Managerial

Economics
Dony Abdul Chalid, Ph.D.

Session 2
Demand Analysis
Overview

I. The Elasticity Concept

 Own Price Elasticity
 Elasticity and Total Revenue
 Cross-Price Elasticity
 Income Elasticity

II. Demand Functions

 Linear
 Log-Linear

III. Regression Analysis

The Elasticity Concept
• Howresponsive is variable “G” to a change in
variable “S”
%G
EG , S =
%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
 The Elasticity Concept Using Calculus
• An alternative way to measure the elasticity
of a function G = f(S) is
dG S
EG , S =
dS G
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
Own Price Elasticity of Demand
%QX
d
EQX , PX =
%PX
• Negative according to the “law of demand.”

Elastic: EQX , PX  1
Inelastic: EQX , PX  1
Unitary: EQX , PX = 1
Perfectly Elastic & Inelastic Demand
Price Price
D

D
Perfectly Elastic ( EQX , PX = −)

Quantity Quantity

Perfectly Inelastic ( EQX , PX = 0)

 Own-Price Elasticity
and Total Revenue
• Elastic
 Increase (a decrease) in price leads to a decrease (an increase) in total revenue.

• Inelastic
 Increase (a decrease) in price leads to an increase (a decrease) in total revenue.

• Unitary
 Total revenue is maximized at the point where demand is unitary elastic.
 Elasticity, Total Revenue
and Linear Demand
P
TR
100

0 10 20 30 40 50 Q 0 Q
 Elasticity, Total Revenue
and Linear Demand
P
TR
100

80

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue
and Linear Demand
P
TR
100

80

60 1200

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
 Elasticity, Total Revenue
and Linear Demand
P
TR
100

80

60 1200

40

800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
Elasticity, Total Revenue
and Linear Demand
P
TR
100

80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
Elasticity, Total Revenue
and Linear Demand
P
TR
100
Elastic
80

60 1200

40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic
Elasticity, Total Revenue
and Linear Demand
P
TR
100
Elastic
80

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
Elasticity, Total Revenue
and Linear Demand

P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
Demand, Marginal Revenue (MR) and
Elasticity
P • For a linear inverse demand
function, MR(Q) = a + 2bQ,
100 where b < 0.
Elastic
80 Unit elastic • When
 MR > 0, demand is
60
elastic;
Inelastic
40  MR = 0, demand is unit
elastic;
20  MR < 0, demand is
inelastic.

0 10 20 40 50 Q

MR
Factors Affecting the
Own-Price Elasticity
• Available Substitutes
 The more substitutes available for the good, the more
elastic the demand.

• Time
 Demand tends to be more inelastic in the short term than
in the long term.
 Time allows consumers to seek out available substitutes.

• Expenditure Share
 Goods that comprise a small share of consumer’s budgets
tend to be more inelastic than goods for which consumers
spend a large portion of their incomes.
Cross-Price Elasticity of Demand
%QX
d
EQX , PY =
%PY

If EQX,PY > 0, then X and Y are substitutes.

If EQX,PY < 0, then X and Y are complements.

Predicting Revenue Changes
from Two Products
Suppose that a firm sells to related goods. If
the price of X changes, then total revenue
will change by:

( ( ) )
R = RX 1 + EQX , PX + RY EQY , PX  %PX
Income Elasticity

%QX
d
EQX , M =
%M

If EQX,M > 0, then X is a normal good.

If EQX,M < 0, then X is a inferior good.
Uses of Elasticities
• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and
recessions.
• Impact of advertising campaigns.
• And lots more!
Example 1: Pricing and Cash Flows
• According
to an FTC Report by Michael
Ward, AT&T’s own price elasticity of
demand for long distance services is -
8.64.
• AT&T needs to boost revenues in order to
meet it’s marketing goals.
• Toaccomplish this goal, should AT&T
raise or lower it’s price?
Answer: Lower price!

• Sincedemand is elastic, a reduction in

price will increase quantity demanded by
a greater percentage than the price
decline, resulting in more revenues for
AT&T.
Example 2: Quantifying the Change

• If
AT&T lowered price by 3 percent, what
would happen to the volume of long
distance telephone calls routed through
AT&T?
Answer: Calls Increase!
Calls would increase by 25.92 percent!
%QX
d
EQX , PX = −8.64 =
%PX
%QX
d
− 8.64 =
− 3%
− 3%  (− 8.64 ) = %QX
d

%QX = 25.92%
d
Example 3: Impact of a Change
in a Competitor’s Price
• According
to an FTC Report by Michael
Ward, AT&T’s cross price elasticity of
demand for long distance services is 9.06.
• If
competitors reduced their prices by 4
percent, what would happen to the demand
for AT&T services?
Answer: AT&T’s Demand Falls!

AT&T’s demand would fall by 36.24

percent!
% Q X
d
EQX , PY = 9.06 =
% PY
% Q X
d
9.06 =
− 4%
− 4%  9.06 = % QX
d

% QX = −36.24%
d
Interpreting Demand Functions
• Mathematical representations of demand
curves.
• Example:

QX = 10 − 2PX + 3PY − 2M
d

 Law of demand holds (coefficient of PX is negative).

 X and Y are substitutes (coefficient of PY is positive).
 X is an inferior good (coefficient of M is negative).
Linear Demand Functions and
Elasticities
• General Linear Demand Function and Elasticities:

QX =  0 +  X PX + Y PY +  M M +  H H
d

PY M
P
EQX , PX =  X X EQ X , PY = Y EQX , M =  M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
Example of Linear Demand
• Qd = 10 - 2P.
• Own-Price Elasticity: (-2)P/Q.
• If P=1, Q=8 (since 10 - 2 = 8).
• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
Log-Linear Demand
• General Log-Linear Demand Function:

ln QX d = 0 +  X ln PX + Y ln PY +  M ln M +  H ln H

Own Price Elasticity : X

Cross Price Elasticity :  Y
Income Elasticity : M
Example of Log-Linear Demand
• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.
Graphical Representation of Linear
and Log-Linear Demand
P P

D D

Q Q
Linear Log Linear
Regression Analysis
• Oneuse is for estimating demand
functions.
• Important terminology and concepts:
 Least Squares Regression model: Y = a + bX + e.
 Least Squares Regression line: Yˆ = aˆ + bˆX
 Confidence Intervals.
 t-statistic.
 R-square or Coefficient of Determination.
 F-statistic.
An Example
• Use a spreadsheet to estimate the
following log-linear demand function.

ln Qx =  0 +  x ln Px + e
Summary Output
Regression Statistics
Multiple R 0.41
R Square 0.17
Adjusted R Square 0.15
Standard Error 0.68
Observations 41.00

ANOVA
df SS MS F Significance F
Regression 1.00 3.65 3.65 7.85 0.01
Residual 39.00 18.13 0.46
Total 40.00 21.78

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

Intercept 7.58 1.43 5.29 0.000005 4.68 10.48
ln(P) -0.84 0.30 -2.80 0.007868 -1.44 -0.23
 Interpreting the Regression Output

• The estimated log-linear demand function is:

 ln(Qx) = 7.58 - 0.84 ln(Px).
 Own price elasticity: -0.84 (inelastic).

• How good is our estimate?

 t-statistics of 5.29 and -2.80 indicate that the estimated coefficients are statistically
different from zero.
 R-square of 0.17 indicates the ln(PX) variable explains only 17 percent of the
variation in ln(Qx).
 F-statistic significant at the 1 percent level.
 Conclusion
• Elasticities are tools you can use to quantify the impact of changes in
prices, income, and advertising on sales and revenues.
• Given market or survey data, regression analysis can be used to
estimate:
 Demand functions.
 Elasticities.
 A host of other things, including cost
functions.
• Managers can quantify the impact of changes in prices, income,
advertising, etc.
The Theory of Individual Behavior
 Overview
I. Consumer Behavior
 Indifference Curve Analysis.
 Consumer Preference Ordering.

II. Constraints
 The Budget Constraint.
 Changes in Income.
 Changes in Prices.

III. Consumer Equilibrium

IV. Indifference Curve Analysis & Demand Curves
 Individual Demand.
 Market Demand.
 Consumer Behavior
• Consumer Opportunities
 The possible goods and services consumer can
afford to consume.
• Consumer Preferences
 The goods and services consumers actually
consume.
• Giventhe choice between 2 bundles of
goods a consumer either:
 Prefers bundle A to bundle B: A  B.
 Prefers bundle B to bundle A: A  B.
 Is indifferent between the two: A  B.
 Indifference Curve Analysis
Indifference Curve Good Y
 A curve that defines the III.
combinations of 2 or more goods
that give a consumer the same II.
level of satisfaction. I.

Marginal Rate of
Substitution
 The rate at which a consumer is
willing to substitute one good
for another and maintain the
same satisfaction level.
Good X
Consumer Preference Ordering
Properties
• Completeness

• More is Better
• Diminishing Marginal Rate of
Substitution
• Transitivity
 Complete Preferences
• Completeness Property
Good Y
 Consumer is capable of
expressing preferences (or III.
indifference) between all possible
bundles. (“I don’t know” is NOT II.
an option!) I.
 If the only bundles available to a consumer
are A, B, and C, then the consumer A
B
 is indifferent between A and C (they are
on the same indifference curve).
 will prefer B to A.
 will prefer B to C. C

Good X
 More Is Better!
• More Is Better Property
 Bundles that have at least as much Good Y
of every good and more of some
good are preferred to other III.
bundles.
 Bundle B is preferred to A since II.
B contains at least as much of I.
good Y and strictly more of good
X.
A
 Bundle B is also preferred to C 100 B
since B contains at least as
much of good X and strictly more
of good Y. C
33.33
 More generally, all bundles on
ICIII are preferred to bundles on
ICII or ICI. And all bundles on
ICII are preferred to ICI. 1 3
Good X
 Diminishing MRS
• MRS
 The amount of good Y the consumer is willing to give
up to maintain the same satisfaction level decreases as Good Y
more of good X is acquired.
 The rate at which a consumer is willing to substitute III.
one good for another and maintain the same
satisfaction level. II.
• To go from consumption bundle A to B the I.
consumer must give up 50 units of Y to get A
one additional unit of X. 100

• To go from consumption bundle B to C the B

consumer must give up 16.67 units of Y to get 50
one additional unit of X. C
33.33 D
• To go from consumption bundle C to D the 25
consumer must give up only 8.33 units of Y to
get one additional unit of X.
1 2 3 4 Good X
 Consistent Bundle Orderings
• Transitivity Property Good Y
 For the three bundles A, B, and
C, the transitivity property III.
implies that if C  B and B  A,
II.
then C  A.
 Transitive preferences along I.
with the more-is-better property 100 A
imply that C
75
 indifference curves will not intersect.
B
 the consumer will not get caught in a 50
perpetual cycle of indecision.

1 2 5 7 Good X
 The Budget Constraint
• Opportunity Set Y The Opportunity Set
 The set of consumption bundles
that are affordable.
 PxX + PyY  M. Budget Line

• Budget Line
M/PY
Y = M/PY – (PX/PY)X

 The bundles of goods that exhaust a

consumers income.
 PxX + PyY = M.

• MarketRate of
Substitution
M/PX
 The slope of the budget line X
 -Px / Py.
 Changes in the Budget Line
Y
• Changes in Income M1/PY
 Increases lead to a parallel,
outward shift in the budget
M0/PY
line (M1 > M0).
 Decreases lead to a parallel,
downward shift (M2 < M0). M2/PY

• Changes in Price
 A decreases in the price of X
good X rotates the budget Y
M2/PX M0/PX M1/PX

line counter-clockwise (PX0 New Budget Line for

> PX1). M0/PY a price decrease.
 An increases rotates the
budget line clockwise (not
shown).

M0/PX0 M0/PX1
X
 Consumer Equilibrium
• The equilibrium consumption
bundle is the affordable bundle Y
that yields the highest level of
satisfaction. Consumer
M/PY
 Consumer equilibrium Equilibrium
occurs at a point where
MRS = PX / PY.
 Equivalently, the slope of
the indifference curve
equals the budget line.
III.
II.
I.
M/PX
X
 Price Changes and Consumer
Equilibrium
• Substitute Goods
 An increase (decrease) in the price of good X leads to
an increase (decrease) in the consumption of good Y.
 Examples:
 Coke and Pepsi.
 Verizon Wireless or AT&T.

• Complementary Goods
 An increase (decrease) in the price of good X leads to a
decrease (increase) in the consumption of good Y.
 Examples:
 DVD and DVD players.
 Computer CPUs and monitors.
 Complementary Goods

When the price of

Pretzels (Y)
good X falls and the
consumption of Y
rises, then X and Y M/PY
1
are complementary
goods. (PX1 > PX2)

B
Y2

Y1 A II

I
0 X1 M/PX1 X2 M/PX2 Beer (X)
Income Changes and Consumer
Equilibrium
• Normal Goods
 Good X is a normal good if an increase (decrease) in income leads to an
increase (decrease) in its consumption.

• Inferior Goods
 Good X is an inferior good if an increase (decrease) in income leads to a
decrease (increase) in its consumption.
Normal Goods
Y
An increase in
income increases
the consumption of M1/Y

normal goods.

(M0 < M1).

B
Y1
M0/Y
II
A
Y0
I
X0 M0/X X1 M1/X X
0
Decomposing the Income and
Substitution Effects
Y
Initially, bundle A is consumed. A
decrease in the price of good X
expands the consumer’s opportunity
set.
The substitution effect (SE) causes the C
consumer to move from bundle A to B.
A higher “real income” allows the A II
consumer to achieve a higher
indifference curve. B

The movement from bundle B to C I

represents the income effect (IE). The
new equilibrium is achieved at point
C. 0
IE X
SE
A Classic Marketing Application
Other
goods
(Y)

A
A buy-one,
C E
get-one free
D
pizza deal. II
I

0 0.5 1 2 B F Pizza
(X)
 Individual Demand Curve
Y
• 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. II

$ X

P0

P1 D

X0 X1 X
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.

$ Individual Demand $ Market Demand Curve

Curves
50

40

D1 D2 DM
1 2 Q 1 2 3 Q
Conclusion
• Indifference curve properties reveal information about consumers’
preferences between bundles of goods.
 Completeness.
 More is better.
 Diminishing marginal rate of substitution.
 Transitivity.
• Indifference curves along with price changes determine individuals’ demand
curves.
• Market demand is the horizontal summation of individuals’ demands.