Department of Business Administration
FALL 2007-08
Demand, Supply, and EquilibriumDemand, Supply, and Equilibrium
by
Asst. Prof. Sami Fethi
2 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Demand, Supply and EquilibriumDemand, Supply and Equilibrium
Economics begins and ends with the “Law” of supply and demand. The laws of supply and demand are an important beginning in the attempt to answer vital questions about the working of a market system.
3 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Demand, Supply and EquilibriumDemand, Supply and Equilibrium
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.
4 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Demand, Supply and EquilibriumDemand, Supply and Equilibrium
The supply of a good or service is defined as quantities of a good or service that people are ready to sell at various prices within some given time period, other factors besides price held constant.
5 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Demand, Supply and EquilibriumDemand, Supply and Equilibrium
Every market has a demand side and a supply side. The demand side can be represented by a market demand curve which shows the amount of commodity buyers would like to purchase at different prices.
Demand curves are drawn on the assumption that buyers’ tastes, income, the number of consumers in the market and the price of related commodities are unchanged.
6 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Law of DemandLaw of Demand
The inverse relationship between the price of the commodity and the quantity demanded per period is referred to as the law of demand.
A decrease in the price of a good, all other things held constant (ceteris paribus), will cause an increase in the quantity demanded of the good.
An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.
7 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in Quantity DemandedChange in Quantity Demanded
Quantity
Price
P0
Q0
P1
Q1
An increase in price causes a decrease in quantity demanded.
8 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in Quantity DemandedChange in Quantity Demanded
Quantity
Price
P0
Q0
P1
Q1
A decrease in price causes an increase in quantity demanded.
9 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Changes in DemandChanges 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.
10 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Changes in DemandChanges in Demand
Nonprice determinants of demand– Tastes and preferences– Income– Prices of related products– Future expectations– Number of buyers
11 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Changes in DemandChanges 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, steaks, travel, automobiles, education – Inferior Goods– i.e., potatoes, hotdogs, hamburger
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.
12 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in DemandChange in Demand
Quantity
Price
P0
Q0 Q1
An increase in demand refers to a rightward shift in the market demand curve.
13 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in DemandChange in Demand
Quantity
Price
P0
Q1 Q0
A decrease in demand refers to a leftward shift in the market demand curve.
14 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Demand, Supply and EquilibriumDemand, Supply and Equilibrium
Every market has a demand side and a supply side. The Supply side can be represented by a market supply curve which shows the amount of commodity sellers would offer a sale at various prices.
Supply curves are drawn on the assumption of technology and input or resources (as such labor, capital and land) and prices.
15 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Law of SupplyLaw of Supply
The direct relationship between the price of the commodity and the quantity supplied per period is referred to as the law of supply.
A decrease in the price of a good, all other things held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good.
An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.
16 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in Quantity SuppliedChange in Quantity Supplied
Quantity
Price
P1
Q1
P0
Q0
A decrease in price causes a decrease in quantity supplied.
17 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in Quantity SuppliedChange in Quantity Supplied
Quantity
Price
P0
Q0
P1
Q1
An increase in price causes an increase in quantity supplied.
18 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Changes in SupplyChanges in Supply
Nonprice determinants of supply– Costs and technology– Prices of other goods or services offered by the
seller– Future expectations– Number of sellers– Weather conditions
19 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Changes in SupplyChanges in Supply Change in Production Technology
- An improvement in the technology and a reduction in input prices would make it possible to produce a commodity at a lower cost. This indicates that sellers would be willing to sell more the goods at each price
Change in Input Prices-↓ in agriculture product, ↓ price of lamb meat, ↑ quantity supplied so rightward shift in the market supply curve
Change in the Number of Sellers- ↑ in no of sellers, the market supply curve shifts to right or ↓ in no of sellers, the market supply curve shifts to left
Prices of other goods or services offered by the seller- i.e., BMW, Mercedes, Woswagen (Subs. Goods)- i.e., lamp meat and lamp leather (comp. Goods)
20 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in SupplyChange in Supply
Quantity
Price
P0
Q1Q0
An increase in supply refers to a rightward shift in the market supply curve.
21 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Change in SupplyChange in Supply
Quantity
Price
P0
Q1 Q0
A decrease in supply refers to a leftward shift in the market supply curve.
22 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium Market equilibrium is determined at the
intersection of the market demand curve and the market supply curve.
Equilibrium price: The price that equates the quantity demanded with the quantity supplied.
Equilibrium quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level.
The equilibrium price causes quantity demanded to be equal to quantity supplied.
An increase or decrease in the demand or supply curve, it defines a new equilibrium point.
23 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Quantity
Price
P
Q
D S
If the quantity supplied of a commodity exceeds the quantity demanded, this is called excess supply or surplus between D and S over point p.
If the quantity demanded of a commodity exceeds the quantity supplied, this is called excess demand or shortage between D and S below point p.
24 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Shortage: A market situation in which the quantity demanded exceeds the quantity supplied.– A shortage occurs at a price below the
equilibrium level.Surplus: A market situation in which the
quantity supplied exceeds the quantity demanded.– A surplus occurs at a price above the
equilibrium level.
25 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
26 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Quantity
Price
P0
Q0
D0 S0
Q1
P1
D1
An increase in demand will cause the market equilibrium price and quantity to increase.
27 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Quantity
Price
P1
Q1
S0
Q0
P0
D0D1
A decrease in demand will cause the market equilibrium price and quantity to decrease.
28 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Quantity
Price
P0
Q0
D0 S0
Q1
P1
An increase in supply will cause the market equilibrium price to decrease and quantity to increase.
S1
29 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Market EquilibriumMarket Equilibrium
Quantity
Price
P1
Q1
D0
Q0
P0
A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.
S1 S0
30 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
The Demand Schedule and the demand curveThe Demand Schedule and the demand curveExampleExample
How can the relationship between quantity demanded and price be portrayed?
Demand schedule
Demand curve
31 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Table 1: A demand schedule for carrotsTable 1: A demand schedule for carrots
Av income:$ 20000
60Z 120
62.5Y 100
67.5X 80
77.5W 60
90V 40
110U $ 20
Thousands ton per months
D (quantity demanded) P (price per ton)
Table 1 is a hypothetical demand schedule for carrots. It shows the quantity of carrots that would be demanded at various prices on the assumption that average household income is fixed at $ 20000 and all other price do not change. (i.e. if the price of carrots were $60 per ton, consumers would desire to purchase $77,500 tons of carrots per month.
32 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
A demand curve for carrotsA demand curve for carrots A second method of showing the relation between
quantity demanded and price is to draw a graph. It is a downward slope which indicates quantity demanded increases as price falls.
0
20
40
60
80
100
120
140
1109077.567.562.560
Quantity
Pri
ce
33 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Shifts in the demand curveShifts in the demand curve-Example-Example
A demand curve or line is drawn on the assumption that everything except the commodity’s own price is held constant. A change in any of variables previously held constant will shift the demand curve or line to a new position. (i.e. A rise in household income has shifted the demand curve or line to the right.
A demand curve can shift in mainly two ways: If more bought at each price, the demand curve shift right so that each price corresponds to a higher quantity than before. If less is bought at each price, the demand curve shifts left so that each price represents to a lower quantity than before.
34 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Table 2: Two Alternative Demand Schedule for Table 2: Two Alternative Demand Schedule for carrotscarrots
7860120
81.362.5100
87.567.580
100.877.560
1169040
140110$ 20
Q1 (D1)Q (D)P
An increase in average income will rise the quantity demanded at each price. When AV income rises from $20000 to $ 24000 per year, quantity demanded at price of $60 per ton increases from 77500 tons per month to 100800 tons per month. Similar rise occurs at every other price.Av in: $ 20000 $ 24000
35 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Table 2: Two Alternative Demand Schedule for Table 2: Two Alternative Demand Schedule for carrotscarrots
Put differently, A rise in av household income shifts the demand curve for most commodities to right so this indicates that more will be demanded at each possible price. Ultimately, the demand schedule relating columns P and D is replaced by one relating columns P and D1 in the previous table. The graphical presentation of the two functions are seen in the following graph.
36 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Shifts in the demand curveShifts in the demand curve-Example-Example
020406080
100120140160
60 80 90 100 120 140
Quantity
pri
ce
Q D
Q1D1
7860120
81.362.5100
87.567.580
100.877.560
1169040
140110$ 20
Q1 (D1)Q (D)P
37 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Other PricesOther Prices
Earlier, we saw that the downward slope of a commodity’s demand curve occurs because the lower its price, the cheaper the commodity is relative to other commodities that can satisfy the same needs or desires. Those other commodities are called substitutes (i.e. Carrots can be made cheap relative to cabbage either by lowering the price of carrots or raising the price of cabbage).
A rise in the price of a substitute for a commodity shifts the demand curve for the commodity to the right.
38 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Other PricesOther Prices
Another class of commodities is called complements. These are the commodities that tend to be used jointly each other. Such as cars and gasoline or electric stove and electricity.
A fall in the price of a complementary commodity will shift a commodity’s demand curve to the right.
For example, a fall in the price of airplane trips to Paris will lead to a rise in the demand for Disney Land tickets at paris even though their price is unchanged.
39 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
TastesTastes
Tastes have a large effect on people’s desired purchased. A change in tastes may be long-lasting such as the shift from fontain pens to ball-point pens. In this case, a change in tastes in favor of a commodity shifts the demand curve to the right.
40 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Distribution of IncomeDistribution of Income
A change in the distribution of income will shift to the right the demand curves for commodities bought most by those gaining income. On the other hand, it will shift to the left the demand curves for commodities bought most by those losing income.
If, for example, the government increases the deductions for children on the income tax and compensates by raising basic taxes, income will be transferred from childness persons to the large familes. So commodity more heavily bought by families with no child decline in demand.
41 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
PopulationPopulation
Population growth does not by itself create new demand. The additional people must have purchasing power before demand is changed.
Extra people of working age, however, usually means extra output and if they produce, they will earn income.
When this happens, the demand for all the commodities purchased by the new income earners will rise. Thus a rise in population will shift the demand curves to the right.
42 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Individual Demand functionIndividual 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.
43 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Functional formFunctional form
Qdx= (Px, I, Py, T)
An inverse relationship is expected between the quantity demanded of a commodity and its price (law of demand). That is, when the price rises, the quantity purchased declines, and when the price falls, the quantity sold increases.
44 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Functional formFunctional form
Qdx= (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
45 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Recall: Consumer Demand TheoryRecall: Consumer Demand Theory
Consumer demand theory postulates that the quantity demanded of a commodity per time period increases with a reduction in its price, with an increase in the consumer’s income, with an increase in the price of substitute commodities and a reduction in the price of complementary commodities, and with an increased taste for the commodity. On the other hand, the quantity demanded of a commodity declines with the opposite changes.
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, the number of consumers in the market, and the tastes of the consumer.
46 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Relating ConceptsRelating Concepts
The 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.
The movement along a given demand curve resulting from a change in the commodity price is referred to as a change in the quantity demanded, while a shift in the demand curve resulting from a change in any of the factors that affect demand, other than the commodity price, is referred to as a change in demand.
47 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory Individual and Market Demand Curve Individual and Market Demand Curve
Example Example Horizontal Summation: From Individual to Market Horizontal Summation: From Individual to Market
DemandDemand
48 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Individual and Market Demand Curve Individual and Market Demand Curve ExampleExample
Given the following data: Pdx=$4 and Qdx=4 and Qddx=400, while at Px=$3, Qdx=6 and Qdd=600, construct the relevant individuals and market curves
Market
0
2
4
6
8
0 200 400 600 800 1000 1200
Qdx
Px
Individuals
0
2
4
6
8
0 2 4 6 8 10 12
Qdx
Px
49 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Price Elasticity of DemandPrice Elasticity of Demand
The price elasticity of demand (Ep) is measured by the percentage change in the quantity demanded of the commodity divided by the percentage change in commodity’s price, holding constant all other variables in the demand function.
/
/P
Q Q Q PE
P P P Q
50 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Price Elasticity of DemandPrice Elasticity of Demand
/
/P
Q Q Q PE
P P P Q
Point DefinitionOr Elasticity at given point
Linear Function1P
PE a
Q
51 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Price Elasticity of DemandPrice Elasticity of Demand
2 1 2 1
2 1 2 1P
Q Q P PE
P P Q Q
Arc Definition
52 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Marginal Revenue and Price Elasticity of Marginal Revenue and Price Elasticity of DemandDemand
11
P
MR PE
53 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand TheoryPrice Elasticity of Demand- Example 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=(200-0/ 5-
6) (6/0) Ep=-200 (6/0)= - indefinite At point B, Ep= (-200/1)
(5/200)=-5 At point C, Ep=(-200)
(4/400)=-2 At point G, Ep=(-200)
(0/1200)=0
54 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Price Elasticity of Demand- ExamplePrice Elasticity of Demand- Example
Find Ep at point A, B, C and GEp=(ΔQ/ ΔP) (P/Q)At point A, Ep=(200-0/ 5-6) (6/0)Ep=-200 (6/0)= - indefiniteAt point B, Ep= (-200/1) (5/200)=-5At point C, Ep=(-200) (4/400)=-2At point G, Ep=(-200) (0/1200)=0
55 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Arc Elasticity of Demand- ExampleArc Elasticity of Demand- Example
Find arc Ep between points B and C Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) Ep= (400-200)/(4-5) (4+5)/(400+200) Ep=-3 Absolute value of Ep Greater than 1- elastic Equals 1- unit elastic Less than 1- inelastic
Market
AB
CD
EF G
0
2
4
6
8
0 200 400 600 800 1000 1200
Qdx
Px
56 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
MR and TR based on Elasticity- ExampleMR 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
52321
MRTREpQP
57 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
MR and TR based on Elasticity- ExampleMR and TR based on Elasticity- Example
Find MR by using P and Ep at Px =$4 and $3 MR= P{1+(1/Ep)} At Px =$4 MR=4{1+(1/-2)=$2 At Px =$3 MR=3{1+(1/-1)=0 Based on the previous table: P decreases TR increases when Ep is elastic TR max or unchanged when Ep is unitary elastic TR decreases when Ep is inelastic
58 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Graphically Showing Elasticities and MR-TRGraphically Showing Elasticities and MR-TR
MR>01PE 1PE
MR<0TR
1PE MR=0QX
600 12000
59 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Graphically Showing Elasticities and MR-TRGraphically Showing Elasticities and MR-TR
MRX
PX
1PE 1PE
1PE
QX600 12000
6
60 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income Elasticity of DemandIncome Elasticity of Demand
/
/I
Q Q Q IE
I I I Q
Point Definition
Linear Function 3I
IE a
Q
61 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income Elasticity of DemandIncome Elasticity of Demand
2 1 2 1
2 1 2 1I
Q Q I IE
I I Q Q
Arc Definition
Normal Good Inferior Good0IE
Luxuries Good necessities Good
0IE
1IE 1I0 < E <
62 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Cross-Price Elasticity of DemandCross-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
63 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Cross-Price Elasticity of DemandCross-Price Elasticity of Demand
2 1 2 1
2 1 2 1
X X Y YXY
Y Y X X
Q Q P PE
P P Q Q
0XYE
Arc Definition
Substitutes Complements
0XYE
64 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income, Cross and Arc Elasticises- ExampleIncome, Cross and Arc Elasticises- Example
Find arc EI between two levels of income i.e I=$10000 and I=$ 11000
Ep=(Q2-Q1)/(I2-I1) (I2+I1)(Q2+Q1) Ep= (600-400)/(11-10) (11+10)/(600+400) EI= 4.2
Thus commodity x is normal and luxury. Find arc Exy between two levels of price y i.e Py=$ 1 and Py =$
2 Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) Ep= (600-400)/(2-1) (2+1)/(600+400) EI= 0.
Thus commodity y is substitute compared to commodity X
Market
AB
CD
EF G
0
2
4
6
8
0 200 400 600 800 1000 1200
Qdx
Px
65 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticises In Managerial Decision Making-Using Elasticises In Managerial Decision Making-ExampleExample
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
66 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticities In Managerial Decision Using Elasticities In Managerial Decision Making-ExampleMaking-Example
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 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
67 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticises In Managerial Decision Making-ExampleUsing 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
68 Managerial Economics © 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
The EndThe End
Thanks