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Demand Function

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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

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

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

13

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

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

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