BUSINESS ECONOMICS

Slides by CAO Thi Hong Vinh and LU Thi Thu Trang

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Chapter 3:
CONSUMER BEHAVIOR
& DEMAND

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— Required: Business Economics and
Managerial Decision Making, C.4-6
— Recommend: Economics for
Business and Management, C.2

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 STRUCTURE
1. Consumer behavior
2. Demand analysis
3. Demand function estimation

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 1. Consumer behavior
1.1. Maximize utility with budget
constraint
1.2. Characteristic approach
1.3. Behavioral approach

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 1.1 Maximize utility
Indifference curve: same level of
utility over dif. bundles of goods
Assume: 2 substitutes, the more is better
- Never cross
- The farther from origin, the higher utility
- Slope downward (the more is better)
- Convex to the origin (Diminishing marginal
utility)
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Slope of Indifference Curve? = Changing
along the curve
D -> B -> E: Same utility, different slope:
Steeper? Flatter? (Diminish Marginal Utility)

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Marginal Rate of Substitution (MRS)?
Δ TUx = - Δ TUy -> MUx * Δ Qx = - MUy* Δ Qy ->
Δ Qy/Δ Qx = - MUx/ MUy = MRS
=> Slope of Indifference Curve = MRS

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Budget constraint:
M = Px Q x + Py Q y
M Px
Þ Qy = - Qx
Py Py

Slope?
Slope of budget line = −(Vertical intercept)/(Horizontal
intercept) = -Px/Py

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Optimal Consumption?
Slope of Indifference Curve =
Slope of Budget Line
MRS = - Px/Py
-MUx/ MUy = - Px/Py
àMUx/ MUy = Px/Py
The marginal rate of
substitution between any
two goods is equal to the
ratio of their prices
Value = Cost
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Price change?

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Income change?

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Price change?
= Substitution + Income Effects

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Criticism of indifference curve:
- How to set/change preferences?
- Static theory
- Imperfect Information make decisions?
- Ordering NOT just based on utility?
- No interactions among individuals
- Private goods, consumed instantly

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1.2 CHARACTERISTIC APPROACH
Lancaster (1966):
Consumers make choices not only between distinct goods but
also similar with dif. combinations of characteristics
(ex: same 4 wheels of car, but many dif. body shapes and other
features)
- Consumers want goods for their inherent characteristics- a
property of goods that generates utility
- A consumer’s ability to buy a good with the most desirable
set of characteristics = function of income and price of char.
- Main Assumption: Characteristics are measurable
objectively…. à Criticize
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 1.3 BEHAVIOURAL APPROACH
— Consumers are not perfect and fully rational decision maker
— Consumers utilize rules of thumb and decision routines to
overcome limited abilities and partial information à NOT
Maximize but Satisfy their utilities
— Consumption = Previous experience + purchase position in
budget
— Choice = process of problem solving, involving decision-
making cycle: Recognition, Search, Evaluation, Choice,
Implementation, Hindsight. Develop Rules of Thumb
— Decision making = constructing a choice matrix with rival
product on one axis and relevant characteristics on the other
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 2.Demand analysis
2.1 Market demand
2.2 Revenue
2.3 Elasticity

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 2.1 Market demand
Function of:
Q x = f (Px , Py , A x , Y, T, O)
Q x : quantity demanded of good X
Px : price of good X
Py : price of good Y
A x : advertising expenditure
Y: real disposable income
T: consumer tastes
O: other factors
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 2.1 Market demand
For simplicity:
Q x = f (Px )
àInverse demand function?

i.e. Linear demand function: Q x = a + bPx

à Q (P=0) = horizontal intercept: a
à P (Q=0) = vertical intercept: -a/b
à Slope ΔPx/ ΔQx = -1/b
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 2.2 Revenue
TR? AR? MR?

i.e. Q x = a + bPx
àa linear MR curve
à a MR curve: slope is twice that of the demand
curve
àTR is maximized where MR is 0

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 — TR = a/bQx - Qx^2/b
— AR = TR/Qx = a/b – Qx/b = Demand Curve = Px
— MR = ΔTR/ΔQ = TR’(Q) = a/b – 2Qx/b
— TR max when TR’(Q) = ΔTR/ΔQ = 0 -> MR = 0

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 2.3 Elasticity
Responsiveness of Demanded Quantity to
changes in price
2.3.1. Own price elasticity
a. Formula: e = DQ x / Q x
DPx / Px
- Sign? Law of demand? -
- Magnitude? 1

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Perfectly
Inelastic Inelastic Unit- Elastic
Demand Demand

Elastic Perfectly 26
Demand Elastic
TR? MR?
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 2.3 Elasticity
Q x = a + bPx
a
e = f (a, Q x ) = -1
Qx
1
MR = f (e , Px ) = Px (1 + )
e
e MR (0) Change in TR
(as P falls)
Inelastic - D

Elastic + I

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 — b = 1/slope of Demand Curve = ΔQ/ΔP -> e = a/Qx – 1
— MR = TR’(Q) = ΔTR/ΔQ = ΔP*Q/ΔQ + P*ΔQ/ΔQ = P +
P*Q/P*ΔP/ΔQ = P + P*1/e

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 2.3 Elasticity
b. Factors affecting e :
Price effect = substitution effect + income effect
- Substitution effect: Closer substitute à more
or less elastic?
- Income effect: Large proportion of income à
more or less elastic?
- Time: Longer period à more or less elastic?

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 2.3 Elasticity
c. Arc elasticity :
Non-linear, large change in price….
Q 1 + Q2
DQ/( )
e = 2
P1 + P2
DP / ( )
2

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 2.3 Elasticity
2.3.2. Cross-price elasticity
Responsiveness of demand for X to a
change in price of Y
Formula:
DQ x / Q x
eC =
DPy / Py

Substitute or complementary?

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 2.3 Elasticity
2.3.3. Income elasticity
Responsiveness of demand for a product to a
change in income
Formula: DQ x / Q x
eI =
DI / I
Normal or inferior?
- Engel curve
- Factors affecting: initial income level, status of the
goods (necessities or luxuries), age of the goods…
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 2.3 Elasticity
2.3.4. Advertising elasticity
Responsiveness of quantity demanded for
a change in Advertising expenditure
Formula:
DQ x / Q x
eA =
DA / A
Informative or persuasive?
Elastic or Inelastic?
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3. Demand function estimation
Different methods:
- Interviews and surveys (using
questionnaires)
- Consumer experiments
- Market studies
- Statistical analysis (using regression)

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3. Demand function estimation
Statistical analysis (using regression)
3.1 Setting model:
Linear equation:
Q x = a + b1 Px + b 2 Py + b 3 A x + b 4 Y + b 5 X n
Log-linear equation:
logQ x = a + b1logPx + b 2 logPy + b 3 logA x
+ b 4 logY + b 5 logX n
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 3. Demand function estimation
3.2 Checking results:
a. Coefficient of Determination- R2 and
adjusted R2
SST- Total Sum of Squares

SSE- Explained Sum of Squares

SSR- Residual Sum of Squares

R2 = SSE/SST = 1 - SSR/SST à R2 = 1: perfect fit; R2 = 0: poor fit of OLS line

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3. Demand function estimation
3.2 Checking results:
BUT: more variable -> higher R2 à using
adjusted R2

. Too low à misspecification of the model

(omission of imp. variables or wrong
functional form)
. Too high à multi-collinearity
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3.2 Checking results:
b. F-test: dep. & a group of ind.
H0: no significant statistical rel.
F > Fb à reject H0
Fb = Function of degree of freedom and the probability of
being wrong
c. t-test: dep. & an ind.
H0: no significant statistical rel.
t > tb à reject H0
tb = Function of degree of freedom and the probability
of being wrong
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3.2 Checking results:
d. Coefficients:
. Sign: if not the expected
à Omission
à Identification (simultaneous change
between the variable included and the one
not included): price and income
. Statistical significance (standard error)
95% probability of the actual value falls into
(estimated value +/- 2* standard errors)
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3.2 Checking results:
e. Auto-correlation:
Error terms: serially correlated
à Overestimating/underestimating the unexplained
variation
à Durbin-Watson statistic:
H0: there is no auto-correlation
Compare DW to upper and lower limit derived from the
statistical tables
DW > upper limit à H0 accepted
DW < lower limit à H0 rejected
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