. The point elasticity is used to measure a very small or infinitesimally small change in the price. a) Perfectly elastic (E = ∝ ) consumers are very responsive to the change in price. price elasticity is infinity. When there is a slight decrease in the price. PRICE ELASTICITY OF DEMAND (Ex) Price elasticity of demand measures the responsiveness of quantity demanded when there is a change in its price. Consumers are not very responsive to the change in price. 104 .

the method of calculating the percentage differs. Arc Price Elasticity: As mention earlier the basic formula is the same. Px and Qx is the price and the quantity demanded of the product X respectively. Quantity demanded remain unchanged when the price changes. Based on Eqn 3.P1 X P2 + P1 Q2 + Q1 Where: Q1 Q2 P1 P2 is original quantity demanded. The formula is: Ep = ∂Qx ∂P x x Px Qx eqn 3k The first term is the partial derivative of the demand function in terms of Px. however.Q1 P2 . It takes into consideration the average of the old quantity and the new quantity on the denominator and the average of old price and new price on the numerator The formula is: Q2 . is original price and is new price Point Elasticity: Point elasticity calculates elasticity for an infinitesimally small change in the independent variable (price). is new quantity demanded.Chapter 3 Demand Theory b) Perfectly inelastic (E = 0) consumers are not responsive to change in price.1 the demand function is 105 . The demand curve is a vertical straight line. MEASUREMENT OF PRICE ELASTICITY The price elasticity is measured by dividing the percentage change in quantity demanded by the percentage change in price.

∂ Qx = .0 .2.44 (inelastic) When the price changes by one percent the quantity demanded will change by 0.β 0 X Px /Qx Example 7 Based on Example 1 where : Qx = 1.44 percent. Ex = .8Py + 2.0.β 0 Px + β 1 Py + β 2 I + β 3 T The point price elasticity based on the above formula will be.Chapter 3 Demand Theory Qx = α .2.0T Given Px = RM2 Py = RM2.2. Qx = 9 Px = 2 106 .0 ∂ Px The point price elasticity is Ex = .0Px + 1.5 I = 4 and T = 2 Qx = 9 units The point elasticity can be calculated by differentiating the equation in terms of Px and then multiplying by the ratio of Px to Qx.5I + 0.0 x 2/9 = .

That is: TR MR = PQ = dTR dQ = P + Q ∂P ∂Q 107 .6 Elasticity along the Demand Curve THE IMPORTANCE OF PRICE ELASTICITY The concept of elasticity is useful in decision-making. Price E=∞ E>1 E = 1 (Mid . The elasticity at different points along the demand curve can be determined by calculating the quantity demanded at different price level and then substituting it into the elasticity formula). total revenue and marginal revenue. marginal revenue and total revenue can be summarized in a single number known as price elasticity of demand. whether to change or maintain the price of the product when the objective is to maximise revenue.point) E<1 E = 0 Quantity Diagram 3. Diagram 3. This is because ∂ QX /∂ PX is constant but Px / Qx will increase as price increase. The relationship between price. (You may want to check it out yourselves. It helps managers to understand the relationship between elasticity.Chapter 3 Demand Theory ELASTICITY ALONG A DEMAND CURVE In a linear demand curve function the elasticity along the demand curve varies from zero to infinity.6 shows elasticity along a demand curve at different points. It assist the manager in terms of pricing decision that is.

Chapter 3 Demand Theory = P P 1 + Q ∂Q ∂P Given the elasticity formula as E = ∂Q . the positive sign in the above equation becomes negative when multiplied by a negative. MR = 0) 108 .P ∂P and next: MR = P 11 E For normal good the price elasticity is negative. Q 1 = Q . When price elasticity is greater than one the marginal revenue is positive (Ex > 1. MR < 0) c. When price elasticity is equal to one the marginal revenue is zero (E x = 1. b.∂Q E P ∂P MR = P 1+1 E eqn 3l Bases on the above equation the following relationship can be develop: a. MR > 0) When price elasticity is less than one the marginal revenue is negative (E x < 1.

the Thus. Elasticity. This is because the total revenue is decreasing and the marginal revenue is negative as more units are sold. The demand for the product is said to be elastic if the expenditure on the product forms a large proportion of the total expenditure For example. The demand for coca-cola will decrease rapidly with a slight increase in price. students who are 109 . b) Proportion of income spent on the product. By reducing the output the producer will be able to increase his profits: as total revenue will increases and total cost decreases.7 Price E>1 TR DD MR = 0 Quantity MR Diagram 3. Products with substitute have a higher price elasticity compared to products with poor or no substitutes. relatively elastic. E=1 E<1 DETERMINANTS OF DEMAND ELASTICITY a) Availability of substitutes Substitutes play an important role in determining the elasticity of the product.7. the demand for coca-cola is demand for its substitutes will increase. Total Revenue and Marginal Revenue A producer will not sell his output in the region where elasticity is less than one. For example if the price of coca-cola increases.Chapter 3 Demand Theory The relationship can be diagrammatically represented as in diagram 3.

consumers are able to find other energy sources.Q1 I2 . consumers will not reduce their consumption of electricity. The demand for rented rooms can be considered elastic. Consumers may still use their electrical appliances. For arc income elasticity the variable price is changed to income. is original income and is new income 110 .e. replace electrical appliances with non electrical appliances or to use them less frequently. when the price of electricity increases.I1 X I2 + I1 Q2+ Q1 is old quantity demanded. In the short run. But given some time (long run). salt. demand is inelastic for products that account for a small proportion of total expenditure e. Consumers are more responsive to the changes in price in the long run. Arc Income Elasticity: The formula is very much like the arc price elasticity. if the rent increases.Chapter 3 Demand Theory staying outside campus and are renting rooms. INCOME ELASTICITY (EI) Income elasticity measures the responsiveness of demand to the change in income. The formula is: EI = Where: Q1 Q2 I1 I2 Q2. i. reducing the consumption of electricity in the long run.g. demand for electricity. For example. c) Length of the period In the long run demand is more elastic than in the short runs as consumers are able to adjust to new prices. is new quantity demanded. On the other hand. MEASUREMENT OF INCOME ELASTICITY Income elasticity is measured by dividing the percentage change in quantity demanded by the percentage change in income. these students will find alternative accommodation as a large proportion of their income is spent on rental.

β 0 Px + β 1 Py + β 2 I + β 3 T The income elasticity is: EI = β 2 X I / Qx Example 8 Based on Example the income elasticity for product X is: Qx Given Px Qx = 1.5.0 .0Px + 1. I = 4 ∂I EI EiI = = 1. Qx = 9.67 111 I = 4 and T = 2 . The formula is: Ei = ∂Qx x ∂I I Qx eqn 3m Based on demand function in equation 3.5I + 0.8Py + 2.Chapter 3 Demand Theory Point Income Elasticity: Where the change in income is infinitesimally small.5 x 4/9 0.2.0T = RM2 Py = RM2.5 = 9 ∂Qx = 1.1: Qx = α .

when income increases. b) Forecasting the future demand A producer will need to forecast the future demand and be prepared to supply the amount of quantity demanded. The rate of increase in demand for these good is greater than the rate of income (economic growth). On the other hand. that is in which phase (recession. whereas for luxury good the income elasticity is greater than one. associated with normal goods. level (economic growth). the spending power increases the demand for an inferior good will decrease.e. It is also recession proof product since the impact on quantity demand is smaller compare to the fall in the income IMPORTANCE OF INCOME ELASTICITY As a decision maker income elasticity is important. peak and contraction) is the economy. One-way to forecast the demand the product is to determine the phase of business cycle in the economy. Income elasticity is useful to: a) Determine the type of good. For basic necessities the income elasticity is less than one or close to zero. The reverse is true during recession.67 percent. Positive income elasticity is Income elasticity can either be positive or negative. when income increases the quantity demanded for these goods increase. That is. This product can be classified as a basic necessity. . Normal goods can further be divided into basic necessities and luxury goods. If the economy is expanding or during economic prosperity. It shows how the consumers react towards the quantity demand when there is a change in the income. 112 . Consumers will buy better quality goods and reduce their purchase of inferior quality goods.Chapter 3 Demand Theory When income increase by one percent the quantity demanded will increase by 0. negative income elasticity is associated with inferior goods. consumers are willing to spent more on luxury goods and the demand for luxury goods will increase. expanding. i.

1 Where: Qx. 2 Py.1 Qx.1 Qx.Qx. is new quantity demanded. 2 . 2 . is original price of product y and is new price of product y 113 .1 X Py. Arc Cross Elasticity:: The formula is : Exy = Qx. MEASUREMENT OF CROSS ELASTICITY The cross elasticity is measured by dividing the percentage change in quantity demanded of one product (X) by the percentage change in the price of another product (Y). These products are also be displayed in an exclusive manner Whereas normal products can be promoted in daily media and be displayed to reach the general public . that are consumed by higher income-group are advertised in media that reaches them. c) Promotional strategies Luxury products Income elasticity is also useful in promoting or marketing a product. CROSS ELASTICITY (Exy) Cross elasticity measures the responsiveness of the demand of one product (X) when the price of another changes (Y). 1 Py. Their promotional strategies would differ in terms of service and are given ‘personal touch’.1 Py.2 + Py. During this time producers should concentrate on basic necessities.Py.Chapter 3 Demand Theory the demand for luxury goods is weak. 2 is old quantity demanded. Basic necessities are said to be recession proof as the percentage decrease in demand is much smaller compare to the percentage decrease in income The consumers spending on these goods is consistent or the impact of decreasing income is very small.2 + Qx.

for example pen and ink. If the cross elasticity is zero. If the cross elasticity is negative the two goods are complementary. for example Pepsi and Coke. 114 .Chapter 3 Demand Theory Point Cross price Elasticity: Measure the change in the quantity demand of a product when there is an infinitesimally small change in price of another product. That is • • • If the cross elasticity is positive the two goods are substitutes. The higher the value of the cross elasticity the better the substitutes.β 0 Px + β 1 Py + β 2 I + β 3 T The elasticity is: Ex = β 1 X Py /Qx IMPORTANCE OF CROSS ELASTICITY The cross elasticity is used to it determine the relationship between the two goods. The formula is : Exy = ∂Qx ∂Py x Py Qx eqn 3 n Based on equation 3a demand function: Qx = α . it shows that the two products are not related.

2.5I + 0.0 .8.5 Qx = 9 The cross elasticity is ∂Qx = 0.22 Qx = 9.22 percent.8Py + 2. the cross elasticity for product X is Qx = 1. ∂Py Exy = = 0.0T Given Px = RM2 Py = RM2.5 / 9 0.Chapter 3 Demand Theory Example 9 From Example 1 above.5 I = 4 and T = 2 When the price of X changes by one percent the quantity demanded for X will change by 0. Py = 2.0Px + 1.8 x 2. The two products are said to be poor substitutes 115 .

2PX + 5Py + 8I Where Qx and Px is the quantity and price of X respectively PY is the price of another product. (Calculate income elasticity)? What is the price and cross elasticity? Interpret the elasticity 2.50 and I = 4. I is the income per capita in RM The current values of the independent value are AL = RM10.20PL + 28 Pc . a) b) c) d) PL = RM 1. and I is per capita income.Chapter 3 Demand Theory QUESTIONS 1. At what output is the total revenue maximum? Calculate the price at this output? If the income decrease by 10% what is the impact on Rainbow Lemonade. 116 . Given the following demand function Qx = 7 .17Ac + 20AL + 5I Where QL is the quantity of Rainbow Lemonade (in cases) PL is the price of Rainbow Lemonade in RM PC is the price of competitor in RM AL is the advertising expenditure of Rainbow lemonade. AC is the advertising expenditure of competitor.50. AC = RM 15 Derive the demand curve function and the total revenue function. The demand function for Rainbow Lemonade has been estimated as QL = 26 . PC = RM 1. I = RM12. Given Px = RM5.8. Py = 5.

000 kg.00 per kg and a per capita income of RM30. Interpret the elasticity. 000. If the per capita increase to RM30.6 and income elasticity is 0. how much should the per capita income change for the quantity demanded to remain at 25.7. Calculate the income elasticity.00 when per capita is RM30. should the firm maximise its total revenue? change the price to 4. 000. what is the price elasticity? 5.Chapter 3 Demand Theory a) b) c) Calculate the price elasticity. The price elasticity for fish is estimated to be -0. what will the quantity demanded? If the price of fish increases to RM9. Given the current price is RM50. a) b) c) Is fish a basic or Luxury good? Explain. A firm XYZ has written children’s comic books. What can you say about the product? Calculate the cross elasticity.000 kg? 117 . 500. the demand for fish is 25. The estimated total revenue function for the sales is TR = 150Q .20Q2 a) b) c) Over what range is demand elastic? Derive the demand curve function.25 Q a) b) c) At what output is demand unitary elastic? At what output is marginal revenue zero? At price RM7. What is the relationship between this two product? 3. A consultant estimates the price-quantity relationship for Alice Pizza to be P = 75 . At a price of RM8.

17 (15) + 20 (10) +5(12) = 81.5) + 28 (1.17 .7) = 2.07 .a) QL QL PL TR = 26 .7 cases and the priceRM2.05 QL = 4.20PL + 28 (1.0.035.4 = ∂QL ∂I EI = 5 x 51.4 118 x I QL 12 = 1.1Q ∂Q Q P = 40.8) . c) Income elasticity: QL QL EI = 26 – 20(1.07Q .17 (15) + 20 (10) +5(12) = 51.0.07 .0.8) .7 = 4.0.05 (40.4 .035 = Q Marginal Revenue function Total revenue maximising quantity is 40.Chapter 3 Demand Theory SUGGESTED SOLUTIONS 1.07 .20PL = 4.05QL2 Total Revenue function Demand curve function b) TR maximising output is ∂TR = 4.

4 = -20 X 1. Cross elasticity ELC = ∂QL x ∂PC ELC = 28 x PC QL 1.17 x 10 = 11.2 (5) + 5 (5.98%. 2.50) + 8 (4) Qx = 56.58 When price increase by 1% the quantity demanded decreases by 0.17 (15) + 20 (10) +5(12) = 51.Chapter 3 Demand Theory When income falls by 10% quantity demanded will decrease by 1.8 = 0.98 51.5 119 .4 = .7 %.5) + 28 (1.a) The quantity demanded is Qx = 7 .4 When the price of competitor increases by 1% the quantity demanded for Rainbow Lemonade will increase by 0.0.8) . d) Price elasticity Ep = ∂QL ∂PL QL QL Ep x PL QL = 26 – 20(1.5 51.58%.

49%. The two products are substitutes.18%. c) Cross elasticity Exy = ∂Qx ∂Py Exy = 5 x 56. b) Income elasticity EI = ∂Qx ∂I EI = 8x 4 56. 120 .5 = 0.49 x Py Qx 5.57%.5 When the price increases by 1% the quantity demanded decrease by 0. The product is a basic necessity.5 x I Qx = 0.18 When the price of Y increases by 1% the quantity demanded for X will increase by 0.57 x Px Qx = -0.5 When income increases by 1% the quantity demanded increases by 0.Chapter 3 Demand Theory Price elasticity Ep = ∂Qx ∂P x Ep = -2 x 5 56.

20 (3.a) TR maximizing quantity is: TR ∂TR ∂Q Q = 3.Chapter 3 Demand Theory 3.25 Q2 121 .75 = 150Q . The elastic range will be 0 to3.75 units.75) = RM 75 Demand curve function The firm should increase the price to maximise to RM75 to increase total revenue.20 Q2 = 150 . 4.20Q2 = 150 . In this case it will be before 3.20 Q Q c) To find the total revenue maximising price substitute the total revenue quantity calculated in (a) into the demand curve function: TR P P = 150 Q .75 units b) Demand curve function is: P = TR = 150 . elasticity is unitary.a) Unitary elasticity (calculate the quantity that maximise total revenue). TR = 75 Q .40Q =0 When the total revenue is at the maximum. Therefore the demand curve is elastic just before the total revenue maximizing quantity is achieved.

Chapter 3 Demand Theory ∂TR ∂Q = 75 .103 . c) MR MR =0 = 75 .50 Q Q = 0 = 1.demand price elasticity.25Q = 2. When the price increases by 1% quantity demanded will decrease by 0.5. 122 .103%.72 x Px Qx = 0.5 When total revenue is maximum when elasticity is unitary at Q = 1. substitute into the demand curve function 7 Q = 75 .25 Q Q c) TR P = 75 Q .72 =75 -25Q Demand curve function = 0 = 1.5 Price elasticity Ep = ∂Qx ∂P x 1 25 x 7 2.25 Q2 = TR Q Given P = 7 .

= 0.5 c) At price RM9. 123 .00 the quantity demanded will be.5.67 x 0.7%.8 x 100 = 12.67 quantity demanded will change by : 1.7 = 1.30000 X 100 = 1.5% The total quantity is 7.5) = 25292.5 units 100 The quantity demanded will be (25000 + 292.5% 8 The percentage change in quantity demanded is: 12.6 = 7.7) b) The percentage change is income is 30500 .Chapter 3 Demand Theory 5.17 x 25000 = 292.17%.5% x 25000 = 1875.67% 30000 When the income changes by 1% quantity demanded will change by 0.5 x 0. that is The change in quantity is: 1. Percentage change in price of fish 9 . a) Fish is an Basic good because the income elasticity is less than one (EI.If income changes by 1. The percentage change income to offset the decrease in quantity demanded will be.

It showed how the above three functions are interrelated. What is the demand curve function if Px = RM1200 Y = RM5500 Pz = RM1500.5% = 10. The demand function for TV set is given as follow Qx = 350 – 3. PRACTISE QUESTIONS Q1.7% The income will increases by 10. income and cross elasticity.7% x 30.7Px + 0.000 = 3214. total marginal and average revenue curve function from a demand function. As a manager you will be made aware of the importance of elasticity in decisionmaking.7 % 0.2Y + 4. Here emphasis was given on point elasticity and it looked at price. 124 . You will also notice how elasticity is calculated.Chapter 3 Demand Theory 7.2 Pz Where Qx is quantity of TV set demanded per month Px is the price of TV set Y is the per capita income Pz is the price of a competitive brand a.28 SUMMARY This chapter explained how to derive the demand curve.

a) Assuming P = 10. Q3. The market demand for good X is Q = 70 –3.6M + 4Pz Where Q is the number of units of good X demanded P is the price of good X M is income of buyers Pz is the price of related good. hence.Chapter 3 Demand Theory b. The company is the low-cost provider of firewood in this market with 125 . If the firm wishes to increase its total revenue. Perak. Hardwood cutters offers seasoned. income and cross elasticity of demand of good X. Zaid’s Frozen Pizza has enjoyed rapid growth in West Malaysia. should he increase or decrease price? State your reason. and Pz = 6. should the price be increased or decreased? c. Q = 1000 – 3000P + 10A Where Q = quantity demanded P = product price (in RM) A = advertising expenditure (in RM) a) Assume that P = 3 and A = 2000 Suppose the firm reduces price. compute the price. Would this increases total revenue? Explain. b) Is X a normal or inferior good? Explain.5P –0. calculate Q. d) Is demand for X elastic or inelastic? Why do you say so? e) Suppose the producer of X wishes to increase total revenue by changing price. c) Are X and Z substitute or complements? Explain. M= 20. From the analysis it was found that the demand curve follows this pattern. At what price and output would total revenue maximize? Q2. split fireplace logs to consumers in Kampung Parit. Would this increase total revenue? Explain. b) Assume that P =4 and A = 2100 Suppose the firm reduces price. Q4.

write the equation for: i. Based total revenue Average revenue Marginal revenue b) What is the maximum total revenue per week that Syarikat Alpha-Beta can obtain from sales of its product? c) Calculate the arc price elasticity of demand for Syarikat Alpha-Beta’s product between Q = 3. a) Determine the marginal revenue and the marginal cost function. plus variable costs of RM25 for each unit of firewood.200.02A Where: QV PV PC Y A = the number of the firm’s vehicles sold weekly = the price of the firm’s vehicle = the price of a close competitor’s vehicle = average household income. Q5. ii.125 Q Where p is the price of firewood per unit and Q is the number of units of firewood.Chapter 3 Demand Theory fixed costs of RM10 000 per year. b) Calculate the profit maximizing quantity. Annual demand for the company is: P= 225 – 0. iii. price and profit. a) on the estimated demand curve.000 and Q = 3. and = weekly advertising dollars spent 126 . c) Calculate the price elasticity at the profit maximizing price. Syarikat Alpha-Beta has estimated the demand curve for its product as follows: Q = 8000 . The marketing department for a firm that manufactures vehicles has determined the following demand function for their vehicles: QV = 5000 – 0. Q6.2PC + 0.5P where Q is quantity sold per week and P is the price per unit.6PV + 0.04Y + 0.

000 – 8P Where Q = Quantity demanded for “Cage XP” cages P = Price of “Cage XP” cages (RM70) A = Advertising expense. find the price elasticity of demand. c) The industry supply equation is given by QS = -1000 + 10P. unitary elastic.125QC Where Q is the quantity demanded and P is the price. “Cage XP”.Chapter 3 Demand Theory a) If PV = RM10. or inelastic? Why? If the firm decreases price. A demand function had been estimated on 120 respondents using regression analysis. 000. Interpret your answer. Y = RM12. The demand function is as follows: Q = 12. The research department of White Pigeon wished to estimate the demand function for its new product. a) Calculate the market demand function. in thousands (RM54) 127 + 1300A + 5Pc + 2I . what will happen to total revenue? c) Assuming values of the variable is as given in part (a) above. The following functions describe the demand of 3 small firms: A. b) Using the market demand function. PC = RM8000.25QB Firm C : P = 200 – 0.5QA Firm B : P = 300 – 0. determine the income elasticity. Firm A : P = 500 – 0. Q7. d) Calculate the cross price elasticity of demand and interpret your answer. determine the total revenue maximizing price and quantity. B and C that sell hand phone accessories to the customers. b) Is demand elastic.000 and A = RM4000. Determine the market equilibrium price and quantity Q8.

Are “Cage XP” cages and interpret it. STUDY NOTES 128 . “Cage XP” cages If the firm’s objective is to maximize total revenue from the sales of “Cage XP” cages.Chapter 3 Demand Theory Pc = Price of competitor's product (RM80) I = Average monthly income (RM400) a) Derive an expression for the firm’s conventional demand curve for the new product. Is the “Cage XP” cages a luxury. inferior or necessity good? d) Calculate the cross elasticity of demand. at what price should the firm charge? b) Should White Pigeon Company consider reducing its price in order to increase its total revenue? Explain. c) Calculate income elasticity of demand.

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