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Demand

• Demand for a good or service is defined as quantities of a good or service that people are ready (willing and able) to buy at various prices within some given time period, other factors besides price held constant.

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Demand Function

• The demand for a commodity arises from the consumers’ willingness and ability to purchase the commodity. Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, and the tastes of the consumer.

• Qd = f(p){Y,Pr , T, N}

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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

An increase in price causes a decrease in quantity demanded.


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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

A decrease in price causes an increase in quantity demanded.


Changes in demand

• Changes in price result in changes in the quantity demanded.– This is shown as movement along the demand

curve.

• Changes in nonprice determinants result in changes in demand.– This is shown as a shift in the demand curve.

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Changes in demand

• Nonprice determinants of demand– Tastes and preferences– Income– Prices of related products– Future expectations– Number of buyers

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Changes in demand• Change in Buyers’ Tastes

-Today’ consumer purchases leaner meats compared to old generations-due to the level of blood cholesterol and body weight

• Change in Buyers’ Incomes– Normal Goodsi.e., shoes, travel, automobiles, education – Inferior Goods– i.e., potatoes, salt

• Change in the Number of Buyers• Change in the Price of Related Goods

– Substitute Goods• i.e., Carrots can be replaced by cabbage

– Complementary Goods• i.e., cars and gasoline or electric stove and electricity.

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Change in Demand

Quantity

Price

P0

Q0 Q1

An increase in demand refers to a rightward shift in the market demand curve.


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Change in Demand

Quantity

Price

P0

Q1 Q0

A decrease in demand refers to a leftward shift in the market demand curve.


Mathematically

Qdx= f(Px, I, Py, N,T)

• QdX/PX < 0

• QdX/I > 0 if a good is normal

• QdX/I < 0 if a good is inferior

• QdX/PY > 0 if X and Y are substitutes

• QdX/PY < 0 if X and Y are complements

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Related conceptsThe increase in Qx when Px falls occurs because

in consumption, the individual consumer substitutes commodity x for other commodities which are now relatively expensive. This is called the substitution effect.

In addition, when Px falls, a consumer can purchase more of x with a given amount of money (i.e., the consumer’s real income increases). This is called the income effect.

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To remember..

• Band wagon effect: “ to keep up with the Joneses” “Me too”

• Snob Effect: “Me only”

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Using elasticity in managerial Using elasticity in managerial decision makingdecision making

• Controllable factors

– Setting the price of its product– Expenditures on advertisement– Quality of its product– Customer service

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Using elasticity in managerial making decision…. continued

• Uncontrollable factors– Level and growth of consumer income

– Competitor price decisions

– Competitors expenditures on advertisement

– Competitor’s Product quality and customer service

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Price Elasticity of Demand/Demand sensitivity Analysis

• Price Elasticity of demand is the measure of the response of the change in the quantity demanded due to the change in the price of the product.

• Decision: If demand for a product is price inelastic, the firm would not decrease the price of the product, by doing so the firm would decrease its profit.

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Ep = ΔQd × P ΔP Q


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Mathematically

/

/P

Q Q Q PE

P P P Q

Linear Function 1P

PE a

Q


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Price Elasticity of Demand- Example

Market

AB

CD

EF G

0

2

4

6

8

0 200 400 600 800 1000 1200

Qdx

Px

Find Ep at point A, B, C and G

Ep=(ΔQ/ ΔP) (P/Q) At point A, Ep=(0-200/

6-5) (6/0) Ep=-200 (6/0)= -

indefinite At point B, Ep= (200-

400/5-4) (5/200)=-5 At point C, Ep=(400-

600/4-3) (4/400)=-2

At point G =??


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MR and TR based on Elasticity- Example

-31,000-1/51,0001

-5001,2000

-11,600-1/28002

11,800-16003

31,600-24004

51,000-52005

-$ 0-indefinite0$ 6

(5)(4)(3)(2)(1)

MR=DTR/DQTR=P.QEpQP


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Graphically Showing Elasticities and MR-TR

MR>01PE 1PE

MR<0TR

1PE MR=0QX

600 12000


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Graphically Showing Elasticities and MR-TR

MRX

PX

1PE 1PE

1PE

QX600 12000

6


Price Elasticity & Firm's Total Revenue

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P Q Ep TR=P.Q Situation

6 0 ∞ $0 Perfectly Elastic

5 100 5 500 More Elastic

4 200 2 800 More Elastic

3 300 1 900 Unitary Elastic

2 400 0.5 800 Less Elastic

1 500 0.2 500 Less Elastic

0 600 0 0 inelastic


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900

Price elasticity, total revenue, and Demand

0

1

300

600300

2

3

4

5

6600

TR

E

EP

=1

TR

P <1

EP>1

F

P ($)Qd


Reference page 138

• Case study 4-3 (Price elasticity of Demand)


Income Elasticity of Demand

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Income Elasticity of Demand measure the response of the change-in-quantity-demanded due to the change-in-income of the people.

Income elasticity of demand suggests the growth potential of a market. It also shows the nature of good.

If Ey = 0 the good is income inelastic and has no potential for the market growth.

If Ey= +ve the good is a normal good and is income elastic

If Ey= -ve the good is an inferior good and is income elastic

Ey = ΔQd × Y ΔY Q


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Normal Good Inferior Good

0IE

Luxuries GoodNecessities Good

0IE

1IE 1I0 < E <


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Point Definition

Linear Function

3I

IE a

Q


Using Income Elasticity in managerial making decision…. continued

• Decision:

• If income elasticity of demand is very low for the firm’s product is Negative, management must know that firm will not benefit from the rising incomes of the people and may want to improve its product or move into new product line with more income elasticity of demand.

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Reference page 140

• Case study 4-4 (income elasticity of demand)


Cross Elasticity of Demand

Cross Elasticity of Demand measures the response of the change-in-quantity demanded of a product due to change-in-the price of competitor’s product.

Cross Elasticity of demand shows the rivalry of the product.Ecr= +ve the good will be substitute goodEcr=-ve the good will be complimentary goodEcr= 0 the goods are uncorrelated.

For Example,

Ppepesi increase Qcoke increases (Substitute good)

Pcar increase Qpetrol decreases (Complimentary Good)

Pbutter increase Qbooks remains the same (Uncorrelated goods)

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ECr = ΔQa × Pb

ΔPb Qa


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Cross-Price Elasticity of Demand

/

/X X X Y

XYY Y Y X

Q Q Q PE

P P P Q

Point Definition

Linear Function 4Y

XYX

PE a

Q


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Cross-Price Elasticity of Demand

0XYE

Substitutes Complements

0XYE


Using Cross Elasticity in managerial making decision…. continued

• Decision:• If the firm estimated that cross elasticity of

demand for its product with respect to the price of competitor’s product is very high. It will be good to quickly respond to the competitor price reduction ,otherwise, the firm would lose a great deal of its sale.

• However the firm would think twice before lowering its price for fear of starting a price war.

• For reference: read case application 3-7 p#117, 5th edi. “demand elasiticities for beverages in USA”

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Commodity X Commodity Y EXY

Substitute Goods:Natural Gas Electricity 0.80Coke Pepsi 0.40Tea Coffee 0.29

Complementary Goods:Car Petrol -0.50Mobile SIM Card -0.72Pen Ink -0.87

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Commodity X Commodity Y EXY

Substitute Goods:McIntosh apple Golden delicious apples 0.80Apples Apple Juice 0.50Apples Energy Drinks 0.10


Case Study 4-5 page 143

• 1) Cross elasticity of demand

• Case study 4-6 page # 147• Price ,income and cross elasticities


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In case of substitute goods

Price of Tea ($) Q.D of Coffee

P0Tea 10 Q0Cofee 100

P1Tea 40 Q1Cofee 200

Ed=?


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In case of complementary goods

Price of PetrolPer liters ($)

Q.D of Cars

P0Petrol 10 Q0Car 100

P1Petrol 40 Q1Car 20

Ed=?


Advertising Elasticity of Demand

Advertising Elasticity of Demand measure the response of the change-in-quantity-demanded due to the change-in-Advertising expenditures.

Decision:If elasticity of sale with respect to advertising is positive and higher than for its expenditures on product quality and customer service then firm must concentrate more on advertising rather than on product quality and customer service.

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EA = ΔQd × A ΔA Q


Using Elasticises In Managerial Decision Making-Example

A firm selling coffee brand X and estimated relevant demand regression as follows:

Qx=1.5-3.0 Px+0.8 I+2.0 Py-0.6 Ps+1.2 A Qx is sales of coffee brand X, I is disposable

income, Py is price of competitive coffee brand, Ps is price of sugar and A is advertising expenditures for coffee brand X.

Suppose: Px=$2, I=$2.5, Py=$1.80, Ps=$0.50 and A=$1

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Using Elasticities In Managerial Decision Making Example page 145

Calculate Qx and the elasticities of sales with respect to each variable in the relevant demand function

Qx=1.5-3.0(2)…1.2(1)=2 mn pounds coffee Calculate the elasticities of the demand for coffee brand X Ep=-3(2/2)=-3,Ei=0.8(2.5/2)=1, Exy=2(1.8/2) Exs=-0.6(0.5/2)=-0.15, Ea=1.2(1/2)=0.6 RECALL the Formulae

3I

IE a

Q

1P

PE a

Q 4

YXY

X

PE a

Q


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Using Elasticises In Managerial Decision Making-Example

Next year, the firm would like to increase Px by 5%, A by 12%, I by 4%, and Py 7% whereas Ps fall by 8%.

Determine sales of coffee brand X in the next year. Qxx=Qx+Qx(DPx/Px)Ep……+Qx(DA/A)Ea Qxx=2+2(5%)(-3)…..+2(5%)(0.6) Qxx=2.2 or 2,200,000 pounds


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QuestionQuestion

Given the demand for beef in the country.

Qd= 4850 – 5Pb + 1.5Pc + 0.1Y

Y = National Income = 10,000Pb = Price of Beef = 200Pc = Price of Chicken =100

Find the Following Elasticities of Demand for Beef in the Country:

a. Price Elasticity of Demand

b. Income Elasticity of Demand

c. Cross Elasticity of Demand.


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Thanks


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The important steps by using Elasticities

The analysis of the forces or variables that affect on demand and reliable estimates of their quantitative effect on sales (elasticities) are essential in order for firm to make best operating decisions in shor-run and to plan for its growth in the long-run.

The firms can use the elasticities of demand of the variables under their controls to find out best policies as well as to maximize their profits.

If the demand for the firm’s product is price inelastic, the firm will want to increase the product price since that would increase its total revenue and reduce its total cost.

If the elasticity of the firm’s sales wrt the variable beyod its control or If the cross-price elasticity of demand for the firm’s product is very high, the firm will need to respond quickly to a competitor’s price reduction otherwise losing a great deal of its sales.


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The important steps by using Elasticities

• The size of the price elasticity of demand is larger, the closer and the greater is the number of available substitutes for the commodity. For example, sugar is more price elastic than table salt (e.g. honey)

• In general, the greater is its price elasticity of demand, the greater will be the number of substitutes

• For a given price change, the quantity response is likely to be much larger in the long run than short run so the price elasticity odf demand is likely to be much greater in the long run than short run .


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• Following forces effect the demand of a firm.• Own Price of the product• Consumer income & taste• Price of related goods• Numbers of consumers in market • Level of Advertisement and promotional policies• Availability of credit in the country

The demand faced by a firm (cont….)


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QD=F(P, Y , Pr ,T, A, etc)

Where as Qd=Quantity demand of commodity XP=Price of commodity XY= Income of the householdPr=Price of related goods (substitutes or complementary)T=Taste of consumerA= Advertising

Mathematically….


Results

• QdX/I > 0 if a good is normal

• QdX/I < 0 if a good is inferior

• QdX/PY > 0 if X and Y are substitutes

• QdX/PY < 0 if X and Y are complements

0XYE

Substitutes

Complements

0XYE


Normal Good Inferior Good

0IE

Luxuries GoodNecessities Good

0IE

1IE 1I0 < E <


• SALES = [(number of print ads) x .34] + [(number of radio ads) x .42]," which allows you to forecast SALES based on easy-to-visualize predictors

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