QUANTITATIVE DEMAND ANALYSIS Cross Price Elasticity

ELASTICITY - measures the responsiveness of the demand for good

- measures the responsiveness of one variable to a X to changes in the price of a related good Y.

change in another variable

- if goods X and Y are substitutes, an increase in the
- primary tool used in measuring the magnitude of such price of Y leads to an increase in the demand for X

change is the Elasticity Analysis

- if goods X and Y are complements, an increase in the
Elasticities for Linear Demand Functions price of good Y will will to a decrease in the demand
- linear demand function:
for X

- Formula:

- own price elasticity, cross price elasticity, income

elasticity

Own Price Elasticity of Demand

- measures the responsiveness of quantity demanded
to a change in price

- Factors a ecting own price elasticity

- availability of consumption (no close substitute =

demand is inelastic)

- time/duration of purchase horizon (more time to Cross Price Elasticity Kind of good
react to a price change = demand is elastic)

- expenditure share of consumers’ budget Positive (+) Substitutes

(consumers spend small shares in the budget =
inelastic)
Negative (-) Compementary
- Formula:

Income Elasticity
- measure of responsiveness of consumer demand to
changes in income

- Formula:

Income Elasticity Kind of good

Positive (+) Normal Good

Absolute Value of Elasticity Description Negative (-) Inferior Good
|e| > 1 elastic Examples/Exercises:
|e| < 1 inelastic

|e| = 1 unitary
Suppose good X sells at P25 a pair, good Y sells at
|e| = 0 perfectly inelastic P35, the company utilizes 50 units of advertising,
and average consumer income is P20,000. Calculate
|e| − >∞ perfectly elastic Own price, cross-price, and Income elasticities of
Elastic — there is a greater change in quantity demand.
demanded than the change in price

Inelastic — change in quantity demanded is lesser

than the change in price

Unitary — change in qty is equal with change in price

Perfectly Elastic — no change in price, but the quantity

continuously changes ; demand curve is horizontal

Perfectly Inelastic — any changes in price do not

a ect the quantity demand for good X ; demand curve
is vertical

Total Revenue Test

- shows relationship of the changes in price, elasticity,
and total revenue

- if demand is elastic, an increase in price will decrease

the total revenue

- if demand is inelastic, an increase in price will

increase total revenue.

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 Elasticities for Non-Linear Demand Functions
- log linear demand function

Own Price Elasticity — Bx

Cross Price Elasticity — By
Income Elasticity — Bm
REGRESSION ANALYSIS
How does one obtain information on the demand
function?

- published studies

- hire consultant

- statistical technique called regression analysis using

data on quantity, price, income, and other important
variable
P-Values
Regression Line - much more precise measure of statistical signi cance

- True (or population) regression model

- current example: 0.0012 = only 12 in 1000 chance
Y = a + bX + e that we’ll get an estimate at least as big as -2.6 in
a = unknown population intercept parameter
absolute value if the true coe cient is actually zero

b = unknown population slope parameter

- 0.05(alpha) = estimated coe cient is statistically

signi cant at the 5% level

e = random error term with mean zero and standard - P-value < 0.05 = reject null hypothesis, there is
deviation o signi cant relationship between the parameters/
Least squares regression line variables

- P-value > 0.05 = accept null hypothesis, there is no
signi cant relationship between parameters/variables

= least squares estimate of the unknown parameter a

Evaluating the Overall Fit of the Regression Line

= least squares estimates of the unknown parameter b

^ parameter estimates that represents the values of a R-Square (coe cient of determination)
and b that results in the smallest sum of squared errors - fraction of the total variation in the dependent
between a line and the actual data
variable that is explained by the regression

- ranges between 0 and 1

- values closer to 1 indicate “better t”

Adjusted R-Square
- a version of the r-square that penalize researchers for
having few degrees of freedom.

- n = total observations

- k = number of estimated coe cients

- n-k = degrees of freedom for the regression

F-Statistic
Evaluating Statistical Signi cance - measure of the total variation explained by the
Standard Error regression relative to the total unexplained variation

- measure of how much each estimated estimate varies - the greater the f-stat, the better the overall regression
in regressions based on the same true demand model t

using di erent data

- P-value is another measure of the F-stat

95% Con dence interval rule of thumb - the lower the P-value, the better the overall
-
regression t

t-statistics rule of thumb

- when |t| > 2, we are 95% con dent the true parameter
in the regression is not zero

- when t-stat is large, we are con dent that it is not

zero thus he standard error is small relative to the
absolute value of the parameter estimate.

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 - ex: the consumer is indi erent between bundles A
and B. Moving from A to B, the consumer gains 1 unit
of X and to remain on the same IC, the consumer
gives up 2 unit of good Y. Thus, in moving from point
A to B the MRS between goods X and Y is 2

3. Diminishing Marginal Rate of Substitution

- after the consumer obtains more of good X, the
amount of good Y the consumer is willing to give up
to obtain another unit of good x decreases

(graph for 2 and 3)

4. Transitivity
- For any 3 bundles, A, B, C, either:

- If A > B and B > C, then A > C

THEORY OF INDIVIDUAL BEHAVIOR - If A ~ B and B ~ C, then A ~ C

Consumer - the assumption of transitive preferences, together

- an individual who purchases goods and services from with the more-is-better assumption, implies that
rms for the purpose of consumption
indi erence curves do not intersect one another

- as a manager of a rm, you are interested in who - it also eliminates the possibility that the consumer is
consumes the good and in who purchases it
caught in a perpetual cycle in which he/she never
Consumer Behavior makes a choice

- Consumer Opportunities
- set of possible goods and services consumers can
a ord to consume

- Consumer Preferences
- determine which set of goods and services will be
consumed

4 Basic Properties of Consumer Preferences

1. Completeness
- For any 2 bundles of goods either:

- A > B

- B > A
CONSTRAINTS — The budget constraint
- A ~ B
Budget Constraint
- consumer is capable of expressing a preference for, - restrictions set by prices and income that limits
or indi erence among all bundles. If preference were bundles of goods a ordable to consumers

not complete there might be cases where a consumer - restricts consumer behavior by forcing the consumer
would claim not to know whether he/she preferred to select a bundle of goods that is a ordable

bundle A to bundle B, or preferred bundle B to A or Budget Set

was indi erent between the 2 bundles

2. More is better
- if bundle A has at least as much of every good as
bundle B and more of some good, bundle A is
preferred to bundle B

Indi erence Curve Budget Line

- shows the combination of Goods X and Y that gives
the consumer the same level of satisfaction

Marginal rate of substitution

- the MRS between 2 goods is the rate in which a
consumer is willing to substitute one for the other and
still maintain the same level of satisfaction

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If we multiply both sides of the budget line by 1/Py
we get:

solving for Y yields:

Y is a linear function of X with a vertical intercept of

and a slope
- increase in income = shift to the right, slope is
constant

If the consumer spent his/her entire income on good - decrease in income = shift to the left towards the
Y, expenditures on Y would exactly equals income: origin, slope is constant

Consequently, the MAXIMUM QUANTITY of good Y

is a ordable is:

- decrease in price = counterclockwise rotation of

budget line

- increase in price = clockwise rotation of budget line

Consumer Equilibrium
- shows the consumption bundle that is a ordable and
yields the greatest satisfaction to the customer

- consumption bundle where the rate a consumer

choses (marginal rate of substitution) to trade
between goods X and Y equals the rate et which
these goods are traded in the market (mrs)

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Price Changes and Consumer Behavior Review: The Law of Demand
- price and income changes impact a consumer’s Income E ect — a lower price frees income for
budget set and level of satisfaction that can be additional purchases and vice verse

achieved
Substitution E ect — a lower price relative to other
- price and income changes will lead to consumer goods attracts new buyers and vice versa

equilibrium changes
Substitution and Income E ects
Price changes and Equilibrium - moving from one equilibrium to another when the
- price increases(decreases) reduce(expand) a price of one good changes can be broken down into
consumer’s budget set.
2 e ects:

- the new consumer equilibrium resulting from a price - Substitution E ect — the movement along a given
change depends on consumer preferences:
indi erence curve that results from a change in the
- Goods X and Y are
relative prices of goods, holding real income constant

- Substitutes when an increase (decrease) in the - Income E ect — the movement from one
price of X leads to an increase (decrease) in the indi erence curve to another that results from the
consumption of Y
change in real income caused by a price change

- Complements when an increase (decrease) in the

price of good X leads to a decrease (increase) in
the consumption of good Y

Applications of Indi erence Curve Analysis

Income Changes and Consumer Behavior - Choice by Consumers
- income increases (decreases) reduce (expand) a - buy 1 get 1 free

consumer’s budget set

- cash gifts, in-kind gifts, and gift certi cates

- the new consumer equilibrium resulting from an

income change depends on consumer preferences:

- Good X is:

- a normal good when an increase (decrease) in

income leads to an increase (decrease) in the
consumption of good X

- an inferior good when an increase (decrease) in

income leads to a decrease (increase) in the
consumption of good X

- Choices by Workers and Managers

- income-leisure choice

- managers preferences

Labor Leisure Choice Model

- workers view both leisure and income as goods and
substitutes between them at a diminishing marginal
rate

- a typical workers indi erence curve has the usual

shape where we measure the quantity of leisure and
income consumed by an employee

- when workers enjoy leisure, they also enjoy income

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The Relationship between Indi erence Curve

Analysis and Demand Curves
- indi erence curves along with price changes
determine individuals’ demand curves

- market demand is the horizontal summation of

individuals’ demands

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