Chapter-3:

Quantitative Demand Analysis

by Traheka Erdyas Bimanatya, M.Sc.

Managerial Economics | 21 March 2019

Outline
―The Elasticity Concept
▪ What is elasticity?
▪ Linking elasticity to revenue
▪ Empirical evidence
― Introduction to regression analysis

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PART 1:
THE ELASTICITY CONCEPT
What is elasticity?
A measure of the responsiveness of one variable to changes in
another variable.
▪ Sign of the relationship: positive or negative
▪ Absolute value of elasticity magnitude relative
to unity:
‒ 𝐸𝐺,𝑆 > 1 𝐺 is highly responsive to changes in 𝑆.
%Δ𝐺
𝐸𝐺,𝑆 =
‒ 𝐸𝐺,𝑆 < 1 𝐺 is slightly responsive to changes in 𝑆.
%Δ𝑆
▪ When a functional relationship exists, like
𝐺=𝑓(𝑆), the elasticity is:
𝑑𝐺 𝑆
𝐸𝐺,𝑆 =
𝑑𝑆 𝐺
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Type of elasticity

Elasticity

Own price elasticity Cross-price Income elasticity Other elasticities

of demand elasticity

%Δ𝑄𝑋 𝑑 %Δ𝑄𝑋 𝑑 %Δ𝑄𝑋 𝑑 ▪ Advertising elasticities

𝐸𝑄 𝑑
,𝑃𝑋 = 𝐸𝑄 𝑑
,𝑃𝑌 = 𝐸𝑄 𝑑
,𝑀 = ▪ etc.
𝑋 %Δ𝑃𝑋 𝑋 %Δ𝑃𝑌 𝑋 %Δ𝑀

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 What is own price elasticity of demand ? #1
Measures the responsiveness of a percentage change in the quantity
demanded of good X to a percentage change in its price.
Price Demand
▪ Sign: negative by law of
𝐸𝑄𝑋 𝑑 ,𝑃𝑋 = 0
demand.
▪ Magnitude of absolute value
Perfectly Demand relative to unity:
elastic 𝐸𝑄𝑋 𝑑 ,𝑃𝑋 = −∞ ‒ 𝐸𝑄 𝑑
,𝑃𝑋 > 1: Elastic.
𝑋

‒ 𝐸𝑄 𝑑
,𝑃𝑋 < 1: Inelastic.
𝑋

‒ 𝐸𝑄 𝑑
,𝑃𝑋 = 1: Unitary elastic.
𝑋

Perfectly Inelastic Quantity

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What is own price elasticity of demand ? #2

Three factors can impact the own

price elasticity of demand:
▪ Availability of consumption
substitutes
▪ Time/duration of purchase horizon
▪ Expenditure share of consumers’
budgets

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What is own price elasticity of demand ? #3
▪ When demand is elastic:
– A price increase (decrease) leads
to a decrease (increase) in total
revenue.
▪ When demand is inelastic:
– A price increase (decrease) leads
to an increase (decrease) in total
revenue.
▪ When demand is unitary elastic:
– Total revenue is maximized.

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What is cross price elasticity? #1
Measures responsiveness of a percent change in demand for good X
due to a percent change in the price of good Y.

▪ If 𝐸𝑄 𝑑 ,𝑃 > 0, then 𝑋 and 𝑌 are

𝑋 𝑌
substitutes.
▪ If 𝐸𝑄 𝑑 ,𝑃 < 0, then 𝑋 and 𝑌 are
𝑋 𝑌
complements.

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What is cross price elasticity? #2
It is important for firms selling multiple products.
▪ Assessing the overall change in revenue from a price change for one good when a firm sells
two goods is:

∆𝑅 = 𝑅𝑋 1 + 𝐸𝑄 𝑑 + 𝑅𝑌 𝐸𝑄 𝑑 × %∆𝑃𝑋
𝑋 ,𝑃𝑋 𝑌 ,𝑃𝑋

▪ Example: Suppose a restaurant earns $4,000 per week in revenues from hamburger sales
(X) and $2,000 per week from soda sales (Y). If the own price elasticity for burgers is
𝐸𝑄𝑋,𝑃𝑋 = −1.5 and the cross-price elasticity of demand between sodas and hamburgers is
𝐸𝑄𝑌 ,𝑃𝑋 = −4.0, what would happen to the firm’s total revenues if it reduced the price of
hamburgers by 1 percent?

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What is income elasticity?
Measures responsiveness of a percent change in demand for good X
due to a percent change in income.

▪ If 𝐸𝑄 𝑑 ,𝑀 > 0, then 𝑋 is a normal

𝑋
good.

▪ If 𝐸𝑄 𝑑 ,𝑀 < 0, then 𝑋 is an inferior

𝑋
good.

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Q & A #1
ANY QUESTIONS UP TO THIS
POINT?
PART 2:
INTRODUCTION TO
REGRESSION ANALYSIS
What is regression? #1
A statistical measurement that attempts to determine the strength of the
relationship between one dependent variable and a series of other changing
variables.
▪ True (or population) regression
model
𝑌 = 𝑎 + 𝑏𝑋 + 𝑒
– 𝑎 unknown population intercept
parameter.
– 𝑏 unknown population slope
parameter.
– 𝑒 random error term with mean
zero and standard deviation 𝜎.
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What is regression? #2
Since using population data is rarely available, most regression analysis is based
on sample data.

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What is regression? #3
Least square method becomes the most common method to estimate the
parameters
▪ Least squares regression line
෠
𝑌 = 𝑎ො + 𝑏𝑋
– 𝑎ො least squares estimate of the
unknown parameter 𝑎.
– 𝑏෠ least squares estimate of the
unknown parameter 𝑏.
▪ The parameter estimates 𝑎ො and 𝑏, ෠
represent the values of 𝑎 and 𝑏 that result
in the smallest sum of squared errors
between a line and the actual data.
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How the regression analysis looks like
SUMMARY
OUTPUT
Estimated Demand:
Regression Statistics 𝑄 = 1631.47 − 2.60𝑃𝑅𝐼𝐶𝐸
Multiple R 0.87
R Square 0.75 𝑎ො = 1631.47
Adjusted R Square 0.72
Standard Error 112.22 𝑏෠ = −2.60
Observations 10.00

ANOVA
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37
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Some important regression statistic concepts #1
Standard error (𝜎𝑎ො ; 𝜎𝑏෠ )

Measure of how much each estimated coefficient varies in regressions

based on the same true demand model using different samples of data. A
smaller value indicates the smaller variations.

t-statistics rule of thumb (𝒕𝒂ෝ = 𝒂ෝൗ𝜎𝑎ෝ )

When 𝑡 > 2, we are 95 percent confident the true parameter is in the

regression is not zero.

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Some important regression statistic concepts #2
R-Square / Coefficient of determination

Fraction of the total variation in the dependent variable that is explained

by the regression. It ranges between 0 and 1. Values closer to 1 indicate
“better” fit.

The F- Statistic

A measure of the total variation explained by the regression relative to the

total unexplained variation. The greater the F-statistic, the better the
overall regression fit.

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Q & A #2:
ANY QUESTIONS UP TO THIS
POINT?
 THANK YOU
Traheka Erdyas Bimanatya, M.Sc. traheka.erdyas.b@ugm.ac.id

Traheka Erdyas Bimanatya