CHAPTER 3

Quantitative Demand Analysis

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 Learning Objectives
1. Apply various elasticities of demand as a quantitative tool
to forecast changes in revenues, prices, and/or units sold.
2. Illustrate the relationship between the elasticity of
demand and total revenues.
3. Discuss three factors that influence whether the demand
for a given product is relatively elastic or inelastic.
4. Explain the relationship between marginal revenue and
the own price elasticity of demand.
5. Show how to determine elasticities from linear and log-
linear demand functions.
6. Explain how regression analysis may be used to estimate
demand functions, and how to interpret and use the
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 The Elasticity Concept

The Elasticity Concept

• Elasticity
– A measure of the responsiveness of one variable
to changes in another variable; the percentage
change in one variable that arises due to a given
percentage change in another variable.

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 The Elasticity Concept

The Elasticity Concept

• The elasticity between two variables, and , is
mathematically expressed as:

• When a functional relationship exists, like , the

elasticity is:

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 The Elasticity Concept

Measurement Aspects of Elasticity

• Important aspects of the elasticity:
– Sign of the relationship:
• Positive
• Negative
– Absolute value of elasticity magnitude relative to
unity:
• is highly responsive to changes in .
• is slightly responsive to changes in .

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 Own Price Elasticity of Demand

Own Price Elasticity of Demand

• Own price elasticity of demand
– Measures the responsiveness of a percentage
change in the quantity demanded of good X to a
percentage change in its price.

– Sign: negative by law of demand.

– Magnitude of absolute value relative to unity:
• : Elastic.
• : Inelastic.
• : Unitary elastic.

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 Own Price Elasticity of Demand
Linear Demand, Elasticity, and Revenue
Linear Inverse Demand:
• Revenue = $
Demand: • Elasticity:
Price • Conclusion: Demand is inelastic.
• Revenue = $
$40
• Elasticity:
$35 • Conclusion: Demand is unitary elastic. • Revenue = $
• Elasticity:
$30 • Conclusion: Demand is
elastic.
$25

$20

$15 Observation: Elasticity

varies along a linear
$10 (inverse) demand curve

$5
Demand

0 10 20 30 40 50 60 70 80 Quantity

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 Own Price Elasticity of Demand

Total Revenue Test

• When demand is elastic:
– A price increase (decrease) leads to a decrease
(increase) in total revenue.
• When demand is inelastic:
– A price increase (decrease) leads to an increase
(decrease) in total revenue.
• When demand is unitary elastic:
– Total revenue is maximized.

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 Own Price Elasticity of Demand

Perfectly Elastic and Inelastic Demand

Price
Demand

𝐸𝑄 𝑑
,𝑃𝑋
=0
𝑋

Perfectly Demand
elastic 𝐸𝑄 𝑑 =− ∞
𝑋
,𝑃𝑋

Perfectly Inelastic Quantity

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 Own Price Elasticity of Demand

Factors Affecting the Own Price

Elasticity
• Three factors can impact the own price
elasticity of demand:
– Availability of consumption substitutes
– Time/duration of purchase horizon
– Expenditure share of consumers’ budgets
As any of these factors increases, elasticity of
demand increases.

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 Own Price Elasticity of Demand

Marginal Revenue and the Own

Price Elasticity of Demand
• The marginal revenue can be derived from a
market demand curve.
– 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:

– When then, .
– When then, .
– When then, . © 2017 by McGraw-Hill Education. All Rights Reserved. 3-11
 Own Price Elasticity of Demand

Demand and Marginal Revenue

Price
6
Ela
sti Unitary
c
𝑃

MR
Ine
las
ti c

Demand

0 1 3 6 Quantity

Marginal Revenue (MR)

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 Cross-Price Elasticity

Cross-Price Elasticity
• Cross-price elasticity
– Measures responsiveness of a percent change in
demand for good X due to a percent change in the
price of good Y.

– If , then and are substitutes.

– If , then and are complements.

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 Cross-Price Elasticity

Cross-Price Elasticity in Action

• Suppose it is estimated that the cross-price
elasticity of demand between recreation and
transportation is -0.18. If the price of
transportation is projected to increase by 10
percent, by how much will demand for
recreation change?

– That is, demand for recreation is expected to

decline by 1.8 percent when the price of
transportation increases 10 percent.

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 Income Elasticity

Income Elasticity
• Income elasticity
– Measures responsiveness of a percent change in
demand for good X due to a percent change in
income.

– If , then is a normal good.

– If , then is an inferior good.

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 Income Elasticity

Income Elasticity in Action

• Suppose that the income elasticity of demand for
transportation is estimated to be 1.80. If income
is projected to decrease by 15 percent,
• what is the impact on the demand for
transportation?

– Demand for transportation will decline by 27 percent.

• is transportation a normal or inferior good?
– Since demand decreases as income declines,
transportation is a normal good.

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 Obtaining Elasticities From Demand Functions

Elasticities for Linear Demand

Functions
• From a linear demand function, we can easily
compute various elasticities.
• Given a linear demand function:

– Own price elasticity: .

– Cross price elasticity: .
– Income elasticity: .

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 Obtaining Elasticities From Demand Functions

Elasticities for Linear Demand

Functions In Action
The daily demand for PED shoes is estimated to be:

Suppose good X sells at $25 a pair, good Y sells at $35,

the company utilizes 50 units of advertising, and
average consumer income is $20,000. Calculate the
own price, cross-price and income elasticities of
demand.
– units.
– Own price elasticity: .
– Cross-price elasticity: .
– Income elasticity: .
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 Obtaining Elasticities From Demand Functions

Elasticities for Nonlinear Demand

Functions
• One non-linear demand function is the log-
linear demand function:

– Own price elasticity: .

– Cross price elasticity: .
– Income elasticity: .

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 Obtaining Elasticities From Demand Functions

Elasticities for Nonlinear Demand

Functions In Action
An analyst for a major apparel company estimates that
the demand for its raincoats is given by

where denotes the daily amount of rainfall and the

level of advertising on good Y. What would be the
impact on demand of a 10 percent increase in the
daily amount of rainfall?
. So, .

A 10 percent increase in rainfall will lead to a 30

percent increase in the demand for raincoats.
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 Regression Analysis

Regression Analysis
• How does one obtain information on the
demand function?
– Published studies
– Hire consultant
– Statistical technique called regression analysis
using data on quantity, price, income and other
important variables.

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 Regression Analysis

Regression Line and Least Squares

Regression
• True (or population) regression model

– unknown population intercept parameter.

– unknown population slope parameter.
– random error term with mean zero and standard deviation .
• Least squares regression line

– least squares estimate of the unknown parameter .

– least squares estimate of the unknown parameter.
• The parameter estimates and , represent the values of
and that result in the smallest sum of squared errors
between a line and the actual data.
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 Regression Analysis

Excel and Least Squares Estimates

SUMMARY
OUTPUT
Estimated Demand:
Regression Statistics
Multiple R 0.87
R Square 0.75 ^ =1631.47
𝑎
Adjusted R Square 0.72 ^
𝑏=−2.60
Standard Error 112.22
Observations 10.00

ANOVA
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

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

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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 Regression Analysis

Evaluating Statistical Significance

• Standard error
– Measure of how much each estimated estimate
varies in regressions based on the same true
demand model using different data.
• 95 Percent Confidence interval rule of thumb

• t-statistics rule of thumb

– When , we are 95 percent confident the true
parameter is in the regression is not zero.
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 Regression Analysis

Excel and Least Squares Estimates

SUMMARY
OUTPUT

Regression Statistics ^
𝑠𝑒 (𝑎)=243.97
Multiple R 0.87 ^
𝑠𝑒 (𝑏)=0.53
R Square 0.75
Adjusted R Square 0.72 , the intercept is different
Standard Error 112.22 from zero.
Observations 10.00 , the intercept is different
from zero.
ANOVA
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

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

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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 Regression Analysis

Evaluating the Overall Fit of the

Regression Line
• R-Square
– Also called the coefficient of determination.
– Fraction of the total variation in the dependent
variable that is explained by the regression.

– Ranges between 0 and 1.

• Values closer to 1 indicate “better” fit.

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 Regression Analysis

Excel and Least Squares Estimates

SUMMARY
OUTPUT

Regression Statistics
Multiple R 0.87
R Square 0.75
Adjusted R Square 0.72
Standard Error 112.22
Observations 10.00

ANOVA
Df SS MS F Significance F
Regression 1 301470.89 301470.89 23.94 0.0012
Residual 8 100751.61 12593.95
Total 9 402222.50

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

Intercept 1631.47 243.97 6.69 0.0002 1068.87 2194.07
Price -2.60 0.53 -4.89 0.0012 -3.82 -1.37

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 Regression Analysis

Regression for Nonlinear Functions

and Multiple Regression
• Regression techniques can also be applied to
the following settings:
– Nonlinear functional relationships:
• Nonlinear regression example:

– Functional relationships with multiple variables:

• Multiple regression example:

or

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 Regression Analysis

Excel and Least Squares Estimates

SUMMARY
OUTPUT

Regression Statistics
Multiple R 0.89
R Square 0.79
Adjusted R Square 0.69
Standard Error 9.18
Observations 10.00

ANOVA
Df SS MS F Significance F
Regression 3 1920.99 640.33 7.59 0.182
Residual 6 505.91 84.32
Total 9 2426.90

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

Intercept 135.15 20.65 6.54 0.0006 84.61 185.68
Price -0.14 0.06 -2.41 0.0500 -0.29 0.00
Advertising 0.54 0.64 0.85 0.4296 -1.02 2.09
Distance -5.78 1.26 -4.61 0.0037 -8.86 -2.71

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