Managerial Economics 1

Victoria Febrina R Simangunsong

40P20035

Eks B 40 A

Chapter 3: Quantitative Demand Analysis

I. The Elasticity
Definition Elasticity: A measure of the responsiveness of one variable to changes in another
variable; the percentage change in one variable that arises due to a given percentage
change in another variable.
The elasticity between two variables, quantity (Q) and price (P), can be expressed as:
% ΔQ
EG ,S =
% ΔP
Two important aspects of elasticity
1) Sign determines the relationship : whether it is positive or negative
2) Value : whether is greater than 1 or less than 1 in absolute value
The absolute Magnitude of elasticity:
 Is highly responsive to changes in
 Is slightly responsive to changes in

II. Price Elasticity

Definition Own Price Elasticity of Demand: A measure of the responsiveness of the quantity
demanded of a good to a change in the price of that good; the percentage change in
quantity demanded divided by the percentage change in the price of the good.

% Δ Q dx
EQx , Px =
% Δ Px
Sign : negative by law of demand
Magnitude of absolute value relative to unity:

 |EQx , Px|>1 : price elasticity of demand is Elastic

 |EQx , Px|<1 : price elasticity of demand is inelastic
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 |EQx , Px|=1 : price elasticity is unitary elastic

III. Elasticity and Total Revenue
Principle Total Revenue Test:
If demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total
revenue. If demand is inelastic, an increase (decrease) in price will lead to an increase
(decrease) in total revenue. Finally, total revenue is maximized at the point where demand
is unitary elastic.
 Perfectly elastic : infinite elasticity of demand, EQx , Px =−∞
 Perfectly inelastic : demand elasticity is zero, EQx , Px =0

IV. Factors Affecting Their Own Price Elasticity

Three factors can influence the own price elasticity of demand:
a) Availability of consumption substitutes : one key determinant of elasticity of demand
of the good is the number of its close substitute goods
b) Time : Demands tends to be more elastic in the short term than in long term
c) Expenditure of consumers’ budgets: small share of consumer’s budget is more inelastic
than consumers spend large proportion of their income.

V. Elasticity and Marginal Revenue

The marginal revenue can be derived from a market demand curve.
Marginal revenue measures the additional revenue due to a change in output.
This link relates marginal revenue to the own price elasticity of demand:
 When then, . demand is elastic
 When then, . demand is unitary elastic
 When then, . demand is inelastic

VI. Cross Price Elasticity

Definition: Measures responsiveness of a percent change in demand for good X due to a
percent change in the price of good Y.

∂Qdx P y
EQx , Py =
∂ Px Q x
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More generally, whenever goods X and Y are substitutes, an increase in the price of Y leads
to an increase in the demand for X. Thus, EQx, Py > 0 whenever goods X and Y are substi-
tutes. When goods X and Y are complements, an increase in the price of Y leads to a
decrease in the demand for X. Thus, EQx, Py < 0 whenever goods X and Y are complements.
 Cross-price elasticity is important for firms selling multiple products
Price changes for one product that affect changes in demand for other products.
 Assessing the overall change in revenue from a price change for one good when a
firm sells two different goods

VII. Income Elasticity

Definition: A measure of the responsiveness of the demand for a good to changes in
consumer income; the percentage change in quantity demanded divided by the percentage
change in income.

% Δ Q dx
EQx , M =
% ΔM
 If EQx , M >0, then X is a normal good

 If EQx , M <0, then X is an inferior good

VIII. Elasticities for Linear Demand Functions

From a linear demand function, we can compute various elasticities of demand
Given a linear demand function:

Qdx =α 0+ α x P x + α y P y +α M M + α H P H
Px
 Own price elasticity :α x
Qx
Py
 Cross price elasticity : α y
Qy
M
 Income elasticity : α M
Qx
For a linear demand curve, the value of an elasticity depends on the particular price and
quantity at which it is calculated. This means that the own price elasticity is not the same as
the slope of the demand curve. In fact, for a linear demand function, demand is elastic at
high prices and inelastic at lower prices. In other words, for prices near zero, demand is
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inelastic. On the other hand, when prices rise, Qx decreases and the absolute value of the
elasticity increases.

IX. Regression Analysis

How does manager obtain information on the demand function?
 Published studies.
 Hire consultant.
 To estimate the demand function using Statistical technique called regression
analysis
 using data on quantity, price, income and other important variables.
Given market or survey data, regression analysis can be used to estimate:
 Demand functions.
 Elasticities.
 Other things, including cost functions.
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Chapter 4: The Theory of Individual Behavior

I. Consumer Behavior
A consumer is an individual who purchases goods and services from firms for the
purpose of consumption.
Consumer Opportunities: The possible goods and services consumer can afford to
consume.
Consumer Preferences: The goods and services consumers actually consume.
 Given the choice between 2 bundles of goods a consumer either:
 Prefers bundle A to bundle B: A ≻ B
 Prefers bundle B to bundle A: B ≻ A
 Is indifferent between the two: A  B.
A. Indifference Curve Analysis
Indifference Curve: A curve that defines the combinations of 2 or more goods
that give a consumer the same level of satisfaction.
Marginal Rate of Substitution: The rate at which a consumer is willing to
substitute one good for another and maintain the same satisfaction level.
B. Consumer Preference Ordering
 Completeness
Consumer is capable of expressing preferences (or indifference) between all
Possible bundles. (“I don’t know” is NOT an option!)
 More is Better
Bundles that have at least as much of every good and more of some good
are preferred to other bundles.
 Diminishing Marginal Rate of Substitution
- The amount of good Y the consumer is willing to give up to maintain the
same satisfaction level decreases as more of good X is acquired.
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- The rate at which a consumer is willing to substitute one good for

another and maintain the same satisfaction level.
 Transitivity
- For the three bundles A, B, and C, the transitivity property implies that if
C ≻ B and B ≻ A, then C ≻ A.
- Transitive preferences along with the more-is-better property imply that
 Indifference curves will not intersect.
 The consumer will not get caught in a perpetual cycle of
indecision.

II. Constraints
A. The Budget Constraint
 Opportunity Set: The set of consumption bundles that are affordable.
 Budget Line: The bundles of goods that exhaust a consumers income.
 Market Rate of Substitution : The slope of the budget line
B. Changes in the Budget Line
 Changes in Income
- Increases lead to a parallel, outward shift in the budget line (M1 > M0).
- Decreases lead to a parallel, downward shift (M2 < M0).
 Changes in Prices
- A decreases in the price of good X rotates the budget line counter-
clockwise (PX0 > PX1).
- An increases rotates the budget line clockwise (not shown).

III. Consumer Equilibrium

The equilibrium consumption bundle is the affordable bundle that yields the highest
level of satisfaction.
- Consumer equilibrium occurs at a point where MRS = PX / PY.
- Equivalently, the slope of the indifference curve equals the budget line.

IV. Comparative Statics

A. Price Changes and Consumer Behavior
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(i) Substitute Goods

An increase (decrease) in the price of good X leads to an increase
(decrease) in the consumption of good Y.
Examples: a) Coke and Pepsi b) Verizon Wireless or AT&T.
(ii) Complementary Goods
An increase (decrease) in the price of good X leads to a decrease
(increase) in the consumption of good Y.
Examples: a) DVD and DVD Players b) Computer CPUs and monitors

B. Income Changes and Consumer Behavior

(i) Normal Goods
Good X is a normal good if an increase (decrease) in income leads to an
increase (decrease) in its consumption.

(ii) Inferior Goods

Good X is an inferior good if an increase (decrease) in income leads to a
decrease (increase) in its consumption.
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V. Substitution and Income Effects

Definition: The movement along a given indifference curve that results from a
change in the relative prices of goods, holding real income constant.

VI. Applications of Indifference Curve Analysis

1) Choices by Consumers
Buy One, Get One Free
Cash Gifts, In-Kinds Gifts, and Gifts Certificates
2) Choices by Managers
A Simplified Model of Income – Leisure Choice
The Decisions of Managers
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VII. The Relationship between Indifference Curve Analysis & Demand Curves
A. Individual Demand
An individual’s demand curve is derived from each new equilibrium point found
on the indifference curve as the price of good X is varied.
B. Market Demand
The market demand curve is the horizontal summation of individual demand
curves. It indicates the total quantity all consumers would purchase at each
price point.