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
• How responsive 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
• Analternative 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
d
%QX
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.
Example
• Profit = Revenue – Cost

• Revenue = P x Q

• Q = 2. P = 20  R = 40
• Q = 3, P = 10  R = 30
• Q = 4, P = 5  R = 20
 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 elastic;
60
 MR = 0, demand is unit
Inelastic
40 elastic;
 MR < 0, demand is
20 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.
• 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.
• Time
 Demand tends to be more inelastic in the short term than in the
long term.
 Time allows consumers to seek out available substitutes.
Cross-Price Elasticity of Demand
d
%QX
EQX , PY 
%PY

If EQ > 0, then X and Y are substitutes.

X,PY

If EQ < 0, then X and Y are complements.

X,PY
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
d
%QX
EQX , M 
%M

If EQ > 0, then X is a normal good.

X,M

If EQ < 0, then X is a inferior good.

X,M
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!

• Since demand 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!
d
% Q X
EQX , PX  8.64 
%PX
d
% Q X
 8.64 
 3%
 3%   8.64   %QX
d

d
%QX  25.92%
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!

d
%QX
EQX , PY  9.06 
%PY
d
%QX
9.06 
 4%
d
 4%  9.06  %QX
d
%QX  36.24%
Interpreting Demand Functions
• Mathematical representations of demand curves.
• Example:

d
Q
 Law of demand holds  10  2 P  3PY  2 M
X (coefficient of PX is negative).
X
 X and Y are substitutes (coefficient of P Y 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

P PY M
EQX , PX   X X EQX , 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 Q X 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
• One use is for estimating demand functions.
• Important terminology and concepts:
 Least Squares Regression model: Y = a + bX + e.
 Least Squares Regression line:
 Confidence Intervals. Yˆ  aˆ  bˆX
 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(Q x).
 F-statistic significant at the 1 percent level.
Example:
Data – Cross Section
Results
•
Discussion
Model Analysis
 F-Stat
 Significant
 R-Square
 The R-square of .79 indicates that the regression explains 79 percent of the variation in the the quantity of apartments rented across the 10
building
 Standard Errors

• Variable Analysis
 t-stat
 Coefficient
 Discussion
• Qd = 135.15 - 0.14P - 5.78D + error
 P, A, and D represent price, advertising, and distance from campus

• The coefficient of price is -0.14, a $100 increase in price reduces the quantity demanded at an apartment
building by 14 units.
 The own price elasticity of demand for FCI’s rental units, calculated at the average price and quantity, is 1.11. (0.14 x
P/Q)
 􏰏demand is elastic, raising the rent at an average apartment building would decrease not only the number of units rented,
but total revenues as well.
 Discussion
• Variable A is not significant

• Distance to campus is significant

 Every 1 mile away from campus, FCI loses between 2.71 and 8.86 renters.
 Huge impact but nothing we can do
 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.
• Given
the 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 level II.
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
 Consumer is capable of expressing preferences Good Y
(or indifference) between all possible bundles. (“I III.
don’t know” is NOT an option!)
 If the only bundles available to a consumer are A, B, and C, then II.
the consumer
I.
 is indifferent between A and C (they are on the same
indifference curve). A
B
 will prefer B to A.
 will prefer B to C.

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

• To go from consumption bundle B to C the

consumer must give up 16.67 units of Y to get one B
additional unit of X. 50
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 implies that if C III.
 B and B  A, then C  A.
II.
 Transitive preferences along with the
more-is-better property imply that I.
 indifference curves will not intersect. 100 A
 the consumer will not get caught in a perpetual C
cycle of indecision. 75
B
50

1 2 5 7 Good X
 The Budget Constraint
• Opportunity Set The Opportunity Set
Y
 The set of consumption bundles that are
affordable.
 PxX + PyY  M. Budget Line
M/PY Y = M/PY – (PX/PY)X
• Budget Line
 The bundles of goods that exhaust a
consumers income.
 PxX + PyY = M.

• Market Rate of Substitution

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

• Changes in Price
 A decreases in the price of good M2/PX M0/PX M1/PX
X
X rotates the budget line Y
counter-clockwise (PX0 > PX1). New Budget Line for
M0/PY a price decrease.
 An increases rotates the budget
line clockwise (not shown).

M0/PX M0/PX
X
0 1
 Consumer Equilibrium
• The equilibrium consumption
bundle is the affordable bundle that Y
yields the highest level of
satisfaction. Consumer
M/PY
 Consumer equilibrium occurs Equilibrium
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 consumer
C
to move from bundle A to B.
A higher “real income” allows the consumer to A II
achieve a higher indifference curve.
The movement from bundle B to C represents the B
income effect (IE). The new equilibrium is
achieved at point C. I

IE X
0
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
I

$ 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.
 Short-Run versus Long-Run Elasticities

(a) GASOLINE: SHORT-RUN AND LONG-RUN

DEMAND CURVES
(a) In the short run, an increase in price has only a
small effect on the quantity of gasoline demanded.
Motorists may drive less, but they will not change the
kinds of cars they are driving overnight.
In the longer run, however, because they will shift to
smaller and more fuel-efficient cars, the effect of the
price increase will be larger. Demand, therefore, is
more elastic in the long run than in the short run.
 SUPPLY AND DURABILITY

COPPER: SHORT-RUN AND LONG-RUN

SUPPLY CURVES

Like that of most goods, the supply of primary

copper, shown in part (a), is more elastic in the
long run.
If price increases, firms would like to produce
more but are limited by capacity constraints in the
short run.
In the longer run, they can add to capacity and
produce more.