Lecture 2

All about Demand
MGEC Lecture 2
2023-24
MGEC Lecture-2 2023-24

Decisions’ managers make
▶ Determine the amount to produce

▶ Decide the capacity to invest
▶ Entry decisions to new markets
▶ Devise price strategy
▶ Make advertising decisions
What knowledge is needed for these decisions?





What kind of decisions do managers make?

Knowledge of market demand

The demand curve
What does this picture mean?

The law of demand
The law of demand

As the price of a good goes up, its quantity demanded will not increase.
▶ The demand curve is not upward sloping

▶ As individuals who frequently buy goods in the market, this picture
makes perfect sense to us - we do buy less when things cost more.
▶ Why?

First principles
▶ Individuals seek to maximize their total utility (or pay-off) from the
consumption of goods and services
▶ Goods and services typically increase utility
▶ However, more of any good or service typically increases utility at a

decreasing rate
▶ i.e., each successive unit of a good gives less joy than the previous unit
▶ This is the Law of Diminishing Marginal Utility

Demand for light bulbs
▶ Diminishing Marginal Utility of extra light

▶ Note that an individual’s utility is not directly observable.
▶ Still, law of diminishing marginal utility means that they would be
willing to pay less for each successive light bulb.
▶ Example: I may be willing to pay Rs. 150 for the very first light bulb,
but only Rs. 120 for the next, and Rs. 70 for the one after that.
▶ Therefore, consumers will buy more units of commodities only when
the price of that product begins to fall.

Demand for light bulbs
▶ This decline in willingness to pay will hold for all individuals, giving
rise to a downward sloping demand curve.

Another reason why demand curve is downward sloping
▶ When the price of a commodity decreases, the “real income” of the

consumer increases because she has to spend less in order to buy the
same quantity of that good.
▶ with a fall in price, the consumer will buy more units of that
commodity and also spend a portion of income in buying other
commodities.

Individual Demand for light bulbs
Tabular representation
P Q = D(P)
0 40
5 30
10 20
20 0
Demand equation for consumer-1:
Q1 = D (P ) = 40 − 2P

Market Demand for light bulbs
Tabular representation
P Q1 Q2 Q3 QM
0 40 20 10 70
5 30 10 8 48
10 20 7 5 32
20 0 0 0 0
Individual demand curves for consumers 1 to 3 can be aggregated to

compute the market demand curves

Some pointers on Demand
example demand for biscuits

increase if it is for a month vs a
week
▶ Demand Curve does not slope upwards.
▶ Demand pertains to a particular time period. The longer the time
period, the greater the demand.
▶ At each price, consumers demand that particular quantity but they do
not ‘actually’ buy.
▶ Transactions happen only at equilibrium price (more later).

Shifts in demand
▶ Does the demand curve move/shift left or right?

▶ Why/how?
Income of buyers, Consumer Trends, Expectation of Future Price,

Price of related goods, number of potential buyers

Shifts in demand
▶ A particular demand schedule assumes related-product’s prices,

income, tastes to be constant
▶ If income, tablet’s-price, or advertising effort changes, then we have a
different demand schedule.

Shifts in demand for light bulbs

Shifts in demand for light bulbs
▶ Changes in income
▶ Prices of substitute goods (tubelights)
▶ Prices of complementary goods (lamp shades)
▶ Tastes (an increase in fear of the dark, or an environmental backlash

against light bulbs)
▶ Expectations about future prices
▶ Population

Shifts in demand
Source: The Financial Express, May 6, 2013

Shifts in Demand
▶ What are the shifters of demand curve for the City Bakery in
Manhattan?

Aside: How do we get a demand function?
▶ Survey/Focus Group
▶ Ask people their WTP
▶ Sort and plot
▶ You have your demand curve!
▶ Experiments
▶ Change the price or features in different markets or to different
consumers and measure the reaction
▶ Regression
▶ You will learn more about this in marketing
▶ In general, you can hire consultants to do this - there is a whole
cottage industry of demand estimation!

New York City Transport Authority
▶ In May 2003, NY city transport authority planned to raise fares to

improve its business situation.
▶ Raised single-ride fares from $1.50 to $2, One-day unlimited pass
from $4 to $7, 30-day unlimited pass from $63 to $70
▶ Average fares would increase from $1.04 to $1.30, and that total
subway ridership would decrease by 2.9%.
▶ Management expected to raise an additional $286 million in revenue.
▶ Notice that despite a decline in subway readership, total revenue can
increased.
▶ This is possible (not always necessarily), depending on how demand
responds to prices changes.

▶ How did the NY MTA calculate changes in revenue as a result of the

price increase?
▶ They would need a quantitative measure of how demand changes
when the price changes.
▶ More generally, managers should be able to answer questions like:
▶ How much should we cut price to achieve 3.2% sales growth?
▶ How much should sales change if our rivals cut price by 2%?
▶ How much will our sales change if a recession hits and household
incomes decline by 2.5%?
▶ To get there, we should first define some basic concepts


price increase?


price increase?

Elasticity of demand
▶ In economics, the sensitivity of customers to price changes is known

as the (price) Elasticity of demand.

Mathematically speaking
▶ Elasticity is the % change in quantity demanded due to a % change

in price
∆Q
▶ ϵd = % Change in quantity demanded Q
% Change in price = ∆P
P
▶ Elasticity ̸=Slope of demand curve

Features of elasticity
▶ As such a negative number since the demand curve is downward

sloping.
▶ People (including your instructor) often use the absolute value of
elasticity.
▶ Unit independent.
▶ Is different at different points on the demand curve.

Elasticity
▶ Larger the change in quantity demanded in response to a unit change

in price, the greater the elasticity.

Whose demand is more elastic?
▶ Diners at the departure area of the Delhi airport, or diners at

Connaught Place?
▶ Someone buying salt or someone buying dal?
▶ Someone buying milk or someone buying coke?

Factors affecting own price elasticity
▶ Availability of substitutes
▶ Share of budget
▶ Necessities versus luxuries
▶ Time horizon under consideration
▶ Switching costs

Some nomenclature
▶ Infinitely/Perfectly elastic (=∞)

▶ Relatively elastic (> 1)
▶ Unitary elastic (= 1)
▶ Relatively inelastic (< 1)
▶ Zero elasticity/Perfectly inelastic (= 0)

Extreme elasticities
What are the elasticities of these demand curves?

Extreme elasticities
Q- this means to say at the

given price the demand is
infinite?
drugs, petrol close

Elasticities
▶ Even though elasticity is calculated at a point, we can still talk of

demand curves as being more or less elastic.
▶ This depends on the slope or the average elasticity along the entire
curve.

Relatively inelastic and elastic demand

Elasticity of Demand
▶ What should buyers’ price elasticity of demand for the Mac OS X be

for Apple’s pricing strategy to be successful?

Elasticity and revenue
▶ A firm’s revenues are given by the price per unit times quantity sold
Revenue = P X Q
▶ Elasticity measures how much Q goes down when P increases.
▶ How will elasticity of demand impact a firm’s revenue?
P (⇈) X Q (↓) ⇒R (↑)
P (↑) X Q (⇊) ⇒R (↓)

▶ What should buyers’ price elasticity of demand for the Mac OS X be

for Apple’s pricing strategy to be successful?

Other elasticities
cross-price elasticity

Other elasticities
cross-price elasticity
▶ Responsiveness of the demand for good X to a change in the price of

good Y
∆Qx
▶ ϵxy = % Change in demand of X Qx
% Change in price of Y = ∆Py
Py
▶ Positive: Substitute
▶ Price of other goods increases →Demand increases
▶ Examples?
▶ Negative: Complements
▶ Price of other goods increases → Demand decreases
▶ Examples?
▶ Zero: Unrelated goods

Estimates of cross-price elasticity
substitutes
Source: Allen et al.

Other elasticities
income elasticity
▶ Responsiveness of demand to a change in income
∆Qx
▶ ϵI = % Change in demand of X Qx
% Change in income = ∆I
I
▶ Positive: Normal good

▶ Income increases →Demand increases
▶ Examples?
▶ Negative: Inferior good

▶ Income increases → Demand decreases
▶ Examples?

Income Elasticity Estimates for Selected Goods
Goods Income Elasticity

Potatoes (UK) -.32
Grains (China) -0.12 to +.15
Apples (UK) +1.32
Milk (US) +1.72
Domestic Cars (US) +1.62
European Cars (US) +1.93

Consumer surplus
▶ In any market, only those individuals who value a good at least as

much as the market price, will purchase the good.
▶ Typically, there are some transactions where the willingness to pay is

greater than the market price.
▶ How do we interpret this difference between a consumer’s willingness

to pay and the market price?
▶ This difference between a consumer’s willingness to pay and the

market price is a net benefit to that consumer.
▶ In Econspeak, we call this consumer surplus

Consumer surplus

Consumer surplus

Consumer surplus
▶ CS = ∑i =units (WTPi − Price )
▶ Area under the demand curve and above the price

Recap
▶ Additional utility decreases as the number of units consumed increases
⇒ Willingness to pay decreases with quantity
⇒ Demand curve is downward sloping
▶ Demand curve may shift due to changes in income, price of

substitutes, price of complements, tastes, expectations, and
population
▶ Individual demand curves aggregate to market demand curves

▶ Price elasticity captures consumer sensitivity to price changes
▶ A firm’s revenue will increase or decrease after a price change

depending on the elasticity of demand for its products
▶ Consumer surplus is the net benefit to consumers from market

transactions.
Practice Problem 1
The Dolan Corporation, a maker of small engines, determines that in 2008

the demand curve for its product is P = 2000 - 50Q, where P is price (in
dollars) of an engine and Q is the number of engines sold per month.
a. To sell 20 engines per month, what price would Dolan have to charge?
b. If managers set a price of $500, how many engines will Dolan sell per
month?
c. What is the price elasticity of demand if price equals $500?
d. At what price, if any, will demand for Dolan’s engines be unitary elastic?

Practice Problem 2
After a careful statistical analysis, the Chidester Company concludes the

demand function for its product is Q = 500 - 3P + 2Pr + 0.1I where Q is
the quantity demanded of its product, P is the price of the product, Pr is
the price of its rival’s product, and I is per capita disposable income (in
dollars). At present, P = $10, Pr = $20 and I = $6000.
a. What is the price elasticity of demand for the firm’s product?

b. What is the income elasticity of demand for the firm’s product?
c. What is the cross-price elasticity of demand between its product and its
rival’s product?
d. What is the implicit assumption regarding the population in the market?

Practice Problem 3
From November 2007 to March 2008, the price of gold increased from
$865 per ounce to over $1,000 per ounce. Newspaper articles during this
period said there was no increased demand from the jewelry industry but
signicantly greater demand from investors who were purchasing gold
because of the falling dollar. For each of the following demand curves,
indicate whether the curve shifted inwards, outwards, or did not shift at all.
a. Gold demand by jewelery industry

b. Gold demand by investors
c. Aggregate demand for gold

Practice Problem 4
Given demand equation Q=40000-4P
a. Find the revenue that the firm may earn if the price is Rs. 5000.
b. Graph the function and use the ‘area under the curve’ approach to do
the above computation.
c. Find the consumer surplus
d. Find change in revenue and change in consumer surplus if the price
increases to Rs. 7500.

Lecture 2

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All about Demand

MGEC Lecture-2 2023-24

▶ Determine the amount to produce

MGEC Lecture-2 2023-24

▶ Determine the amount to produce

MGEC Lecture-2 2023-24

▶ Determine the amount to produce

MGEC Lecture-2 2023-24

▶ Determine the amount to produce

MGEC Lecture-2 2023-24

What does this picture mean?

MGEC Lecture-2 2023-24

The law of demand

▶ The demand curve is not upward sloping

MGEC Lecture-2 2023-24

▶ Goods and services typically increase utility

▶ However, more of any good or service typically increases utility at a

▶ This is the Law of Diminishing Marginal Utility

MGEC Lecture-2 2023-24

▶ Diminishing Marginal Utility of extra light

MGEC Lecture-2 2023-24

MGEC Lecture-2 2023-24

▶ When the price of a commodity decreases, the “real income” of the

MGEC Lecture-2 2023-24

Demand equation for consumer-1:

MGEC Lecture-2 2023-24

Individual demand curves for consumers 1 to 3 can be aggregated to

MGEC Lecture-2 2023-24

example demand for biscuits

MGEC Lecture-2 2023-24

▶ Does the demand curve move/shift left or right?

Income of buyers, Consumer Trends, Expectation of Future Price,

MGEC Lecture-2 2023-24

▶ A particular demand schedule assumes related-product’s prices,

MGEC Lecture-2 2023-24

MGEC Lecture-2 2023-24

▶ Prices of substitute goods (tubelights)

▶ Prices of complementary goods (lamp shades)

▶ Tastes (an increase in fear of the dark, or an environmental backlash

▶ Expectations about future prices

MGEC Lecture-2 2023-24

Source: The Financial Express, May 6, 2013

MGEC Lecture-2 2023-24

MGEC Lecture-2 2023-24

MGEC Lecture-2 2023-24

▶ In May 2003, NY city transport authority planned to raise fares to

MGEC Lecture-2 2023-24

▶ How did the NY MTA calculate changes in revenue as a result of the

MGEC Lecture-2 2023-24

▶ How did the NY MTA calculate changes in revenue as a result of the

MGEC Lecture-2 2023-24

▶ How did the NY MTA calculate changes in revenue as a result of the

MGEC Lecture-2 2023-24

▶ In economics, the sensitivity of customers to price changes is known

MGEC Lecture-2 2023-24

▶ Elasticity is the % change in quantity demanded due to a % change

▶ Elasticity ̸=Slope of demand curve

MGEC Lecture-2 2023-24

▶ As such a negative number since the demand curve is downward

MGEC Lecture-2 2023-24

▶ Larger the change in quantity demanded in response to a unit change

MGEC Lecture-2 2023-24

▶ Diners at the departure area of the Delhi airport, or diners at