Managerial Economics

Importance of market demand (in

understanding revenue and profit)
Price elasticity of demand

Term I

Sumit Sarkar, XLRI Jamshedpur

Importance of market demand
Definitions: Revenue, cost and profit
Revenue[R] = Quantity Sold [x] . Price [p]

Cost [C] = Var.Cost [c(x)] + Fixed Cost [F]

Will be discussed later. For now, C = c.x, where c = unit cost

Profit [] = Revenue[R] – Cost [C]

= p.x – c.x = D(x)x – c.x

Demand function: p = D(x)

Revenue and the demand function

Revenue(R) = Quantity Sold (x) . Price (p)

R = xD(x)
p

p0

p1

x
x0 x1
Profit and the demand function

What should be your price?

px

90
 =2100
80  =3600

50  =3900
 =1700
30
20  =0
Unit cost = 20
30 60 130 170 200 x
Profit maximization and the demand function
Profit = Rev. – Cost

or,

By first-order condition of profit maximization,

Or,

Or, MR = MC[MR => Marginal revenue

MC => Marginal cost]

MR = [MR depends on the demand fn.]

Price elasticity of demand – a measure of price
sensitivity of consumers
• Price elasticity of demand captures the responsiveness of
quantity demanded to changes in price
 = (percentage change in quantity demanded) / (percentage
change in price)
=

 < 0 as < 0 [Demand fn is downward sloping]

• Suppose, other things remaining constant, an increase in your

price from Rs. 10 / unit to Rs. 12 / unit resulted in sales drop
from 15000 units / day to 13000 units / day. Can you calculate
the price elasticity of demand for your product?
Marginal revenue and price elasticity of demand
MR =

=

Therefore, MR = ] = ] =

If  < -1, ( + 1) < 0 and hence, MR > 0

If  = -1 MR = 0
If 0 >  > -1, ( + 1) > 0 and hence, MR < 0
Marginal revenue, demand and elasticity

p = D(x)

 < -1
 = -1
 > -1
D(x)

x0 x
MR = ]

The MR = 0 at x0.
At x = x0, price elasticity of demand is -1.
Reading and problems
• Besanko & Braeutigam (6th ed.)
• Ch. 2 (Section 2.2)
• Problems: 2.4, 2.6b, 2.11, 2.17, 2.18, 2.21-22, 2.27, 2.30.
• Ch. 12 (Section 12.1 – up to p. 477)
• Problems: 12.1-5.
Individual Choices and Decisions

Consumers' behavior –
Utility function, Marginal utility
 A consumer tries to solve the following
optimization problem…
Max U(x1, x2, …, xn)
S.t. p1x1 + p2x2 + … + pnxn < M

Household as Consumer in the Goods market

 Consumer’s goal: To maximize utility

 Consumer’s constraint: Budget (determined by
consumer’s income) and market prices

Sumit Sarkar, XLRI

 Utility function - Definition

A one to one correspondence between quantity of

a ‘good’ consumed and utility derived from that
consumption.

 The utility function of a typical consumer

◦ increases with increase in consumption till the point of
satiation (increasing function)
◦ increases at a decreasing rate (concave function)
◦ for every marginal (infinitesimally small) increase in
consumption there is increase in utility (continuous
function)

Sumit Sarkar, XLRI

 Marginal Utility - Definition

 Additional utility derived from consumption of an

additional unit.

 (Technical definition)
Utility derived from marginal consumption.
If U = u(x)
MU = du(x)/dx

Sumit Sarkar, XLRI

 Consumers’ psychology

 More is better
◦ Utility increases with consumption,
i.e., MU > 0

 Diminishing Marginal Utility:

◦ Marginal Utility decreases with increase in consumption.

Sumit Sarkar, XLRI

 U

ΔU
Δx

x
MU x0 x1

MU(x0)

x
x0

Sumit Sarkar, XLRI

Reading
• Besanko & Braeutigam (6th ed.). Ch. 3. Section 3.1,
3.2(up to page 83)
• Problems 3.1 to 3.5.

Sumit Sarkar, XLRI