Chapter 3:

Quantitative Demand Analysis

The Elasticity Concept

o Measures the responsiveness of a
 Elasticity percentage change in the quantity
demanded of good X to a percentage
o A measure of the responsiveness of change in its price.
one variable to changes in another
variable; the percentage change in d
% ΔQX
one variable that arises due to a EQ d
, PX
=
X
% Δ PX
given percentage change in another
variable.
o Sign: negative by law of demand.
o The elasticity between two
variables, G and S, is o Magnitude of absolute value relative
mathematically expressed as: to unity:

EG ,S =
% ΔG |E Q ,P |>1: Elastic.
X
d
X

% ΔS |E Q ,P |<1: Inelastic.
X
d
X

o When a functional relationship |E Q ,P |=1: Unitary elastic.

X
d
X

exists, like G=f ( S ), the elasticity

is:
Linear Demand, Elasticity, and Revenue
dG S
EG ,S =
dS G

Measurement Aspects of Elasticity

 Important aspects of the elasticity:

o Sign of the relationship:

– Positive
– Negative

o Absolute value of elasticity

magnitude relative to unity:
– |E G , S|>1 G is highly
responsive to changes in S.
– |E G , S|<1 G is slightly
responsive to changes in S.
Own Price Elasticity of Demand
Total Revenue Test
 When demand is elastic:
o A price increase (decrease) leads to
a decrease (increase) in total
revenue.
 When demand is inelastic:
o A price increase (decrease) leads to
an increase (decrease) in total
revenue.

 Own price elasticity of demand  When demand is unitary elastic:

 o Total revenue is maximized.

Perfectly Elastic and Inelastic Demand

Cross-Price Elasticity

Factors Affecting the Own Price Elasticity  Cross-price elasticity

 Three factors can impact the own price o Measures responsiveness of a

elasticity of demand: percent change in demand for good
X due to a percent change in the
o Availability of consumption price of good Y.
substitutes
o Time/duration of purchase horizon d
% ΔQX
o Expenditure share of consumers’ EQ d
, PY
=
X
% Δ PY
budgets

Marginal Revenue and the Own Price o If EQ , P >0 , then X and Y are
X
d
Y

Elasticity of Demand substitutes.

 The marginal revenue can be derived from a
market demand curve.
o Marginal revenue measures the
additional revenue due to a change
in output.
 This link relates marginal revenue to the
own price elasticity of demand as follows:
o If EQ , P <0 , then X and Y are
X
d
Y
complements.
Cross-Price Elasticity in Action
 Suppose it is estimated that the cross-price
elasticity of demand between clothing and
food is -0.18. If the price of food is
projected to increase by 10 percent, by how
much will demand for clothing change?

( )
1+ E d
MR=P % ∆ QClothing d
E −0.18= ⇒ % ∆ QClothing =−1. 8
10
When −∞ < E←1 then, MR> 0.
When E=−1 then, MR=0 . That is, demand for clothing is expected to
When −1< E< 0 then, MR< 0. decline by 1.8 percent when the price of
food increases 10 percent.
Demand and Marginal Revenue
Cross-Price Elasticity

 Cross-price elasticity is important for firms

selling multiple products.
  Suppose that the income elasticity of
o Price changes for one product demand for transportation is estimated to be
impact demand for other products. 1.80. If income is projected to decrease by
15 percent,
 Assessing the overall change in revenue
from a price change for one good when a o What is the impact on the demand
firm sells two goods is: for transportation?

[
∆ R= R X ( 1+ EQ X
d
, PX ) + RY E Q Y
d
, PX ] ×% ∆ P X
1.8=
% ΔQX
d

−15
Cross-Price Elasticity in Action
Demand for transportation will
 Suppose a restaurant earns $4,000 per week decline by 27 percent.
in revenues from hamburger sales (X) and
$2,000 per week from soda sales (Y). o Is transportation a normal or inferior
good?
If the own price elasticity for burgers is
EQ , P =−1.5 and the cross-price elasticity
X X
Since demand decreases as income
of demand between sodas and hamburgers is declines, transportation is a normal
EQ ,P =−4.0, what would happen to the good.
Y X

firm’s total revenues if it reduced the price

Other Elasticities
of hamburgers by 1 percent?

∆ R=[ $ 4,000 ( 1−1.5 )+ $ 2,000 (−4.0 ) ] (−1% )=$ 

100Own advertising elasticity of demand for
good X is the ratio of the percentage change
in the consumption of X to the percentage
That is, lowering the price of hamburgers 1
change in advertising spent on X.
percent increases total revenue by $100.

Income Elasticity  Cross-advertising elasticity between goods

X and Y would measure the percentage
 Income elasticity change in the consumption of X that results
o Measures responsiveness of a from a 1 percent change in advertising
percent change in demand for good toward Y.
X due to a percent change in
income. Elasticities for Linear Demand Functions
d
% ΔQX
EQ d
,M
=  From a linear demand function, we can
X
%ΔM easily compute various elasticities.

o If EQ d
,M
>0 , then X is a normal  Given a linear demand function:
X

good.
o If EQ d
,M
<0 , then X is an inferior d
Q X =α 0 +α X P X + α Y P Y + α M M +α H PH
X

good.
PX
Income Elasticity in Action o Own price elasticity: α X d.
QX
 PY o Income elasticity: β M .
o Cross price elasticity: α Y d.
QX
M Elasticities for Nonlinear Demand Functions
o Income elasticity: α M d. in Action
QX
 An analyst for a major apparel company
Elasticities for Linear Demand Functions in estimates that the demand for its raincoats is
Action given by:

 The daily demand for Invigorated PED d

ln Q X =10−1.2 ln P X +3 ln R−2 ln A Y
shoes is estimated to be:
Where R denotes the daily amount of
Q X d=100−3 P X + 4 PY −0.01 M + 2 P A X
rainfall and AY the level of advertising on
good Y. What would be the impact on
Suppose good X sells at $25 a pair, good Y demand of a 10 percent increase in the daily
sells at $35, the company utilizes 50 units of amount of rainfall?
advertising, and average consumer income is
$20,000. Calculate the own price, cross-
EQ d
,R
=β R =3. So,
price and income elasticities of demand. X
d d
% ∆ QX % ∆ QX
EQ , R = d ⇒ 3= .
o X
%∆R 10
d
Q X =100−3 ( $ 25 ) +4 ( $ 35 )−0.01 ( $ 20,000 )+ 2 ( 50 )=65
units. A 10 percent increase in rainfall will lead to
o Own price elasticity: a 30 percent increase in the demand for
25 raincoats.
−3( )=−1.15.
65
Regression Analysis
35
o Cross-price elasticity: 4 ( )=2.15
65  How does one obtain information on the
. demand function?
o Income elasticity: o Published studies
20,000 o Hire consultant
−0.01( )=−3.08.
65 o Statistical technique called
regression analysis using data on
quantity, price, income and other
important variables.

Elasticities for Nonlinear Demand Functions

Regression Line and Least Squares
 One non-linear demand function is the log- Regression
linear demand function:
 True (or population) regression model
d
ln Q X = β0 + β X ln P X + β Y ln PY + β M ln M + β H ln H
Y =a+bX + e
o Own price elasticity: β X .
o Cross price elasticity: β Y .
 o a unknown population intercept
parameter.
o b unknown population slope
parameter.
o e random error term with mean zero
and standard deviation σ .
o b^ ± 2 σ b^
 T-statistics rule of thumb
o When |t |>2, we are 95 percent
confident the true parameter is in the
regression is not zero.

 Least squares regression line Excel and Least Squares Estimates

Y = a^ + b^ X

o a^ least squares estimate of the

unknown parameter a .
o b^ least squares estimate of the
unknown parameterb .

 The parameter estimates a^ 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.
Excel and Least Squares Estimates
Evaluating the Overall Fit of the Regression
Line
 R-Square
o Also called the coefficient of
determination.
o Fraction of the total variation in the
dependent variable that is explained
by the regression.

2 Explained Variation SS Regression

R= =
Total Variation SSTotal

o Ranges between 0 and 1.

Evaluating Statistical Significance
 Standard error
o Measure of how much each
estimated estimate varies in
regressions based on the same true
demand model using different data.
– Values closer to 1 indicate
“better” fit.
 Adjusted R-Square
o A version of the R-square that
penalize researchers for having few
degrees of freedom.

 95 Percent Confidence interval rule of n−1

R =1−( 1−R )
2 2
thumb n−k

o a^ ± 2 σ a^ – n is total observations
 – k is the number of estimated  Regression techniques can also be applied to
coefficients. the following settings:
– n−k is the degrees of
freedom for the regression. o Nonlinear functional relationships:

 The F- Statistic – Nonlinear regression

o A measure of the total variation example:
explained by the regression relative
to the total unexplained variation. ln Q=β0 + β p ln P+e

– The greater the F-statistic, – Functional relationships

the better the overall with multiple variables:
regression fit.
– Equivalently, the P-value is Multiple regression
another measure of the F- example:
statistic.
d
Q X =α 0 +α X P X + α M M + α H P H + e
– Lower P-values are
associated with or
better overall
regression fit. d
ln Q X = β0 + β X ln P X + β M ln M + β H ln P H +
Excel and Least Squares Estimates

Excel and Least Squares Estimates

Regression for Nonlinear Functions and

Multiple Regression