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Lecture 9-2

Using demand functions


Note:
This material is not in BH
Topics
Using the concept of a demand function to explain behavior
Properties of demand functions
Alternative formulas for a demand function
Implications for price/income elasticities
The Stone-Geary demand model
Demand for water example of how the shape of the demand
function makes a difference
Incorporating variables other than price and income (e.g., weather,
demographics) into the demand function
The demand function
The demand function encapsulates the
economic and non-economic determinants
of demand behavior.
If we know the demand function, we can use
this knowledge
To explain past behavior
To predict future behavior
To design policies involving price changes, or other
changes, that will change behavior.
Using the theory
How the theory is used for the second
task is discussed in a later lecture.
Explaining/predicting behavior
It has been forecast that, within two decades,
the number of automobiles in the world will
double from about 1 billion vehicles to about
2 billion. The increase will occur primarily in
Asia (China, India, Indonesia, etc) and South
America (Brazil, Mexico, etc) and, to a lesser
extent, eastern Europe (Russia).
What could explains this increase in demand?
Possible explanations
Price change
Auto manufacturers rushing to produce
inexpensive vehicles for Asian market
Income change
Rising household income
Demographic change
More young families with children in urban areas
Change in preferences
Rise of aspiration for a middle-class lifestyle
Estimating demand functions and
measuring elasticities
If we wish to use a price change to induce a
change in behavior, we need a reliable estimate
of the price elasticity of demand in order to
design the appropriate price change.
This focuses the attention on empirical
estimation of demand functions.
A key fact is that different formulas for demand
functions generate demand elasticities with
different properties.
Need to bear this in mind in choosing a formula
for the demand function.
Generating a functional form for a
demand equation
Two approaches have been used:
(1) Start with a specific functional form for the utility
function; then go through the process of maximizing
the utility function, and find the formula for the
demand equation
(2) Start with the demand equation, and just write
down a formula for the demand equation.
Approach (2) is the older approach. But, by 1950
questions were raised: how can one be sure that
there is some underlying utility function that
would generate this particular demand equation?
Properties required of demand functions
Homogeneity property
If income and all prices change by the same proportion,
there is no change in the demand for any good.
This implies that demand really depends on relative prices

Adding up condition
Multiplying each demand function by the corresponding
price and adding up must equal total income.
This has implications for price and income elasticities
Income elasticities, weighted by budget shares, must sum to 1.
Also restriction on the sum of price elasticities
Adding-up conditions on elasticities
Suppose there are 3 goods: u(x,y,z). Let I
denote income and let px, pz, pY denote the
prices of the goods.
sx( = xpx/I), sy( = ypy/I) and sz( = zpz/I) are the
budget shares. Note that sx+ sy+sz = 1.
The adding up conditions
Income elasticities: weighted sum adds up to 1

Own and cross-price elasticities with respect


to px (similarly for other prices)
Traditional forms of demand equation
Why does it matter which demand formula is
used?
The different formulas for demand functions
imply difference in whether and how the
demand elasticities vary.
They also imply different shapes of the
demand function, and therefore different
patterns of behavior.
Some shapes of the demand function may not
be plausible for some commodities.
Different formulas have different shapes

Linear demand function Log-log (56) demand.


At some finite price, demand falls Demand goes asymptotically to
to zero. zero as price rises to infinity
The semilog (57 & 58) have
similar shapes
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The Cobb-Douglas utility function
Estimating a demand equation
Estimating the demand equation
The Stone-Geary demand function
In this model, the consumer never chooses a
consumption level xi that is lower than i.
As the price of a good, pi, rises towards infinity,
the consumption level xi shrinks down to i.
In he water application presented below, good 1
is water. Here 1 is represented as depending on
weather variables, rather than being a constant
the hotter the climate, the larger the minimum
consumption of water, 1.
There is just one other good, x2, representing all
non-water consumption.
For this other good, 2 = 0.
Al-Qunaibet and Johnston focus on the question of the
shape of the demand curve for water (in this case, in
Kuwait).
They argue that the linear demand function, which had
often been used in the literature, is not very plausible,
because it is impossible that any household would go
entirely without water if the price is high.
For the same reason they argue that the log-log
demand (56) and the semi-log models (57 & 58) are
implausible.
Therefore some other type of demand formulation
may be more plausible. They suggest the Stone-Geary
model, since demand doesnt go to zero.
Using data on residential demand in Kuwait they fit
these various demand models, and compare the
results.
Traditional forms of demand equation
Extending Stone-Geary to incorporate
other demand factors
The effect of weather on demand
MODELING HOW WEATHER (H) AFFECTS DEMAND

Approach (A)

xt = pt + yt + Ht

xt
Here, is not affected by Ht.
pt

xt
Similarly, is not affected by Ht.
yt

Approach (B)

Winter demand

xt = 1 1pt + 1yt

Summer demand

xt = 2 2pt + 2yt

xt x
In this case, 1 in the winter, but t 2 in the summer.
pt pt

xt
Similarly, with .
yt
Approach (C)

xt = [ + Ht]pt + yt + Ht = pt + yt + Ht + Htpt

xt
Here, H t is affected by Ht .
pt

If > 0, demand is more responsive to a change in price when Ht is high.

If < 0, demand is less responsive to a change in price when Ht is high.


To summarize the modelers choice
Does the modeler formulate a model in which
Weather affects the level of demand but it does not
affect how demand responds to other factors, such as
price [model A].
Weather affects the level of demand and it affects
how demand responds to certain other factors (e.g.,
price) but it does not affect how demand responds to
all factors (e.g., how demand responds to income)
[model C].
Weather affects the level of demand and it affects
how demand responds to all other factors, because
there are separate demand equations for summer and
winter [model B].
Incorporating demographic variables
How would you modify the log-log demand
function (56) to represent this?
Having more children affects the level of
demand and the price elasticity of demand
A warning: individual versus aggregate
demand functions
Example: aggregate demand